Do BRICS (and Germans) Eat Pigs?
Niels C. Jensen, Absolute Return Partners LLP, London
Absolute Return Partners LLP is a London-based private partnership that provides independent asset management and investment advisory services globally to institutional as well as private investors, charities, foundations and trusts.
The ‘doomed’ euro
When the euro was introduced about 10 years ago, the pessimists didn’t give the currency much chance of reaching its 10th anniversary. The euro, or so the argument went, was doomed from the outset because of the disparity in economic performance among the member countries of the European Union (EU). In this respect, not much has changed. At one end of the scale, you still have the highly disciplined, but also slow-growing, economies of Germany and the Netherlands; at the other end, you find faster growing but ill-disciplined countries such as Spain and Greece. As icing on the cake, you also have countries that lack in both departments, such as Italy, making it difficult for the union to ‘gel’ — well, according to sceptics.
There is admittedly an embedded weakness in the way that the European currency union is structured. In the US, arguably the largest currency union in the world, fiscal transfers between member states allow for the Federal Government to adjust for variances in economic performance. There is no such mechanism within the eurozone, which explains why the member states are subject to a number of rules.1 These rules require strict fiscal discipline. The problem is that few countries play by the rules.
Unit labour costs out of control
The best example of this variance in economic performance is the huge spread in the rise of unit labour costs over the past few years. Unit labour costs measure labour (wage) costs adjusted for changes in productivity. It is probably the best measure that exists in terms of tracking the changes in competitiveness between nations. The currency union is governed by the so-called Stability and Growth Pact. There is no mention of unit labour costs in the pact which, with the benefit of hindsight, is a major mistake. Even Jean-Claude Trichet, the Head of the European Central Bank (ECB), who rarely admits mistakes, has publicly stated that if he could design the currency union all over again, he would push for a unit labour cost stability pact.
Back to the early sceptics. What they failed to realise was that Europe, together with the rest of the world, was about to enter a period of unprecedented prosperity. The good times would not only gloss over the deeper problems, but the euro would actually go from strength to strength, to a point where it now threatens to unseat the US dollar as the premier reserve currency of the world. It will be a mystery to some of you, then, why one should question the longer term viability of the euro. That is nevertheless what I intend to do.
The PIGS are in trouble
Ever heard of the four PIGS? This less than flattering acronym stands for Portugal, Italy, Greece and Spain, four members of the eurozone which are in much deeper trouble than they are prepared to admit. They are often considered the ‘antidote’ to the BRIC countries, the fast growing emerging market economies of Brazil, Russia, India and China. One of the PIGS’ (many) problems is escalating unit labour costs. Bearing in mind that the Organisation for Economic Co-operation and Development (OECD) numbers for Greece and Portugal do not yet include 2007, the conclusion we can draw from Table 1 is that, since the introduction of the euro, the PIGS have lost competitiveness to Germany at a frightening pace.
Brazil (the only BRIC country on which the OECD reports unit labour costs) scores very well on this account, a fact which is not going to make life any easier for the PIGS.
The devaluation tool
EU countries outside the eurozone, such as the UK, have also lost out to Germany in recent years, but the UK has been able to play a card which is not at the disposal of the eurozone members. That card is called devaluation. Whether by design or otherwise, the UK has received a massive boost to its competitiveness in recent months as a result of the sharp fall in the value of the pound. Italy used to play this card repeatedly with the Lira. So did countries like Denmark during the dark days of the 1970s.
Back in those days, there was less economic integration and recessions were rarely global. Devaluations could, therefore, be used to stimulate exports. The situation today is fundamentally different. The global nature of the current crisis makes it far more difficult for any country to grow its way out through higher exports. The UK will offer a great case study as to whether devaluations are still a powerful tool.
The ageing of Europe
Another issue, which is potentially even more destabilising for the currency union in the long- term, is the massive liabilities facing Europe as its population ages. We have borrowed Table 2, on the opposite page, from Goldman Sachs, which
orgclearly identifies the enormous challenges facing Europe — none more so than Greece. Its public debt, which currently stands at about 95% of GDP, will grow to a whopping 555% of GDP by 2050, if the current pension and social security programme is left unchanged. The Greek Government is painfully aware of this, and has been working on several new initiatives. It was the passing of one of those new laws that caused the riots in Athens before Christmas.
