dec 2006 london hedge funds services 2006 - … hedge funds services 2006 ... all data as at 30 june...

European hedgefund model provesits worth

Human capitalspurs London’sindustry dominance

The new primebrokerageparadigm

London HedgeFunds Services

2006

Dec 2006

In this issue…03 London tightens grip as Europeanhedge funds boomBy Simon Gray

05 Investors see benefits in funds of fundsapproachBy Martin Harrison and Nora O’Mahony, GAM

08 European hedge fund model proves itsworthBy Andrew Collins, Fortis

11 Managers face up to technologicalchallengeBy Mats Berggren, Advent

14 The Cayman-London axis flourishesBy Gray Smith, Ogier

15 Hedge funds build on London’s humancapitalBy Simon Gray

17 The new prime brokerage paradigmBy Lou Lebedin, Bear Stearns

20 Managing the hedge fund businesschallengeBy Joe Seet, Sigma Partnership

23 Is tax killing London as a fund domicile?By Simon Gray

LONDON Hedgeweek Special Report Dec 2006 www.hedgeweek.com | 2

CONTENTS

Special Report Editor: Simon Gray, [email protected]

Sales Manager: Simon Broch, [email protected]

Publisher/Editor-in-Chief: Sunil Gopalan, [email protected]

Marketing Director: Oliver Bradley, [email protected]

Graphic Design (Special Reports): Siobhan Brownlow at RSB Design

Photographs: Siobhan Brownlow / various

Published by: Hedgemedia Limited, 72 New Bond Street, London W1S 1RR

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Less stellar returns over the past couple ofyears have done little to brake theenthusiasm of European hedge fundmanagers and their institutional investors,with both the number of new fund launchesand the level of total fund assets run byEuropean managers setting new records inthe first half of 2006. And as the industrygrows in size, London’s grip as theundisputed centre of the continent’s hedgefund management industry continues totighten.

According to a survey by EuroHedge,more than 170 new European hedge fundswere launched in the first six months of thisyear, up from 150 in the same period a yearearlier. However, the total assets raised bythe new funds fell back to USD11.4bn fromUSD13bn in the first half of 2005, when thenumbers were buoyed by five funds thatwere launched with assets in excess ofUSD1bn.

According to the survey, equity strategies

dominated the new European fundslaunched this year. European long/shortequity was the largest category with 41 fundsraising USD2.2bn, followed by global equitywith 32 funds and USD1.6bn, Asian equitywith 12 funds and USD1.3bn and equitymarket-neutral with five funds and USD 1.1bn.Macro, event-driven, multi-strategy and fixedincome funds each raised more thanUSD800m.

Total European industry assets reachedUSD401bn at the end of June this year, anincrease of 44 per cent from the June 2005total of USD280bn and of 23 per cent fromthe total of $325bn at the beginning of 2006.The asset growth came partly from theimpact of fund performance, but mostly as aresult of fresh capital inflows, especially fromprivate sector and local authority pensionfunds.

But ‘European’ is something of amisnomer. Nearly 80 per cent of all Europeanhedge fund assets are in fact managed by

O V E R V I E W


London tightens gripas European hedge

funds boomBy Simon Gray

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London

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Demand continues to be strong for funds ofhedge funds because with more than 6,500funds in the hedge fund universe, fewinvestors have the extensive resourcecapabilities to research the market, let alonethe experience and expertise to determinethe optimum blend of strategies andmanagers that will provide the best risk-return profile. While basic due diligence onlong-only funds is possible from informationin the public domain, this is not an optionwith less regulated hedge funds whereinformation is much more difficult to obtain.

Multi-strategy funds of hedge funds arecurrently most popular among investors.GAM’s flagship multi-strategy fund of funds,GAM Diversity, has around 50 underlyinghedge funds and can cover all availablestrategies across the hedge fund universe.Manager David Smith and his team makeallocations by strategy, then by sub-strategyand manager.

However, more sophisticated hedge fundbuyers such as private banks and familyoffices are increasingly carrying out theirown research and due diligence anddevising their own investment processes.These investors may buy more specialistfunds of hedge funds, such as arbitrage ormacro funds, often from different providers,but still prefer a fund of funds approach thatdiversifies the risks associated with single-manager funds. As with a multi-strategy fund,the performance of a single strategy fund ofhedge funds depends on blending managerswith different styles and approaches.

This kind of granularity is starting to justifythe prediction some years ago of Smith,chief investment director of GAM’s fund ofhedge funds business, that in the future

funds of funds could become much narrowerin focus – for example, moving frominvesting solely in Europe to specialising inhedge funds investing in France. However,this remains some way off, and for nowmore than 80 per cent of demand at GAM isfor global or regional multi-strategy funds.

A continuing conundrum for the UKinvestment sector is that since nearly all hedgefunds are domiciled offshore, and therefore fallinto the non-distributor fund category, there isan active tax disincentive for investors in theUK, who are required to pay income tax oncapital gains achieved by the fund.

To some extent this has been overcomeby the recent introduction of investmenttrusts that invest in hedge funds. Since theinvestment trust is a quoted security, capitalgains are taxed as such, rather than asincome. However, investment trusts face theproblem of liquidity. Investors may lose outsignificantly if they buy at a premium to NAV,when the fund is in strong demand, and sellat a discount as other investors try toliquidate their holdings.

With Barclays Capital, GAM has overcomethis problem by creating a ten-year note tobe listed on the London Stock Exchange thattracks the performance of GAM Diversity’ssterling class. Many issues associated withclose-ended company structures, such as alack of true liquidity and the additional equityrisk premium of the shares going to adiscount or premium to NAV, are counteredby the note. The value exactly matches thatof the GAM fund, and the note is availablefor inclusion within SIPPs or SASSs, and atpresent qualifies for an ISA. In addition,liquidity is available daily rather than monthlyas with GAM Diversity. ■

G A M


Investors see benefitsin funds of funds

approachBy Martin Harrison and Nora O’Mahony

Martin Harrison is head ofmutual funds (UK) and NoraO’Mahony is productdevelopment director at GAMin London

London-based managers, according to thesurvey, up from 76 per cent in mid-2005. Infact, according to the financial industrypromotional organisation InternationalFinancial Services London, the UK’sproportion of the continent’s hedge fundassets probably rises to 90 per cent whenthe European offices of US hedge funds areincluded.

