IV. Emergence of The Family of Hedge Funds (FHF)

While the prospects for growth in the industry appear good, some structural aspects of the industry will need to evolve to support the future asset growth. It is our view that the sustained growth and maturation of the industry will alter its structure or at least provoke a debate over the form the industry will eventually assume.

To continue growing assets at 25%, the hedge fund industry must be able to retain and reach-out for new customers. Considering the facts that the total capital pool available for investments; over $5 trillion from high net worth individuals and over $10 trillion from institutional investors, and the present allocation rates to hedge funds in these segments; less than 2% in high net worth market and less than 1% in the institutional market, one can conclude that the industry has a plenty of room to increase its market share.

In the initial growth stage of any industry, products are more easily accepted by a select set of customers, often sold without much marketing and sales activities or even without infrastructure for customer support and services. However, as the industry matures and becomes more competitive, the mode of competition switches from convincing customers to try a new product to explaining to them the product advantages, attracting new customers and even encouraging customers to switch away from competitors. One of the challenges in the future will be to expand the investor base of high net worth individuals while targeting the much larger institutional investor base. In the long run, institutional capital will be key for sustainable asset growth.

Another challenge facing the hedge fund industry is that the market is becoming increasingly global. Recently, we have seen how our stock market can be impacted by events in Asia. The development of a global economy and the emergence of multinational asset management companies are forcing investment managers to view their business on a global basis. It is our view that the competition to manage assets will evolve into a single global market. The battle for investment assets, especially from high net worth and institutional investors, will shift from one that is primarily fought among domestic funds to one involving global competitors.

In the very near future, hedge funds will need to be able to conduct a significant part of their business electronically, at least as far as the distribution of information is concerned. A new class of sophisticated investors, the "www.generation" is emerging. They share and access information anywhere, anyplace and anytime without concern for physical location. For the first time, on May 29, 1997, a no-action letter from the Securities & Exchange Commission was issued which has paved the way for delivery of hedge fund performance and related information over the Internet⁽¹⁷⁾. Today more than 70% of affluent households own a computer and are interested in on-line delivery of information. Investors would like to buy and sell financial products, monitor their returns and analyze the performance of their portfolios on a real time basis using their PC.

Another recent development addresses the number of investors hedge funds can accept. Under reforms enacted by the SEC in early 1997, hedge funds now have the option of reorganizing under a provision known as 3(c)(7) that permits them up to 499 investors⁽¹⁸⁾ that meet the standard of "qualified purchasers." "Qualified purchasers" are defined as individuals or family businesses with over $5 million of investable assets and institutions with over $25 million. Prior to this change, U.S. hedge funds were limited to 99 investors with a significant portion required to be "accredited". This regulatory change increases the potential number of investors for an individual fund by five-fold.

There are a number of other, more specific structural needs that came to light during a KPMG survey of hedge fund managers and investors. These needs center around the marketing of hedge funds and servicing of hedge fund customers which is at the heart of the major structural challenge of expanding the customer base. Essentially, hedge funds need to make it easier for investors to find, evaluate, obtain, and liquidate their investments. To a lesser extent there are operational needs that must be addressed to insure future growth.

Marketing is the one aspect of hedge fund management that was cited most frequently as a distraction from investment activities. Many fund managers expressed frustration at the time and effort required to grow their fund’s assets and how those activities prevented them from focusing on their core business: generating investment returns for their current investors.

Key to the marketing dilemma is the problem of access to information. Whether seeking data on specific funds or general industry information, there are relatively few good sources easily accessible by investors. This shortage primarily affects private investors and smaller institutions. Large institutions have more access to data and regularly employ outside data gatherers such as consultants. The rating agencies and league tables fill some of this void and their data is slowly creeping into the mainstream (Bloomberg terminals now have access to both Van Hedge Fund Advisors and Hennessee Group data).