The sad reality is that most of Europe is still in denial about their economic situation. The problems are so massive — and the solutions so painful — that most politicians prefer to chicken out and pass the problem on to the next generation...
To read the complete article, and all others in this issue, sign up here for a six-month free trial or email: info@isipublications.com
An Investment Decision for the Economic Reality: Hedge Funds or Discretionary Managed Accounts?
Victor L. Zimmerman, Joshua Geller and Bradley H. Doline, Curtis Mallet-Prevost & Mosle LLP
Curtis, Mallet-Prevost, Colt & Mosle LLP is an international law firm headquartered in New York, with branch offices in the United States, Mexico, Europe and the Middle East. Founded in 1830, Curtis has a diversified practice and range of experience which permits our lawyers to offer global representation in the most challenging assignments.
Managers of funds of funds, institutional investors and family offices have long sought to invest their assets with professional money managers, with the expectation that the investment advice provided by these professionals will lead to greater returns. In the wake of Bernard Madoff’s arrest, and the allegations against him of perpetrating a massive criminal securities fraud and similar allegations against other managers, these investors should now put greater thought into the means with which they invest with professional managers and the degree of control afforded to those managers. This article will provide guidance with respect to the relative benefits and risks associated with investments in unregistered collective investment vehicles, particularly hedge funds, versus the retention of third-party managers who have discretionary investment authority over managed accounts.
Investments in hedge funds
In recent decades, investors have increasingly directed a substantial amount of their investments to hedge funds. Generally, a hedge fund is a private investment vehicle that pools capital from a number of investors and invests the pool’s aggregate assets in securities and other tradable instruments, often using leverage to take positions that are larger than would be otherwise available. Hedge funds generally operate under exemptions from registration available under the Investment Company Act of 1940, as amended. Therefore, investment companies (ie, mutual funds). Hedge funds employ one or more of a wide variety of investment strategies and often utilise a sophisticated hedging of their positions to minimise investment risks and provide superior returns to their investors.
Positive attributes of hedge funds
The benefits of investing in hedge funds have long been championed by hedge fund managers. These benefits include:
Experience: most fund managers have the investment experience and industry know-how necessary to allocate resources and assume risk in a manner that maximies profit. This experience is often a significant factor in the manager's ability to draw new investors to the fund.
Economies of scale: hedge funds, as collective investment vehicles, are able to take advantage of economies of scale by using large pools of capital to take long positions, and hedging positions that are significant from a size and/or risk perspective.
Cost efficiciences: unlike solitary investors, hedge funds are often able to negotiate better brokerage and clearing rates, due to their high volume of trading.
Investment opportunities: the availability of a large pool of capital offers hedge funds the ability to participate in investments with high minimum investment requirements and to have proprietary access to certain investment opportunities and information.
Negative attributes of hedge funds
The benefits of investing in hedge funds are tempered by the risks associated with investments in unregistered entities. These risks include:
Lack of transparency: investors in hedge funds are often unaware of the securities held by the fund, and such investors may, in fact, be restricted from accessing or disclosing such information. Periodic hedge fund reporting is often limited to monthly or quarterly reporting of the fund’s net asset value (NAV) and the value of the investor’s capital account or share-holding.
Liquidity: hedge fund managers are often able to limit the rights of investors to withdraw their capital. For example, managers may impose lock-ups, gates, holdbacks and/or suspensions, each while the investor’s capital is still at risk and potentially still subject to fees. Furthermore, withdrawals from hedge funds by large investors could cause the
fund to be forced to liquidate some of its investments, which could have an adverse effect on future returns for the remaining investors. Managers of funds of funds must take further care to match the liquidity terms offered to their own investors to the liquidity of the funds of funds’ underlying investments, which efforts on the part of such managers may include the co-ordination of redemption periods, the prior notice period, and the distribution of redemption proceeds.