The increase in the share of London-based managers reflects the fact that assetgrowth has been fastest at the largest hedgefund management groups, which areoverwhelmingly London-based. The top 25European managers accounted forUSD180bn, or 44 per cent of overall industryassets, at the end of June, and several of thebiggest groups have seen assets grow bymore than 50 per cent, and in some casesmore than 100 per cent, over the previous 12months.

All of Europe’s top 10 managers ranked byassets – Man Group/AHL, GLG, BlueCrest,Brevan Howard, Lansdowne, SloaneRobinson, The Children’s Investment Fund,Cheyne, BlueBay and Marshall Wace – arebased in London, which accounted forUSD317.5bn, or 79.2 per cent of all Europeanhedge fund assets, and 856 funds out of1,332, or 64 per cent. Next by asset volumecame French-based managers, who ranUSD20.6bn, or 5.1 of all European assets,while Swiss managers’ 102 fundsrepresented assets of just USD8.6bn.

The growth in both funds and assets runout of London is all the more strikingbecause across the hedge fund industry asa whole, the number of fund launches hasfallen over the past year. Says Paul Watthey,marketing director for Europe with leadinghedge fund IT systems provider AdventSoftware: “The number of new start-ups hasfallen globally and was 50 per cent lower atthe end of June this year than at the sametime last year. But that seems to be down toa trend among US funds – the Europeanmarketplace is still very buoyant.”

In addition, London has also taken thelead in the exchange-traded fund of hedgefunds sector, an area of the industry inwhich it had been hitherto lagging. Followingthe raising of more than USD1.9bn by fundsof hedge funds on the London StockExchange in the first eight months of this

year, London boasted 22 listed funds offunds with nearly USD4.8bn in assets,compared with seven funds totallingUSD2.7bn for its nearest rival, Zurich.Typically listed in Guernsey, these closed-ended investment companies benefit fromthe fact that they are not consideredcollective investment schemes, so unlike withopen-ended offshore funds, UK investors areliable to capital gains tax rather than incometax on disposing of their shares.

European hedge fund assets alsocontinue to outpace the global trend, eventhough Chicago-based Hedge FundResearch reported that asset flows intohedge funds set new records in both thesecond and third quarters of this year, ofUSD42.1bn and USD44.5bn respectively. HFRestimates that total industry assets grew by19 per cent in the year to June 30, toUSD1.225trn, less than half the rate forEuropean managers. This continues a trendevident since 2003, according to EuroHedge,with European head fund assets growing by80 per cent between 2003 and 2005,compared with 28 per cent for US managers.

Industry professionals see few signs of alet-up given the continuing pressure onpension fund managers and otherinstitutional investors to seek both higherreturns than those available from thetraditional equity markets and diversificationinto less correlated asset classes. SaysAndrew Collins, a director of Fortis PrimeFund Solutions: “Pension funds need toproduce greater returns than traditional assetclasses can deliver, and alternative assets

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While in 2006 there has been a continuingstream of new hedge fund set-ups, thedevelopment of the industry this year hasalso been characterised by the success ofexisting funds in increasing their assetsthrough both new investment inflows andperformance. It’s too early to say whetherthis is a lasting trend, but it certainly wouldappear that the bar is being raised in relationto capital raising and that gathering assets isbecoming more difficult for new managers,given the wide choice of good opportunitiesfor potential investors.

Of course, the ability of existing funds toaccommodate fresh investment varies widelydepending on their structure and strategy.The capacity of certain esoteric singlemanager strategies is limited by theavailability of investment opportunities, whilefunds of funds may face constraints in highlyspecialised areas such as asset-basedlending due to the number of managersactive in the area. However, more genericstrategies such as long/short equity continueto be able to offer substantial capacity.

It would appear that the continuing inflowof assets to funds managed by London’shedge fund community is being driven moreby institutions than by private investors, andstems principally from the need of pensionfunds and other institutional investors toachieve greater returns than traditional assetclasses can deliver.

However, the particular needs of this typeof investor appear to be having an impact onthe performance of hedge funds. Hedge fundperformance, it seems, is currentlycharacterised by both lower returns andlower volatility – which is the risk-rewardprofile favoured by institutional investors.Their lower tolerance of volatility could be

the reason that managers’ returns are not ashigh as in the past.

The flow of institutional money is havingother effects on the hedge fund industry inLondon. Demand is growing from investorsfor greater transparency as well as increasedprofessionalism with respect to middle andespecially back-office capabilities andfunctions. This focus on operational issues isbeing led by the European industry becauseit has been shaped by the outsourcedadministration model, in contrast to theUnited States where self-administrationremains fairly common.

While it is partly the quality of itsinvestment managers that has made Londona centre of excellence for the hedge fundindustry, its other industry-leadingcharacteristic is the high quality of theoutsourcing available for back officefunctions. The typical model of a Cayman-domiciled fund with an Irish listing andindependent administrator, and aninvestment manager regulated by the FSA,seems to offer an appropriate level ofregulation and comfort for many investors.

The greater robustness of the Europeanmodel may be one reason why the hedgefund industry here has tended to suffer fewerfund scandals and blow-ups than in NorthAmerica. Indeed, its success is reflected inan increasing trend within the US industrytoward third-party administration. Europeaninvestors wouldn’t for a second tolerate aself-administered fund, which doesn’t fitwithin the model of what is consideredacceptable, and the evidence suggests thatthe level of regulation of UK-managed fundsis doing its job of protecting the investorwithout throttling the industry with excessivecaution. ■

F O R T I S


European hedge fundmodel proves its worth

By Andrew Collins

Andrew Collins is a director ofFortis Prime Fund Solutions inLondon

are the most obvious way to achieve this.Institutional and pension fund inflows willcontinue to drive the hedge funds industry.”

