We spoke recently with Mark Casella, U.S. Alternative Investments leader at PricewaterhouseCoopers. Casella, also the chair of the accounting advisory committee of the Managed Funds Association and a member of the Board of Advisors of the Georgetown University McDonough School of Business, seemed the ideal partner especially in light of the recent publication of PwC’s white paper on the hedge fund industry, (which we summarized in late June), for a wide-ranging discussion of that industry’s structures and opportunities.
The discussion breaks down naturally into two parts: market structures first, then the question of the alignment and re-alignment of the interests of managers and investors. We’ll begin at the beginning.
Q: Let me start by asking you about funds of hedge funds. The knock on FoHFs has always been that they create an extra level of fees, and that eventually investors will be savvy enough to ignore the middleman and deal directly with the underlyings. Has that day come?
A: Funds of funds will still have an important role to play and will continue to exist and, like the overall industry, to evolve. That said, their role has already changed over the last few years and we could expect more change going forward. They continue to be very useful to certain investors that don’t have the same level of access or resources as larger institutions, pensions, endowments. Investors who do have access to the underlyings and the sophistication needed to make allocations among them, will do so. We have seen more and more institutions invest directly in hedge funds rather than through fund of funds. But other investors don’t.
Fund-of funds are evolving just like the overall industry. Fund of funds are in an interesting position within the industry: they are both investors in underlying funds, and managers with their own products and investors. Perhaps more than managers of direct funds, fund of fund managers are moving from providing a product (that is, a commingled fund) to a service, which may include helping an institutional investor through a managed account or who has otherwise gone direct with their manager selection, evaluation and monitoring process. There is a lot of talent and experience at the best fund of funds and we expect that they will evolve as the overall industry does.
Q: Another market-structure question: Would you guess that five or even 10 years down the road there are going to be significantly fewer players in the hedge fund management space than at present, due to consolidation on the one hand and barriers to entry on the other?
A: There has been some shrinkage since 2008. We’re seeing start-ups recover though. The size of funds will change. The big will get bigger, and start-ups will have to be scaled up, but it doesn’t seem to me that there is any significant further shrinkage ahead of us.
Ultimately, it’s all about delivering alpha and those managers that can do that, on behalf of their investors, will survive and thrive. Emerging managers and large managers both have challenges to deliver strong risk adjusted performance while also delivering quality and confidence to their investors, and the regulators, through a world-class infrastructure. Emerging managers and large established managers may each have different challenges to strike that balance but both can, and will, do so going forward.
Q: The report, “From black box to open book,” is a 46 page answer to the question, how can hedge funds earn back or enhance investor confidence. Can you give me the elevator-pitch form of the argument?
A: As our report says, right in the subtitle, managers have to earn confidence through “trust and transparency.” They have to recognize that the investors, especially the institutions, to which they make their pitch, have their own stakeholders and their own environment. They have to work to align their own interests with their investors’ interests. It all starts with first understanding their needs.