Australia’s Hedge Fund Industry – the current state of play

Hedge funds are faced with challenges from regulatory reforms, but their ability to survive the GFC and the potential for Australia to emerge as an Asian financial hub could create opportunities. Nikki Bentley asked a range of industry experts for their views on the way forward for a vital segment of the financial services industry.

Kim Ivey
President of AIMA Australian Network

Q. How has the GFC impacted the Australian hedge fund industry?

Many of the contributing factors to the GFC, such as over-leveraged financial institutions, poor risk management practices and opaque structured investments, did not surface in the Australian financial system. Banks had little exposure to US mortgages and were extremely conservative in both their credit and trading desk practices. Indeed, bank operating profits in FY 2009 showed a slight improvement over 2008.

It was the local hedge funds that had exposure either to overseas markets or to overseas counterparties, such as prime brokers, that felt the ripples emanating out of New York, Geneva and London. The vast majority of the 80 or so Australian-based hedge fund managers in 2008 invested in local equity and debt markets. The resilience of the banking and resource sectors in Australia also helped minimise capital losses. The average long/short equity manager performance was minus 21% versus a minus 40% decline in the ASX 200 Index.

Probably the one issue caused by GFC events which is still being felt in the local industry is the diminution of investor confidence in hedge fund strategies, and perhaps the managers themselves. This is particularly the case with fund-of-hedge-funds, which were marketed to institutional and retail investors as prudent, liquid and well diversified investment vehicles.

Q.  What are the main obstacles faced by investors in Australian hedge funds?  

Investors who invest directly are probably gaining exposure to a long/short equity strategy in the Australian equity market. This concentration means that the offering is quite limited because there is often no exposure to other strategies, such as macro or convertible arbitrage. The other obstacle, again which is strategy dependent, is capacity. Many large superannuation funds are forced to bypass local hedge funds because they are already over-exposed to domestic equities. Also, a hedge fund manager’s ability to accept $50 million-plus investment allocations from local super funds can be limited when they have an overall upper capacity limit of less than $500 million.     

Q. What do you see as being the key regulatory reform for the development of the Australian hedge fund industry?

It has been well regulated since 2002, in the sense that hedge funds must be licensed by ASIC and abide by prescribed principles on disclosure, compliance and conduct. This gives investors a heightened degree of comfort that regulatory checks and balances are in place.

The grey area on the regulatory front is probably in the area of taxation. Reforms to the Managed Investment Trust (MIT) regime, the election of capital versus revenue based accounting for investment vehicles, and FIN 48 tax provision for US GAAP, are significant areas of contention that are still being resolved with tax authorities.
The uncertainty, particularly over the FIN 48 issue, is resulting in some creative work around solutions in the short term. There is no doubt that potential unknown tax provisioning is keeping some investors from making commitments.

The other possible regulatory development is the gathering of systemically significant risk data by global regulators. There are 11 proposed categories of data involved. If done correctly and interpreted prudently, it may curtail fears by regulators that hedge funds pose systemic risk to the financial system. I expect Australian hedge funds will be reporting more data about their strategies, assets under management, performance, leverage and information on key service providers to ASIC in 2011.

Q. How will the Australian hedge fund industry benefit from the Government’s goal to make Australia an Asian financial hub? What is the largest obstacle to achieving this goal?

Australian hedge funds have managed money on behalf of offshore investors for many years, and have had to construct identical offshore fund structures for them. This has resulted in a duplication of infrastructure costs, and has led to higher running costs. In a competitive, skill-based industry with constrained capacity on assets, the operating risk of the business is unnecessarily heightened.  

The government’s goal in making Australia an Asian financial hub needs some rethinking. As a general objective, it is probably unrealistic. The overall asset management industry is following what has been occurring in the hedge fund industry for years. That is, a push towards specialisation and a pursuit of differentiation. Therefore, what the government and their advisors should be looking at is what areas of specialisation do Australian asset managers have that are missing in Asia, and how can the government assist in making companies competitively differentiated so that national borders are seamless?

The local hedge fund managers that already compete and win allocations from overseas investors would love to hold offshore assets in local Australian investment vehicles. Removing the punitive withholding tax provisions on offshore investors would be the best way forward. 

Andrew Baker
Chief Executive Officer, AIMA*

Q. How has the GFC impacted the global hedge fund industry?

If the concern of international policymakers after the financial crisis was that they had insufficient information about the build-up of systemic risks in financial markets, the response of the global industry and of AIMA specifically was to offer its full co-operation in contributing to structures that would supply them with the timely, relevant information which they needed to address financial stability issues. Our work since then has been about working with individual regulators and with supranational bodies to create the right supervisory framework for the industry. After all, we share their desire for improved financial stability.

Q. What are the main obstacles faced by investors in Australian hedge funds?

Investors are increasingly focusing on transparency and liquidity, and ensuring that these are priced appropriately. In particular, institutional investors, who we believe now account for an absolute majority of assets under management by the industry globally, are driving moves to greater transparency, as is right and proper. There has also been much greater emphasis placed on liquidity, particularly following the “gating crisis” of 2008/9. While this is welcome, investors in hedge funds should not lose sight of the fact that an element of illiquidity is often necessary to create alpha. A balance must always be struck between performance, volatility
and liquidity.

* Note: As Andrew is based offshore, he was asked for his views on the first two questions.

