Transformation future alternative_investments

INVESTMENT MANAGEMENT

Transformation The Future of Alternative Investments

FINANCIAL SERVICES

© 2010 KPMG International Cooperative (“KPMG International”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. All rights reserved.

Acknowledgements

This report, produced by KPMG International in cooperation with International Fund Investment, examines in detail the transformational change of the alternative investment industry as it enters a period of significant growth, set against scrutiny from regulators and institutional investors. It investigates how, in light of significant market volatility and regulatory uncertainty, alternative investment managers, institutional investors and administrators are adapting their business models to maximize chances of success.

Our foremost thanks go to 200 organizations from 26 countries who participated in this research.

We would also like to offer our special thanks to those 85 CEOs, CIOs and Board level Directors who participated in our structured interviews. Their insights and foresights have helped produce a comprehensive vision of the future of alternative investments.

We would also like to thank the members of the project team, editorial board, and other colleagues around the world who have helped us in carrying out this research, in particular: Marie Parker from KPMG in the Cayman Islands, Mireille Voysest and Una Clarke from KPMG in the UK, Cara Scarpino from KPMG in the US, and Simon Osborn and Rebecca Gooch from International Fund Investment.

Anthony Cowell Partner KPMG’s Investment Management Practice

Andrew Stepaniuk Partner KPMG’s Investment Management Practice

Project Team Chaired by Anthony Cowell, KPMG in the Cayman Islands Giles Drury, KPMG in the UK Mikael Johnson, KPMG in the US Jon Mills, KPMG in the UK Andrew Stepaniuk, KPMG in the Cayman Islands Simon Whicker, KPMG in the Cayman Islands

KPMG Editorial Board* Chaired by Wanda Mellaneo Kris Beighton Keith Blake Tully Cornick

Grant Green Mark Harris Tanis McDonald** Gordon Rajamohan

*KPMG in the Cayman Islands**KPMG in the BVI

Additional Contributions Leah Dering-Ridley, KPMG in the UK Tim Fundell, KPMG in the UK Nicholas Griffin, KPMG in the UK David Yim, KPMG in the UK


ContentsAbout this research 1

Headline messages 2 Executive summary 4

Alternative Investment managers 16

Administrators 26

Institutional investors 36


About thisresearch

The Future of Alternative Investments

Transformation: The Future of Alternative Investments explores the ways in which the alternative investment industry is adapting and evolving.

Up until late 2007, the industry had largely enjoyed uninterrupted growth. From 2007 to 2009 a series of dramatic market events coupled with poor performance, exacerbated in a number of cases by operational shortcomings, resulted in an overall loss of confidence in the sector. Since early 2009, the industry’s fortunes have improved considerably. The credit crisis is receding into the background. Managers are refining business models and focus; institutional investors are reviewing allocations and operational requirements; administrators are eyeing technology and the labor pool; and the industry as a whole is preparing for the anticipated impact of increased regulation. What is clear is that the structure of the industry ahead will be vastly different than it is today.

Written in cooperation with International Fund Investment, this report is based on surveys and structured interviews conducted globally between February and June 2010. The study has benefited from the participation of 200 respondents across 26 countries, and includes: alternative investment managers with US$515 billion under management; administrators with US$4.2 trillion under administration; and, institutional investors with US$884 billion under management. In addition to the above groups, interviews were also conducted with lawyers and independent directors.

References within the report to alternative investment managers are based on a sample of respondents that invest in either (or a combination of) hedge funds, private equity, real estate, infrastructure and structured products, although the main focus has been on the hedge fund sector.

Location of participants: Australia Austria Bahamas Belgium Bermuda Brazil British Virgin Islands Canada Cayman Islands China Curacao Denmark France Guernsey Ireland Jersey Korea Luxembourg Malta Netherlands South Africa Sweden Switzerland United Kingdom United Arab Emirates United States

The information reflected in the graphs and charts was obtained by KPMG International Cooperative and International Fund Investment during both the structured interview stage and questionnaire stage. The anonymous interview quotes throughout this document were obtained during the interview stage of the research project. Please note that with the graphs illustrated, not all answers add up to 100 percent because of rounding or because respondents were able to provide multiple answers to some questions.

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© al”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. 2010 KPMG International Cooperative (“KPMG Internation The Future of Alternative Investments

KPMG International provides no client services. All rights reserved.

HeadlinemessagesThe following headlines represent the views expressed from each of the three main groups of participants involved in our research: alternative investment managers, administrators and institutional investors. Their insights are developed as 10 key themes in the rest of this executive summary, and further in sections 2, 3 and 4. Together, they provide a detailed analysis of the future of the alternative investment industry as it faces unprecedented change.

• The majority of institutional investors intend to increase their allocations to alternative investments in the next 3 years. As a result, they will have a far greater influence over the shape of the industry in the future.

• Anticipated regulation, driven by external forces that continue to blame alternative investments for the meltdown of the global financial system, is not wanted by the majority of investors, managers or service providers. The widely held view is that the industry did not cause or contribute to the credit crisis. Furthermore, investors believe more regulation will not produce any tangible benefits.

• Managers and administrators believe that regulation and governance are the most important challenges facing the alternative investment industry over the next 3 years.

• There will be four different manager business models that will come to dominate the industry in future. In addition to ‘niche’ boutique managers and the ‘super-boutiques’ (independent managers moving on to become multi-billion dollar players) there will be further and significant development of managed account platforms as well as the emergence of what might be termed the ‘entrepreneurial-institutional’ manager.

• Investors forecast that managed account structures will experience substantial growth. Whilst their benefits include improved transparency, liquidity, control and customized fee arrangements, managers believe that cost and operational complexity are some of their key shortcomings.

• Investors want a better alignment of interests with managers. The main changes will likely feature longer term performance fee arrangements, increased capital investment from managers, and a move towards enhanced liquidity and transparency.

�

© 2010 KPMG International Cooperative (“KPMG International”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. The Future of Alternative Investments


• The overwhelming majority of existing alternative investors are happy to continue to allocate to funds that are located in offshore jurisdictions.

• There will be a further move towards independent administration, particularly in the US where many alternative investment managers administered their funds in-house. This will exacerbate the capacity mismatch that is developing in the industry. Administrators report that they are operating at near to full capacity whilst less than half of managers interviewed stated that they are in a similar position.

• The ‘bifurcation’ of the alternative investment industry is continuing. Newer institutional investors into alternatives are more likely to be attracted to managers promoting funds with greater liquidity and transparency than experienced, longer term institutional allocators.

• Levels of investor satisfaction with alternative allocations are correlated to the length of time that they have been active in allocating to alternatives because of their detailed understanding of the industry. Investors with the most experience of this activity tend to be the most satisfied with their allocations.

• There is little to no consensus amongst investors on the route to take to allocate to hedge funds. The popularity of fund of funds is in decline but there is no obvious replacement for most investors. As a result the well known billion dollar fund of funds will prosper but there is also likely to be significant consolidation amongst the smaller players.

• Manager fee structures are expected to be less uniform in the future, as institutional investors negotiate more local agreements.

• Barriers to entry from regulation and institutionalization will impact the rate of new start-ups. Moreover, managers with assets of less than US$100m will find it increasingly challenging to run a long term business as a result of increased costs from regulation.

• Fund servicing related issues are growing in importance. Investors now take fund servicing very seriously and a number of managers report that events over the last 18 months have had a dramatic effect upon the type of firms that they would want to hire as service providers.

• The fallout from the credit crisis and events such as Madoff have led to substantially increased levels of due diligence across investment management, particularly from institutional investors.

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© al”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. 2010 KPMG International Cooperative (“KPMG Internation The Future of Alternative Investments


Executive Summary“Twas the best of times, ‘twas the worst of times. ‘Twas the age of wisdom, ‘twas the age of foolishness” Charles Dickens

The era of transformationOne of the constants in the alternative investment industry is the presence of change. From its origins to expansion in the 1990s and through the explosive growth of the 2000s, the one thing that the industry could count on was continued change. However, in reality, the basic structures of the alternative investment business were not very different in 2007 than they were in 1997. The industry was a great deal larger but practices and structures remained largely unaltered. Investors considering alternatives, including the world’s largest institutions, had to do so on the manager’s terms, not their own.

Those days are now over. The industry is going through a period of transformational adjustment to a very different and more regulated operating environment. The majority of institutional investors included in the survey intend to increase their allocations to alternative investments in the next 3 years, with some intending to allocate over 10% of their total assets. As a result, these investors will have a far greater influence over the shape and culture of the industry in the future - they will demand institutional grade controls, increased transparency and flexible product strategies in order to invest their capital. In addition to the credit crisis, events such as Madoff, whilst not a hedge fund, highlighted the need for a robust due diligence process. The influx of more institutional capital into alternatives will result in further substantial growth of the well known, billion-dollar managers.

The desire for more transparency and liquidity is the main driver behind the recent growth in new product structures in hedge funds, including managed accounts and managed account platforms as well as onshore regulated products. Managers are being forced to make adjustments to the new environment, whether they like it or not (and some emphatically do not). For many of them, the frustration of having to review internal procedures and systems, consider different domiciliation options, gear up for more regulation and so forth has a pay off. They believe that this painful and expensive process will enable them to attract many more and different types of investors to their funds.

“For a brief moment, the industry had a heart attack. It’s now being resuscitated”

“Headline risk scares us out of our minds”

“Transparency, liquidity and understanding risk are paramount; everything else is a bonus”

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What do you believe are the major challenges facing the alternative investment industry over the next 3 years?

75%67%

44%

78%

33%

33%

44%

97%

56%

56%

13%

34%

31%

6%

13%

28%

63%

55%

55%

43%

35%

25%

20%

13%

% of respondents

0 20 40 60 80 100

Administrators

Insitutional Investors

Managers

Shortage of talent

Systemic risk

Taxation

Operational risks

Downward fee pressure

Liquidity risk

Transparency

Investment performance

Regulation and governance

The paradox of regulation The results of this survey show that the anticipated increase in regulation is not wanted by the majority of investors, managers or service providers. Despite regulation being widely promoted as a way to protect the investor, it is these investors who are most strongly against it. Few investors believe it will produce any tangible benefits. Some see it as being protectionist to certain jurisdictions and therefore detrimental to the development of the global alternative investment industry whilst others fear that it will inhibit the competitive positioning of investment managers by adding to costs. As a result, many investors in Europe believe it will reduce the number of new start-ups, thereby stalling the industry’s engine of creativity – the production line of boutiques that provide vitality and talent in the future.