Fraud: as evidenced by the Madoff case and others, the potential for fraudulent activities is as prevalent in the hedge fund In a study of the operational risks associated with hedge funds, the EDHEC Risk and Asset Management Research Centre reported that fraud is a prominent factor in hedge fund collapses and that three sources of risk were prevalent in 85% of hedge fund debacles analysed in their study.1 These risks may be summarised as follows:
Misappropriation: the risk of deliberate diversion of assets from the fund by the fund manager occurred in 30% of the cases analysed by EDHEC.2 Generally, misappropriation the inception of the fund, in which case the assets may never reach the diversion of capital through basic transfers or through unauthorised trading activities with third-party accomplices.
Misrepresentation: the risk of misrepresentation, which comprises all cases where the fund manager delivered to investors, occurred in 41% of the cases analysed by EDHEC.3 In a hedge fund context, misrepresentation may take the following forms: the modification of audited accounts or statements provided from the administrator incorrect marking of securities to the fund.
Alternative Investments: The Coming Wave of US Regulation
Keith T. Robinson and Derek B. Newman, Dechert LLP, Hong Kong
Keith Robinson is a partner in the financial services group of Dechert LLP, resident in the firm’s Hong Kong office, and is the head of the firm's Asian financial services practice. Derek Newman is a senior associate in the financial services group of Dechert LLP, resident in the firm’s Hong Kong office.
As the current financial crisis continues to unfold, the global alternative investments industry has resigned itself to the fact that increased regulation is inevitable. As recently stated by Andrew Baker, chief executive of the Alternative Investment Management Association, ‘we know which way the wind is blowing’. Recently, the US Congress has taken its first steps in making the anticipated regulation a reality, proposing legislation that could have far-reaching implications for alternative investments.
At the end of January 2009, the ‘Hedge Fund Transparency Act of 2009’ (the Hedge Fund Bill) was introduced into the US Senate. The Hedge Fund Bill would effectively eliminate the Section 3(c)(1) and 3(c)(7) exceptions of the Investment Company Act of 1940 (the Investment Company Act) on which many alternative investment funds (both US and non-US) currently rely to avoid US registration under the Investment Company Act. If the Hedge Fund Bill is passed by the US Congress, alternative investment funds with US$50 million or more in assets will be required to register with the US Securities and Exchange Commission (SEC). Shortly before the introduction of the Hedge Fund Bill, separate legislation was introduced in the US House of Representatives entitled the ‘Hedge Fund Adviser Registration Act of 2009’ (the Advisers Bill). The Advisers Bill would eliminate the ‘private adviser exemption’, which is used by many alternative investment fund managers to avoid registration with the SEC.
The scope of the proposed legislation, as currently drafted, is potentially very far-reaching. For instance, the scope of each Bill is much broader than ‘hedge funds’, and may impact the operations of private equity funds, venture capital funds, structured products and other privately-offered funds. In addition to the above, there have been recent calls to substantively regulate hedge fund operations, and there are pending initiatives at the US federal and state levels to revise tax laws and regulations, so as to permit the taxation of carried interest or performance fee income of hedge and private equity fund managers at a significantly higher rate.
This article provides an overview of the Hedge Fund Bill and Advisers Bill, and attempts to highlight areas of uncertainty with respect to the application of the new requirements, including their application to non-US funds and non-US managers. In addition, we briefly discuss the calls for substantive regulation of hedge fund operations and the proposed adverse changes to the taxation of carried interest. We conclude with suggested steps an investment adviser may wish to take to prepare for impending regulations and a new market focus on compliance controls and transparency.
The Hedge Fund Bill
Currently, most hedge funds, private equity funds, venture capital funds and other private investment vehicles (collectively, we will refer to them as private funds) rely on the exceptions from the definition of ‘investment company’ provided by Section 3(c)(1) and 3(c)(7) (commonly referred to as the ‘100 person exception’ and the ‘qualified purchaser exception’, respectively). These exceptions effectively remove a private fund from most provisions of the Investment Company Act. The Hedge Fund Bill proposes to eliminate these exceptions and, instead, convert them into conditional exemptions under new Section 6(a)(6) and 6(a)(7), which correspond to current Section 3(c)(1) and 3(c)(7), respectively. Under these new provisions, private funds would continue to be exempt from most substantive provisions of the Investment Company Act. Although this appears to be a technical change, the implications of this change may be far-reaching, as private funds seeking to rely on the new exemptions must:
• in the case of certain private funds with ‘assets or assets under management’ of US$50 million or more (large private funds), register as investment companies with the SEC and disclose specified information;1 and
• comply with specified anti-money laundering rules.
