After the Mulligan – An Asian Hedge Fund Perspective Richard Johnston, Managing Director
Albourne Partners (Asia)
Mulligan (games): when a player gets a second chance to perform a certain move or action.
To some degree, the markets of 2009 and the start of 2010 make it seem that 2008 never happened. This is especially true in Asia where we have less of the structural issues that the Western economies suffer from, ie, high consumer debt, unemployment and deteriorating government balance sheets. Many hedge funds have regained their high-water marks. So we are asking the question: "Is the Asian hedge fund industry taking advantage of a second chance to do things better?"
The first point is to recognise that there was no second chance for those investors who redeemed around one third of total assets. In the case of many Asian-based managers, closer to half their assets were redeemed. Unfortunately, this was, at levels, much closer to the bottom than the top. Some funds failed in their risk management, some investors failed in their own liquidity management and some can be put down to the fears arising from the 2008 crisis. The situation was compounded by the funds managed by Madoff in early 2009.
So let's focus more on the industry that is left and how it has changed in the last two years.
Independent Service Providers
Asian funds have typically always had independent administrators and a few reputable companies have most of the market share. There has been a major shift away from investors accepting self-administration, but this has only affected a handful of Asian managers which are part of a US-based stable. In general, this is a much bigger issue in the US, where around 50% of investors self-administered a few years ago.
Asian managers have typically always used the larger prime brokers, auditors and lawyers so there has been little change. One area where we see more focus is the use of independent valuation agents for funds investing in difficult-to-value instruments. There is an increasing reluctance not to tolerate any instruments being self-valued.
Due Diligence Process
Some firms have always done extensive due diligence on funds. For them, the process has been constant evolution to incorporate best practice as suggested by AIMA, the Hedge Fund Standards Board and the Presidents Working Group. The main difference we are now seeing is the increase in the number of investors trying to undertake thorough due diligence and a broader acceptance that funds which score poorly in the process should be rejected. It is more common now to see the investor's operational due diligence team have a right of veto over new fund investments.
This has increased both the need for an Asian manager to build a more comprehensive infrastructure as well as the demand on their time before any new investment is made. Many managers now complain that the number of meetings before any investments has risen significantly. In the past, it was common for funds in Asia to get away with less infrastructure. They are now being held to a higher global standard which has increased the barrier to entry for any new start-up.
Two years ago, the hedge fund structures were often based around monthly or quarterly liquidity regardless of strategy and liquidity of the underlying instruments. It appeared as if 'one size fits all'. It now seems that the industry has bifurcated into one group who want shorter liquidity terms and the other that is keener that the liquidity terms are appropriate to the investments even if it makes them longer.
The shorter liquidity terms argument is being driven by many of the fund of fund groups. Historically, they took more mismatch risk between the shorter terms they gave their investors and the long terms they got from the funds. Within a certain level of redemptions, this would work, but in 2008, it broke down, forcing the fund of funds to restrict redemptions. They are now cautious on taking any mismatch risk so they need to force the underlying funds to improve on liquidity terms. This is particularly the case with retail fund of funds. The European UCITS III structure has also gained popularity since it allows for daily, weekly or fortnightly liquidity. These investors are also keen to see restrictions on any ability of the manager to limit redemptions.
The longer liquidity terms argument is being driven by institutional investors, particularly in North America. They like to see the liquidity terms which match the underlying portfolio and want to limit the ability of any short-term investor to disrupt the portfolio. Limiting shorter-term investors can be achieved by having no less than quarterly liquidity or, in more extreme structures, having investor level gates. What has also become more common is to trade better commercial terms for longer-term lock-ups.
Managers have also reduced their own liquidity risk. Prior to 2008, a manager might have taken 10% to 25% risk in low liquidity assets. Now, they will only invest in such assets in a predefined side-pocket or in a separate vehicle.
Asian managers have always given fairly good transparency and most meet investor's requirement for monthly risk bucketed data. They also tend to have been supportive in supplying data to any risk aggregator that the investor may use. Therefore, they have had to change very little to meet investors' requests for improved transparency, though many will draw the line at requests for 100% transparency.
