The financial crisis and the collapse of Lehman Brothers unearthed several challenges to the traditional operating model of the hedge fund industry. Today, addressing these challenges has become an integral part of operating a successful fund, especially as many sophisticated investors are increasingly focusing on operational due diligence as much as on performance. The prominent challenges facing hedge funds today include:
Liquidity Management
Over the crisis years, access to liquidity has become one of the most if not the most important precondition for investors. Volatility is expected to remain elevated in all major asset classes and until there are signs of economic stabilization and/or clear visibility in global growth, hedge funds will therefore have no choice but to accommodate investors liquidity requirements or risk being sidelined by competitors more willing to make a transition. This means that hedge funds will have to overcome operational hurdles relating to the frequency of redemptions and the associated portfolio cash management whilst ensuring there is minimal interruption to investment strategies and therefore returns. The extremely low interest rate environment that penalizes liquid holdings further raises the need for a robust reporting and cash management system. In certain cases, hedge funds have started to go the extra mile to accommodate this need by offering managed account structures, whereby investors have the added comfort of direct access to the assets in the account. This raises challenges such as choosing the right managed account platform especially as new service providers potentially create integration challenges with existing providers.
Multi Prime Brokerage Model
The crisis has also led hedge funds to opt for multiple prime brokers where counterparty risk can be managed more effectively. The collapse of MF Global, for example, brings to the forefront the need for a thorough and on-going assessment of counterparty risks associated with prime brokerage relationships. In the case of MF Global, not only was trading halted but liquid cash from customer accounts vanished. For hedge funds, transitioning to such a model poses several challenges. A deep understanding of the complex and specialized agreements and the ability to negotiate terms with big brokers does not come easy. Execution management (where cross trading of several products through different brokers becomes an issue) and managing liquidity across several brokers where margin requirements or collateral earmarking could vary adds further complexity. Lastly, back office integration also becomes complex given the need to collect data generated from different systems, collate and process them in order to reconcile positions and present them in a required format threatens operational efficiency.
Regulation
Over the last few years we have seen regulators placing increased scrutiny on hedge funds operational standards. Additional reporting requirements, enhanced transparency and increased taxation at the investment manager level have made the decision of where to incorporate and where to operate funds, a difficult one. Each jurisdiction comes with its own characteristics, for example, regulations, the ease and speed of setting up shop and its perception amongst investors. Additionally, issues such as the cost of operation, availability of infrastructure, talent pool, attraction and ease of relocating existing staff all have become necessary inputs to viability. For example, even though Geneva is considered a hedge fund friendly location, it has a huge problem with availability of housing and English speaking schools. Choosing a jurisdiction and a regulator is a long term decision that cannot be changed that easily and it could end up being very expensive. The days where London was considered a default location are gone due to challenges such as increased costs, higher taxes and regulatory overreach. The financial crisis has also spawned new regulations such as the Dodd-Frank reforms which have numerous ramifications which directly influence the operational set-up of hedge funds based, or those who have a presence, in the US. Similarly, investors are increasingly opting for funds that are UCITS compliant. New compliance requirements pose additional overhead expenses and eat into valuable management time.
Information Management
Information technology has brought about a lot of enhancements in the accessibility and dissemination of information in the hedge fund industry, but at the same time, it has magnified the quantity of available information. Today, the volume of information has substantially increased and we expect it will continue to increase going forward. Being able to process information expeditiously and filter out noise has become a challenging and complex operational hurdle. Additionally, todays expectation for the availability of data or information is in live or near live format. Receiving live data feeds from various service providers poses challenges as information feeds in through multiple sources in different formats. Hedge funds need to have the necessary information management systems in place that catalogue, archive and process such large volumes of information. The complex IT systems that are required are usually not available as off the shelf solutions and could require infrastructural changes and added capital expenditures.
Size and Diversification
Growth for many start-up funds has been prompted by the shift from single strategy to multi-strategy platforms. For example, a global macro player adding long/short or managed futures to the investment strategy has helped to attract the interest of various investors and has the added benefit of diversification across overall assets under management. This strategy of increasing size raises new operational challenges to the setup and integration of front, middle and back offices. Different strategies may imply new brokerage relationships, different hours of operation and different tools across the investment process. In addition, as most funds choose to increase in size in order to remain visible and be able to afford the new compliance requirements, it forces them to move from the simple structure of a small boutique firm to a much more complex mid-size establishment. This results in a situation where the fixed cost base dramatically increases and becomes dependent on performance fees until certain economies of scale targets can be achieved.
Risk Management
The extraordinary events of 2007 and 2008 have demonstrated that traditional risk management models were not robust enough and did not manage to limit losses for many hedge funds. Backward looking and other probabilistic models gave a low probability to the occurrence of such events as they were outside the realm of normal expectations. Since then, risk management has risen to the forefront of investors due diligence processes and traditional methodologies no longer provide the additional comfort that is required. Consequently, hedge funds have been actively pursuing building in-house risk management solutions that cater for specific investment strategies and investor needs. The main challenge to this approach, even though more unique in nature, is that it adds to the necessary operational support that is required to design, implement and manage the process.
In summary, hedge fund investors are becoming increasingly sophisticated and require additional protection measures from hedge funds in an environment where there is a downward pressure on fees they are willing to pay. To be successful in such an environment going forward, managers will have to quickly embrace and adapt to this new normal of operational requirements or risk being sidelined.
This article was co-authored by Marios Kalochoritis, Managing Director and Hemaad Khan, Director of Auvest Capital Management.