Martin Harrison, the UK head of mutualfunds at GAM, notes that institutionalinvestment remains patchy and that manyinvestors will have to increase their allocationsubstantially in order to benefit fromdiversification effects. “A lot has been saidabout the average institutional investment inhedge funds still being tiny at about threeper cent,” he says. “In reality this is made upof some institutions that have 15 per centand others who have none. Hedge funds willonly have a significant impact in reducingvolatility if you have got a decent weighting.”

But old habits die hard in the pensionindustry and to some observers the pace ofits switch to alternative assets remainsglacial. Says Joe Seet, senior partner withcompliance accountants Sigma Partnership:“So much is entrenched in pension practice,tax rules and suchlike, that a significant shiftof UK pension assets into hedge funds willtake a few more years. Even Hermes, whichsaid it would put 10 per cent of its enormouspool of assets into hedge funds, hasn’tachieved it, because its pension fund clientsfail to act on its advice. Hermes can onlyexecute if it has a mandate to do so.Pension funds may be looking at hedgefunds but actual investment is stillminuscule.”

Institutions such as pension funds andinsurance companies have been among theinvestors driving interest in so-called portablealpha strategies, although GAM’s productdevelopment director, Nora O’Mahony,argues that they also have applications forindividual investors. The fund of fundsmanager combines an alpha generator suchas its flagship multi-strategy GAM Diversityfund with the returns of an index like theS&P 500, delivering the beta of a highlyefficient market where it’s very difficult tobeat the index.

“We put the two together to give animproved risk-return trade-off compared withinvesting directly in the traditional markets,”O’Mahony says. “We invest 100 per cent ofthe client’s assets in GAM Diversity andenter into a swap that provides the return ofthe S&P 500, paying the counterparty aLIBOR-plus spread. GAM Diversity has a very

high correlation to LIBOR-based returns,which is a very important component of anyportable alpha structure. It’s a natural playfor pension funds that are buyers throughindexes of the S&P 500, the FTSE 100 orother official markets to which they feel theyneed exposure, by offering a structure thatcan enhance their returns.”

She adds: “There’s been talk aboutportable alpha for a long time, but only morerecently has the swaps market developedenough to provide the kind of liquidityrequired to offer portable alpha in smallersizes. At the same time, investment banksare more comfortable with the credit riskthey’re taking on the hedge funds. Untilrecently that wasn’t something they werewilling to do, but they’re now happy dealingwith funds that have long track records andvery significant assets.”

O’Mahony also notes that the use of Self-Invested Personal Pensions is set to growmarkedly following the reform of pensiontaxation earlier this year and that listed fundsof hedge funds in particular are likely to beprime beneficiaries of the relaxed investmentrestrictions applicable to SIPPs. She says:“Simplification of the pension rules and therelaxation of restrictions, combined with a fallin cost and a massive increase in supply,have made SIPPs the preferred pensionwrapper. Because SIPPs are tax-exempt,investors don’t have to worry about offshoreversus onshore funds, so they have muchgreater freedom. In this environment, hedgefunds are set to become a natural part ofany pension.”

Another important development that couldalso potentially boost inflows for London-based managers is the stated intention ofthe Financial Services Authority to easerestrictions on retail access to funds ofhedge funds next year. Given that investorscan already buy products such as listedfunds of hedge funds, structured hedge fundindex products and Ucits III absolute returnfunds, the regulator reasons that it makessense to permit the retail marketing ofonshore funds of hedge funds under theprotection of the authorised funds regime.

The FSA plans to consult the industry onits proposals but says that authorised fundsof hedge funds would be subject tostructural and operational safeguards such

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Times are changing for hedge fundmanagers. The greater focus on regulation inthe industry is forcing funds to think moreabout transparency and audit trails, and inturn to examine the capabilities of their ITinfrastructure. At the same time, the growthin the number of new funds entering themarket is creating a highly competitivelandscape, which obliges managers to focuson the actual return of their funds.

Finding new ways to generate that returnmay involve different types of financialinstrument and more complex strategies,posing a further challenge to the managers’IT infrastructure. Meanwhile, funds may needto ensure that their IT systems are capableof dealing with more complex operationalrequirements, such as dealing with a rangeof prime brokers rather than just one.

The need for effective operational controlsand risk management systems has beenthrown into stark relief by a handful of recenthigh-profile setbacks for hedge funds. Inparticular, the spectacular losses incurred byAmaranth Advisers has turned the spotlighton the organisation of hedge fund managersand their investment processes, riskmanagement systems, and ability to monitorpositions through real-time data.

The increasing flow of institutional moneyinto hedge funds is adding a further sourceof pressure on managers to ensure that theirtechnological infrastructure is capable bothof handling larger investment flows and ofstanding up to the due diligenceexaminations that these more demandinginvestors insist on.

Funds are also facing new requirementsin terms of the level of transparency requiredby investors and the depth and frequency ofreporting. Traditionally, funds have been usedto reporting what they wanted when theywanted, but they must now adapt if they

want to attract big pension funds and otherinstitutions, which need evidence of a solidoperational infrastructure to be sure that theirinvestment will not be a step in the dark.Meanwhile, funds of hedge funds are facingtheir own challenges as they adapt to a newwillingness by regulators in Europe tocontemplate direct investment in alternativesby retail clients.

With more than 500 hedge fund managerclients globally, including around 20 in theEurope, Middle East and Africa region ofwhich some 15 are based in London, AdventSoftware is in the frontline of changes in theindustry as managers respond to thesechallenges. Managers increasingly requiresystems that enable them to access data inreal time, track transactions from front toback office, and provide an audit trail andevidence of best execution.

Traditionally many smaller funds have reliedon spreadsheet-based systems or other morebasic products geared to the requirementsand pockets of start-ups. If these funds thriveand grow, however, they may find that their ITsystems cannot keep pace with the newlevels of complexity and volume required bytheir development, and that in order to remaincompetitive in the market and attractive tonew investors they need to take a step up toa more sophisticated and flexibletechnological infrastructure.