In addition to registering with the SEC, large private funds would be required to: (i) maintain certain books and records; (ii) co-operate with SEC requests for information or examination; (iii) disclose to the SEC various information, such as the large private fund’s primary accountant, prime broker, ownership structure, affiliation with other financial institutions, minimum investment commitment, total number of investors and current asset value. While the current language of the Hedge Fund Bill also requires the disclosure of the name and addresses of its investors (including natural persons), industry lawyers and other professionals were quick to point out that this disclosure requirement is at odds with most privacy requirements. Its sponsors have subsequently clarified that the Hedge Fund Bill is not intended to require disclosure of the identity of large private fund’s investors but, rather intends disclosure regarding the managers that collect fees from the large private fund.
Impact of the registration requirement
The Hedge Fund Bill does not distinguish among the different entities that currently rely on the exceptions provided by Section 3(c)(1) and 3(c)(7) of the Investment Company Act. As a result, many types of large private funds, including private equity funds, venture capital funds, real estate funds, many collateralised debt obligations and other structured products, and some larger family offices, may be required to register in addition to ‘hedge funds’. In addition to subjecting large private funds to SEC oversight and inspection, registration also may affect the operation of large private funds. For example, registration may trigger notice requirements or default provisions under existing agreements, such as service provider agreements, side letters and structured product indentures. Also, certain large private funds required to register may be obligated to provide notice to investors and, possibly, the opportunity to redeem.
Positive attributes of hedge funds
The benefits of investing in hedge funds have long been championed by hedge fund managers. These benefits include:
• Experience: most fund managers have the investment experience and industry know-how necessary to allocate resources and assume risk in a manner that maximises profit. This experience is often a significant factor in the manager’s ability to draw new investors to the fund.
• Economies of scale: hedge funds, as collective investment vehicles, are able to take advantage of economies of scale by using large pools of capital to take long positions, and hedging positions that are significant from a size and/or risk perspective.
• Cost efficiencies: unlike solitary investors, hedge funds are often able to negotiate better brokerage and clearing rates, due to their high volume of trading.
• Investment opportunities: the availability of a large pool of capital offers hedge funds the ability to participate in investments with high minimum investment requirements and to have proprietary access to certain investment opportunities and information.
Negative attributes of hedge funds
The benefits of investing in hedge funds are tempered by the risks associated with investments in unregistered entities. These risks include:
• Lack of transparency: investors in hedge funds are often unaware of the securities held by the fund, and such investors may, in fact, be restricted from accessing or disclosing such information. Periodic hedge fund reporting is often limited to monthly or quarterly reporting of the fund’s net asset value (NAV) and the value of the investor’s capital account or share-holding.
• Liquidity: hedge fund managers are often able to limit the rights of investors to withdraw their capital. For example, managers may impose lock-ups, gates, holdbacks and/or suspensions, each while the investor’s capital is still at risk and potentially still subject to fees. Furthermore, withdrawals from hedge funds by large investors could cause the fund to be forced to liquidate some of its investments, which could have an adverse effect on future returns for the remaining investors. Managers of funds of funds must take further care to match the liquidity terms offered to their own investors to the liquidity of the funds of funds’ underlying investments, which efforts on the part of such managers may include the co-ordination of redemption periods, the prior notice period, and the distribution of redemption proceeds.
• Fraud: as evidenced by the Madoff case and others, the potential for fraudulent activities is as prevalent in the hedge fund industry as it is in the entire financial system. In a study of the operational risks associated with hedge funds, the EDHEC Risk and Asset Management Research Centre reported that fraud is a prominent factor in hedge fund collapses and that three sources of risk were prevalent in 85% of hedge fund debacles analysed in their study¹. These risks may be summarised as follows:
Misappropriation: the risk of deliberate diversion of assets from the fund by the fund manager occurred in 30% of the cases analysed by EDHEC.2 Generally, misappropriation may occur at two levels: first, from the inception of the fund, in which case the assets may never reach the fund’s accounts; and second, by the diversion of capital through basic transfers or through unauthorised trading activities with third party accomplices.