“We always want to see alignment of interests. If the manager isn’t prepared to lose his shirt then we’re not in the business of investing”

“Growth will be phenomenal, unless regulation stifles it”

“The halcyon days are back – we want star performance and star treatment!”

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© , a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. 2010 KPMG International Cooperative (“KPMG International”)MG International provides no client services. All rights reser


KP ved.

What do you think will be the impact of forthcoming regulations in the below regions on worldwide growth of alternative investments?

% of respondents

0 20 40 60 80 100

Positive Impact Neutral Negative Impact

I. Investors

Administrators

Managers

I. Investors

Administrators

Managers

I. Investors

Administrators

Managers 13% 51% 36%

44% 38% 18%

64% 18% 18%

10% 61% 29%

32% 35% 33%

72% 6% 22%

11% 11%78%

67% 22%

33%56%

11%

11%

Asia

North America

Europe

Nevertheless, the universal view is that further regulation is on the way. Investors, managers and service providers take a fatalistic approach to this subject. It is viewed as an inevitable consequence of the recent well publicized scandals affecting the industry, combined with the dramatic market volatility in recent months. Furthermore, numerous respondents made the point that alternative investments were in no way responsible for the market crisis. Indeed they were often victims themselves. Nonetheless, managers recognise that they cannot escape from the increase in financial regulatory supervision occurring around the world.

Regulation is coming to the alternative asset management industry on both sides of the Atlantic. The impact of various US regulatory and legislature initiatives, including the so called ‘Volcker’ rule, which proposes a ban on proprietary trading by banks, will likely be considerable for the alternative investment industry, as talent migrates towards boutiques. In Europe, the Alternative Investment Fund Managers Directive (the “AIFM Directive”) is closer to finalization. The European Parliament’s Committee for Monetary and Economic Affairs recently voted for the draft directive and the EU council’s group of finance ministers followed suit on its version of the text.

“Fear and greed motivate managers - both in equal proportions”

“Independent directors are the panacea for the industry. Too much self interest is a bad thing”

“All the talk of extra regulation is creating insecurity amongst investors”

“Making money is obvious; telling everyone how you’re going to do it is the challenge”

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A new breed of manager and what it means for the industryAs the alternative investment industry expands and matures so it continues to add variety to its manager models. The business started as a fragmented collection of niche boutiques. As the industry developed, a number of these managers then became ‘super-boutiques’ - investing institutions in their own right. For many years, the industry was characterized as being divided between these multi-billion dollar ‘super-boutiques’ and numerous smaller ‘niche’ boutiques.

• Partners/shareholders• Asset gathering• Standardization• Processes and rules• Diversification• Strong governance/

control• Regulation e.g.

EU AIFM Directive• Transparency• Liquidity• Brand name

service providers

• Owner/Manager led• Performance and innovation• Creativity• Flexibility• Lifestyle • Infrastructural

constraints• Low staff numbers and/or

staff retention• Regulation

e.g. ‘Volcker’ rule• Small service providers

“This is going to be a really critical year for a lot of managers... 2010 is the right time for them to prove their worth”

Forces pushing and pulling the Alternative Investment industry between boutique and institutional

Timeline

1990

BoutiqueSuper Boutique

2010

Entrepreneurial- institutional

Pure institutional

The Alternative Investment

Industry

Two other types of structures have come into the business to challenge the boutique model. In addition to the next generation of niche boutique managers and the ‘super-boutiques’, there will be further and significant development of managed account platforms as well as the emergence of what might be termed the ‘entrepreneurial-institutional’ manager.

‘Entrepreneurial-institutional’ managers started out as smaller alternative investment managers but have since diversified their businesses into mainstream fund management, as well as other complementary investment activities such as financing, private placements, proprietary trading, restructuring, and structured products. This development will have consequences for the entire financial world, not just alternative asset management. ‘Entrepreneurial-institutional’ managers will be able to outflank competitors by offering allocators a range of investment opportunities covering other alternative, and perhaps even mainstream, asset classes. Their controls and processes are likely to be institutional grade, yet they retain their creativity and focus on alpha, rather than asset gathering.

“Administrators had to step up their game, and they have done”

“Blow ups happen because no-one understands the strategy”

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The rise of the ‘entrepreneurial institutional’ manager does not, however, signal an end to the boutique – far from it. As the industry institutionalizes, through increased bureaucracy, formalization and rigidity, the allure of reward, creativity and freedom will continue to attract talent to the niche end of the industry. Hence, the number of boutiques will thrive. Furthermore, their numbers may be impacted considerably by the proposed ‘Volcker’ rule in the US, as proprietary traders are forced out of the mainstream to set up their own firms. Nonetheless, if they are successful in their diversification strategy, whilst maintaining healthy performance in their core funds, the coming breed of ‘entrepreneurial-institutional’ managers will likely attract a large proportion of institutional capital – the boutiques may be able to compete on numbers, but not on asset size.


The Matrix: Growth and Transformation

•

•

••

•

•

•

••

•

Glo

bal R

each

Glo

bal

US$5 billion +• Global investment management capability

(US, Asia, EU)

••••

•

Super Boutique

US$5-20 billion + US$20 billion +• Strong risk-governance arrangements

(comprising 3 lines of defence, multiple governance committees with integrated risk/control framework and non-exec directors)Formalized risk/control arrangements (high degree of discipline and formalized control evidence); and strong compliance cultureHigh focus on assurance agenda – SAS70/AAF/GIPS/HFSBHigh degree of transparencyRegulator “relationship-managed”

Inte

rnat

iona

l

US$1 billion +• International sales reps (US, Asia, EU…)

US$3 billion +• More formalized risk-governance arrangements

(Board/Executive Committees)Moderate adoption of investor assurance agenda e.g. SAS70 or GIPSGreater degree of process/control discipline Moderate interaction with regulatory bodies

US$10 billion +

Entrepreneurial Institutional

Manager

Sing

le O

ffice

US$100 million +• Entrepreneurial, craft orientated

One main fundLow degree of transparencyInformal risk-governance/control arrangementsHigh degree of reliance on legal vs compliance cultureLow relationship with regulator (deemed “low risk”)

Boutique

US$1 billion +• Multiple funds / managed accounts

Multiple strategies

US$5 billion +• Multiple product ranges (Hedge funds, absolute

return strategies, long only)Multiple distribution channels – fund of funds, managed accounts, retail, directPerformance focused, no mediocrity

Single Product Multiple structure / product Multi Channel

Product Breadth

“Three years ago, investors were looking for a hot manager; now the focus is on more established managers with proven track records”

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The Future of Alternative Investments The Future of Alternative Investments

Managed accounts: great in theory, more difficult in practiceSeparately managed accounts have always been a mainstay of the investment management industry. Managed account platforms, however, are a relatively new phenomenon.

Using managed account structures as a method of investing in alternative investments, has become considerably more attractive than fund of funds with institutional allocators. Investors surveyed forecast that managed account structures will experience substantial growth. (After direct investment into single manager funds, managed accounts are predicted to see the largest increase in asset allocations over the next 3 years.)

The control that managed accounts offer investors was mentioned by all those that use, or intend to use, these structures. After control, liquidity (in particular avoiding gates, lock-ups etc) and transparency were the next most popular reasons for turning to managed accounts. As a result, managed accounts are being used almost systematically by large institutions when they wish to make a large allocation to a manager.

However, managed accounts have drawbacks. Their biggest drawback is that they do not provide access to all managers or strategies. They are also difficult to implement for illiquid strategies, like distressed funds, due to increased reporting and administration demands. In addition, investors are conscious of the added costs, resources and responsibilities that are imposed upon them. Only large institutions have the means to employ the staff to implement and monitor a successful managed accounts program. Other concerns included performance diminution and the fact that they place more operational risk on the investor (and less on the manager). In addition to complexities with implementation, capacity constraints are already emerging in the managed account sector and investors are likely to have some difficulty finding the managers they want via these structures. Managers interviewed complain that managed accounts are taking up too much of their time and resources. They are concerned that their own fund investors must come first. Some managers have declined to take on managed accounts and others are imposing limits.

Imposing limits on managed accounts could become a badge of honour with successful, well known managers in the future. Pre market crisis, finding capacity with such well regarded managers, those that were often technically closed, was a concern for large investors. Post crisis, a variation of this problem could reappear within the managed account universe. Hence, direct investment into alternative investments is forecast by investors to increase more quickly than investment via managed accounts over the next three years.

“There is no shortage of talent. Money supply is the biggest challenge”

“Stars are the life source of the industry; they know what they want and they know how to get it”

“We want respected names, known to investors, on the prospectus”

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© 2 wiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. 010 KPMG International Cooperative (“KPMG International”), a SG International provides no client services. All rights reserved.


KPM

Twin track alternative fund domiciliationThe alternative investment industry has always been drawn to offshore jurisdictions. They have grown up together. These domiciles are ideal locations both for their original core investors – the high net worth crowd – and managers. Locations offering regulation where it is quick, flexible and inexpensive to launch funds are what alternative managers want. However, a combination of increased investor nervousness, and the evolving regulatory environment have led managers to question whether they should continue to domicile their funds offshore or re-domicile onshore. Some managers have taken the step of re-domiciling onshore. Others have launched funds in onshore locations, such as Dublin, whilst keeping their offshore funds in operation.

Results indicate that the overwhelming majority of investors are happy to continue to allocate to alternative funds that are located in offshore jurisdictions. There is no evidence that the domiciliation structure of the alternative investment industry is of concern to those that currently allocate to these products. These respondents represent the bedrock of the industry’s investor base. Investors in this category often view with disdain more regulated alternative fund domiciliation, which has become something of a craze in Europe.

In addition, investors with longer tenures of investing in alternative investments tend to be the least concerned with operational issues and fund domiciliation, whilst being the most sceptical that more regulation is in any way beneficial. Managers would therefore be wise to maintain their offshore fund range for their bedrock investors. For the next wave of investors, a different strategy looks likely to be beneficial to secure such investors’ capital (at least for European allocators). They are more likely to want onshore funds in addition to their offshore structures.

Alternative investment domiciliation is diverging. The traditional homes of the hedge fund and private equity industries are not under significant threat. They will continue to be the logical place to go for funds aimed at the traditional alternative investor. However, EU domiciles are developing complementary structures to compete for this business and appeal to the new generation of investors. How these funds fare remains to be seen.

