Hedge fund managers are setting their sights on Hong Kong, but are mainland Chinese investors ready to get involved?
It is the nature of high-risk investments that there will be good times and bad times, but the ups and downs experienced by hedge funds over the past two decades have truly been a rollercoaster ride.
After taking a beating in the wake of dot com crash, hedge funds quickly rebuilt themselves, amassing an estimated US$1.5 trillion in assets by the middle of 2008. The good times, however, were not to last long. The impact of the financial crisis was grave indeed, with some funds losing as much as US$8 billion of their investors’ assets.
In the wake of the crash, a very different animal has emerged. Fund managers no longer have the luxury of being able to turn investors away and they can no longer demand huge start-up capital or make high risk investments. With developed markets still struggling, they are looking for new frontiers and, like so many other businesses, entrepreneurs and job seekers, they are looking to Asia.
It is a fact that is being recognized increasingly in Hong Kong. Swiss bank UBS recently claimed to have been approached by over 50 new hedge funds in 2009, while offshore corporate service providers and law firms speak of a renewed interest from fund managers looking to set up in China’s Special Administrative Region (SAR).
‘We’ve seen quite a number of start-ups over the past four to six months,’ said Denise Wong, a partner at Hong Kong law firm Walkers.
This is little surprise given the consistency Hong Kong has afforded the fund industry during the last two years. Recent research by Singapore-based hedge fund consultancy Eurekahedge found that the number of funds in Hong Kong has remained steady since 2007 despite the financial crisis, rising from 237 in December 2007 to 242 in September 2009.
While this stability does not by any means indicate a massive boost in start-ups of the like suggested by UBS, it is impressive given the beating that the market took in other global financial centers. Hong Kong only lost 26 hedge funds in 2008 – four of which had only launched that year – compared to more than 200 in New York. This year only nine funds have shut up shop, and none of them were newly launched.
"The fact that the total number of funds has not dropped below end-2007 levels shows the strength of the industry in Hong Kong,” said Farhan Mumtaz, an analyst at Eurekahedge.
There is a growing optimism in Hong Kong that the rate of start-ups will increase as the region begins to put the financial crisis behind it, with proximity to emerging markets such as India and China, and access to the Asia Pacific region as far south as Australia.
"We are quite fortunate in Asia because growth rates will be higher in the next one or two decades, and we will all get a lift from that. Also, wealth is being accumulated both by individuals and institutions,” Christophe Lee, the Hong Kong chairman of the Alternative Investment Management Association (AIMA), a hedge fund industry body, told a Reuters hedge fund summit last month.
But while in the past fund managers would not have been interested in operating a fund with assets of less than US$100 million, they may be forced to lower their standards in the wake of the financial crisis. This fact is already evidenced in Hong Kong, where the assets under management (AUM) of all funds in the region has already suffered a massive decline, falling from US$34.7 billion in 2007 to just US$23.4 billion in 2009.
Rex Chan, the editor of online industry magazine //China Hedge//, said that he is aware of a number of small funds who are setting up in Asia, many of which have far lower AUMs than in the past. "These small hedge funds usually have no more than US$50 million, and are led by Hong Kong or Taiwan people,” Chan said.
But size is not the only difference between post-financial crisis hedge funds and their predecessors. The balance of power has also shifted. Fund managers can no longer demand high fees and restrict liquidity with lock-in periods and redemption provisions, under which investors are charged to withdraw their money outside of a set timeframe.
"We are seeing changes in terms of the redemption provisions, we are seeing provisions that give more protection to investors,” Wong, at Walkers, said. "These things used to be very much set in stone, but they’re not anymore. It’s a very different landscape.”
A recent survey of financial advisers and institutional investors by research firm Morningstar revealed that the biggest concern amongst investors was a lack of liquidity in hedge funds – 61% of financial advisers cited it as a top reason to hesitate in making an investment, up from 52% in 2008.