Hedge Fund Cost Survey: A UK Perspective
KPMG, London
Background
The hedge fund industry is going through a period of significant change, with three main factors helping to shape the future:
• The challenging financial markets following the ‘credit crunch’. Total hedge fund industry returns were negative in quarter one 2008, for the first time since 2004, and several large hedge funds closed down or defaulted in 2007 and 2008.
• The self-regulatory best practice and governance standards proposed by various bodies, including the Hedge Fund Working Group (HFWG) and the Alternative Investment Management Association (AIMA) in the UK and the President’s Working Group in the US, in an attempt to head-off direct regulatory intervention.
• An increased interest in outsourcing and the expanding suite of products offered by service providers, prime brokers and administrators.
This survey explores the structure of the cost base for small- to medium-sized hedge fund managers in the current market, looks at managers’ appetite for outsourcing and also where costs are expected to change in future.
Survey approach
The participants were London-based and have US$13 billion in total assets under management (AUM), with a significant proportion under US$1 billion.
Twenty hedge fund managers took part in the survey, which included hour-long interviews and the completion of a questionnaire.
Costs are often categorised in different manners, which poses challenges in obtaining a meaningful comparison of costs. Therefore, an interview approach was adopted to conduct this survey, supported by a structured questionnaire. This allowed KPMG to probe behind the figures, ensure ‘like for like’ comparisons were obtained and explore emerging trends. This survey was sponsored by PCE Investors Limited (PCE), who provide a range of business support services to hedge funds of varying size. PCE can perform operations, risk management, marketing, compliance and an IT infrastructure, as well as providing physical amenities if necessary. They can also provide independent FSA fund vehicles under the PCE regulatory umbrella. PCE currently have clients with c. US$1.5 billion under management.
Executive summary
The findings indicate that:
• costs are, on average, 45% of management fees;
• one out of 10 managers are not currently covering costs by their management fees, plunging some into net losses; and
• operations are the greatest cost, comprising 19% of revenue or 35% of management fees.
Investors exert an increasing influence on costs and, in particular, their desire for improved governance standards and compliance. Where over 70% of a manager’s clients are institutional investors, the proportion spent on corporate control increases significantly. Eight out of 10 of those polled consider that investors are placing more emphasis on the back- and middle-office.
Half of managers are taking steps to reduce costs either in premises, staff or front-office systems.
The degree of outsourcing is high and the appetite for and extent of outsourcing is increasing; 30% of managers are looking to outsource additional services.
Segregation of duties continues to be a challenge within small- and medium-sized funds; only 6% of respondents performed risk management by someone independent of the front office.
Survey findings
Costs as a proportion of management fees and revenue
For one out of 10 managers surveyed, costs are currently greater than management fees and the generation of performance fees is needed in order to cover costs. 20% of managers did not generate performance fees in the last year. The average cost base is 45% of management fees, or 25% of revenue (management and performance fees). Operations are the greatest cost, comprising 19% of revenue or 35% of management fees.
Most managers state they are carefully monitoring and controlling costs. In this report, costs excludes front office salaries and bonuses since these contain a high discretionary element which otherwise would not allow a meaningful comparison between firms.
Increasingly, managers are looking to move to a more variable cost model, geared to activity or performance. The services and technology offered by service providers have expanded from monthly net asset value (NAV) calculations to ‘full office’ support including daily valuations, compliance, risk management, front-to-back office processing, premises and IT. Managers are able to outsource more of their operations, providing flexibility and leaving them free to focus on performance. The high fixed cost elements of operations, particularly for small- to medium-sized firms usually make a clear business case for outsourcing in financial terms alone.
Costs need to be at least covered by management fees for a sustainable business model. Where this is not the case, management should take urgent action to resolve this.
Current cost breakdown
Respondents provided cost information in the following categories:
• front-office;
• operations:
- business support;
- corporate control;
- facilities;
- infrastructure; and
- IT;
• marketing and PR; and
• other.
Front-office — 12% of costs
Front-office costs include dealing and market data systems, but excludes salaries and bonuses since these contain a high discretionary element which otherwise would not allow a meaningful comparison between firms. Front-office costs, as a proportion of total costs for managers under two years old, are more than double that of established managers.
To read the complete article, and all others in this issue, sign up here for a six-month free trial or email: info@isipublications.com