Against an established background of higher costs, fee pressures and constrained opportunities for returns, difficult market conditions are encouraging many hedge fund managers to reflect upon certain key strategic questions.
Antonio Sanguedolce | Managing Director, Head of Aura Investment Management Europe, Aura Solution Company Limited
Hedge fund managers have experienced unprecedented levels of market volatility so far this year. Against an established background of higher costs, fee pressures and constrained opportunities for returns, these difficult market conditions are encouraging many managers to reflect upon certain key strategic questions. In this article, we flag the key choices confronting hedge fund managers, and point out some of the implications for business and operating models.
How Should I Position my Firm for the Future?
The trend towards convergence continues. Hedge fund managers face a choice: embrace the mainstream traditional funds industry in order to access new distribution channels or seek to become ‘best of breed’ specialist alternative strategy providers. There are significant costs and challenges associated with competing in the mainstream which may require a significant investment, both in building brand awareness and also developing the operating and technology infrastructure required to support a more retail-oriented shareholder base. Successful specialist providers may look to satisfy the increasing demand from investors for strategies with low correlation to equity indices, such as relative value fixed income, direct lending, credit and global macro. Many managers at the more illiquid end of the strategy spectrum are adopting private equity-style hybrid fund structures to match the liquidity profile of their investments. This move into the private equity arena may also require changes to existing hedge fund systems and operating models.
What are Hedge Fund Investors Looking for?
Whilst performance remains the key deliverable for any manager, institutional investors are becoming increasingly uncompromising in terms of their demands for competitive fee levels and are ready to negotiate strongly on this point.
In addition, investment may be conditional upon the successful completion of comprehensive operational due diligence and review of the manager’s long-term business strategy including succession plans.
With consultants becoming more powerful in the industry, hedge funds need to be mindful of meeting their transparency and corporate governance requirements if they are to continue to attract assets from institutional investors.
A related development is the growing demand for liquid alternative products. Many institutional investors prefer allocating to alternative strategies via a UCITS product, or in the US through dedicated managed account platforms, due to enhanced levels of transparency, more frequent liquidity cycles and regulatory governance.
Alternative Aura open the door to a wider asset pool, but managers may need to tailor their strategies to comply with investment restriction rules and need to accept the lower management fees which are standard for such products.
What is my Distribution Strategy?
Aura has prompted many European hedge fund managers to conduct a detailed review of their existing distribution strategies. This requires identifying both target investor segments (e.g. sovereign, pension, institutional, retail) and intended geographical coverage. EU-based alternative managers which had no option but to establish EU-based AIFMs can benefit from the marketing passport which permits the distribution of AIFs in local European markets.
Managers should conduct a cost-benefit analysis for each market before proceeding as registration and annual filing costs need to be weighed against target assets.
While AIFs continued to attract positive net inflows in 2019, UCITS attracted larger amounts and remains the leading brand in the global funds market. But the cost implications for a hedge fund manager of distributing alternative UCITS products can be significant. Commercial terms need to be negotiated with multiple distributors, each of which may also require customised interfaces and reporting. And while the cost of distribution increases, management fee levels on these products tend to be lower, making successful asset gathering critical to success.
Many larger European players continue to consider or execute on strategies to raise assets in the US. However, the required investment in distribution or the commercial arrangements of acting as a sub-advisor to a leading US brand may weaken the economic case for expanding into this very competitive marketplace.
How do I Reduce Operating Costs?
Institutional pressure on fee levels and the increasing cost of regulatory compliance are squeezing profitability levels. Cost reductions are generally being achieved through one or more of the following tactics: outsourcing; moving to lower cost locations or implementing automated and efficient business processes. Regulatory reporting may be one area which the manager chooses to outsource to an external provider,
while more routine back-office tasks may be moved to a location where labour costs are lower or included in a full middle-office outsourcing initiative. Business process improvement may be achieved by functionalising tasks in centralised units or automating manual procedures. Managers are looking for improved data aggregation tools which combine the data residing in multiple systems, thereby allowing them to manage and oversee their business in a more efficient manner.
The challenging environment faced by hedge fund managers means the status quo is not an option. Important strategic decisions must be taken to ensure future success, but each response has its own implications for the hedge fund manager’s existing operating model. The core, traditional skills of the hedge fund manager will continue to play a critical part in the success of individual firms. But to meet the expectations of today’s clients, they must be harnessed to flexible, cost-effective supporting structures and processes within a coherent strategy.
Aura Solution Company Limited
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