The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

Regulation is the catalyst for a division in the European hedge fund industry

Marc Russell-Jones

Northern Trust

Q1 2006


Demand in Europe for hedge fund exposure shows no sign of relenting, led by strong institutional asset flows. A clear division is emerging between those managers with a business model firmly founded on servicing the assets of high-net worth private clients and those firms targeting this rapidly growing institutional sector.

Regulation is going to have the single biggest influence on shaping the future of the hedge fund industry. Firms seeking to develop business with institutional investors believe improved regulation will help them boost their inflows by creating an asset class which provides the transparency and integrity demanded by their investors. In contrast, those managers focused on the high net worth market feel the opposite, viewing increased regulation as a barrier to their talent and performance.

This emerging two-tier industry architecture is suggested in the recent Northern Trust survey, “The ‘Forced’ Institutionalisation of the Hedge Fund Industry”. The wide-ranging study explores the effects that changing investor profiles and increased institutional asset flows are having on the European hedge funds industry. Survey respondents included single strategy hedge fund managers, fund of hedge funds managers and institutional investors who, collectively, either invest or manage in excess of US$132 billion in hedge fund assets. This represents approximately 40% of the European hedge fund market.

The study confirms hedge funds growing appeal amongst institutional investors as a way of diversifying their asset allocations. In 2003, one in five institutional investors in Europe invested in hedge funds or fund of hedge funds. By 2005 this had increased to one in three. Other recent industry surveys indicate that industry growth rates have doubled in the first six months of 2006 compared to the same period in 20051. All the signs point to money continuing to flow into hedge funds - even in a lower return environment.

These increased inflows are impacting the hedge fund industry right now and will act as a catalyst to the emergence of a two-tier hedge fund industry in Europe, namely:

? Boutique managers servicing private clients and high net worth individuals.
? “Supra” alternative asset managers with the infrastructure to service institutional clients.

Boutique managers

The survey highlights the additional raft of operating costs facing boutique managers from increasing reporting and regulatory challenges. While, traditionally the boutique administrator has been focused on providing investors with broad snapshots of performance, they are now being compelled to provide comprehensive reporting on portfolio composition and risk and sector exposure as the new wave of investors seek the levels of transparency they receive from their long-only asset managers.
For this group, the third-party fund administrator can help by delivering the international infrastructure and resources to help meet the differing needs of their investors.

The survey suggests some small, boutique managers may find the costs associated with the institutional dollar (or euro) simply too high for them to participate and may be content to remain embedded in the private money space.

Supra alternative asset managers

In Europe we are seeing the emergence of the “supra” alternative asset manager offering in-house multi-strategy, multi-structure product offerings, allowing investors to gain diversification. In the case of these big fund management houses, much of the necessary infrastructure and personnel is already in place to cope with new regulatory requirements. However, the study indicates that funds which accept institutional investments, or deal with large funds of funds that represent predominantly institutional cash, will face a much heavier operational burden in the future.

The regulatory environment

The survey demonstrates how the flow of institutional funds into hedge funds is creating a significant change in the global regulatory environment. Increased industry participation is bringing a greater focus on areas such as asset valuation, risk monitoring and internal operational and management controls.

Respondents’ views of the additional regulatory and reporting issues were clearly split with 46% welcoming an increase in regulatory supervision and 32% against further regulation. Institutional investors, their advisers and fund of funds mangers specifically targeting the institutional market were most in favour of more regulation, seeing increased regulation as an integral part of improvement in professional standards, which would encourage more investors to diversify into hedge funds.

In contrast single strategy managers and fund of funds managers serving high net worth investors were, on the whole, against the increase in regulation. They warned increased regulation could lead to higher infrastructure and compliance overheads, stifle creativity and discourage fund managers from setting up new hedge fund firms. The prospect of a “one size fits all” regulatory model was questioned, particularly by those without a large in-house support infrastructure.

The survey suggests a two or three tier regulatory environment should be considered for hedge funds and fund of hedge funds managers, dependent on their size and target market of investors. The criteria for regulatory compliance and reporting should be dictated by factors such as the distribution channel and profile of investors. This discerning regulatory treatment is already in operation and being further developed in international finance jurisdictions such as the Channel Islands.


A by-product of institutional flows will be increased standardisation benefiting both managers and investors in areas such as asset identification, pricing and subscription and redemption documentation, according to the survey. The development of a more uniform set of standards was welcomed by 76% of respondents with an institutional investor base, particularly those with established traditional businesses who can transport approaches to their hedge fund division. In contrast, those that believed they would continue to source the bulk of their business from private individuals indicated they were less inclined to implement changes, again further demonstrating the potential for a split in the industry.

Asset Allocation

Despite the significant growth of institutional investors in hedge funds and funds of hedge funds, the survey highlights the significantly higher allocations for real estate and private equity funds. The following chart shows the breakdown of assets across alternative asset classes amongst institutional survey respondents:

Figure 1

Regulation is the Catalyst - Figure 1


From these results it appears that many institutional investors still do not consider hedge funds to have a significant role to play in their portfolios compared to other alternative asset classes. This is something for hedge funds to be mindful of as ultimately they often compete for the same alternative investment dollar.


Transparency in hedge fund managers operations emerged as a universal concern for institutional investors. In the survey, 100% of respondents agreed there would be a need for further transparency in a hedge fund manager’s operations to encourage more investors to allocate to hedge fund strategies in the future. Areas where investors are seeking clearer information included the underlying securities or funds and accuracy and timeliness of pricing and valuation. The granularity sought by institutional investors is not something favoured by all managers and again suggests they will need to make a conscious decision about whether their primary objective is to attract either institutional or private investors.

Administration and custody

With 77% of institutional investors allocating assets to hedge funds through the fund of hedge funds route today, core administration and custody competencies are coming under greater scrutiny. Some managers complained that new entrants were not sufficiently up to speed with the more sophisticated strategies and instruments and volumes they trade. Accuracy and responsiveness were singled out to be the most important factors, with access to accurate pricing and speed of valuation, key. Independence, staff quality, transparency, reputation and proximity also emerged as important selection criteria.

Of those surveyed, 99% outsourced their core custody and fund administration services to independent third-party providers in Europe. Other areas that are outsourced include FX hedging, cash management, risk management, middle office and performance analysis. The following graph highlights the services outsourced by fund of hedge funds managers.


Figure 2

Regulation is the Catalyst - Figure 2


The survey highlights the “added-value” service providers can bring through their wider experience in banking and asset management in a range of areas such as portfolio attribution analysis, cash management and credit and liquidity financing.


The survey results clearly point to a division emerging between those managers with a business model firmly founded on high net worth and private clients and those focused on the institutional market. As a result of the dynamic investor base, the inevitable increase in regulation and the greater focus on operational transparency, it is clear that one size most certainly does not fit all!

Ultimately it is the target investor who will dictate the profile of the administrator /custodian and asset manager for alternative assets.


1 - EuroHedge September 2006

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