Managing change in the Hedge Fund industry

June 24th, 2012
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Contributed by: Shane Brett, Global Perspectives
"It must be considered that there is nothing more difficult to carry out nor more doubtful of success nor more dangerous to handle than to initiate a new order of things."

Niccolò Machiavelli (1446-1507), Italian statesman and philosopher, in "The Prince"

Machiavelli got it right. Trying to successfully manage the implementation of widespread change is one of the most difficult tasks an organisation in our industry can undertake.

Over the last 10 years the Hedge Fund has experienced change on an enormous scale. The first years of the new century were marked by huge growth across the industry. Hedge Fund Managers and their service providers struggled to absorb massive asset growth, a high volume of fund launches and an ever increasing number of investors.

Then came the Post-Lehman/Madoff carnage where funds instead had to manage a more negative period of change, primarily driven by funds reorganising, gates being imposed, irate investors trying to redeem and difficult to price illiquid securities.

All of this has made the last decade in the Hedge Fund industry one of great change. The evidence suggests this change has largely been managed in an organic fashion (i.e. uncontrolled and haphazard).

Whereas change ten years ago was primarily driven by positive factors – AUM’s rising, subscriptions into Hedge Funds increasing and positive stock market returns – change in recent years has been the result by more negative trends – increased competition, an unstable economic environment, a wave of new global regulation and far more demanding investors.

Current status

Up to this point companies in the industry have been either growing very quickly or trying to deal with the consequences of the economic meltdown. This meant few have had the chance to put firm controls in place around the process of change management. Change which is constant and on-going and needs to be project managed effectively. Particularly as the Hedge Fund industry had moved from adolescent into adulthood and is now becoming a mature industry in its own right.

The result of the industry moving from adulthood to full maturity can be seen all around us. More regulation, more demanding client requirements and more competition for existing Hedge Fund.

For this White Paper, firstly we’ll look at the current main drivers of change in Hedge Fund industry, before looking at some of the techniques we can use to manage this change more effectively.

Regulatory Change – This is currently the largest driver of change in our industry.

Specifically the Hedge Fund industry is in the early adoption stage of a huge wall of legal and regulatory requirements, which will likely change the way the industry operates in the future.

The Dodd Frank Act in particular contains onerous regulatory reporting requirements (by previous industry standards) and even sometimes contradictory requirements (as pointed out by The Economist newspaper recently). There is confusion across the industry and yet the deadline for Hedge Funds to register is now upon us.

Similarly from July next year the European AIFM directive will come into force across the EU. This legislation is still in the process of been finalised. What Hedge Fund Managers will have to do in respect of issues like domiciliation or reporting is still unclear and will make the process of applying these required changes internally very difficult, given a relatively short timescale.

Finally in the US the IRS has issued requirements around foreign tax compliance (FATCA) and this has meant a wave of registration and documentation for many Hedge Fund entities worldwide. Again the details regarding compliance and operational requirements are still being clarified.

Even if the changes projects proposed in your organisation are not regulatory driven in nature, Hedge Funds need to ensure that internally operational or outsourcing projects are organised is such a way that their output will easily satisfy both existing and future likely legislative requirements like Dodd Frank and the AIFMD.

Investor appetite – The launch of new funds, new fund structures (e.g. Managed Accounts) and the provision of new operational requirements (e.g. enhanced, flexible and far more granular investor reporting) is been largely driven by the rise of Institutional Investors among many Hedge Fund’s shareholder base.

High Net Worth Investors will continue to be an important source of many Hedge Fund’s subscriptions, however the future will see large institutional investors coming to dominate the shareholder register and with that a demand for increased liquidity and transparency

Industry Growth - 2012 is expected to be the most promising year for the Alternative Investment industry in 5 years. Growth in net inflows is expected from Institutional Investors and particularly Pension Funds. Hedge Funds are now an established part of the investment landscape and many Institutional Managers are increasing their allocation. This means proposed changes to the operation and structure of your organisation must be scalable and able to accommodate growth.

Financial, Operational, Investment, Counterparty & Liquidity Risk - Post- Lehman Investors, Regulators, Hedge Funds and the wider world have all become far more risk aware. Risk management seems to be at the centre of everyone’s strategy and this is likely to continue in the near future. All proposed changes to operations and strategy need to ensure they at least maintain, if not tighter your risk controls and processes.

Due Diligence – Post-Madoff Operational Due Diligence had increased massively in importance for most Investors, Hedge Funds and particularly for the Fund of Hedge Fund community. Investors do not want to be told about your processes - they want to see them. They expect durable and transparent operational controls and the process for ensuring these are in place is an important driver of many upscale projects across the industry.

All of these crucial regulatory changes, as well as the demand from Institutional Investors for greater fee flexibility and enhanced reporting, has added the pressure on Hedge Fund Managers, their Administrators and Software Vendors to meet this challenge.

The importance of all the drivers of change identified above illustrates how change in the industry must be managed in an ordered and controlled manner. Global Perspectives has managed change programmes for some of the largest Hedge Fund Managers, Administrators and Software Vendors in the world. This exposure to many projects of different scale and size has enabled us to identify the key steps to managing change successfully in the industry.

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