Good year ahead for credit funds
So much has happened in the past three months, so I will try and put down some thoughts on how our industry might fare in 2009. Hopefully this will serve as an imperfect guide to the future for investors and for practitioners in these turbulent times.
Fund of Funds
Watch this space. Sold as low risk, low volatility, quasi bond-like products with reasonable (quarterly) liquidity, this section of the industry finds itself with the most difficult business conditions of all. The average Asian fund of funds is down by at least 15% year to date (there are very few exceptions) and is experiencing massive redemption activity as well. Fortunately, most Asian Fund of Funds are invested mainly in liquid underlying funds, so are able to deal with their redemption activity. However, those funds that do have exposure to credit (especially to distressed) will have assets that they cannot sell and will already be “gated” on some of their holdings. Charging 1% and 10% for anaemic performance in the boom years of 2006 and 2007 and then giving it all back in 2008 is simply not sustainable as a business model. Fund of funds have primarily functioned as an access and aggregation product, with little active management overlaying this process. Funds will have a choice to make in 2009 between driving their business model closer to that of the asset consultants, or moving to a more active management style. Both are possible but fees for consultancy are not 1% and 10%.
Whether performance has been good, bad or indifferent, funds are faced with redeeming investors who, on average, are removing around 30% of the capital under management in this sector. Coupled with investment losses of circa 20% the hedge fund business halved in the fourth quarter of 2008. This is a truly eye-popping event. However, don’t underestimate managers’ ability to reinvent themselves, or their ability to persist with their business when most reasonable people would have given up and done something else months ago. Closures will not be as many as people think. Asia is cheap to operate from and as long as the belief persists that Asian equity markets might have a substantial bounce in 2009, managers will be tempted to try to reset high water marks or to raise fresh capital for new products rather than to shut down. It will take 12 months of sideways trending markets to force this most optimistic crew to throw in the towel.
On a more positive note, good managers are now obvious to all. Large Asian-based managers who have done well will survive and get a lot bigger. There will be a gradual acceptance that over a certain size (say US$750m) a multi-strategy, low volatility approach will be one good way of growing a business for which there is significant investor demand. This will be an asset gathering approach rather than a performance driven strategy. Over time I would expect there to be fee pressure for this sort of business which will become increasingly mainstream in terms of its investors and, hence, consultant driven.
At the other end of the scale there are some clear winners in the Long/Short Equity space; managers who have distinguished themselves in a terrible market by preserving capital and in some cases by making some money. As a generality, these have been the smaller managers who have been able to run sensible short books and to be quick on their feet in cutting back their gross and net exposures. Larger equity managers in Asia have, by and large, been very closely correlated to market movements. I would expect to see some managers become more aggressive in Asia in capping out their funds at around US$500m so that they can continue to perform in what are now much smaller markets. Fee pressure in this group of winners will be non-existent.
Expect to see a rapid increase in credit funds all along the curve from plain vanilla through high yield to distressed. Perceived wisdom is that the distressed cycle will really get going by the middle of next year. So my advice is that if you are going to invest here (and I am) get in by end of the first quarter. Products in this sector will now be much better (more honestly) structured than in the past, so expect longer lock ups and treat these vehicles as private equity holdings.
Strategies uncorrelated to equity markets will be very much in vogue. Market neutral funds, volatility funds and relative value funds will increase as a percentage of the fund population.
Above all else watch out for “old friends” re-spraying their corporate vehicles and re-emerging under new guises to lure the unwary one more time into their personal compensation plan. Memories are short in the hedge fund world.
Not many tears are being shed for investment banking personnel but in this the season of goodwill to all men it is worth remembering that most staff in prime broking operations work very hard for reasonable but not excessive reward. Staff cuts are swingeing in this industry and I would anticipate that by the time the dust settles there will be 30% fewer staff in this sector. Morgan Stanley and Citigroup got this process going before Christmas. There has been a pronounced move away from the independent American Investment Banking owned prime brokers, towards the European Money Centre Bank owned type. Deutsche, UBS, CSFB, NewEdge have been the beneficiaries. Merrills, Morgan and even Goldmans the sufferers. This will continue.
Counterparty risk is now the topic du jour and every hedge fund is having to respond to investor demand in this area. PBs need to respond by improving their service through providing managers with a clearer menu of service options which enable them to better manage cash risk, re-hypothecation risk and liquidity risk. Agreements also need to be re-written so that clients can understand them in the future! Incomprehensible derivatives documentation is at the core of this crisis. Expect to see managers being much more aggressive in their use of legal advisors in future to help them navigate their way through this process.
Managers will try to use multiple financing sources in the future and PBs need to get used to this and to adjust services and prices accordingly. There is an opportunity within this move for a master custodian to become a data aggregator ( eg HSBC, JP Morgan, BNP). However, leverage in general will be much harder to come by so expect to see a focus on the less levered strategies and for those that do need leverage a much greater need to shop around for the best providers.
Finally, we all need to see a concerted effort towards standardizing and simplifying ISDA documentation and towards moving many OTC contracts onto an exchange traded basis. The PBs should be at the forefront of this move if they are to avoid another meltdown in the future.
Are there any left and who are the survivors? 60% to 70% of the Asian Hedge Fund industry was driven by Fund of Fund money. As mentioned earlier, the fund of funds are on their knees. It will take two more quarters for most Funds to figure out what assets they have left and how they wish to invest those assets. The deleveraging of the hedge fund industry is by no means complete and 2009 will see negative flows for at least the first half if not the first three quarters of the year. It is too early to call which Fund of Funds will survive this process. The effect on hedge funds though, is clear. New assets will be virtually impossible to find in 2009. This has a dramatic knock on effect on performance fee generation and on the viability of many businesses.
However, there are pockets of money out there for good managers and for new, thoughtful strategies. Some estimates have it that up to 50% of the investment capital in Asia has fled the region one way or another in the last few months. This leaves the field open to those managers who are still standing and who have the skills to take advantage of an investment landscape that has severe dislocations in all asset classes and a dearth of investors willing to take the risks necessary to access those opportunities. There is a lot of money to be made over the next two years and there will be many smart investors who will be prepared to take advantage of these circumstances. Finding them will be hard as all categories of clients have been hit hard but there are plenty of investors who are sitting on large cash balances waiting for their moment.