Demand for software providers such asAdvent is being driven by various factorsincluding greater transaction volumes,increased requirements from institutionalinvestors or the need for multiple primebroker support. But in a ruthlesslycompetitive marketplace, all managers arestarkly aware that they need the right toolsto generate the returns their investors requirewhile avoiding the pitfalls of inadequate riskmanagement. ■

A D V E N T


Managers face up totechnological challenge

By Mats Berggren

Mats Berggren is salesdirector for Europe, theMiddle East and Africa withAdvent Software

as the requirement for an independentdepositary. In addition, the range ofunderlying hedge funds in which fund offunds managers can invest will beconstrained by liquidity criteria in order toenhance investor protection.

Says Harrison: “The FSA is activelylooking now at regulating the retaildistribution of funds of hedge funds, whichwould be very positive. Hedge funds mayhistorically have been seen as products forthe wealthy investor, shrouded in mysteryand with an image of high risk and volatility,but this is not what 95 per cent of the hedgefund industry is about. These investmentsare becoming more mainstream anywaybecause under Ucits III, long-only managersare allowed to do more in their portfolios tohedge out risk.”

Unlike other parts of the UK financialservices industry, and in contrast with theircounterparts in some other jurisdictions,London’s hedge fund professionals arebroadly content with the regulator’s approachto the industry. For example, Seet describesHector Sants, the FSA’s managing directorfor wholesale and institutional markets, as “avery reasonable guy” and applauds hisemphasis on principles-based regulation.

Says Seet: “Unlike many complianceconsultants who will go in and check tickets,we think it is a waste of time and the FSAhas said it’s a waste of time. Our wholeattitude toward compliance is principles-

based. If people want to break rules, youcan only stop it by being sensitive to thepattern of their revenue and of their risk.That’s what the FSA is focusing on throughthe risk assessment programme it is nowrolling out, with the top 30 hedge fundmanagers being relationship-managed.”

Some London-based managers have atleast seen the shadow of double regulationlifted following the court defeat of theSecurities and Exchange Commission’s rulerequiring investment advisers to funds withmore than 14 US-resident investors toregister with the SEC and submit toinspections, even if they were based outsidethe United States and, in the case ofLondon-based managers, already regulatedby the FSA.

For some the relief is palpable, says GraySmith, head of the London office of leadingoffshore law firm Ogier. “A lot of people inthe US hedge fund industry were quitesurprised that the regulation was passed inthe first place. A number of UK-basedmanagers found the process [of SECregulation] painful and tortuous. They wouldsay, ‘If the FSA is happy with me, whyshould I have to be inspected by someoneelse?’

“Others simply decided they would notmarket their funds in the United States orclosed the funds off to US investors to getout of the registration requirement. Nowthere’s a sigh of relief and while not manymanagers may have deregistered yet, I thinkthey will at some point.

“The point is that regulators have to beable to trust each other. In any case, theFSA is probably better resourced tosupervise someone in the industry than theSEC.”

Perhaps most importantly, there is a largedegree of confidence across the industrythat the UK authorities understand theindustry or at least appreciate its importanceto the country’s economy. Seet cites a recentmeeting involving representatives of the FSA,HMRC and the Treasury in which the officialscandidly acknowledged the importance ofhedge funds to the City and the fact thathedge funds were there to stay. “It’s veryevident that the government recognises this,even if it would like to get more tax fromhedge fund people,” he says. ■

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INVESTMENTFUNDS

The Cayman Islands fund with a London-based manager remains the standard modelfor Europe’s hedge fund industry. And whileboth Cayman and London can expect to facegreater competition in the coming years, as agrowing clutch of rival jurisdictions look toboost their position as a domicile for funds,an attractive environment for managers orboth, there’s no sign that either centre is setto lose their dominance any time soon.

Cayman has long been the market leaderfor hedge fund domiciliation and continues toresist the challenge of other jurisdictionsseeking to emulate its delicate balance ofregulation and flexibility. For more than adecade, the islands’ Mutual Fund Law hasprovided the vehicle of choice for managers,subject only to the occasional adjustmentand without any need to create specialisedlegislation geared to funds for sophisticatedinvestors.

The regulation of funds in Cayman isbased on the principle of disclosure of anyinformation that is material to the investor,rather than a complicated checklist of detailedrequirements that imposes a more intrusiveregulatory model. The disclosure principleenshrined in the Mutual Funds Law leavesinvestors with similar levels of protection andsimilar remedies as would be available inother jurisdictions. This is complemented bythe assurance provided by a UK-regulatedinvestment manager, in many cases listing ona stock exchange in Dublin or the ChannelIslands, and by a third-party administratorsubject to its home-territory regulation.

Dublin, and to a lesser extent the ChannelIslands and Luxembourg, are the maincentres for third-party administration ofCayman funds managed out of London.Jersey and Guernsey have had one or twosuccesses in attracting investment managersto establish a physical presence in theislands, and we are starting to see hedge

funds managed in other parts of Europeincluding Russia, Switzerland and theBenelux countries. But London remains thecentre of choice for the vast majority ofEuropean managers.

To a degree the pattern of hedge fundactivity reflects the confidence of investors ina tried and tested model. Managers settingout to raise capital don’t have to justify adomicile in Cayman, administration in Dublinand investment management in London’sWest End. They can concentrate on talkingto investors about their fund’s strategy andinvestment policy rather than why they choseto domicile it in the Cook Islands andmanage it from Egypt.

Still, a group like Ogier can help its clientsto establish hedge funds in whateverdomicile they prefer – especially following itsrecent merger with the leading British VirginIslands firm of WSmiths. The BVI hasreinvented itself successfully in recent yearsby moving upmarket, and is today thesecond-ranking offshore hedge fund domicile,with strong interest from US managers.