“The credit crunch was a symptom, not a disease”

“Politics and regulation are killing our business. We can work on our performance, but its difficult to work on politics!”

The growing role of the administratorThird party, independent fund administrators find themselves in a pivotal position as the alternative investment industry is transformed in this new era of increased regulation, investor scrutiny and institutionalization.

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What do you think are the key challenges facing the administration industry overthe next 3 years?

97%66%

66%

59%

50%

19%

16%

43%

63%

65%

28%

33%

40%

0 10 20 30 40 50 60 70

Managers

Administrators

Shortage of skilled staff

Developing asustainable client base

Maintaining margins asassets under management fall

Independent valuationof complex securities

Regulatory compliance

Continuous IT developmentand investment

% of respondents

Administrators are at the center of structural changes occurring throughout the industry. Increased standardization of administration will be the main change, particularly with regards to reporting transparency and liquidity requirements for investors. The anticipated increase in regulation is also forecast to have consequences for all industry practices, including administration. One respondent referred to the speed at which internal control reports (e.g. SAS70) have become standard in the industry as an example of how quickly practices can change.

Administrators included in our survey also believe there will be significant developments in the use of technology, in order to keep pace with increased demands placed upon their businesses by the alternative investment industry. There will be a requirement to accommodate an exponential increase in data demanded from fund managers, investors and regulators. As a result, administrators will need robust and flexible technology platforms that are capable of high volume transaction processing and customized ‘real-time’ reporting. Furthermore, for several years, administrators have been diversifying into services that are complementary to their core activities, such as performance attribution analysis and risk reporting services. The new environment is likely to see an acceleration of complementary services offered, including functions that support managers’ front and middle office activities. In Europe, administrators have been particularly successful in diversifying their product range to capture reporting requirements for UCITS funds. Globally, it is significant that when asked the question, ‘Which services do you provide currently and which do you expect to grow significantly in the next 3 years?’ Administrators said that they expect there will be a big jump in front and middle office services and risk management.

“Institutional investors are like royalty - they attract a lot of interest in your fund but they come at a price”

“Investors did not like being told they couldn’t have their money back”

“Managers need administrators more than ever”

“Administrators have distanced themselves from their responsibilities; the crisis has driven them to seek legal protection”

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© 20 Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. 10 KPMG International Cooperative (“KPMG International”), aG International provides no client services. All rights reserve


KPM d.

However, with demand comes challenge. Despite a significant investment in technology, the administration industry remains very labor intensive and lacks operational leverage. There is an increasing capacity mismatch, with nearly 3 in 4 administrators operating at between 71-100% capacity. M&A activity is therefore inevitable. A number of administrators have already expanded into other areas and we are beginning to see convergence (hedge fund administrators buying into private equity for example). New firms and new product offerings are also likely to emerge to service the operational demands of clients. If alternative inflows develop as forecast, or anywhere near to it, administrators will face serious infrastructural challenges. This is an issue that few have yet to address.

“No matter what any manager will tell you, if the world falls apart again and everyone runs for the doors, you’re not going to get your money back!”

The bifurcation businessBifurcation of the alternative investment industry is occurring in a number of ways. It can be seen in the growing gulf between the boutiques, those managers that have stayed focused upon implementing their particular specialist investment strategy, and a number of the multi-billion dollar managers that diversified into other areas of the market and/or whose business models have moved beyond fund management.

“Leverage is an unpopular word these days; its making it hard to raise capital”

��



There is now evidence that bifurcation is also occurring between institutional investors. The offshore fund industry will continue to serve the majority of those currently investing in alternatives, largely sophisticated and experienced investors who remain satisfied with its structure. However, new investors into alternatives are more likely than seasoned allocators to be attracted to managers promoting funds with greater liquidity and transparency than is typical in traditional alternative structures. This has been an important part of the reason for the growth in UCITS, or ‘Newcits’, funds in Europe. Meanwhile, much of the wealth management sector, as well as the longest serving and most sophisticated institutional investors, remain prepared to allocate to funds in offshore jurisdictions that are less transparent and considerably more illiquid than alternative UCITS products. These investors are also more understanding of industry practices such as gates, lock-ups and side-pockets, that evolved and were subject to so much criticism during the credit crisis.

The continued establishment of onshore regulated products will fundamentally change the dynamics of the alternative investment industry. It is likely to lead to a considerable increase in fund launches as parallel, or ‘mirror’ funds, are launched in onshore locations that mimic established offshore funds. Established offshore jurisdictions will continue to thrive and prosper in the new environment. There will also be a lot of activity in locations such as Ireland, Luxembourg and Malta as alternative UCITS become established in Europe.

The changing structures available to allocatorsThe way in which institutional investors currently access alternative investments will change in the next 3 years. At present, investors generally allocate capital to alternative investments through fund of funds, managed accounts, indexed products or direct investment. Institutional investors with the requisite resources are now moving to a hybrid allocation model. A clear trend in favor of single manager funds and managed accounts is emerging as allocations to fund of funds diminish.

Fund of funds did not have a good market crisis, say their investors. Their raison d’être to reduce market risk through enhanced diversification failed to materialize when it mattered most. Whilst large institutional investors favor a hybrid model of single manager funds and managed accounts, smaller institutional investors have more limited allocation options and fund of funds will remain their gateway to the industry. A number of these investors note that larger fund of funds are proving to be adaptable and innovative; some have enhanced their communication with investors and provide a far more customer centric experience.

Fund of fund managers with assets in excess of US$5 billion have the resources to expand into managed accounts and to diversify their offerings in other ways. In 2010 and beyond, the best of these large, multi purpose operations are likely to continue to expand into new areas (offering investors different structures and strategies). Convergence and divergence across strategies and structures will drive consolidation. Recent mergers in the hedge fund industry, including that of two well known firms in the business, both with assets in excess of US$5 billion, are an example of this. This is widely expected to lead to a further wave of M&A activity. There is always a possibility that something similar to the ‘merger mania’ that gripped the custody industry in the 1990s could be replicated amongst today’s independent alternative asset managers.

Do you believe the alternative investment industry will become...

6%6%

14%

74%

Remain the same

More boutique focused

More institutional

Bifurcated between large asset providers and small boutiques

49%

33%

5%13%

% of respondents

“You don’t send a football team onto the field without some reserves. Why would we do the same here. We’re always looking for star managers and have reserves to allocate when we find them”

“We won’t accept lock ins anymore; we’ll barely tolerate gates”

��

© 20 , a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. 10 KPMG International Cooperative (“KPMG International”) The Future of Alternative Investments


The future is much bleaker for smaller fund of fund managers. For far too many, the market crisis exposed shortcomings in their core business proposition. Unlike their larger competitors they do not have the resources to fight back. The largest fund of funds are diversifying and/or using their brand name to attract institutional and high net worth investors in order to grow in different directions. But the smaller players are unable to compete in these areas. They are struggling.

Challenge to the � and �0The majority of investors interviewed do not believe that the industry’s 2 and 20 fee structure is sustainable. Whilst not top of their list of priorities for industry reform, fee reduction is still something that they want and anticipate will happen. Equally, manager fee structures are expected to be less uniform in future.

Manager fee structures are under pressure because investors have much greater negotiating power as a result of the market crisis. Added to which the industry is being driven forward by super-sized allocators. They have always been able to negotiate lower fees, including with many of the most sought after managers. This was common practice even at the height of the boom. It is these institutions, with their significant fee negotiating power, that are chiefly responsible for the recent strength of inflows into alternative investments.

In addition, a number of the largest institutions want to see more alignment of their interests with managers. They believe managers should make a greater effort to build a long-term business compensation culture. For certain strategies, this may simply require a performance hurdle feature. One institution made the point that they are long term investors and they want to work with managers who think, and act, like them. There is evidence that a number of the more recent start-ups have recognized this issue by redesigning their business models to incorporate longer term fee structures and hurdle features.

It is believed that differences in fees will only grow in the future. The uniformity is gone. In its place will be many more ‘local’ agreements. Some managers will be able to charge more than 2 and 20, as has always been the case. But results from this research suggest that with the largest institutional investors in the driving seat, most fee negotiations will be going in the opposite direction.

Professional fund servicing is now key to investor contentmentFund servicing related issues are becoming ever more important for investors. The growing institutionalization of the industry have made topics surrounding fund servicing central to the well being of the industry. Fund servicing issues such as investor demands for due diligence procedures had been growing in importance well before Madoff, a fraud that has added impetus to this trend. That such a relatively simple fraud could have taken place on such a large scale in a highly regulated environment, indirectly affecting numerous investors, has profoundly shocked many constituents across financial services.

All investors now take fund servicing very seriously. A number of managers noted that events over the last 18 months have had an effect upon the type of firms that they would want to hire as service providers. Recognized names that prospective investors are familiar with have become more important than was the case pre crisis. It has become essential to have organizations listed on the fund’s prospectus that reassure investors. Service provider name recognition is becoming paramount.

“We’ll pay performance fees for performance but we don’t like a manager making money from management fees”

“Fund servicing issues are the most important business decisions that you can make. 60% of the success of the fund depends upon it”

“We’re asking so many questions, we don’t have space to write the answers”

��



What impact, if any, has the market crisis and/ or the news of recent financial scandals had on your operational due diligence process?

0 10 20 30 40 50 60 70 80

No Impact

Low Impact

High Impact

I. Investors

Administrators

Managers

43%

49%

8%

41%

53%

6%

67%

22%

11%

% of respondents

As the industry grows its institutional investor base, managers expect that scrutiny of their operational procedures by investors will only increase further in future. This includes their third party service providers. Due diligence on administrators, in particular, has become a lot more intrusive and regular. In 2009 alone, administrators say that there was a substantial increase in investor requests for due diligence meetings as well as detailed and regular due diligence reports. One administrator has noted that this type of activity has increased by 30% alone in 2009.

The point is that the institutional investor now has far more power to shape operational aspects of the industry, as a result of the sheer weight of its capital. Managers surveyed say that both their existing and prospective investors and regulators want clear and transparent operational oversight. This is now occurring.

