Hedge funds are searching for ways to boost fund value, increase ROI, and ensure the sustainability of their businesses. In our view, few have the level of institutionalization in place to succeed.
In the aftermath of the financial crisis, hedge funds face growing pressure from regulators, investors, the media, and the public to increase transparency and enhance risk management.
Hedge funds face a myriad of regulatory initiatives designed to increase transparency and improve reporting. These include, among others, Dodd-Frank (including Form PF regulation), the Foreign Account Tax Compliance Act (FATCA), IRS form 5500 schedule C, and GASB Statement No. 53. Institutional investors, which accounted for 60% of hedge funds’ total capital in 2011, have substantial influence in determining how funds are managed today. These investors are becoming more rigorous in evaluating fund managers’ execution of investment strategies.
They are demanding higher quality reporting and infrastructure, and avoiding funds that fail to clearly demonstrate adherence to, and support for, regulatory risk management standards.
PwC’s Gary Meltzer, Mike Greenstein, Bhushan Sethi, and Melanie Prusinski talk about how hedge funds need institutionalization to create transparency for investors, build confidence with regulators, increase return on investment, and help ensure sustainability in their business.
A: Institutionalization is simply the process of making core functions scalable. Within hedge funds, functions include marketing and investor relations, human resources, risk and regulatory, systems and technology, and tax and finance. The ability to scale functions allows organizations to create sustainable processes and procedures to support growth.
A: Since the financial crisis, hedge funds have been under pressure from regulators and investors alike to strengthen controls, focus on risk management, and increase transparency. The crisis also led to an increased awareness that functions like human resources, compliance, and tax need to adapt to support the growth of the overall fund. That has meant taking many processes that were once manual and automating them. It also means building capacity and job functions to better support growth.
For example, many institutions now realize that, as they grow, succession planning has become a larger issue for investors. That had led human resources departments to institutionalize the process of talent management, creating teams and processes to promote a hedge fund’s culture at different levels of management.
In short, expectations have changed. Investors want more transparency. Regulators are more aggressive. Consultants have more questions about the middle and back offices of funds where they place assets. Institutionalization is vital to hedge funds being able to attract capital amid these new expectations.
A: Funds can be nimble and entrepreneurial on the front end of their business, and still profit from the benefits of institutionalization. Not only are they compatible, they are complementary.
A: Many funds are taking a reactive approach—responding only when issues are raised by regulators. As a result, this may lead an institution to focus on their regulatory function. In our view, an effective approach requires taking a step back and evaluating which functions need to be strengthened through institutionalization.
A: Not all functions will require institutionalization, but a full review will help make that determination. It often takes building a business case to decide how to prioritize areas and functions that need institutionalization. That means asking whether institutionalization of a specific process or function would drive returns, whether it benefits investors, and how it would benefit transparency with regard to regulators. In some cases, funds may find they don’t need to change existing technology or change talent.
A: Institutionalization depends on having the right people with the right talents and retaining them. Funds are not going to grow assets under management without being able to recruit the best talent. And it’s important to keep in mind that it’s not just about compensation and bonuses, but also about other benefits and job opportunities.
A: More hedge funds have added positions like Chief Risk Officer, Chief Compliance Officer, and Chief Technology Officer. Because of institutionalization, many of these functions now exist, whereas in the past you might have had a Chief Financial Officer overseeing risk. Now, not only are these separate functions at funds, but these leaders tend to have a seat at the table for key decisions. Not only are there individuals in these roles, but teams have evolved. Many funds now have a separate Tax Director with his/her own team, whereas in the past Tax may have been the function of another individual’s work portfolio.
A: There is a new focus on making sure that institutions have a handle on the vast amounts of data available. Management of that data is key from a regulatory perspective, as well as making sure the structure supports the sharing of that data among different functions, from portfolio management to finance to legal.
A: Compliance is the area where regulators tend to look first to assess whether that department has the right profile and proper authority within an institution. Traditionally, hedge funds have viewed controls as being just about books and records, but that thinking has evolved to include areas like risk management and compliance. There is also more of a focus on the interplay of controls across different functions within an institution. Now the emphasis is on whether internal controls are scalable, repeatable, and documented; this makes it easier for investors, regulators, and auditors to assess them.
A: In the past, the human resources function often rested with just one person. Now, as these departments build scale, there are new positions being created based on responsibilities. The departments take more of a team approach, where one person might work on talent management while another handles compensation.
A: Hedge funds that focus on institutionalization tend to have more consistency in messaging. Messaging refers to the information that funds tell investors in meetings, the information they deliver in documents, and how they approach their financial and regulatory reporting. With strong institutional processes, there is a high degree of certainty that all communications have been reviewed by the right parties and are consistent from an investor-relations and a compliance perspective.
A: Trust is vital. Investors now demand transparency, and evaluate funds not only on their returns, but also on how they manage internal functions. They want to know how people are compensated and look for diversity within teams. For fund leadership, it means balancing a focus on the core business with institutionalizing the fund. Institutionalization enables funds to deliver performance for investors and provide confidence to regulators, all in a cost-effective way.
PwC refers to the US member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.
This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.