While most London managers continue toprefer Cayman, the range of alternativesincludes Jersey and Guernsey, in the sametime zone as London and only an hour’sflight away. As well as providing a domicilefor hedge funds, Guernsey and Jersey areimportant centres for private equity business,and Jersey for real estate funds.

Ogier, which established itself in Caymanthrough an earlier merger with leading hedgefunds practice Boxalls, has consolidated itsplace in the “magic circle” of law firms thatoffer services in most of the main offshorejurisdictions. With all its offices enjoying asizeable presence in their respectivemarkets, more than 500 employeesworldwide and a global reach stretching fromHong Kong to Montevideo, the group hascritical mass in the marketplace. ■

O G I E R


The Cayman-Londonaxis flourishes

By Gray Smith

Gray Smith is managingpartner of Ogier LLP in London

London has many qualities that have luredthe cream of Europe’s hedge fund managersto set up their headquarters in and aroundthe West End: a tax regime that meets withwidespread acceptance if not necessaryunanimous approval, a regulator generallycredited with striking the right balancebetween flexibility and oversight, and thepresence close at hand of a broad range ofhigh net worth and institutional investors.That’s before one gets down to theintangible yet important factors wrapped upin the concept of ‘lifestyle’.

But probably more important than any ofthese factors is London’s remarkable pool oftalent, drawn from all over the world andfound not only in the city’s hedge fundmanagement firms but across the array of

service providers that make it possible formanagers to flourish, from domestic andoffshore law firms, auditors and tax advisersto IT specialists, business consultants andprime brokers.

This blend of talent and experience owesmuch to the internationalisation of the City ofLondon 20 years ago following the financialservices liberalisation process dubbed ‘BigBang’. It not only confirmed London’sposition as the leading European financialcentre but, through the swallowing up of UKmerchant banks by foreign rivals, created apowerhouse of investment banking activitythat in recent years has spun off a wave ofnew hedge fund managers.

To the chagrin of other European citiesthat would like to challenge London’s

C O M P E T I T I O N


Hedge funds build onLondon’s human

capitalBy Simon Gray

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Bear Stearns has long recognised thechallenges for prime brokers as the hedgefund industry grows in size, diversity andcomplexity. One of the features that make ourfirm unique in the sector is that our primebrokerage business is proportionately muchlarger relative to the rest of the organisationcompared with most of our competitors. Thishas enabled Bear Stearns to build a range ofcapabilities and expertise focused on thehedge fund community and to respond bycreating new products and services as hedgefunds diversify into new markets.

The relationship between hedge fundsand prime brokers continues to evolve. Forexample, there has been a trend in recentyears among bigger managers to developmore than one prime brokerage relationship,in some cases expanding their panel ofprime brokers to numbers that becamedifficult to manage.

Many hedge funds now have settled onrelationships with two or three prime brokersafter finding that having numerous primebrokers added to the complexity of theirbusiness. This rationalisation has contributedto the intensified competition in the market.As hedge funds reduce the number ofcounterparties they use, prime brokers needto prove themselves worthy of making theshort list.

In the European market, investors areincreasingly attracted toward larger hedgefunds and a more institutional type ofmanager. Start-up managers must scale higherhurdles as institutional investors demand solidoperational platforms and complianceprocedures, reputable service providers, soundbusiness policies and procedures, andexperienced front, middle and back office staff- all the trappings of a well-run business.

When we launched our business consultinggroup over three years ago, we built the

model based on the needs of the start-upmanager. Today, more than half of ourconsulting group’s engagements are withglobal, multi-billion-dollar funds seekingassistance in building out their infrastructure inorder to establish and maintain best practices.

In turn, more institutional type managersexpect prime brokers to provide a broadplatform of capabilities and support a diverserange of investment strategies. Bear Stearnsoffers an integrated fixed income, equities andderivatives trading platform to suit moresophisticated hedge funds, and has devisedservices for derivatives such as ourDerivClear platform for margin managementwith multiple counterparties. Prime brokerage,structured products and equities were recentlybrought together to form a new GlobalEquities group at Bear Stearns, reflecting theintegrated nature of hedge funds’ relationshipsacross multiple product areas.

In some ways, the increasing demands ofinstitutional investors are overshadowing therole of regulators. For example, despite thewithdrawal of the SEC registrationrequirement for hedge fund managersfollowing a successful court challenge,investor demand continues to drive thestandards of professionalism and matureinfrastructure expected of hedge funds.

Funds using multiple prime brokers andspreading their borrowing across differentlenders has made it more difficult to assesswhether the leverage being utilised posessystemic risks to the financial markets. BearStearns has made monitoring of such riskscentral to our prime broker business. Thesuccess of this approach speaks for itself –no defaults in the sector for nearly 20 years.The close attention paid by all prime brokersto the amount of leverage extended to theirclients represents a strong safeguard for thefinancial system as a whole. ■

B E A R S T E A R N S


The new primebrokerage paradigm

By Lou Lebedin

Lou Lebedin is seniormanaging director and co-head of prime brokerageservices with Bear Stearns

dominance, it is a magnet for many of thecontinent’s best and brightest – who in turnare eagerly sought after for skills that maynot be so readily available at home. ExclaimsJoe Seet, senior partner with complianceconsultants and business advisers SigmaPartnership: “Look how many French hedgefund managers are in London! Every hedgefund manager wants French employees,because the French education systemfocuses on maths and science, abilities thatare greatly in demand in London.

He adds: “London is now the secondbiggest hedge fund centre in the world andwill always be a strong place in which to dobusiness because it is a melting pot fortalented people. This came about during theinvestment banking bull market, when theywere bringing in people to London from allover the world. The diversity of talent isincredible. For example, West Coast lawfirms may have Chinese-speaking lawyers,but you find them in London, too. And I wasrecently speaking to a law firm that has abranch in Montevideo, Uruguay.”

London’s domination of the Europeanmarket is not just solid but increasing. “Itnow accounts for 79 per cent of Europeanassets, up from about 70 per cent two yearsago,” says Andrew Collins, a director atFortis Prime Fund Solutions. What makes theindustry’s momentum seem unstoppable forthe foreseeable future is its critical mass interms of infrastructure, something none of itsrivals can match. Adds Collins: “The supportnetwork for the hedge fund industry includesthe best law firms in the world, and taxadvisers are very strong.”