“Hedge funds were not out of control; they did not cause the crisis”

“Our checklists have doubled”

“Robust due diligence is critical – we won’t even open the door to a manager without this”

“High Net Worth investors have been hibernating for over a year now; surely its time they woke up”

��

© 20 ational”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. 10 KPMG International Cooperative (“KPMG Intern The Future of Alternative Investments


“Only when the tide goes out do you discover who’s been swimming naked” Warren Buffet

Managers

This section presents the results from the survey and structured interviews involving alternative investment managers. Case studies with industry participants are presented at the end of the section.

Core capacity The supply side of the alternative investment industry has changed considerably in recent years. Prior to the credit crisis, questions were raised regarding the availability of talented managers who could generate alpha at a rate demanded by investors. Currently, there is significant amount of capacity available to manage funds, with only two in five managers operating at or near full capacity.

Our interviews revealed evidence of a next generation of talent migrating from brand name investment houses to set up new businesses. Whilst the industry continues to institutionalize, the allure of reward, creativity and freedom on offer from the boutique sector will always attract alpha generators. Hence, the number of boutiques will continue to thrive, although in capital terms, they will represent a far smaller proportion of the industry. The pace of change may be impacted further by the proposed ‘Volcker’ rule in the US, as proprietary traders are forced out of the mainstream.

The future choice for investors looks bright - the difficulty will be finding the star in all the mediocrity.

Approximately, how much of your company’s core capacity is currently being used?

6%6%

14%

74%

71-100%51-70%

31-50%10-30%<10%

21%

13%

44%

21%

1%

% of respondents

“In a downturn, transparency is trendy, but when the industry moves on, trends change. The return to the status quo is inevitable”

“Sometimes the red flags are so huge, you have to close your eyes to miss them. Even then, your other senses tell you its not quite right”

��



Products and performance

Which alternative investment products do you expect your clients will be attracted to in the next 3 years?

0 10 20 30 40 50 60

Other

Reinsurance products

Infrastructure

Real Estate

Structured products

Fund of hedge Funds

Multi strategy hedge funds

Private Equity

Single strategy hedge funds 59%

39%

33%

28%

26%

26%

22%

4%

13%

% of respondents

What returns do they expect?

0 20 40 60 80 100

31-40 %21-30 %11-20 %1-10 %

Fund ofhedge Funds

Real Estate

Single strategyhedge funds

Structured products

Infrastructure

Multi strategyhedge funds

Private Equity 19% 50% 19% 12%

42% 58%

43% 57%

50% 30% 20%

23% 73% 4%

38%62%

78% 22%

% of respondents

“Our investors want us to do well, but there are plenty waiting to write about us if we fail”

“I feel sorry for administrators - they get a tough deal, but at last they’re being recognized as being an important part of the process”

“Investors got hurt, but time is a great healer”

��

© 20 a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. 10 KPMG International Cooperative (“KPMG International”),G International provides no client services. All rights reserv


KPM ed.

As investor appetite for absolute returns continues to grow, over 3 in 5 managers expect that single strategy hedge funds will be the main route to market, with the majority of them expecting returns of between 11-20%. This data is confirmed by investors who are increasingly searching for direct investment into funds.

Expectations for returns favor private equity, single strategy hedge funds and structured products, although it is unlikely that we will see a significant increase in the latter before the next year. Whilst investors have short memories, they will likely not forget the term CDO (“Collateralized Debt Obligation”) in a hurry. The events in recent years, however, have not caused the structured product industry to close, and a number of larger managers have expressed a desire to ramp up their CLO (“Collateralized Loan Obligation”) businesses when the market fundamentals change. Our interviews suggest that investors are regaining confidence in the sector and are beginning to search for innovative products, with a growing interest in

higher risk bonds and other investments such as art funds.

Hedge fund and private equity products are preferred by managers – an indication, perhaps, that investors have short memories and are willing to try again, albeit under new and improved terms.

From our interviews, it is clear that the fund of fund industry is at a crossroads. Transparency, liquidity, alignment of interests and customer centricity are all changes which the industry is making. Many managers commented that they lost sight of investors and with that the trust between investor and manager was broken. The surviving fund of fund brand names will continue to thrive as institutional investors have limited opportunities with which to access talent. For the smaller fund of funds, there needs to be a mindset change towards the investor, and improvements in communication will be essential. Nonetheless, we are likely to see stronger asset growth from managed account platforms in the next 3 years as investors seek more control and transparency in their investments.

“When the markets are rising, who cares about hedge funds when you can have long only”

“Regulation is depressing; its costly and will not prevent a blow up”

“We didn’t lock down investors. Now we’re getting the benefit of that confidence with new investments”

��



Managed account platforms are expanding their capabilities and many of the larger houses are in the process of adding significant capacity to their already successful structures. Despite the paradigm shift in investor approach to alternatives, and the ensuing demand for managed account platforms, there are a number of caveats which will impact their growth.

Firstly, operational complexities and increased costs have been cited in the interviews as key challenges for managers. The implication is that if alpha is compromised to such an extent, then direct routes to investment will likely become more appealing to investors.

Secondly, some of the larger administrators claim that they expect other service providers, such as themselves, will provide competition for managed account platforms, by offering similar products that are less expensive in the medium term. The impact of such competition could change the face of the industry.

Whatever the outcome, the competition will have many benefits, not least expanded options for institutional investors, pricing between managed account platforms and new entrants, and a customer centric focus by smaller fund of funds.

Future returns

Managers are bullish about the future of their industry, which is confirmed also by their administrators and investors - three quarters of the industry expect double digit returns in the next 3 years.

The positive returns anticipated by managers should easily satisfy investor expectations, but the question is whether or not these returns can in fact be made with increased demands on liquidity. Conventional wisdom has it that investors will move towards more liquid strategies, favoring diversification over performance. However investors are acting in different ways.

On the one hand, the dislocation in markets, particularly on the credit side, has led some investors to pursue illiquid strategies because of the investment opportunities present in the deleveraging of the market. Distressed credit hedge funds, Term Asset Backed Securities Loan Facility (TALF) structures and private equity vehicles have favored some, whilst other managers have gone after illiquid side pockets in the secondary markets. These investors have chosen to ignore issues faced in the credit crunch in favor of returns. On the other hand, the majority of institutions are demanding more liquidity in their portfolio and are preserving their ability to reign in cash.

A number of challenges face investment managers over the short term, but the volatility in the marketplace, combined with legacy issues from the credit crunch, provide a stage for the star managers to shine.

What is your expected average annual return on alternative investment products under your management in the next 3 years?

% of respondents

0 10 20 30 40 50 60

>30%

21-30%

11-20%

1-10% 26%

56%

10%

9%

Annual return

“We are going through a period of profound change – for better or worse”

��

© 20 al”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. 10 KPMG International Cooperative (“KPMG InternationG International provides no client services. All rights re


KPM served.

Industry challenges


0 10 20 30 40 50 60 70 80

Shortage of talent

Systemic risk

Taxation

Operational risks


Liquidity risk

Transparency


Regulation and governance 75%

63%

55%

55%

43%

35%

25%

20%

13%

% of respondents

Having been lashed by the credit crunch, it isn’t surprising that many institutional investors are now fraught with uncertainty when allocating to alternative investments. Although sold on the idea behind absolute returns, many pension funds ultimately lost out as some managers failed to adopt a sound governance culture to back up their front office success. Reputational risk is paramount to investors. Managers’ reticence to invest more heavily in internal governance structures in the past was often led by cost, but they acknowledge that the industry has changed, and with it, so have they. So much so, in fact, that managers are now more concerned with regulation and governance than they are with investment performance (75% respondents noted that this is one of their most significant challenges).

Given the positive performance of alternative investments and volatility in the markets during the past year, it is somewhat surprising that managers believe that investment performance will

be a key challenge. They recognize that the industry is changing and with more entrants, more products and the advent of “Newcits”, making money is going to be harder.

Whilst they are not a uniform body of investors, most pension funds are in agreement that they don’t have the infrastructure to deal with complex strategies. Therefore, in accordance with their internal mandates, larger investors are demanding funds sit on platforms, or set up UCITS wrappers before allocating to certain strategies. The impact is clear – managers will need to use all of their skills to generate sufficient alpha to negate the effects of those performance inhibitors that are beyond their control.

The buoyant future of the industry, as predicted by managers, will come with a new operating paradigm: enhanced governance, more transparency, more liquidity, more costs and a shift towards a client-centric culture. Our interviews suggest that whilst managers may not like it, they accept that the rules have changed.

“The regulators don’t know what they want when they draft these pronouncements. Then it takes 15 updates to get it right”

“There will be a rebalancing between offshore and onshore”

“The big will get bigger, the small will find niche markets where their services are valued”

“More regulation is a price that we have to pay”

�0



Access to Alternative Investments

How do you currently access alternative investments and how do you expect/ plan to invest into alternatives in the next 3 years?

0 10 20 30 40 50 60 70 80

FutureCurrent

Indexationproducts

Fund of funds

Managedaccounts

Direct80%

75%

51%

57%

37%

32%

11%

21%

% of respondents

The way in which managers currently use alternative investments to execute their strategies will not change considerably in the immediate future. However, our interviews highlight two important trends in the medium to longer term:

Firstly, investors and managers believe that the industry currently has limited options to access funds, and fund of funds provide the necessary diversification for institutions. However, some fund of fund managers believe that their investors were frustrated with limited access to portfolios and reporting in recent years. They acknowledge that a lack of ‘live’ information is an inherent weakness in their model compared with managed account structures. Not surprisingly, it has been fund of fund managers focused on their clients through improved communication points, that have been most successful.

Secondly, despite seeing significant expansion over the past 3 years,

managers do not believe managed account structures on their own are the panacea for the industry. That growth from managed accounts will continue is not in question. It has to. However, the extent of its growth must be questioned in light of our research. Whilst they provide more control and transparency to investors, managers have had to accept frustration and challenges with operational aspects of the model. Increased costs, processing and strategy implications arising from frequent liquidity were cited in our interviews as the main barriers to setting up a managed account platform. As a result, larger administrators are now targeting the managed account industry to provide infrastructural support, relieving managers of some of the operational burden. This comes at a price. However, it is an important operational support function for institutional investors who would not otherwise have the ability to access the market.

“Managed accounts are for the weak”

“The current environment has flushed out the criminals in the industry”

“As an asset class, green strategies will be the next exploitable bubble”

��



Advancing the business

Aside from performance, how do you plan to advance your business over the next 3 years?