Successful marketing of the hedge fund concept is also hampered by the financial terms of the investments. Most hedge funds have high minimum initial investments, often as high as $1 million. Compounding the limiting factor of the high initial minimum investments are the long "lock-up" periods common to many funds. Fund managers seek to build some stability into their asset base by requiring that investments remain "locked up" in the fund for a period of time, usually a minimum of one year and up to five years or longer. Even after that initial period, redemptions and liquidations of investments are permitted only at proscribed intervals, sometimes as seldom as once per year, and with significant lead times. Currently, there is a trend within the industry to lower the minimums, reduce the lock-up periods and permit more frequent redemptions. This trend is particularly evident in the newer, start-up funds. In practice however, many managers already exhibit some flexibility with regard to initial minimums and redemptions.

To a lesser extent than with marketing, operational issues may limit the future growth of hedge funds. The small size of today’s hedge fund partnerships (99 or fewer investors) mitigates somewhat the impact of operational issues. While some managers indicated that operational issues distracted them from their investment management duties, many felt that the small investor pool kept these issues at manageable levels. However, the five-fold increase in investors allowed under 3(c)(7) could create an attendant rise in customer account reporting and investor relations inquiries.

Another issue has to do with the lack of transparency. There are significant numbers of institutional investors whose willingness to place assets with hedge funds is contingent upon being able to "see into" the portfolio on a regular basis. As the hedge fund industry grows, the industry will become increasingly transparent. The increase in transparency will increase competition as it will be easier for investors to compare investment performance. The impact of these changes will be an increase in overall performance pressure for hedge fund managers. Hedge fund fees have not yet come under pressure except in the institutional market. Based on the experience in other segments of investment management, it can be assumed that fee pressure will increase in hedge funds, although this may impact performance fees (allocation) more than the management fees. It is our view that these forthcoming demands will cause managers to focus their activities on their core expertise, managing money.

It is our view that the entire hedge fund industry will move from a relatively local and private business to a more mature, globally operating and institutionalized industry. A new structure in the hedge fund industry will evolve to accommodate these changes. One structure that holds significant promises to address the industry’s challenges and needs is the Family of Hedge Funds (FHF). Modeled after the family of mutual funds concept, the Family of Hedge Funds brings together a variety of different hedge funds under a single unified organization. The management of this family of funds would be structured such that each participating fund would operate autonomous with regard to the investment decision making process. These funds would be supported by centralized marketing and operations functions such as international marketing and sales, customer support and services, partnership administration, account reporting, legal compliance, etc.

Exhibit 18
FAMILY OF HEDGE FUND ORGANIZATIONAL STRUCTURE

IV.(d) Benefits of FHF to Investors

The Family of Hedge Funds structure offers investors high quality integrated services and easier diversification for their hedge fund investments. This structure also increases the standardization within the industry. Currently, individual funds have very different pricing structures, minimum investments, lock-ups, redemption terms and reporting quality and frequency. Standardization could simplify the buying and servicing processes. This will be of great service, especially for international investors.

Under the FHF structure, with a single phone call investors would be able to complete the qualification process and get access to a variety of hedge fund investments: from market neutral to emerging markets to convertible arbitrage to short-only. The FHF structure will permit investors to study and evaluate the range of hedge fund options in a manner that could previously have taken a significant amount of research and possibly required specialized consultants.

Furthermore, by having the ability to easily allocate their hedge fund investment across a variety of styles within the same organization, investors would not only diversify their portfolios by adding hedge funds, but will be able to diversify within their hedge fund investment, taking advantage of the low correlation among the various styles. In contrast to the diversification benefit offered by the fund of funds, however, this portfolio of hedge funds can be tailored to the individual investor’s investment goals. Also, the FHF would only subject investors to one layer of fees, rather than the two layers associated with fund of funds.

Depending on the exact structure of the FHF, investors may enjoy increased liquidity. Having multiple funds under one umbrella raises the possibility that investors would be able to examine and adjust their allocations among the component funds at more frequent intervals and much easier than with stand alone funds. If the FHF were structured with a proprietary "liquidity pool" it could allow investors shorter lock-ups or more frequent redemptions by "cashing out" the investor but maintaining the investment in a specific fund for a period of time to allow the fund manager more flexibility in running the portfolio.

Finally, having the operations and customer service functions handled by dedicated groups within the FHF structure would enable investors to get quick answers to operational, administrative or tax questions. By providing a unified customer account reporting function, investors could track their hedge fund investments on one simple statement that would provide an attractive and convenient communication to investors with multiple hedge fund investments.

