Hedge fund managers are experiencing the ripple effects of new regulations on banks and prime brokers, with hedge funds facing increased trading fees and broader changes to business relationships; these dynamics place additional pressure on margins and are leading managers to seek new growth strategies, according to The evolving dynamics of the hedge fund industry, EY’s 2015 Global Hedge Fund and Investor Survey.
Regulations such as Basel III, AIFMD and Dodd-Frank have caused banks and their prime brokerage businesses to focus more closely on liquidity, balance sheet capacity and funding, resulting in changing economics for fund managers who finance trades through prime brokers. 29% of respondents said their prime brokers increased fees in the past year, and an additional 22% expect an increase in fees within the next year.
Fund managers using strategies such as distressed credit, fixed income and global macro, which can be balance-sheet intensive from the prime brokers’ perspective, have been among those who have experienced price increases the most. Respondents now expect price increases and broker limitations to change the way they trade, including moving toward swap-based trade execution and reducing repo financing and overall leverage.
Michael Ferguson, EMEIA Regulated Funds Practice and Luxembourg Wealth & Asset Management Leader at EY Luxembourg, said “These dynamics are the newest challenge to an industry that continues to grapple with margin compression, heightened competition for asset growth and ongoing requirements for technology investments. All forms of financing are becoming more expensive for a majority of managers, and these costs have a direct effect on overall trade economics. Investors will be indirectly affected by the increasing costs and will need to rely on communications from the manager to understand the full effect on the fund’s performance.”
Hedge funds expand their prime broker relationships
Regulatory changes have altered the traditional business relationship between prime brokers and hedge fund managers. Prime brokers have suggested that hedge fund managers concentrate more business with them, though 60% of managers affected by repricing have in fact added more prime broker relationships. Only 12% of respondents who have experienced repricing reduced their prime broker relationships.
Many prime brokers are becoming reluctant to hold cash for hedge funds because of how such balances are classified toward banks’ capital reserves under new regulations. Fifty-eight percent of hedge fund managers have moved cash to custodians as a result, while 35% have purchased highly liquid securities as cash alternatives.
Michael Ferguson said: “Many hedge fund managers are larger and more complex, with increased financing needs. As many prime brokers have less capacity to offer than in the past, hedge fund managers are increasing the number of relationships they have to reduce counterparty capacity risk. We are also seeing the need for hedge funds to dedicate individuals to manage counterparty risk, collateral and treasury functions as a result of these shifting industry dynamics.”
Managers seek financing from non-traditional sources
Hedge fund managers are beginning to explore non-traditional financing sources outside of prime brokers. Thirteen percent of respondents are seeking or plan to seek financing from non-traditional sources in the next two years, from sources including institutional investors and sovereign wealth funds, custodians, or other hedge funds.
Asset growth remains top strategic priority
Achieving asset growth to counteract margin pressure is the top strategic priority for 57% of managers surveyed. New growth methods include adding new hedge fund strategies, identifying new investor bases and increasing penetration with existing investors.
New product launches, which was the top method for achieving growth in last year’s survey, has dropped to less than 20% this year. New products have presented opportunities for managers, but they also have come with challenges, as 24% of managers reported that new products had a negative impact on operating margins.
Michael Ferguson said: “As the hedge fund business has evolved, increased competition, as well as heightened demands from investors and regulators alike, has compressed margins via the two-fold squeeze of lower top-line revenues and larger expenses. Growing assets to critical mass within a shorter timeline is critical for managers looking to run profitable organizations. Liquid alternative asset products using the UCITS Platform in domiciles such as Luxembourg continues to be a key focus of Hedge Fund Managers over the last number of years.
Impact of the AIFMD and the Luxembourg RAIF
The impact of the AIFMD continues to be monitored with a growing view that if Europe is viewed as an important distribution target market, then it’s a necessary to create European product in domiciles such as Luxembourg for this distribution. There is also a growing view that it’s not feasible to build a long-term sustainable EU distribution strategy around reverse solicitation and/or use of national private placement regimes. Those that don’t wish to embrace the AIFMD are alternatively turning to liquid alternative asset products using the Luxembourg UCITS Platform. The cost and time of AIFMD compliance continues to be a discussion point, this should be significantly alleviated with the introduction of Luxembourg`s new investment fund structure – the Reserved Alternative Investment Fund (the “RAIF”). The RAIF which is expected to be implemented in the first quarter of 2016, is an extremely flexible investment fund structure must be managed by an authorized AIFM and will qualify for the AIFMD Passport. The time to market for the launch of the RAIF will rest solely with Governance Body and its Service Providers of the RAIF (i.e. Board of Directors, Lawyers etc),as the Luxembourg regulator will not be involved in its creation or supervision.
Technology investments are critical for transformational change
Respondents plan to allocate 12.4% of their overall expense budgets to major technology expenditures over the next three to five years, similar to the amount budgeted over the past two years, as managers aim to develop robust infrastructures capable of supporting larger and more complex hedge funds. Seventy percent of managers expect to make major technology investments in the next two years, including investment management and trading operations, enterprise infrastructure, and risk management systems.
Michael Ferguson said “Today’s technology environment and the effect it has on the business is rapidly evolving. Managers are investing to develop tools that allow for more seamless front- to back-office data transmission, timelier and customized reporting to various constituents, and to deal with ongoing concerns over cybersecurity. The importance of being strategic with these investments has never been more critical.”