0 10 20 30 40 50 60 70 80

Offer better fee structures aligned to investor's interests (e.g., Fund appreciation rights)

Improve governanceand reporting

Develop new products

Improve transparency

Focus on core products

Concentrate on client service 70%

58%

58%

58%

48%

18%

% of respondents

Aside from performance, the overwhelming majority of managers plan to concentrate on client service as a way to advance their business in the next 3 years. In light of both media and political headlines, this is not surprising; however, our interviews suggest that there is an important evolution in attitudes and culture.

The alternative investment industry was formed on the back of a diverse group of individuals, who were entrepreneurial and performance driven. Many believed that performance was the number one priority for investors. The communication link between the manager and investor was broken in some cases, and missing in others. Against this backdrop, a move from a product centric to client centric culture is underway across the industry – there is a widely held view that investors are not simply looking for the best performance – they want to be treated well. Managers therefore anticipate there will be an increased focus on communication, regulation and transparency.

The ‘super boutiques’ and ‘entrepreneurial-institutional’ firms have responded by launching fund structures which inherently compliment investors’ requirements, namely transparency and liquidity. This includes restructuring their products into managed accounts and launching UCITS wrappers in Europe. They are keen to adopt what we have called “Attentive Anticipation”: building an organizational culture that anticipates clients’ needs and expectations and ignites innovation. Some managers recognize that clarity in client expectations will help them in the longer term make the appropriate strategic and investment decisions. These managers are also those who are listening to clients needs, rather than pushing products onto them; aligning interests in terms of fees and initial seed capital, increasing communication with investors through more frequent calls and meetings, and segmenting clients to match needs and wants.

Overall, managers are being motivated to adopt processes that will build lasting relationships to secure permanent capital; the locking or gating of funds, whilst beneficial to the industry as a whole, led to dissatisfaction at an individual investor level. Our interviews suggest that investors recognized that these tools were effective; their issue was the way they were used.

“We are looking to get more frequent NAV calculations by the administrators – this is a future trend”

“Customer centricity is in our DNA”

��



Fee structures

What do you expect to be the average management and performance fee arrangements in the next 3 years?

88%

8%

13%

40%

43%

5%0 20 40 60 80 100

>20%

16-20%

11-15%

1-10%

2-3%

1-2%

0-1%

5%

Management fee

Performance fee

% of respondents

Fees

Alternative investment managers are expecting some downward fee pressure from investors, although it is not expected to be uniform. Investors were more forgiving towards single manager funds than fund of funds for their poor performance in recent years. Despite performance improving considerably over the past 12 months, managers acknowledge that certain investors are searching for more flexibility in fee structures and hence an alignment of interests.

Our interviews reveal a trend for institutional investors searching for a more flexible and fair fee arrangement. The generic fee structure of 2 and 20 was sold on the basis that it purportedly reduces risk taking by the manager. However, several managers noted that during the credit crisis, short term money flows in and out of fund of funds created a fee paradox. The need to receive management fees actually created incentives for managers to take excessive

risks to drive performance, in order to keep investors in their funds. To partly address this imbalance, investors are now requiring far more capital to be invested by managers as a sign of their longer term commitment to their product.

In the private equity industry, pressure on fees is less than the hedge fund sector. However, there is recognition that the large limited partnerships have been able to negotiate smaller management and performance (carried interest) amounts than previously. Furthermore, the fee structure between hedge funds and fund of funds will widen considerably.

An important point to note is that successful strategies will continue to generate in excess of the 2 and 20 standard fee base in the future. But there will be many more ‘local’ agreements. Power has shifted to the investor to such an extent that it is inevitable that the fee structure for mediocrity will be impacted.

“Higher preferred returns and 2 tiered fee structures are the way forward”

“Our industry is characterized by absolute greed”

“Hedge funds should not become a retail product”

“Look at how many directorships some of these directors hold and how many working hours there are in the day”

��

© 20 al”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. 10 KPMG International Cooperative (“KPMG Internation The Future of Alternative Investments


The industry’s view... A Long Standing UK Based Boutique Manager

“We are witnessing more change in the industry than ever before, and we have been around for longer than most. But we do not think that much of what is happening at the moment will ultimately be to the benefit of investors – or indeed managers – however we understand how we got here. Inevitably much that confronts us is a response to events of the last few years. But what we are getting here is the inevitable overreaction. Mistakes are being made that will then, also, have to be corrected in turn.

For example, we are watching what is happening with the European AIFM Directive with much concern. This is a classic example of what happens when politicians and bureaucrats involve themselves in things that they think that they know something about, but don’t. If it turns out as badly as some fear then we might move – but I don’t want to live in Switzerland, much as I love mountains! Even if we avoid the worst (from AIFM) we still have to contend with a regulatory climate that is only going to become more burdensome. Soon you will need US$200 million to launch a new fund.

I am also concerned about the managed accounts boom. You hear a lot about the benefits of managed accounts but little of the downside. In the next financial crisis these things are going to cause investors some real problems. I believe that the worst losses taken by investors will be in managed accounts. This is a time bomb that is waiting to explode. Again it is easy to see why investors are jumping on this bandwagon but the implications have not been thought through.

The other craze at the moment is the trend to EU domiciliation. Again it appears that no one is considering the full implications of what is happening. Offshore funds are (or should) only be available to people that know what they are doing. Presumably they have investors that understand the strategy, do the due diligence etc. They are grown-ups. If these alternative UCITS take off they will attract some very different investors. It will only take one alternative UCITS fund to go spectacularly bust to end this craze. I fear that these funds will attract investors that think that they are somehow safe investments because they are UCITS. That is not the case – UCITS funds can collapse too!

On the positive side we had a great year in 2009. I am confident that we will do well this year too. I just wish that we could be left to get on with it.”

��



A Global Investment Manager

“Our material outflows ended in February 2009. The financial crisis changed the asset manager and investor landscapes considerably. The continuing uncertainty in markets and the regulatory environment is driving investors to be cautious and therefore ‘manager viability’ and product selection are key. Since before the beginning of the year, as the upturn continues, we are now seeing inflows, but not with the exuberance of old.

There are certainly fewer investment mandates around but those that are worth having are generally bigger, on average, than we have seen in the past. The opportunities that we are seeing are primarily coming from institutions. Notably there are new direct mandates from pension funds. More than 50% of the assets that we manage are now direct mandates from pension funds.

Increasingly, European investors see UCITS and managed accounts products as a ‘must have’ in any portfolio and we are seeing considerable investor preferences switching away from traditional Cayman funds to UCITS platforms. This is especially true for French and Italian funds of hedge funds. Investor due diligence into Cayman funds is more thorough and we have come to expect a longer process than in the past. One client asked about our back-up generators. Clients have a lot more choice among managers offering similar products. They are not in any hurry to allocate capital on the whole and due diligence is becoming a way of differentiating between these managers. It is common for investors to want to see our people one by one – presumably to ensure that we are all saying the same thing. The marketplace for investor assurance services also seems to be growing. We’re seeing increasing numbers of investors use investment consultants for due diligence and frequent e-mail from organizations offering due diligence services.

We are very disillusioned by the developments with the EU AIFMD. Are there any signs that this will add to investor protection? How on earth will it be put into practice in its current form? It is still clear that the Euro-morass do not understand the alternative investments industry, perhaps willfully so and we need enlightened regulators who know what they are doing.

The Hedge Funds Standards Board (HFSB), which to a large extent were compiled to pre-empt burdensome regulation on the industry, have not had a noticeable impact with the European regulators or with the investor community. We have not had a single investor ask us if we are signatories to the HFSB, for example.

FIN 48 has been a serious issue for the industry for managers that had not accrued for taxes that may have been due across the different jurisdictions in which they operate. It took us seven months to decide what to do about it given that there are many different accounting interpretations of the same rule. We have witnessed some material impact in NAV’s in some funds. It’s been that serious.

No one is safe from being acquired in the new market conditions. We want a compelling proposition in everything and we are on the lookout. We want to offer a single brand with a diverse product portfolio. Regulatory, fiscal and investor pressure will drive up the barriers to market entry. You want all sorts of people to succeed in this industry. The hedge funds industry has grown largely organically by talented people who have started small and built significant books of business. It is becoming too difficult to set up now and this is disappointing.”

��



“It’s not the employer who pays the wages. Employers only handle the money. It’s the customer who pays the wages” Henry Ford

Administrators

This section presents the results from the survey and structured interviews involving administrators in the alternative investment industry. Case studies with industry participants are presented at the end of the section.

Core capacity

One of the most surprising results of this survey is that 3 in 4 administrators are operating at between 71-100% capacity - there is a clear pressure point building in the administration industry, based on a lack of human resources and technological capacity. Despite the wind down of a number of funds and structured products in recent years, administrators have taken on additional services and responsibilities, such as middle office, financial reporting and risk management support services. They are now faced with the harsh reality of an industry in transition. They always wanted to service institutional investors, but the question is, can they manage it?

Against this backdrop, the industry will need to create capacity to meet both new regulatory requirements as well as to service the needs of institutional investors. Many administrators downsized during the credit crunch, and

hence are faced with not having spare capacity to rebuild. M&A activity and geographical expansion is therefore inevitable. A number of administrators have already expanded into other areas (hedge fund administrators buying into private equity for example) and we are beginning to see convergence. New firms and new product offerings are likely to emerge to service the infrastructural demands of clients, including services for UCITS structures. Depth and breadth of services are essential. At present, however, there looks to be a significant shortage of resources at a time when managers are focused on improving their operational processes. In response to this, some larger managers are actually bringing parts of their administration in-house – this cannot be the way forward for the industry, particularly given the direction of regulation which most commentators are suggesting will favor a move to greater levels of outsourcing.

Approximately, how much of your company's core capacity is currently being used?

71-100%51-70%31-50%10-30%Less than 10%

6%6%

14%

74%

% of respondents

��



Growth expectations

Administrators surveyed are bullish about the future of their industry.

• 1 in 2 expect growth rates of between 6-10%

• 2 in 5 expect growth rates of between 11-20%

Tier one administrators, in particular, expect significant growth due to a number of key factors:

• New market entrants as a result of regulation and capital restrictions for banks.

• New products and strategies.

• Increased appetite from institutional investors, led by new products and structures.

• The return of high net worth individuals to the industry.

Most administrators believe that growth will not be isolated to one service offering such as calculating the NAV of funds, but rather will cover the waterfront of administrator services. As a result, we are already beginning to see convergence between specialist administrators looking to take advantage of new opportunities. The industry will likely consolidate and continue to bifurcate between large and small players.