Immediately after the crisis, there seemed to be huge demand for managed accounts. However, they have proved difficult to use for many end investors. Fund of fund providers are insisting on this, partly to differentiate their product. The practical reality is that a managed account is a lot of work and cannot commercially be achieved on a small investment. Better managers will only do a managed account if it is significant, so there can be a negative selection bias. Institutions can use other providers' managed account platforms but may be subject to certain costs and biases.
A 1.5% to 2% management fee and 20% has still remained fairly standard for Asian funds over the last few years. Even when a fund is struggling to raise assets, we have not seen reductions other than in the circumstances outlined below. If a fund is producing solid returns in most market conditions, there is no pressure to reduce fees. Where we see some examples of fee reduction pressure are:
Long-bias funds: If beta is clearly part of the overall return, there is a growing reluctance to pay 20% performance fees. Many managers in Asia have been able to do this for years, but we believe it will be harder for new managers unless they can show very significant alpha or an ability to manage their net.
Strategies requiring longer-term capital: There seems to be growing acceptance that locking up capital is traded for fee reductions. This can be by way of lower headline fees, hurdle rates and claw backs. Some strategies need the liquidity profile for their underlying investments and some are just happy to trade for longer-term capital.
While most Asian funds have recovered high-water marks in late 2009 and early 2010, they have still to recover the size of assets under management. 2009 was still an outflow year from Asian managers. Most managers stabilised their outflows by mid-2009 but saw very limited inflows. Some of the volatility-related strategies that did well in 2008 saw heavy outflows as they suffered in 2009. The only area of significant inflows was to institutional quality lower net long/short managers.
One of the reasons that Asia has not seen stronger inflows has been due to the heavy reliance of most non-US-based Asian managers on the European fund of funds, especially the Swiss-based ones. Their problems, in addition to the 2008 crisis, were exacerbated by their high Madoff exposure and reliance on retail and HNW investors. For many managers, this was the easiest source of capital, especially early in a fund life. The extent of recovery in these capital flows has been quite limited but may reverse at some point.
Conversely, institutional flows have been much stronger especially from the pension industry and government-related funds. Many of these investors are going increasingly into single manager portfolio as opposed to fund of funds. A lot of these flows have focused on investing in the larger global managers, getting the US credit opportunities right and investing in managers that have reopened for the first time in many years. The trickle down to smaller managers and Asian managers has been limited. Where an Asia manager is picked, the larger more institutional managers are favoured. We also sense that there is much more reluctance going forward to let the beta of hedge fund portfolios become too high.
Asian investor flows into Asian managers are still very small. In many cases, the Asian investors are simply too big for the local managers.
In 2008, there was so much dislocation caused among larger global managers that a major talent pool has emerged for their Asia offices. We have around 20 start-ups or potential start-ups from people who left global funds in the last few years. They tend to focus on equity long/short, event and credit. They have also attracted the better seeding deals from the limited capital that has remained in that space. Many are personally well enough off to seed themselves and few have some loyal previous investors. Most have built out fairly significant infrastructure for a start-up. However, additional capital is still slow in coming, though it is starting to pick up.
We think that the experience of these managers is a welcome addition to the region's funds. Many have much more experience running hedge positions and a broader strategy mix which should help the Asian industry move away from its 'long biased' reputation. However, they have raised the barrier of other new start-ups in terms of the capital and infrastructure.
While we have yet to see significant asset growth, there is a qualitative improvement to the Asian hedge fund industry. The institutionalisation of the industry has raised the bar on the level of infrastructure expected of a manager. Liquidity mismatches are being addressed and more appropriate structures are being created. The market also seems to be maturing and investors are now looking for more than just the Asian beta story.
Richard Johnston is managing director of Albourne Partners (Asia) based in Hong Kong.
This article first appeared in Investment & Pensions Asia (Pg 12, May-June 2010). For more information, please visit www.ipe.com/asia