Gray Smith, managing partner at theLondon office of leading offshore law firmOgiers – which acquired that Montevideooffice through its merger in October withBritish Virgin Islands-based WSmiths – notes:“There are very good onshore law firms witha great deal of expertise, and the main primebrokers are in London. It’s just geared up forthe hedge fund business.”

It helps that even before the hedge fundboom began in earnest in the late 1990s,London was already a major centre for thetraditional asset management industry,according to Paul Watthey, marketing directorfor Europe, the Middle East and Africa atAdvent Software, a leading supplier ofsophisticated IT systems for the financialservices industry. “There’s a good pool ofexpertise in terms of staff that understandthe investment management industry,” hesays. “There’s a favourable regulatoryenvironment, a lot of clients are here, sothere’s close proximity to the market, and thehedge fund ecosystem of lawyers,accountants, prime brokers and fundadministrators is in plentiful supply.”

For prime brokers, the all-round strengthof the financial sector made London a logicalchoice for expansion out of the industry’s USEast Coast heartland. Says Lou Lebedin,senior managing director and co-head ofprime brokerage services with Bear Stearnsin New York: “All the large financialinstitutions recognised a long time ago thatthis was where the infrastructure was inplace to build out the alternative investmentmarket. We have a vertically integratedcapability for prime brokerage as well as ourtrading of fixed income, equity and derivativeproducts.”

The London Stock Exchange and its juniorAIM market, a listing platform of choice forclosed-ended investment vehicles, are part ofthat infrastructure, but one of the keystrengths of London is that its financial marketis global rather than primarily domestic inoutlook. Says Seet: “You can tradeinternationally, across all markets, aside fromdirect access to the LSE and other Europeanstock exchanges. You can physically tradeany market in the world from London,something you can’t do from Paris, or fromNew York without using local brokers.”

The industry is also attracted by the



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and cost effectively.

FSA authorisation to set you up as quickly as possible.

Our partners and professional staff are here to help and are at your service.

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tel: +44 (0)20 7648 7880email: [email protected]

www.sigmallp.comSigma Partnership∑ TM

The explosive growth of the hedge fundindustry over the past few years hasprompted many investment professionals,including long-only fund managers, analystsand proprietary traders at investment banks,to consider setting up their own hedge fundmanagement firms.

However, the key factors that willdetermine whether a manager succeeds orfails are often less about their professionalskills in picking investments or predictingmarket movements than their ability to build,manage and develop operational capabilitiesin a sustainable business. These are keyfactors that can give investors theconfidence to invest in a fund.

Sigma Partnership is a firm of complianceaccountants whose partners have extensiveprofessional experience with investmentbanks and investment firms. We do muchmore than just providing FSA complianceand accounting services; we evaluate theentirety of our client’s business, including theinvestment objectives and processes of thefund, as well as corporate governance forboth the fund and management companies.We also offer appropriate and pragmaticcompliance, tax and accounting advice toensure the client’s business has solidfoundations, the fund’s strategy meetsinvestors’ expectations, and it can secure atleast $50m in assets within, say, two years.

The first two years of a business,especially for investment bankers branchingout on their own, is like the same period inthe life of a child who needs to learn how towalk and feed itself. No matter how talentedthe principals of the new firm and how acutetheir investment abilities, running a newbusiness presents new challenges of whichthey may not be fully cognisant.

Sigma Partnership helps new andestablished managers, particularly inbound

broker-dealers and managers from the US,continental Europe and Asia, by assistingthem with the advice they receive from expertssuch as tax advisers and lawyers. A commonproblem is that much professional advice ispredicated on success, such as minimisingtax liabilities on incentive fees, when thelikelihood of generating substantial incentivefees in the first two years is usually remote.

During this time, the key issues arebusiness stability, building risk managementprocesses, actively managing cash flow, andthe tax-efficient accounting of any lossesbetween the principals. For example, a firminto which four partners have eachcontributed £250,000 might well lose £1m overthe first couple of years; discussions can bedifficult if the principals have not fully thoughtthrough how the loss is to be shared.

Our discussions with prospective hedgefund managers also cover the likely level ofinterest from potential investors andcomparison of the fund’s projectedinvestment performance with its future peergroup. We advise on compliance and taxissues, different types of fee structure,corporate structures and fund domicile and,if requested, can recommend serviceproviders such as fund lawyers, auditors,prime brokers and administrators.

It may be only after several meetings thatSigma Partnership is formally appointed toprepare the hedge fund manager’sFSMA2000 Part IV authorisation applicationto the FSA, finalising the firm’s businessplan, financial forecasts, regulatory capitaland funding requirements, advising on MiFIDand other relevant regulatory requirementsand perhaps also to advise on fundpresentation and cross-border marketing.Only if all these issues are successfullyresolved can the principals focus fully ontheir core business of managing money. ■

S I G M A PA R T N E R S H I P


Managing the hedgefund business challenge

By Joe Seet

Joe Seet, FCA, is the seniorpartner of Sigma Partnership

English legal system. “From an institutionalpoint of view London is a good place to dobusiness because its legal system issupportive,” he adds. “English law is flexiblerather than prescriptive, unlike US or Frenchlaw. Companies will always want to bedomiciled here because the legal system isfair from a contractual and torts point ofview. The corporate governance rules alsoappeal to US companies which don’t want tohave to deal with Sarbanes-Oxley.”

Nor is the regulation of investmentmanagers by the Financial Services Authoritya deterrent, despite its willingness to take onhigh-profile managers with enforcementactions, as demonstrated by the recent caseagainst GLG Partners and Philippe Jabre, andthe regulator’s new focus on enhancedsupervision of so-called “high impact” fundmanagers through a relationshipmanagement approach.

