Experts: Hedge Funds Must Embrace Transparency To Survive

Oct 14 2010 | 11:39am ET

By Janice Fioravante

Hedge funds used to sell themselves on reputation and returns. But even the most sterling of the former and awe-inspiring of the latter isn’t likely to cut it in a world where the watchwords are liquidity, risk and transparency.

It used to be that if you created a good product and had good, consistent returns, money would find you,” Larry Smith, chief investment officer at Third Wave Global Investors, said. “Not in 2010.”

In the post-Madoff hedge fund world, “everyone’s a criminal” in the eyes of investors, according to Anthony Scaramucci of SkyBridge Capital.

“Investors were expecting absolute return and non-correlation versus equity—non-beta,” Chris Hannon, director of institutional sales at GAM USA, said at the recent State of the Hedge Fund Industry conference, organized by FINalternatives and Capital Markets Consortium. “These days, clients want to know about operations and investor due diligence.”

Hedge funds have traditionally been loathe to deal in such specifics, earning the industry a well-deserved reputation for secrecy. And in the past, they’ve had the leverage to withhold information, as investors were loathe to part ways with star managers over a little thing like lack of transparency. No more. Investors—particularly the increasingly important institutional investors, led by public pension plans—aren’t taking “no” for an answer.

“If you won’t play, you are simply cutting yourself off,” Bruce Ruehl, principal of advisory services at consulting firm Aksia, said. “Investors today not only want to meet the principal manager and several other leading strategists. They want to eyeball the performance analytics on names in your portfolio.”

“We’re seeing a permanent change in investors’ mindsets,” Hannon added.

Another important factor is openness with regulators. Investors want to see that a manager has nothing to hide from the Securities and Exchange Commission. “Every hedge fund manager should be SEC registered,” even though it isn’t required—yet, Gena Lovett, founder of fund of hedge funds firm Little Wolf Capital, said.

Investors want something else, as well: to pay less. “2010 has brought a break in the upward creep of from 2 and 20 across the board in 2008,” Ruehl said. And that’s especially true for funds of hedge funds, rumors of whose “demise” are “premature,” according to Ruehl.

“Along with liquid underlying instruments, more reasonable fee structures are in vogue,” Third Wave’s Smith said. “Any new launch is offering much lower management fees of under 1% with a lot of carry.”

The brave new world for hedge funds is also increasingly hard on smaller hedge funds. There are signs that a greatly anticipated consolidation of the industry is beginning. What’s more, some smaller managers are calling it quits as the bulk of new money flows into larger hedge funds.

“It’s not a meritocracy,” Eric Rosenfeld, CEO of Crescendo Partners, said.

“A smaller manager may be the best in class,” Alan Glatt of placement firm Protocol Capital Management said. “But,” if you want to raise any money, “you are going to have to operate as if you are larger.”

One way to do so is to use top-notch servicer providers, according to Concept Capital’s Rob Davis.

“It’s possible to have the same advantages as the larger firms in using the mini- and micro-primes, which these days are very competent and offer as comprehensive services as the big-name larger brokerages,” he said.

“Remember that Madoff used no-name service providers, so if you use as your prime broker any name that is well-known and safe, you’re ahead of the curve,” said Daniel Solomon, president of Lyford Group International. And smaller firms may have no choice but to turn to well-known mini-primes. “The top tier-brokers don’t really want the smallest firms,” he said.

“You have to display that your fund has what [institutional investors] are looking for,” said Nan Mead, vice president of client development at fund of funds firm IAM Research,  the New York subsidiary of London-based International Asset Management. These things include a stable team, a well thought-out due diligence questionnaire, audited financials from a reasonably well-known accounting firm, and the ability to build a top-notch back office.

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