Don Seymour, managing director of dms Management, a corporate service provider in the Cayman Islands, notes that in order to allay such fears, some new funds have been forced to remove redemption gates altogether. "We now see greater focus on liquidity in fund structuring such as removing gating language, redemption penalties, decreasing notice periods and lock-up periods, and generally creating more investor friendly terms,” he said.
Fund manager’s fees have also suffered. A manager usually earns a "2 and 20” fee – a flat rate 2% of the fund’s annual value plus 20% of the profits. In the glory days, the top managers were receiving performance fees of up to 45%. Even in cases where these fees have not been reduced, investors are demanding more for their money.
"Investors have focused more effort on extracting more value from the current fee structures by demanding more infrastructure, independence and transparency within the control structure,” Seymour said.
While changes to liquidity and fee structures alone are unlikely to be enough to draw investors back into some of the world’s hardest hit hedge fund markets, many fund managers are hoping that in Asia they can tap up wealthy individuals and institutional investors.
Michael Gagie, a Hong Kong-based partner at law firm Harneys, is aware of a number of fund managers formerly working for the major finance houses who have subsequently moved to Asia with the intention of starting their own funds. As many of these individuals are returning Chinese, or of Chinese origin, they are seeking to leverage their local contacts and shared cultural and linguistic backgrounds to attract wealthy Chinese not just in Hong Kong, but from mainland China.
"A lot of these people are ethnic Chinese and they have family connections in China. Some of them have got two or three people and they’ve got US$20 million to invest,” Gagie said.
Wong of Walkers claims to have dealt with a number of mainland Chinese clients over the past four to six months who want to start up hedge funds in Hong Kong.
The advantage these new fund managers have, according to Carol Hall, also a partner at Walkers, is that mainland investors are far more likely to structure their investments through people they know and trust, rather than faceless hedge funds whose managers they may never have met.
Hall adds that new funds will be less risk orientated than in the past, drawing in the more cautious investor. "These will typically be long only funds, and they are pulling together friends and family or a small number of investors to invest in overseas assets,” Wall said.
Some, like dms’s Seymour, believe that fund managers will be successful in attracting new money from China. He believes that flexible structures will go a long way to woo first-timers in the mainland who may be reticent about getting involved in hedge funds.
"I think the Chinese propensity for saving is well known, but what is not well known is the Chinese propensity for risk. It seems inevitable that the Chinese hedge fund industry will grow as wealth expands since hedge funds remain the most proficient way to invest,” he said.
It is also argued that, as Chinese offshore investors become more sophisticated, they will become more receptive to hedge funds as part of a wider acceptance of alternative investments. "In the current market landscape a certain portion of the assets of a wealthy individual or family should be in alternative investments,” said Joseph Chan, Partner at Pillsbury law firm in Shanghai. "Hedge funds are a widely accepted form of alternative investment.”
Others feel that while Hong Kong may indeed continue to shine as an offshore hedge fund hub as New York and London continue to languish, Chinese investors will not be getting involved in them. Alex Mearns, CEO of Eurekahedge, points out that 90% of investment in hedge funds, wherever they are domiciled, comes from the US, UK and European nations such as Switzerland.
"They are too new for China. Emerging economies are still in the wealth generation phase, and if you’re new money you are more likely to be looking at private banking,” Mearns said.
Harney’s Gagie agrees. While start-ups may have increased in Hong Kong, and Chinese investors are keen as ever to increase their wealth offshore, there is a certain degree of ignorance on both sides – both the new fund managers targeting China and their Chinese targets.
"It’s still a very young market for funds, and the majority of people don’t understand what that all means. They get distracted by the dollar signs,” he said. "There are tons of people who talk a great game about China jumping on the mainland bandwagon, but in terms of their level of sophistication, as to the understanding of a fund and investing in a fund, it is very basic.”
This article first appeared in the CER Offshore Quarterly
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