The future of hedge funds

Sean Flynn, Head of Hedge Funds Services for UBS

(l-r) Hezlin Whittaker, Pearse Griffith, Sean Flynn,
Darren Stainrod, Randy Christian hold a conference
call with a prospective client

(l-r) Scott Donnelly, Susan Edwards, Mark Campbell
and Monette Windswer discuss the valuation of
complex instruments

Mehdi Elofir, Miklos Badaloo and Ryan Barrack have an
impromptu meeting on funds

(l-r) Onaidy Hurlston and Desiree Sampang review a
client’s information

(l-r) Patricia Parham, Denis Montpetit and Chris Ruark
working on accounting records for clients

Monday,  January 16, 2006

The 1 February deadline is looming for US investment managers of hedge funds, which have more than 15 investors or more than $30 million in assets, to be licensed with the Securities Exchange Commission (SEC). 

The reality is that even though most hedge funds are domiciled in offshore centres, most investment managers and hedge fund assets are onshore according to Sean Flynn, Head of Hedge Fund Services at UBS.

“Hedge funds are estimated to have over one trillion dollars invested, which play a significant role in trading activity on various stock exchanges around the world,” said Mr Flynn.

“Any offshore product that has that kind of financial impact onshore will attract the attention of regulators.”

He explained that the increased regulations in the US would raise the barrier to entry for small start up hedge fund managers, as there are costs associated with registering with the SEC.

He said hedge funds were once considered risky investments, but that has changed over the last number of years as the industry has evolved and the product has become a more acceptable asset class. 

“Historically, high net worth individual investors, who desired an absolute return and reduced level of risk, have been the main investors into hedge funds. The landscape is now changing with institutional investors increasing their allocation to hedge funds, as they seek out alternative investments that offer low correlation to traditional portfolios of cash, bonds and equities. 

“Hedge funds are seen by pension trustees as one of the possible investment strategies to achieve absolute returns that are essential to reduce pension deficits. This increased interest by institutions will continue to trigger the growth,” he said. 

Mr Flynn added that institutions are looking for more transparency of information and more reporting on a timely basis. There is also more due diligence performed on service providers including fund administrators.

Another emerging trend is the product moving into the retail market. 

“Hedge funds have traditionally only been open to high networth individuals and their family offices and institutional investors. Now, as the broader universe of investors seeks to play, regulators and rule makers are taking notice,” said Mr Flynn.

“The creation of more hedge funds, with vastly reduced minimums from the traditional hedge fund minimum of US$1million is the best indicator of retail investors trying to gain access to the beneficial attributes of hedge fund investments. It is likely this trend will continue both in the US and Europe.”

From an historical viewpoint, the most popular investment strategy for hedge funds was long-short equity. Mr Flynn said that while it is expected that this strategy will continue to be popular, many other strategies from global macro, event driven, and convertible arbitrage to market neutral are used by hedge fund managers.

“In recent years, there has been increased activity by hedge fund managers who are moving beyond the traditional arena of hedge funds to include a broader range of assets and strategies, including private equity, real estate and distressed debt,” he said. 

These hybrid strategies and structures have blurred the line between private equity and hedge investing.

“In addition hedge funds are investing in more complex derivative instruments, which are difficult to value,” Mr Flynn explained.

“This, coupled with the increasing investment in illiquid securities, makes the task of the fund administrator who has the responsibility to determine the net asset valuation of these funds more difficult. Many times the resources and expertise to value these complex derivative instruments do not reside with the administrators, but with the investment bank, who structured the security,”

He added that hedge funds are a subsection of alternative asset products, which not only cover hedge funds, but private equity, market capital and real estate. 

“What is happening now are hybrids, which are a mixture of hedge funds and private equity, as investment managers seek higher returns,” noted Mr Flynn.

To get higher returns many investment managers want to concentrate on investment strategy and outsource the administration of the hedge fund to companies like UBS, which specialise in fund administration, providing accounting, net asset valuation and shareholder services. 

And with the increasing trend in the US and Europe for more regulation on hedge funds, the demand for outsourcing to an independent administrator will continue to grow. 

With approximately 70 percent of the hedge fund market, the Cayman Islands has become the largest domicile for alternative asset products. UBS has become the largest fund administrator in Cayman since it opened its office here in 1972. 

Back then its primary focus was on private banking and trusts. Then as hedge funds began to build momentum in the early 1990s, UBS started to offer fund administration. 

Today, UBS in Cayman has 135 staff dedicated to fund administration with more than US$100 billion in assets. 

The business has experienced substantial growth over the past three years and Mr Flynn expects it to continue to grow, but at a lower rate.

The country has been facing more competition for fund administration from the US and Europe. To meet that competition head on and respond to market needs, UBS has been expanding the hedge fund business around the world.

An office was opened in Dublin in 2004 and has grown to almost 30 staff members. Another office will open in Toronto next month, and potentially an office in Hong Kong later this year. The expansion will enable UBS to service clients in key markets in all time zones. 

Mr Flynn explained the strategy of expanding into Ireland and Hong Kong.

“Hong Kong is a premier financial centre in Asia and is the gateway to China. There is a well-established financial infrastructure in place,” he said.

“Ireland gives us better access to the European hedge fund market. European investment managers want their fund administration in their own time zone. It is estimated that over USD300 billion of hedge funds are administered in Dublin.”

UBS has global fund accounting platform in place to service clients in all time zones. This along with web-based reporting to investment managers and investors, and secure e-mail delivery of information will soon leave faxing a thing of the past.

The primary challenge for fund administrators is recruitment and retention of staff. There is a shortage of qualified accountants, as demand has grown partly due to the increased regulatory environment in the US such as Sarbanes-Oxley.

However, as the Cayman Islands remains an attractive location for professional staff to work, it does not face the recruitment problems to the same extent as other fund administration centres.

“Hedge funds as an asset class are here to stay,” said Mr Flynn emphatically. “And the industry is well positioned in Cayman on both the domicile and fund administration side.”

shurna@caymannetnews.com

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