An Expanded Look At The Hedge Fund Industry

An expanded look at the prospects for the Hedge Fund industry. Not many surprises: the hedge fund boom is expected to resume courtesy of the bubble building that made billionaires out of some of the most pro-cyclical, unimaginative permabulls in existence. With the concept of a free-market out of the picture as a result of direct intervention by the Fed for years to come, hedge fund inflows are coming back with a vengeance (FoF's, not so much). Yet it appears that in the future, the generous fee and lock up structures that were prevalent in the last bubble, will be increasingly more difficult to replicate.

Key points from Morgan Stanley's Huw can Steenis.

What is the growth outlook for the industry?

We think industry flows have turned positive in Q4 after being flattish in Q3 (leaders had been getting inflows but return of gated money or funds with reputational damage impacted overall flows). We think the sector is going through early stage recovery and our base case is for $1.75tr AUM by end-2010e, where we were in 1H07. We nevertheless see risks, given the potential for reputation damage to the industry (e.g. due to Madoff, Galleon and so on) to damage fragile sentiment improvement, whilst redemptions from previously gated funds provide a drag to industry momentum.

Which type of strategies and firms will prosper?

Liquidity, transparency, road-tested risk management, institutionalized and didn’t gate are sine qua non for success today. Fundamentals will matter more (i.e. vs. arbitrage trategies) and we think – much like in the late 1980s/1990s – the greatest focus for flows will be on macro, equity long-short and CTAs, although performance chasing will still drive much of flows. We also see growing interest in EM, distressed and event driven strategies. After the market rout, we also see increased appetite for absolute return products (driving increasing interest in UCITS III product development among a number of providers). While opportunities exist in distressed credit, we see longer-term lock-ups as an obstacle for a number of clients.

Hedge fund of funds: How viable is the strategy?

US institutional appetite remains robust for HFoF; we see continued headwinds for HNW focused firms: Consultant surveys indicate as much as one-third of US institutional allocations were still made to alternatives over the past 12 months, with HFoF accounting for >50% of these allocations. We see growth challenges for firms affected by Madoff, and for those who gated, though even here the ability to re-invent the offering (e.g. reconfigure to managed account offering) presents the potential to reassert a growth dynamic. We expect the HNW offerings will continue to struggle near term as investor risk appetite remains subdued. Players like Man that have the infrastructure to offer managed accounts appear well placed.

Fee compression – is this real?

We see fees compressing to 50-100bps in HFoF; liquidity rather than fee levels a greater focus in single strategies. We expect that vanilla HFoF fees will continue to trend towards 50-100bps over time, though expect that those with the infrastructure to offer additional risk and liquidity management via managed accounts may be able to stabilise fees towards the upper end of this range. For single strategies, our view is that demand is more performance elastic, rather than price elastic, supporting fee levels for those with strong performance and capacity constraints, though we see better terms or retrocessions for longer-term/stickier assets.

What is the risk from regulatory change and which groups appear best/worst placed to manage through this?

Outcomes from US/EU regulations remain uncertain, though we expect they will likely further raise the bar in favour of players with institutional infrastructure. Potential US moves on  position limits (and related removal of swap deal exemptions) risk a reduction in market liquidity, thereby crimping opportunities. Risks from EU regulations centre on (i) leverage, (ii) marketing, (iii) prime broking/custodian arrangements and more recently iv) compensation. While our base case assumes a pragmatic approach will be taken, as we believe regulators will seek to avoid unintended consequences (activities moving offshore or to new venues), we nevertheless see this significant uncertainty as posing risks. We believe scale is the best hedge to regulatory uncertainty – we expect that compliance costs and capital creep will favour players with strong capital and institutional scale. Charles River estimates a potential one-off cost impact for the industry of $1.4bn.

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Summary metrics/valuations of key public asset managers