As alternative investments become more institutionalized, there will be increased requirements for administration services that complement investor needs. Innovation and the search for better technological platforms will be the drivers of growth. The strongest will get stronger, since the capital investment in global platforms remains sizeable.

Geographically, growth will be predominantly led by the US, as banks dismantle their proprietary businesses to meet regulatory requirements.

Finally, an overwhelming majority of administrators warned of severe capacity constraints in terms of talent and technology. Nonetheless, they acknowledged that opportunities, particularly with regard to firms setting up to provide infrastructure to pension funds, exist and will likely be seized on by tier one or two administrators.

What do you expect to be the average annual growth rate in global assets under administration in the alternative investment industry in the next 3 years?

6%6%

14%

74%

< 20%16-20%11-15%

6-10%1-5%> 1%

47%22%

16%

9% 6%

% of respondents“Regulation is the single most worrying part of the future of the industry”

“Structured products are rising from the dead. There’ll be a new name to replace CDO”

“When the water rises, all the boats should be higher. The good model for the administration industry is alignment of interests with employees”

��



What do you expect to be the average annual return on alternative investment products in the next 3 years?

6%6%

14%

74%

Over 50%41-50%31-40%21-30%

11-20%1-10%Negative

44%56%

% of respondents

Future returns

After a few years of moderate returns, administrators expect that the upturn witnessed this past year will continue for the next 3 years. Administrators believe that trading conditions are reaching an optimum level and have confidence that star managers will be successful.

Their bullishness is driven by 3 factors:

• Increased volatility in the market

• New entrants as talent moves out of the banking world

• More strategies geared towards illiquid assets

In a world that expects more transparency and liquidity, the last point is somewhat paradoxical. However, it reveals an interesting point, namely that there are a number of large institutional investors willing to trade liquidity for performance and invest into illiquid strategies, such as distressed debt/credit funds and private equity. When talent was cheaper, the more entrepreneurial funds bought human capital in bulk, knowing that the industry would turn and opportunities would present themselves.

Whilst double digit returns are anticipated by the majority of administrators, some illiquid strategies (other than pure private equity) are beginning to present unique opportunities to produce high returns. Typically these strategies are only for 2 to 3 years, but they highlight that the industry is still awash with stars that can find opportunities and commercialize them.

Administration services

Administration has often been seen as the commoditized end of the industry. These service providers like to conduct standardized NAV calculation activities but most have less interest in involving themselves in the more complex independent valuation of investments, particularly in illiquid strategies. For smaller administrators, this is partly due to their fear of litigation, and the limitations of their IT infrastructure. But times are changing. The next three years will be focused on the ability of the administrator to help to bridge the trust gap between the investors and the managers. Moreover, administrators have become a crucial part of institutional decision making. Some have recognized that there is a notable gap in the provision of infrastructure and due diligence to institutional firms, and have started to actively pursue these new opportunities. This move will accelerate and a new breed of firms will emerge that try to fill the void as more institutional investors favor direct investments over fund of funds.

Administrators expect that front and middle office services as well as risk reporting will be the three largest growth areas in their industry, led by increased investor appetite for regulation, governance and reporting. For many administrators, the days of downsizing are over; some of the larger firms have already begun the search for talent in risk management and law, in anticipation of growth. These areas are not easily

“Everyone makes mistakes, but the large fund of fund houses made some big ones”

��



Which services do you provide currently and which do you expect to grow significantly in the next 3 years?

0 20 40 60 80 100

FutureCurrentPrime services(e.g. Financing

and Stock lending)

Tax planning

Risk managementservices (eg. VAR

analysis)

Custody andsettlement

Performancemeasurement

Front and middleoffice services

Investor reporting

Financial statementpreparation

Registrar & transferagency services

NAV reporting 97%81%

94%81%

94%77%

88%81%

44%77%

41%48%

38%32%

31%55%

13%6%

6%16%

% of respondents

scaleable, but for this reason, they will be the most profitable part of the business. For other administrators, however, the credit crisis has left them severely wounded and they are in the process of seeking exits. Until the regulatory landscape becomes clearer, many players are putting their acquisition strategies on hold.

The administration industry’s growth will, nonetheless, accelerate its bifurcation. Niche administrators will mainly serve niche boutique segments, with the brand name administrators digesting the largest slice of institutional capital.

“Why would pension funds take risks when they can allocate safely to a large equity house?”

“Fund of fund managers have been the hardest hit, but bank platforms still need them around in the long term. The model isn’t dead”

Industry challenges


97%

56%

56%

34%

31%

28%

13%

13%

6%

0 20 40 60 80 100

Systemic risk

Shortage of talent

Liquidity risk

Operational risks

Taxation


Transparency



% of respondents

“There’s a growing gap between technology requirements and platforms”

“The whole industry will institutionalize – managers, investors and administrators”

��



According to administrators of alternative investments, the 3 most widely recognized risks facing the industry over the next three years are:

• Regulation and governance (nearly all respondents)

• Investment performance (three in five)

• Transparency (three in five)

Surprisingly, liquidity risk did not feature as a main challenge for the industry, despite the fact that many investors were impacted by a lack of liquidity during the credit crisis. Interviews confirmed that administrators believe that increased regulation and demand from investors will ensure that the industry’s liquidity profile will change regardless.

The focus on regulation is not surprising given its influence across the entire financial services industry. Administrators view regulation and governance as the number one challenge facing the industry, in recognition that they also expect to be involved in this process. Administrators don’t have a role on the performance side of the business, but they are critical as regulation and the quest for transparency escalates.

The main regulations that administrators note as challenges include the AIFM Directive, regardless of its outcome, UCITS products, and US legislation regarding investment manager registration.

The focus on regulation is worrying as it means that there has been a shift away from operational concerns – an area that also requires attention. Administrators have expressed their view that their industry may not be ready to serve the considerable needs of institutional capital.

“Increased regulation will prevent significant growth of the industry”

“All managed assets are going to more dynamic platforms”

Regulation

What do you think will be the impact of forthcoming regulations in the below regions on worldwide growth of alternative investments?

0 10 20 30 40 50 60 70 80

Positive Impact

Neutral

Negative Impact

Europe

North America

Asia

10%

61%

29%

32%

35%

33%

72%

6%

22%

% of respondents

“NAV lite is not the future; its over”

�0



Administrators’ view of forthcoming regulations is negative for Europe and neutral for Asia and North America. The response regarding Asia-Pacific is likely to be driven by the fact that media attention and political discussion has been focused on Europe and the US.

• 6 in 10 administrators believe that the impact on Asia will be neutral

• 7 in 10 believe it will be negative in Europe

It should be noted that increased regulation will likely benefit administrators in terms of new product offerings, and so their views of the industry are even more alarming. The proposed European regulation (AIFM Directive) is seen by administrators as a huge deterrent on cross border industry growth. Moreover, most agree that it would not prevent major blow ups and it is aimed at the wrong areas in its current form.

Many administrators expressed frustration that the regulators simply don’t understand the industry, and furthermore, question whether they would have the ability to effectively monitor what they don’t understand.

The hallmark of good regulation in asset management is in its ability to also encourage investment. On the whole, administrators believe that tighter regulation will encourage managers to invest less or remain the same in alternatives.

For institutional investors, UCITS products are seen as a good way to access the market in a regulated structure, but the wider industry regulations on managers are not wanted. Regulation such as the proposed AIFM Directive will undoubtedly raise the bar in terms of barriers to entry. In its worst form, however, the cost and operational implications of the AIFM Directive could signal an end to the small organic boutique hedge funds in Europe.

“Processes and talent are the future of the industry”

“The administration industry is vastly more professional than it was a few years ago”

“How do you scale a business with so much red tape? That is the million dollar question”

Administration challenges

Which factors do you expect to impact your business most in the next 3 years?

0 20 40 60 80 100

Capacity constraints

New entrants

Outsourcing opportunities

Shortages of skilled staff

Consolidation of thealternative investment industry

Complexity of products

Sustaining profit margins

Improved technologyand IT development

Regulatory barriers foroffshore products

Regulatory requirements forindependent administration 81%

66%

56%

50%

44%

31%

25%

25%

13%

9%

% of respondents

��



Institutional investors are looking for brand named administrators and managers. They recognize that it will cost more in terms of processing, and that they won’t use boutique managers, but equally they won’t hit the headlines if something goes wrong.

An overwhelming majority of administrators believe that regulatory requirements for independent administrators will have a large impact on their business. Our interviews confirmed that this is primarily led by an expectation that the US will demand an end to self administered funds, in light of events such as Madoff, which has indirectly impacted the industry. This is not a case of hope over reality. Whether it be regulation or a mindset shift in investors’ approach to the industry, it is clear that self administration will not be the way forward.

The basic and value added services provided by administrators will allow alternative investment managers to focus on customer centricity, regaining trust and performance. However, this comes with one caveat – the largest global firms will continue to self administer some operational elements of their portfolio. They have segregated some services to their administrators, but this is within defined parameters and restrictions. They have been reluctant to cede control over the operational process by completely outsourcing it. In their view, their organizations have a premium brand to secure – one that is of greater value than even the largest administrators in the industry.

“How can an administrator call themselves independent if they are simply taking the managers marks and filling in the boxes for reporting?”

“Administrators do not have the systems to identify all the information that AIFM demands”

“The era of a manager trading out of a garage with a Bloomberg terminal and a dog are long gone”

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The administrator business model

Which fund administration business model do you believe will be most successful in the next 3 years?

6%6%

14%

74%

0 5 10 15 20 25 30 35 40

Boutique administrators focused on specificstrategies/ markets

Large scale, multi location

independent firms

Affiliates ofglobal financial

institutions38%

28%

34%

% of respondents

Administrators predict that institutionalization will further revolutionize their industry. Consolidation will drive quality up the value chain, as affiliates of global financial institutions dominate the sector. In 2009 and 2010, we have already witnessed some significant M&A transactions involving global administration businesses and this will continue.

Administrators’ product offerings to the alternative investment industry have accelerated in depth and breadth, covering everything from risk management to services typically seen by prime brokerage firms. With the whole investment world at their fingertips, talent and IT centric organizations are vital.

In order to overcome capacity challenges faced by increased regulation and institutionalization, there are also notable changes occurring.