Says Smith: “It may be easy to set up aninvestment management company in Geneva,where you certainly don’t have anything likethe FSA’s regulation. But most people in theindustry quite like the idea of the investmentmanager being FSA-regulated – and I knowinvestors do. London management of aCayman fund is a good balance. Caymanhas light regulation that allows managers toinvest in anything they want to, provided theyinform their investors, but on a day-to-daybasis they’re covered by the FSA.”

In any case, Collins argues, institutionalinvestors are more than ever in a position todemand that hedge funds set up effectivecompliance procedures covering problemareas such as conflicts of interest andinsider information quite independently of theregulatory regime. “The larger hedge fundmanagers like GLG – notwithstanding therecent FSA disciplinary case – are very muchdriven by the institutional requirement forprotective mechanisms such Chinese wallsand focus on operational practices,” he says.

“As the hedge fund industry matures, itwill look more like the mutual fund industryin terms of the requirement for robustoperations and giving investors confidencethat they are investing in very robustproducts.” These developments make itunlikely that London will be undercut by anyother centres on the basis of regulatoryarbitrage.

Says Smith: “One of the basic things islifestyle – the fact that people want to be inLondon. A lot of managers came from bigLondon investment houses, and when theydo their own thing, they’re to remain livingand working in London. In addition, a lot ofstart-ups are still raising money, so they wantto be on the ground where they can easilysee who their investors are.”

To some extent the industry may start tosee more fragmentation as a result of agreater regional focus; some argue it can beeasier to run a fund investing in marketswhere local knowledge and contacts areparticularly important, such as EasternEurope or the former Soviet Union, fromPrague or Moscow than London. Says Smith:“There are an increasing number of hedgefunds in the wider sense from other parts ofthe world such as the Middle East, Russiaand Switzerland, even the Beneluxcountries.” But Mats Berggren, Advent’s salesmanager for the EMEA region, notes thatmost funds investing in Eastern Europe arebased in London and open satellite offices inthe target countries they are investing in.

Nor do industry members see a seriousthreat from the efforts of a number ofoffshore centres, notably the Channel Islandsand the Isle of Man, to lure hedge fundmanagers with a package of tax incentives.Jersey has already had some success withindividual managers moving their familiesand businesses to the island, and the Isle ofMan is highlighting a cap of £100,000 for anyindividual’s personal income tax liability. Eventhe Cayman Islands now have at least onehedge fund manager and others are



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rumoured to be showing interest in a move.But Collins says: “Most UK managers are

quite happy in London, and I can’t see acompelling reason for most of them to moveto an Isle of Man-type jurisdiction. It’s amatter of personal choice, but mostmanagers would want to be at the centre ofthe market – the research ideas generated bythe investment banks, the support, thenetworks are here, and it would seemsensible to run the money from here as well.”

Seet argues that despite their obviousattractions, the Crown Dependencies are nota panacea for a hedge fund business. “Thereare extra costs, because both Jersey andGuernsey have two-tier property marketswhich makes housing expensive for incomers,and while tax might be lower, there is asmaller talent pool so employee costs will goup,” he says. “And while the Isle of ManTreasury Minister Allan Bell may be able tosay the maximum tax you will pay is £100,000,what he can’t do is change the climate.”

At present most people in the hedge fundindustry regard the tax arrangementsgoverning the business as satisfactory. “Theinvestment manager exception is anacceptable way forward from the tax point ofview,” Smith says, referring to the guidelinesthat investment managers must satisfy,notably to demonstrate an arm’s lengthrelationship with the offshore funds theyadvise, in order to ensure that funds’ profit isnot taxable in the UK.

But that could be under threat, accordingto John Neighbour, a tax partner with KPMGwho previously was in charge of a review ofthe investment manager exception tests forHM Revenue and Customs, following thepublication of proposed changes to theguidelines. He says: “Assuming these newdraft guidelines are adopted, investmentmanagers, particularly in alternatives such ashedge funds, will need to review theirarrangements as a matter of extremeurgency to ensure that the funds for whichthey act maintain their tax-free status.”

Neighbour says that significant changesare proposed to two tests, regarding‘customary remuneration’ and‘independence’. HMRC proposes to use theconcept of arm’s length pricing, as definedby the OECD Transfer Pricing Guidelines, todetermine whether the remuneration received

by the manager is not less than is customaryfor that class of business. This clarifies thetest, he says, but makes it more onerousthan in the past because the burden of proofas to whether the payments are appropriateor not will effectively shift from the taxauthorities to the manager.

By contrast, he says, the proposedchanges to the remuneration test introducegreater uncertainty. Whereas the existingguidelines set out a list of circumstancesunder which HMRC regards manager andfund as independent of each other, the newguidance says no single factor will betreated as decisive and that the list simplyillustrates what may be significant.

While Neighbour expects managers toadapt their arrangements with the funds theymanage in order both to keep their UK baseand keep the funds out of the UK tax net, hesays: “There is a perception that some fundmanagers have played a little fast and loose,and HMRC is tightening up the rules inresponse. Everyone in the industry will needto pay attention to these proposed changesand, at the very least, review theirprocedures.”

Seet argues that hedge fund managersalready “pay their way” as far as the UK taxauthorities are concerned and that few pushthe boundaries too far, but he says: “Thebiggest issue for hedge fund managers istaxation. Although our clients don’t give theimpression that they are ready to relocate toother countries, although they might changethe pattern in which they do business, thereis a natural level at which any of us thinksenough is enough with regard to taxation.

“At the moment UK taxation is running atabout 52 per cent including nationalinsurance. If the threshold reached 65 percent, a lot of people would question the pointof working eight hours a day, when so muchof it was going to the government. That’swhen people would reassess, but it can’t bean instantaneous or an easy decision whenyou have a family, children in school, friendsand parents to consider. One hedge fundmanager who was contemplating a move toMonaco took a year to make the decisionand sort out issues such as schooling andhow he would continue to see his family. It’snot a case of saying: ‘I want to pay less tax,so I’m getting on a plane now.’” ■



The United Kingdom has missed out as adomicile for European long-only funds to thebenefit of Luxembourg and Ireland becauseof a burdensome and over-complex taxsystem, according to a report commissionedby the Investment Management Association.However, say the report’s authors at KPMG,it’s not yet too late for the UK to become asignificant domicile for alternative investmentproducts including hedge funds, propertyfunds and absolute return funds using aUCITS structure.

