LONDON (Reuters) - Firms that make money selecting hedge funds will have to conduct more checks on managers running the assets and show they know what they are buying in order to appease clients disgruntled by the Madoff fraud and poor returns.
The $570-billion fund of funds industry faces the headache of conducting tougher background checks on managers and third parties like prime brokers, as well as researching hidden risks, while at the same time fending off client demands for fee cuts.
Institutional investors, who now account for over half of hedge fund assets, are cranking up the pressure after firms such as Man Group's EMG.L RMF and UBP failed to spot U.S. financier Bernard Madoff's $65 billion fraud, while many funds were slow to reinvest cash in last year's rally, missing out on big gains.
“We will ask for more transparency regarding underlying exposures and negotiate fees,” said Theo Jeurissen, chief investment officer of the 35-billion-euro ($47.65 billion) pension fund for metal and mechanical workers PMT.
“Indeed we would ask for a ‘know your relations’ policy to go beyond formal auditors statements to really know who is running the business and their background.”
Demand is up for checks on hedge fund managers’ academic qualifications and any criminal records, as well as on firms’ registrations with regulators and money laundering databases.
Last week U.S.-based background check provider Financial Risk Mitigation, which works on behalf of many top funds of funds, said it was opening in Europe.
The model adopted by many funds of funds prior to the credit crisis was to research the performance and strategy of hedge funds they invested in and offer access to top managers who had limited new inflows, but this model may now be outdated.
“I think we will continue to see a bifurcation between those that do embrace the new model ... and those that haven’t,” said Ken Heinz, president of data group Hedge Fund Research.
“The old fund of funds business model... which developed through the late ‘90s, is likely to continue to be challenged in terms of the value it’s able to offer investors.”
New steps set to be taken include independent pricing of funds, and greater scrutiny of the prime brokers, auditors, custodians and legal advisers used by a hedge fund.
Investors will also want a clearer picture of risks from an underlying fund’s positions, Heinz said.
“Transparency -- I want to know what they are doing,” said Lars Rohde, chief executive of the 609 billion Danish crowns labor fund ATP. “We also cannot do a proper risk management with assets we do not know.”
Funds of hedge funds charge investors an extra level of management and performance fees, on top of the usual ‘2 and 20’ (2 percent annual fee and 20 percent performance charge) that underlying funds demand, and in return try to spread out risks, avoid blow-ups and pick winning managers.
But many investors have been unhappy about underperformance of the sector over the past two years amid the global financial crisis and a stock market recovery.
Their ire has already helped push fees lower, indicating that the new demands are likely to put pressure on fund firm margins. A survey this month from consultancy bfinance showed 47 percent of funds would be able to charge a management fee of 0.9 percent or more on a $100 million investment, down from 57 percent a year before.
Many funds are now fighting to survive and have little capacity to refuse investor demands.
“It so far remains unclear in early 2010 whether funds of hedge funds can recover and demonstrate their legitimacy as the vehicle of choice,” said ratings group Fitch in a recent note.
The 26-billion-euro Ilmarinen Mutual pension fund said it would stop investing in funds of funds, in part because it was dissatisfied with performance.
In response to such moves, many funds have already started to upgrade the services they offer.
Fund of funds firm Gottex GFMN.S has developed systems to build a picture of each underlying fund's exposure to credit, equity, fixed income, the shape of the yield curve, concentration and leverage.
“Investors want a better understanding of how their hedge fund portfolio behaves in difficult market conditions,” said Gottex head of European business Max Gottschalk.
Funds of hedge funds are also starting to bow to investor demand for segregated accounts. These separate portfolios, where one investor owns the actual assets rather than a stake in a fund, usually require extra administration but let investors sell out whenever they want.
A survey by Preqin this month showed 44 percent of portfolios offer managed accounts while a further 21 percent are considering doing so, with investor demand a key driver.
$1=.7345 Euro Additional reporting by Martin de Sa’Pinto in Zurich, Editing by Sitaraman Shankar
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