Firstly, administrators are consolidating into different sectors, as strategies converge (e.g. Private equity and hedge

funds). Some of the new players will have the ability to serve a far wider manager base than before, and are well positioned to adapt to managed account platforms that are multi-strategy in nature.

Secondly, risk is being revalued, to the extent that small administrators are avoiding the more complex end of the industry. Illiquid strategies and private equity administration are not inherently scaleable, and rely extensively on human capital – they therefore favor the large scale organizations that can attract such talent.

Thirdly, offshoring of back office operations is continuing at speed, as immediate expansion is often a prerequisite for winning contracts. India will continue to benefit from large scale offshoring. The challenge, however, is in the ability of those firms to be able to marry this model with a customer centric approach. Many flaws in business models have been exposed during the credit crisis; regaining trust through communication and service is paramount.

“Investors such as pension funds, endowments and family wealth offices have turned a sharper eye toward valuations and the price determination process”

“We expect that there will be a wave of consolidation on the administration side of the business – there are too many boutiques out there that are struggling”

“There is a greater argument for institutional investors to be in this space – they need the growth”

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The industry’s view... Global Administrator

“As administrators, our plan is to stay very close to our clients. We believe that administrators can play a crucial role, an active role in the industry – we’re very pro-regulation. We would like to see administrators regulated. We think that any hedge fund that has investors in that jurisdiction should have an administrator that is regulated in that jurisdiction. It would mean lower cost and more efficiency to both the tax payer and the investment manager. Unfortunately, everyone is pushing back on this concept, especially those administrators that are offering NAV lite type products.

One of the biggest issues facing the alternative investment industry is a lack of independent valuation of investments. It has got to change. The administrator has got to be able to mark 100% of the books. Managers across the industry need to get third party expertise. People say administrators can’t mark illiquids – that’s not acceptable – administrators, even the small ones, need to go out and get the talent to be able to mark these positions.

The other issues are retaining staff and keeping up with advancements in technology. Our people create the majority of value in the organization and they need to be looked after. When the water rises, all boats should float, not just one or two guys! The next generation of technology will lead to far better reporting and transparency and will further differentiate the good guys.

On the upside, the industry has stayed together during the crisis. What the turbulence showed us is that there were scoundrels committing outrageous fraud and it helped us uncover those. If we’re smart we’re going to take a lesson from that and figure out how to create a compliance regime that would prevent that from happening in the future. The key risk for the industry is a lack of regulation on the manager - a couple of more blow ups that occur because of bad regulation. Some of the high profile cases – how many times were they looked at by the regulators and nothing happened. Nobody picked anything up.

It’s good to see that investors are having a lot more say and more serious operational due diligence is being performed. We now need good regulation to help. If that doesn’t happen, the industry isn’t going to grow the way it should.”

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A Mid-Sized Administrator

“The industry is changing. Dealing with unknowns is risky and clients who do not embrace transparency and only request piecemeal services are heavily scrutinized.

Middle office services will be a key growth area for us in the future. Full NAV processing is now increasingly demanded and less robust services such as “NAV lite” are becoming less and less popular. We believe that managers will look to outsource more middle office functions, to cut down on overheads, focus on portfolio management and satisfy demands of investors for segregation of duties. We expect drivers of growth for us will be daily portfolio reconciliations, NAV estimates and cash management services.

With respect to the broader industry, the key risks are governance and control. Alternative investment vehicles can be mismanaged or even fraudulent without strong corporate governance and segregation of duties. Requiring independent directors of the right quality, along with an independent administrator, are important features that can address these risks. Directors should be more actively involved in portfolio management to ensure the fund is not mismanaged by the manager. Alternative investment managers appear to not have done much in the past year in terms of regulatory change - a wait and see attitude has been taken.

We are also seeing changes in marketing and distribution which are becoming increasingly bifurcated between the institutional market and the “cottage industry” investors. Managers seeking institutional money will have to conform to far more regulation and standards with respect to investment mandates and operations. Smaller managers who by design seek to avoid regulation and infrastructure will be marketed and distributed through private and more intimate channels.

For our specific part of the industry, the challenge will be the ability to deliver. As the demand for middle office services increases, so does the demand for talent and new product offerings. Larger administrators will have an advantage over smaller players. Brand recognition, particularly in growth regions such as Asia, will be crucial to building business in the next three years. We expect to see consolidation within the industry as organizations search for complimentary partners to build a more global brand. In the next 3 years, the product and client mix, branding and re-alignment of our value chain are the three areas that will be most impacted as we seek to increase our global recognition and service offering capabilities.”

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“The important thing is not to stop questioning” Albert Einstein

Investors

This section presents the results from the survey and structured interviews involving institutional investors that allocate to alternative investments. Case studies with industry participants are presented at the end of the section.

Allocations to alternative investments

The majority of institutional investors intend to increase their allocations to alternatives in the next 3 years. Institutional allocations to alternatives are diverging as what might possibly appear, at least superficially, to be contradictory trends.

The days of uniform swings to alternative asset classes by allocators are over – at least for the time being. The largest institutions are increasing allocations to alternatives, whilst those at the other end of the scale are, at most, just maintaining the small presence that they took when they first invested in alternatives a few years ago. Some institutions are pulling out of hedge funds altogether (although maintaining an interest in private equity and other alternative asset classes).

The key differentiators today are resources and experience. Large institutions are of sufficient size to facilitate running a successful alternative investment program that is adequately resourced, should they wish to do so. The biggest pension funds interviewed are adding staff as they build up their

own in-house expertise. In some cases their knowledge base is now considerable. With their acquired expertise they are increasingly investing directly in alternative investments and are using managed account structures.

Added to which, large institutions generally allocated earlier to alternatives than smaller ones. This has also assisted them in their knowledge base development. With longer track records, they were generally less perturbed by the disappointing performance numbers that much of the alternative investment industry produced during the recent market crisis. It is the largest allocators that report they are increasing their exposure to alternative investments.

Smaller institutions, on the other hand, do not have these resources. Some of those surveyed have admitted to being unsure as to which course of action to pursue at present vis-à-vis their alternative investment strategies. Whilst a number of them followed in the footsteps of the largest institutional allocators by diversifying into hedge funds, in many cases they did this in the mid part of the last decade, in other

Do you anticipate that you will be investing more, the same or less in alternative investments over the next 3 years?

6%6%

14%

74%

QuitLess

SameMore

52%33%

5%10%

% of respondents

“There are a lot of investors still sitting on the sidelines”

��



words, not long before the market crisis. Rather than making a long term commitment, their allocations were often done on an experimental basis; in many cases, it was little more than putting a toe in the water. These investors are the likeliest to be concerned with the failure of many alternative managers to consistently generate absolute returns, and report that they will not be allocating more to alternative investments in the next 3 years.

In the aftermath of the market crisis, it is also the smaller institutional investors that have reviewed their alternative fund investment strategy. Equally, it is those that are in this category that have said that recent events have had consequences for their operational due diligence procedures.

“The hedge funds that we invested with have not delivered what we expected”

“Regulation will provide investors with less protection! This is very dangerous because standard approval will be given to managers”

Fee structures

The overwhelmingly majority of investors interviewed, both large and small, are united in the belief that the industry’s 2 and 20 fee structure is not sustainable – and that a number of the practices in the alternative investment industry (such as gates, side-pockets, etc.) will not endure.

Amongst the more experienced institutional allocators surveyed there was a view that, as part of a fundamental reform of the industry, there should be greater efforts made to align the longer term interests of investors and managers. Manager remuneration has been viewed as being too short term in this regard. Investors, who find themselves in a stronger position since the market crisis, know that they can frequently get better terms than 2 and 20.

However, it should not be forgotten that the returns that investors receive net of fees is, or should be, the most important element in all of this. One of the largest institutional allocators interviewed said that he didn’t care less what managers he invests with are paid. What matters to him is his net return. If that isn’t good enough he won’t invest regardless of how far the manager reduces his fees.

Do you think that the traditional (2 & 20) fee structure of the alternative investments industry is sustainable?

6%6%

14%

74%

NoYes

24%

76%

% of respondents

“Managers must start to listen to us – we’re not just looking for alpha, we want a copy of the recipe to see how its made”

“There are good guys and bad guys on wall street. Unfortunately the bad ones were pretty big players!”

“We have the money – where are the managers?”

��



Method of allocation

Our research suggests that there is no single preferred method of allocating to alternatives by investors.

Most expect that direct investment into alternative investments will grow the fastest of the available options over the next 3 years. One interviewee, for example, reported that his organization has decided to concentrate upon a limited number of funds whilst getting to know their managers and organizational set-up exceptionally well.

Several major institutions are currently employing a hybrid model in their alternative allocation programs. They use fund of funds but also invest directly in funds. As time goes by, the objective is to increase their direct proportion and to reduce their fund of fund allocation. But for smaller players, there is an acceptance that they have no real alternative to access a number of managers other than to continue with the fund of fund option. A number of investors made the point that the fund of fund industry “did not have a good crisis”.

Consequently, the larger fund of fund managers are proving to be adaptable and innovative. Therefore, as we move further away from the credit crunch period, it is believed that they could do particularly well in the future. But it is also anticipated that there is likely to be a period of real consolidation amongst the fund of fund managers with assets of much less than US$5 billion.

Assets in managed accounts are forecast to increase over the next 3 years by nearly one in two respondents. The reasons given are the greater transparency, liquidity and operational advantages that these vehicles provide for investors.

After direct investment into hedge funds, managed accounts are predicted to see the strongest increase in asset allocations over this period. The control that they offer investors was mentioned by all those that use these instruments, or intend to use them in the future. A number of the largest institutions now use managed account structures as a matter of routine if they wish to make a sizeable allocation to a manager. Typically, this can be in excess of US$100 million. However, managed accounts are also believed to have limitations. The biggest of these is that they do not provide access to all managers or strategies. This is closely followed by concern over the added costs and resources that are required for the successful implementation of a managed account program, as well as concerns over performance diminution. Being operationally complex, it is also believed that there is no point in employing managed accounts unless an institution has skilled people available to monitor performance.

How do you think that the following methods of investing in hedge funds will do over the next 3 years? Which ones do you expect will grow and which ones will decline?

0 10 20 30 40 50 60 70 80

Decrease

Stay the same

Increase

Hedge fundindexed products

Direct investmentto Hedge Funds

Managed accounts

Fund of Funds

9%24%

67%

43%52%

5%

57%33%

10%

33%48%

19%

% of respondents

Do you welcome the anticipated growth in regulation of the alternative fund industry in Europe and the US?