The FHF could also provide a wealth of economic and industry intelligence culled from the best offerings of the component managers. Conceivably, this information could also be available to FHF investors on-line through a private, password protected internet site. Such a site would provide 24 hour account access with updated information and allow a high degree of interactivity between investors, fund managers, support staff and other investors.

The FHF structure also offers significant benefits to the individual fund managers. One function strongly desired by hedge fund managers and provided by the FHF structure is a unified marketing and sales operation. The single activity that the majority of managers surveyed felt distracted them most from their ability to concentrate on investing, but was nonetheless critical to the success of their business, was marketing and sales. The FHF structure would employ dedicated financial services marketing professionals to present the full range of FHF and hedge fund benefits to the widest possible audience of qualified investors. This allows the fund managers to focus on their greatest strength, managing the money. Most managers, and investors alike, felt it was critical for the manager to communicate the details of the investment strategy directly. A dedicated and skilled sales staff could better leverage the manager’s time by developing and qualifying sales leads before the manager gets involved. This will be especially critical as hedge fund managers increase the promotion of their products in foreign markets.

In addition to the time saving aspect of centralizing these various functions, there would be opportunities for cost savings realized by the FHF structure. Economies of scale can be realized in every area of support: from pure physical space requirements to technology infrastructure to administrative personnel. The ability to deliver the highest quality service at a cost saving will provide a significant competitive advantage to the FHF organization. Moreover, the FHF structure will permit managers to enjoy the benefits of centralized operations while still maintaining independent investment operations.

It is our view that the FHF structure can be quite unique in providing this vertical integration of "product" and "distribution". This not only reduces the cost of operations but more importantly increases customer satisfaction, both in terms of returns and service. These attributes will be critical in the future as we believe hedge fund investors will increasingly have a preference for multi-product firms with global capabilities.

In the coming years, hedge fund managers will need to find a way to promote their products in foreign markets. Instead of developing their own sales force, technology and products, it may be more advisable to be part of a much larger organization like a FHF which can provide the necessary infrastructure, financial resources and, more importantly, name recognition. For example, Japanese institutions prefer dealing with investment management organizations of substantial scope and size.

One additional service that the FHF structure may be able to provide to an individual hedge fund manager is minimizing unnecessary fluctuations of its asset base. As mentioned before, by utilizing its financial resources, the FHF may provide liquidation to investors at their convenience, while holding the investment in the fund for a period of time to ease disruption of the portfolio positions.

The hedge fund industry as it exists today essentially features two strategic segments. At one end, there is a small group of "superfunds" and on the other end a large number of niche players. The superfunds are an outgrowth of the original global macro players. These superfunds generally have over $5 billion of assets under management and feature well known, often quoted managers, like George Soros, Julian Robertson, and Leon Cooperman. The funds are a manifestation of the personality and investment philosophy of their managers. These high profile personalities not only attract media attention but also undue interest of regulators. The number of these macro players should remain relatively small. These funds feature extremely high minimum investments with only a limited number of institutions or the very wealthiest investors able to participate. In fact, many of these ultra-exclusive funds are now closed to the new investors.

The majority of other hedge funds are niche players, each with their own investment strategy, market identity, and support structure. Most of these funds are run by one or a small group of individuals who perform much of the marketing and operations as well as manage the investments. Most of them have assets much less than $100 million. These small niche funds are unable to attract large capital pools due to their lack of resources, marketing expertise or credibility with large investors, especially institutional investors. Smaller hedge funds may not be able to handle large allocations from pension funds. Hedge funds also have some restrictions on accepting money subject to ERISA. If more than 25% of a hedge funds assets are subject to ERISA, then the fund itself would be subject to ERISA. This could be a much more significant constraint on smaller funds.

The net results of these two extreme groups is that a void exists. The industry is looking for market leadership. It is our view that for the hedge fund industry to be a trillion dollar industry in the next ten years, it needs more leadership. Whenever there is any degree of inefficiency in the marketplace in terms of information dissemination or customer focus, there is an opportunity for a brand name to emerge. Just as Fidelity’s name has become synonymous with mutual funds, we see a clear opportunity for a market leader to emerge and lead the industry into the next century.