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Service providers see flight to quality

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The past year has seen extensive redemptions from hedge funds, especially in the final quarter of 2008, as a result of global economic uncertainty and poor performance in many markets and strategies. As a result, a large volume of capital that was previously allocated to alternative investments is now sitting in cash. That capital must ultimately be reinvested in more productive assets – but what criteria will govern investors’ decisions?

The first decision is whether to return to the alternatives arena or to invest in more traditional products. Over the past decade and more, alternatives and notably hedge funds have become an area in which first high net worth individuals and latterly institutions have become increasingly comfortable investing, and it seems likely that significant amounts of capital redeemed over the past few months will eventually be reallocated back into alternatives.

However, the decision-making process is likely to be a more rigorous and painstaking one than was usual in the past. There will be much more intense scrutiny of funds, managers and strategies on the part of potential investors, and no aspect will be examined more carefully than the operational environment maintained by managers. More than ever today, the appointment of an independent administrator to the investment relationship is an essential precondition for many investors.

Having the right operational and service infrastructure in place is particularly important for managers of funds of hedge funds, some of which have found their manager selection and due diligence processes exposed to unflattering examination in recent months. The creation of dedicated operational due diligence teams has previously been limited to the larger fund of funds managers, but it is likely to extend much more widely throughout the sector in the future as investors demand more sophisticated risk management arrangements and closer scrutiny of underlying managers.

The hedge fund industry faces a flight to safety, on a number of different levels. Investors will pay much more attention than in the past to the quality of service providers used by fund managers, including administrators but also auditors, prime brokers and lawyers, and this development is likely to benefit top-tier firms in each area. Institutional investors in particular will favour operational risk frameworks involving service providers that offer the assurance of a well-established name and solid corporate background.

This heightened level of scrutiny is not a one-way process. Just as investors are examining the credentials of the service providers to funds they are considering allocations to, an administrator in discussions with a prospective new client will seek its own assurances.

For example, we would want assurances that the manager was overseen by a recognised and respected regulatory authority with real substance to their supervision, and that they were using counterparties about which we had good working knowledge. All service providers, whether administrators, prime brokers or lawyer, have responded to developments over the past six months by putting in place enhanced review procedures when taking on new clients.

Another aspect of the flight to safety is that more exotic investment approaches are likely to be subjected to careful examination. Strategies that have proved highly volatile over the past year would require a very strong business case for us to take on and would have to satisfy our own risk and compliance requirements.

Guy Martell is head of business development and client relationships for alternative fund services in Europe at UBS Global Asset Management

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