6%6%

14%

74%

Not WelcomeWelcome

43%57%

% of respondents

“UCITS are not for all investors; some of the best strategies cannot work with them”

��



Industry challenges


78%

67%

44%

44%

33%

33%

0 10 20 30 40 50 60 70 80

Liquidity risk


Operational risks



Transparency

% of respondents

The majority of investors do not welcome the increase in regulation that all believe is on the way. After transparency, regulation and governance are seen as being the biggest challenges facing the industry over the next 3 years. The anticipated increase in regulation is more unpopular with European investors than it is with those in the US.

It is not just feared that the increase in regulation will produce little in the way of tangible benefits but there is also concern, particularly by the wealth management sector, that it could also be detrimental to the development of the global alternative investment industry due to jurisdictional protectionist measures. With regards to the AIFM Directive, many investors believe it will increase costs considerably and it may lead to an exodus of manager talent from Europe. As one long term hedge fund investor put it, “Regulation will provide investors with less protection! This is very dangerous because standard approval will be given to managers.” Even if this turns out not be the case it is still widely feared that the growing regulatory burden will deter start-ups, given the extra costs, thereby depriving the industry of vitality and talent in the future.

“An increase in regulation is inevitable”

“We are long term investors; we want managers who think the same”

“Madoff is like a plane crash – terrible for those involved but, because weaknesses in the system are identified and remedied, good for everyone else”

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Fund domicile

There has been much talk over the last 18 months of the redomiciliation of the alternative investment industry, from the offshore jurisdictions to those elsewhere, such as the EU. But the overwhelming majority of investors report that they are happy to continue to allocate to funds that are located in offshore domiciles. There is no evidence that the domiciliation structure of the alternative investment industry is of concern to those that, at least currently, allocate to these products.

The minority of respondents that would prefer to allocate to funds that are domiciled in onshore locations, are very often the same relatively few interviewees who would also like to see more regulation in the business. These are typically the newer allocators to alternative investments and, at least for them, liquidity and transparency are key when determining to invest here. Alternative UCITS funds, in Europe, are aimed at this market (as well as new investors that have been unable or unwilling to invest in offshore funds). But at least for existing, rather than potential, European institutional investors, it is the liquidity and the transparency of alternative UCITS funds which is their chief attraction – not so much that they are part of the EU, per se.

Whilst only a small minority of current alternative investors are concerned with onshore versus offshore domiciliation, all those that participated in this survey said that they now take fund servicing issues very seriously. This has been one of the great changes in the business over the last few years. Following high profile frauds that had a knock on effect for the industry in recent years, investor interest in the back office operations of alternative investments has grown exponentially. This is a permanent change in the business.

Would you prefer to allocate to alternative funds that are domiciled in on-shore locations or does this make little difference to you?

6%6%

14%

74%

Don't CareCare

19%

81%

% of respondents

“Due diligence is no longer a one-off”

“Larger investors are starting to request that independent directors are sourced from separate firms”

“The recent market events proved to be a success story for the alternative investment industry”

“Cayman will always have a role to play in the industry”

“The industry is called alternative because it is alternative. Why should it become a mainstream industry? Alternatives should only be handled by those who have more skill”

�0



Fund servicing

What impact, if any, has the market crisis and/ or the news of recent financial scandals had on your operational due diligence process?

No ImpactLow ImpactHigh Impact

11%

67%

22%

% of respondents

Perhaps the most emphatic result of this survey was the response to the question of whether fund servicing issues are taken seriously by investors. Three years ago, the result to this question may have been somewhat different.

Obviously, some fallout from products which were indirectly impacted by major frauds have played an important part of this. However, it is also a consequence of the ever increasing institutionalization of the business, say respondents. In fact the servicing side of the industry was becoming more professional pre-2008, with investors and therefore managers concentrating more on this topic than was once the case. But recent events, have greatly accelerated the trend.

How seriously do you take alternative fund servicing issues?

6%6%

14%

74%

Not SeriouslySeriously

100%

% of respondents

Interviewees make the point that they expect the trend to continue. The due diligence process is only going to become more rigorous in the future. Having robust systems and reliable service providers, that are also recognizable names, is now absolutely critical to success. Service provider branding is firmly on the agenda, and performance is no longer the major priority, as it once was.

This is changing the priorities of the industry. Managers and service providers both have to react to demands from their existing and prospective clients in this area. Large scale institutions are driving standards higher.

“The industry has stayed together at the core”

“Pension fund consultants need to be trained in investment management. They should be paid more”

“Regulators are becoming more sophisticated which is good for the industry. The amount of interference, however, may be detrimental”

“Structured products will struggle for at least three years, mainly due to everybody blaming them for the economic meltdown”

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The industry’s view... A Large US Based Institutional Investor

“We have watched events unfold over the last few years with a mixture of shock and fascination. Obviously what happened was not foreseen. But what is often overlooked in the analysis of what happened is that alternative asset categories did okay – at least in comparison with other options. Whilst we had some major disappointments, overall, the portfolio that I am responsible for held up reasonably well.

We are gradually increasing our exposure to hedge funds at the moment. 80% of this will soon be direct and we recently added to our staffing capability here to execute this strategy properly. 20% of our hedge fund allocation will continue to be via a fund of funds. We think fund of funds can add value for a large investor like us in certain market areas where we don’t have the internal capability to cover the managers. We like managed accounts for certain situations and use them when we want to allocate in excess of US$100 million to a manager.

We were one of the earlier (institutional) movers into hedge funds in the US and the team has been in place for a long time. We have built up considerable experience over the years.

As direct investors into hedge funds, one of the things that we have learnt is that you have to spend serious time with your managers – not just at the beginning but on a regular basis. I would say this is the most important lesson that we have learnt over the years. You have to get to know them, their systems, their service providers etc. If you do this you get more comfortable when they invest in more esoteric and illiquid areas of the market. But you need to have real resources and commitment to make this work. Fortunately we have the clout to get their time.

A lot of nonsense is talked about management fees. I personally don’t care less what my managers are paying themselves provided that they are doing a good job. We focus on our net returns. That is all that matters.

I would not say that fund servicing issues have grown in importance for us. That’s because we have always focused on operational issues. We need to know something about the administrator. We won’t turn a manager down if he’s got an administrator that we don’t know, but we won’t invest either until we have got to know something about the outfit and are comfortable with the situation.”

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A Major Swiss Private Bank

“We expect that the structure of the alternative investment industry will change considerably over the next few years. There will be more change during this period than there has been for a very long time. In particular there will be more regulation and transparency coming into the business.

Even though we are based in Geneva, and outside the European Union, we like the development of alternative UCITS funds. This was needed after Madoff and other problems that hit the business. A lot of Swiss private banks were very badly affected by Madoff. What happened forced us to review our entire alternative investment strategy. It really did have a considerable impact here. Nothing like this can ever happen again; I don’t think the industry would survive it. In particular we have changed our due diligence procedures. Frauds are always very difficult to uncover but we have refined our operational due diligence methodology with a special emphasis on asset verification and on site walk through.

We will be investing more in alternatives over the next 3 years and will be allocating more to event strategies and emerging markets but less to managed futures. We have not yet decided on the structures that we will be using to allocate to these strategies. It is something that we are reviewing at present. How we go about selecting talent is an evolving process. It is likely that we will use managed accounts more in the future and we will probably be increasing our direct investment into hedge funds. Fund of funds of course have a role too. Our goal is to refine our selection methodology to make sure that the best managers are chosen, and control the associated risks.

I do not think that there will be any real change to the fee structure of the industry. The business is driven by supply and demand parameters: large, established, successful managers will be able to sustain their current fees, while others will have to give up on them as a means to raise assets. But there is likely to be more variety in fees in the future.

It is too early to tell what effect the extra regulation that is coming will have on the industry. It is interesting to note, however, that the vast majority of the excesses which have triggered the need for regulation were initiated in the banking industry more than in the hedge fund sector. If regulation was the solution for investor protection then we would have avoided the last crisis. It wasn’t unregulated funds that caused the problems. Our decision to invest more in alternatives will be influenced by the cost of regulation over the benefits of it. I just hope it doesn’t reduce performance.

We don’t care if a fund is domiciled in an offshore or onshore location. But we do take operational issues extremely seriously. We do our own due diligence on the service providers of the funds we invest in.”

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The Future of Alternative Investments��


For information on issues raised in this report, please contact:

Anthony Cowell KPMG in the Cayman Islands +1 345 914 4338 [email protected] Andrew Stepaniuk KPMG in the Cayman Islands +1 345 914 4315 [email protected]

Global investment management contacts:

Wm David Seymour Global Head and Head of Americas Region KPMG in the US +1 212 872 5988 [email protected]

Bonn Liu ASPAC Region KPMG in Hong Kong +852 2826 7241 [email protected]

Tom Brown EMA Region KPMG in the UK +44 20 7694 2011 [email protected]

John Li Fund Centers Group KPMG in Luxembourg +352 22 51 51 6200 [email protected]

KPMG contacts:

Jacinta Munro KPMG in Australia +61 3 9288 5877 [email protected]

Diveane Bowe KPMG in the Bahamas +1 242 393 2007 [email protected]

Craig Bridgewater KPMG in Bermuda +1 44 1295 5063 [email protected]

Tanis McDonald KPMG in the British Virgin Islands +1 284 852 4805 [email protected]

Peter Hayes KPMG in Canada +1 416 777 3939 [email protected]

Andrew Stepaniuk KPMG in the Cayman Islands +1 345 914 4315 [email protected]

Neale Jehan KPMG in the Channel Islands +44 1481 721 000 [email protected]

Sanjay Agarwal KPMG in the Dutch Caribbean +599 97 32 5176 [email protected]

Brian Clavin KPMG in Ireland +353 14101252 [email protected]

David McGarry KPMG in the Isle of Man +44 1624 681 044 [email protected]

Ravi Beegun KPMG in Luxembourg +352 22 51 51 6248 [email protected]

Juanita Bencini KPMG in Malta +356 2563 1143 [email protected]

Jon Mills KPMG in the UK +44 207 311 6079 [email protected]

Mikael Johnson KPMG in the US +1 212 954 3789 [email protected]

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Publication name: The Future of the Alternative Investment Industry

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Publication date: June 2010

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Transformation future alternative_investments

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