Rick Steele
Executive Director, Eight Investment Partners

Q. How has the GFC impacted the Australian hedge fund industry?

The GFC has had a general dampening impact on all areas of funds management, not just by way of lowering funds under management but also slowing new flows to the sector as investors, fiduciaries and their advisers reassess the framework in which they make investment decisions. The hedge fund industry in Australia was immature when the GFC struck. When investors adopted a more cautious approach, hedge funds, which were seen as risky, were disproportionally impacted.

Q. What are the main obstacles faced by investors in Australian hedge funds?

I believe the issue is one of perception rather than reality. Hedge funds have an image of high risk, high fees, poor liquidity and low transparency. This is not how it is. In fact, the dominant hedge fund strategies in Australia rely on liquid instruments. They carry low levels of gearing, publish their holdings and have fees that fairly reflect the additional returns that they can deliver when compared with more traditional investment approaches. Importantly, as a group, they provided protection from the savage declines in sharemarkets during the GFC, just as they were designed to do.

Q. What do you see as being the key regulatory reform for the development of the Australian hedge fund industry?

Apart from the introduction of ill-advised short selling legislation, driven by a misplaced understanding of the role played by short selling in driving share prices, Australia already has an effective regulatory environment that sensibly requires hedge funds to meet the same standards as all managed funds. Any future reforms that attempt to single out hedge funds for special regulatory treatment will face enormous difficulties based around the definition of such funds and quantification of investment constraints.

Q. How will the Australian hedge fund industry benefit from the Government’s goal to make Australia an Asian financial hub? What is the biggest obstacle to achieving this goal?

The drive to make Australia a financial services centre in Asia is an admirable one. However, it will take political courage to be successful. Australia is coming from behind other jurisdictions and is geographically on the perimeter of the region. Despite the clear policy roadmap provided in the Johnson Report, there is evidence that we haven’t embraced the required policy environment, particularly in relation to tax. For example, Treasury’s concerns about the loss of tax revenue from conduit income are naive and short-sighted because consideration is not given to the lift in taxation from the future growth of the industry. Seeking to tax offshore investors on offshore investments managed by Australian fund managers would be enough to hobble this important initiative and drive funds management activities to other centres in the region.

Hersh Gandhi
Head of Product Development, Man Investments Australia

Q.  How has the GFC impacted the Australian hedge fund industry?

The GFC had a significant impact on several levels. The size of assets managed by the industry diminished due to investor redemptions and negative investment performance. The number of players in the industry also fell, with providers withdrawing from the market voluntarily, especially among fund-of-hedge-funds, and others were forced out due to prevailing economic conditions. The inability to handle liquidity mismatches forced some prominent firms to impose gates, limit redemptions or suspend currency hedges, all of which created negative sentiment towards the industry. Only a few firms held their own, and they stand to prosper going forward.

Q. What are the main obstacles faced by investors in Australian hedge funds? 

FIF and CFC rules have historically constituted “Australia specific” obstacles to investing for certain segments of the Australian investor base. That said, the repeal of the FIF rules from 1 July 2010 is a very positive development. This will mean that Australian funds will no longer have to manage FIF.   

Q. What do you see as being the key regulatory reform for the development of the Australian hedge fund industry?

The main issue is regulatory certainty, which has been impaired due to the ban on short selling. Overall, the regulatory environment for hedge funds is stable relative to other jurisdictions.

Q  How will the Australian hedge fund industry benefit from the Government’s goal to make Australia an Asian financial hub? What is the largest obstacle to achieving this goal?

Irrespective of government initiatives, the size of the market potentially creates an incentive for hedge funds to maintain sales and marketing operations in this country. The real challenge is to establish Australia as a place for fund managers, fund administrators, prime brokers, etc to maintain a significant business presence. It will remain difficult to do this while the tax regime, both business and personal, compares unfavourably with regional competitors such as Hong Kong and Singapore. The regulatory uncertainty created by the recent ban on short selling may also damage Australia’s reputation as a place to do business. 

Nikki Bentley

I understand the financial services industry and thrive on helping our clients in this industry succeed.

Nikki Bentley Partner

Nikki is the Group Leader of Henry Davis York's Corporate Group, which includes the legal teams for Corporate / Mergers & Acquisitions; Investments & Financial Services and Tax.

Nikki is a leading investment funds advisor specialising in financial services and corporate law.  She specialises in business establishment and structuring, fund establishment, funds merger and acquisition, product disclosure and distribution. Nikki leads HDY's corporate group which combines expertise from the Financial Services, M&A and Tax areas.

Nikki provides advice to leading Australian and global fund managers on a full range of corporate, commercial and regulatory issues facing their businesses. She has considerable experience in assisting clients with fund establishment (onshore and offshore), disclosure and distribution. Nikki regularly advises clients on establishing, buying, selling and restructuring their businesses. She also regularly assists clients responding to regulatory enquiries and investigations.

With more than 15 years funds management experience in private practice, government and as an in-house lawyer, Nikki's practice spans the range of funds management products, with particular expertise in hedge funds, property funds and equities.

Nikki is regularly involved in industry and government discussions on regulatory reforms impacting the Australian funds management industry. Nikki is a passionate advocate for the development of a new corporate collective investment vehicle because of the opportunities it could provide to grow the funds management industry. She is the Honorary Legal Counsel and Chair of the Regulatory Committee for the Australian branch of the Alternative Investment Management Association (AIMA) and is a regular participant on the Financial Services Council (FSC) working groups.

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