According to IMA chief executive RichardSaunders and Jane McCormick, head of taxand financial services at KPMG, while the UKis demonstrably a vibrant investmentmanagement centre and by far the leadingEuropean location for hedge fund managers,during the decade to the end of 2005Luxembourg and Ireland saw domiciled fundassets grow six and 31 times respectively,while the assets of UK funds grew onlythreefold.

In addition, the report found, sincelegislative changes in July 2004 lifted taxpenalties on some offshore funds,Luxembourg and Irish funds authorised fordistribution throughout the European Unionhave started to make inroads into the UKdomestic market, which previously had beenlargely restricted to locally domiciled funds,

rising from one to 21 per cent of total sales.However, only a handful of asset managershave sought to distribute UK funds in otherEuropean markets.

The UK-based asset managers andadministrators surveyed by KPMG, whichtogether account for around 60 per cent ofUK authorised funds, mostly attribute thisapparent lack of competitiveness to anunfavourable and over-complex tax regime.The report quotes one participant as saying:“We’re not yet at the tipping point, but thetipping point will be with us within the nextfive years – UK investors are no longersuspicious of offshore funds.” However, thereport’s authors argue changes can still bemade in time to secure a significant share ofthe domicile market for both traditional andalternative funds.

“While there exists significant opportunityto build on current market strength, throughselling UK-domiciled funds into the EU andpositioning the UK as an attractive funddomicile for alternative asset funds, this willnot happen without a proportionate taxregime,” the report says. “The desiredoutcome for the industry is a simpler taxregime able to compete directly with Irelandand Luxembourg, backed by supportive andconstructive tax and regulatory authorities.”

Not everyone believes that the UK needaspire to be a domicile for funds, whethertraditional or alternative. Says AndrewCollins, a director at Fortis Prime FundSolutions: “I don’t see the UK wanting to bea domicile for funds. It is a centre ofexcellence for fund management, whereasLuxembourg and Dublin are centres ofexcellence for the domiciling and servicing ofoffshore fund vehicles. London doesn’t wantto be a Cayman and can’t be, from a

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Is tax killingLondon as afund domicile?

taxation point of view, a domicile for thesetypes of vehicles. What people want to do inLondon is run the money.”

The authors of the report say acombination of actual tax differences andperceptions is currently deterring investmentmanagers from using the UK as a domicilefor alternative fund products including hedge,property and absolute return funds. Theyregard the tax authorities more as anobstacle than a supporter of industrydevelopment and growth, in contrast to thetax and regulatory authorities in other fundcentres, who are often considered moresupportive by facilitating new developmentsand innovations.

The report says: “Administration functionsfor funds tend to follow domicile, primarily forpractical operational reasons, but also due inpart to regulatory requirements. Funds thatare managed in the UK but domiciledoverseas therefore result in a loss to the UKof the economic benefits arising fromadministration, employment and other indirectservices (for example, provision of tax, legal,and accountancy services). This weakensboth the UK investment management industryand the wider UK economy.”

The respondents to the KPMG survey citea broad range of tax measures and otherfactors that make the UK less attractive thaneither Luxembourg or Dublin as a domicilefor alternative funds – let alone otheroffshore jurisdictions such as the Caymanand British Virgin Islands.

These include uncertainty over the taxtreatment of derivatives used in structuredproducts; the decision of HM Revenue andCustoms to directly tax investors who holdmore than 10 per cent of a professionalinvestor fund; and the risk that UK propertyfunds could be subject to corporation tax atfund level.

Respondents also cited the taxation oftotal return – both income and capital gains– imposed on UK-based funds that areregarded as trading as opposed to carryingout investment, which can result in investorssuffering more than one level of tax charge.Since the distinction between trading andinvestment is assessed on a transaction-by-transaction basis, managers simply opt forjurisdictions where this concern does notarise because funds have tax-exempt status.

The report notes that the need to separateincome and capital under the UK funds taxregime also increases the complexity ofadministration, a factor that is “growing insignificance as the industry moves into morealternative and complex products”. Accordingto one fund administrator, every UK fundrequires 0.66 administrators, compared with0.42 administrators for every Luxembourgfund and 0.27 for every Irish fund.

While the report’s authors do not believethe dominant position of Luxembourg andIreland in long-only funds can be reversed,they note that although preferred EUdomiciles exist for alternative investmentproducts, there is as yet no clear Europeandomicile of choice. There is still time for theUK to establish itself as a viable funddomicile centre, particularly by leveragingexisting expertise and strength in coreinvestment management and relatedactivities for more complex products.

Says the report: “The Financial ServicesAuthority will consult on the introduction offunds of unregulated schemes in the firstquarter of 2007, and so the tax treatment ofUK based funds of hedge funds (if not hedgefunds) is likely to come under close scrutiny.This is the next opportunity for the industry,FSA and HMRC to demonstrate a joined–upapproach in developing an environment thatcan support establishing and maintainingproducts in the UK market.”

The report recommends various changesto the UK’s tax regime, including agreementon an appropriate tax regime for open-endedproperty funds, allowing authorised funds totrade without incurring a corporation taxcharge, and considering the case for full taxexemption at fund level, if the industry canreach a clear consensus on the benefits ofsuch a move.

“Participants believe that the EU domicileof choice for alternative and progressive fundtypes (for example, hedge funds andproperty funds) has not yet beendetermined,” the authors conclude. “There isan opportunity for the UK to compete withother locations and win this business. Thiswould require HMRC and other authorities towork constructively and closely with theindustry to agree a tax regime that wouldsupport rather than hinder the growth of thistype of business in the UK.” ■

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dec 2006 london hedge funds services 2006 - … hedge funds services 2006 ... all data as at 30 june...

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