Few financial institutions have been hit as hard by the onslaught of new global regulation since 2008 as hedge funds.
An avalanche of acronyms is threatening to overwhelm the industry’s gentrified enclaves of Connecticut and Mayfair: from AIFMD to Mifid via Fatca and Ucits.
Targeted hedge fund rules in both the EU and US, as well as regulations affecting the markets in which hedge funds trade and the manner in which they do so make for an unprecedented set of rules and costs for the once freewheeling hedge fund world to get to grips with.
All of which is having a profound effect on both the speed and manner in which the hedge fund industry will grow – if at all – in the coming years.
For starters, the business of running a hedge fund is undoubtedly set to become more expensive.
In a survey released earlier this month, based on responses from more than half of the hedge fund industry, KPMG, the consultancy, set figures for the average costs for these rules: $700,000 for a small fund manager, $6m for a medium-sized one and $14m for the largest.
In all, KPMG estimated, hedge funds had spent $3bn meeting compliance costs associated with new regulations since 2008 – equating to, roughly, a 10 per cent increase in their annual operating costs.
“Fund managers around the world are working hard to deal with the challenges of compliance,” says Rob Mirsky, lead partner for KPMG’s global hedge fund practice. “But there is a sense that the investments they are making today will pay off in the future from a competitive standpoint.”
Indeed, many of the largest hedge funds have been broadly welcoming of regulation because of the opportunity it may afford for growth in their ability to raise assets.
Since 2008, the industry’s investor base has changed dramatically – shifting from high net worth individuals to institutions such as pension funds and endowments. The industry’s new investors are more conservative in nature and more inclined to invest with managers with proven checks and balances and tough regulatory oversight.
In the US, new provisions in the Dodd-Frank reforms, the largest overhaul of US financial regulation since the 1930s, mean hedge funds must register with the Securities and Exchange Commission for the first time. It is a move some big firms have been clamouring for for years. “We were asking the SEC to register us in 2006,” says an executive at one of the biggest hedge funds in the US. “Being registered is a huge comfort to our investors . . . it shows we’re not crooks.”
“A big pension fund investor is not going to give $200m to some guy running a hedge fund from some office in Cayman any more,” says the head of one big hedge fund allocator. “But if you’re regulated by the FCA [Financial Conduct Authority] or the SEC, if you meet all the requirements of AIFMD [the EU directive on fund managers], then you’re much more likely to get that cheque.”
For smaller hedge fund firms, however, the opportunity is less easily grasped. Big managers can better absorb the costs of new regulations, and attract big money. But small managers may not survive to do so.
“While the ‘too big to fail’ firms continue to raise assets, boutiques run the risk of being ‘too small to succeed’,” Ed Lopez, executive vice-president of SunGard’s asset management business, said in a recent report. “This matters to all investors as it is the boutiques that drive innovation and are often able to offer a more cost-effective alternative to investors.”
In this sense, regulation is changing the way in which the hedge fund industry has grown. Where money has flowed into hedge funds since 2008, it has mostly flowed to the largest. According to HedgeFund Intelligence, a data provider, about 87 per cent of the hedge fund industry’s $2.4tn in global assets is managed by just 389 funds – in a universe of more than 7,000.
Starting up a hedge fund, meanwhile, has never been harder, say consultants at banks who help new firms raise capital.
Where once a hedge fund like Caxton Associates – widely regarded as one of the most successful hedge funds of all – could start up with $3,000 on its founder’s credit card, now a start-up fund will struggle to get off the ground with anything less than $50m.
One glimmer of hope for growth may come in the form of the Jumpstart Our Business Startups (Jobs) Act in the US. The law means hedge funds will be able to advertise and take money from retail investors for the first time – not just high net worth individuals and institutions. Retail money is still largely untapped by hedge funds, but it could become a huge growth area – and might revive the fortunes of smaller managers by providing a more ready source of initial capital.
For all hedge funds, though, perhaps the most defining characteristic on new regulation and its impact growth is its inescapability.
Europe’s AIFMD contains provisions that must be applied by any fund manager, no matter where they are based, if they take a penny from an EU-based investor. Switzerland was forced to create its own hedge fund laws to bring itself into line with the EU as a result. The US too, has been deft at applying an extraterritorial regime of hedge fund regulation. Fatca, the foreign account tax compliance act, requires all non-US hedge funds to report information on their clients.
For better or worse, a more heavily regulated hedge fund industry is here to stay – growth in assets may not dip, but growth in profitability may have to.