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2013 Hedge Fund OutlookSome gains, more painDeloitte Center for Financial Services

Table of contents21Introduction2Fostering a compliance culture3Competing for new assets with targeted strategies4Addressing fee pressure through operational streamlining5Conclusion6Contacts

IntroductionThey say what doesn’t break you makes you stronger. Forhedge funds, 2012 was a backbreaking year to put it mildly.Heightened market volatility, stressed global macroeconomicconditions, and underperformance relative to traditionalinvesting vehicles were just a few of the factors thatchallenged hedge funds in 2012. Add the extra weight of anincreasing regulatory burden, and many fund leaders mighthave been forgiven for packing it in.But something telling happened instead — the industryemerged from 2012 stronger than it went in, surpassing therecords it set in 2007 for assets under management (AuM)and absolute number of funds.1 Those that remained settledinto a more measured and sustainable pace of growth,with money flowing mainly to hedge funds who alteredtheir routines by adjusting to new demands from regulatorsand investors while looking for new ways to streamlineback-office operations.The coming year will be no less challenging. With theSecurities and Exchange Commission (SEC) registration nowbehind them, hedge funds will be subject to ongoing FormPF reporting and, for the first time, risk-based examinations.We also expect there to be some additional clarity on otherpending matters on the regulatory front. Additionally,institutional investors, whose hedge fund allocationshave increased five-fold since 2003, will continue toexert pressure on companies for greater transparencyand customized fee arrangements, more closely aligningmanager and investor interests.2Despite these ongoing challenges, we believe the industryis positioned to grow opportunistically in 2013. Institutionalinvestors’ appetite for alternatives continues to increaseas bond yields hover near all-time lows, public pensionunderfunding approaches record levels, and equity marketvolatility upends more traditional investments. The averageinstitutional allocation in hedge funds is about 10 percentand is expected to double by 2016.3 Those numbers couldin fact be low if hedge funds return to historic performancelevels; just 43 percent of hedge funds had reached theirhigh-water marks by the end of September.4Make no mistake: The coming year will be an important onefor performance if firms hope to return to earning more thanjust management fees. We expect hedge funds to engagein the following three strategies as they seek to close thisperformance gap and position themselves for increasedallocations in 2013: Fostering a compliance culture Competing for new assets with targeted strategies Addressing fee pressure through operational streamlining1 As per HFR as of 2Q12.2 “Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence,” Citi Prime Finance, June 2012, demo/tutorials41/IIHF June2012/files/assets/downloads/publication.pdf .3 “Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence,” Citi Prime Finance, June 2012, demo/tutorials41/IIHF June2012/files/assets/downloads/publication.pdf .4 “Fewest Hedge Funds At High-Water Mark,” FINalternatives, September 27, 2012 http://www.finalternatives.com/node/21693 .As used in this document, “Deloitte” means Deloitte LLP and its subsidiaries. Please see www.deloitte.com/us/about for a detailed descriptionof the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations ofpublic accounting.2013 Hedge Fund Outlook 1

Fostering a compliance cultureCompliance has become a top priority for hedgefund executives given the increasing regulatoryburden and push by investors for additionaltransparency. The implications of new rules stemmingfrom the Dodd-Frank Wall Street Reform and ConsumerProtection Act (Dodd-Frank), the Foreign AccountTax Compliance Act (FATCA), and the AlternativeInvestment Fund Managers Directive (AIFMD), arefar from settled, but there is a general recognitionamong hedge fund leaders of the need to fortifytheir compliance policies, procedures, and personnelin order to stay agile and responsive in this dynamicregulatory environment. This awareness extends to theneed to ensure that hedge funds maintain adequateoversight of service providers, who are taking on moreresponsibility in performing regulatory functions.Back-office resources were severely tested in 2012by two key compliance hurdles: SEC registration andForm PF. According to a Hedge Fund Alert article,Bank of America estimates, some large hedge fundsspent upwards of 500,000 just in completing afirst-year Form PF.5What’s new for 2013With more than 1,500 new private fund advisers registeredwith the SEC in late 2012, hedge funds will open theirdoors in 2013 to the new SEC inspection regime.6 Inadvance of these risk-based “presence exams,” the SEChas told fund advisers that it will be focused on five keycompliance areas: marketing, portfolio management,conflicts of interest, the safety of client assets, andvaluation.7Some in the industry have expressed concern about theagency’s level of sophistication when it comes to hedgefunds, but we believe regulators have strengthened theirhand by enhancing their capabilities in some importantways. For example, SEC examiners are increasinglyincorporating data analytics to identify aberrational tradingor performance and detect instances of insider trading.We believe 2013 will also bring increased clarity on severalother compliance-related topics among hedge funds,including FATCA, Commodities Futures Trading Commission(CFTC) registration, AIFMD, and tax legislation reform.In addition to stepped-up pressure from regulators, we alsoexpect institutional investors to expand their demands forgreater transparency into new areas such as cyber securityand fraud prevention programs.Bottom lineGiven the reputational harm that can come from anenforcement case, compliance is now a critical componentof a hedge fund’s culture, perhaps as important to theirsurvival as investment performance.The problem is that many pending regulatory mattersremain unresolved. Dodd-Frank is a prime example, withroughly two-thirds of its rules not yet finalized.8 In addition,the role certain regulatory bodies will eventually play hasyet to be determined. And then there is the arrival of ElisseWalter at the helm of the SEC, and the question of howdramatically the agency’s priorities may change as a result.One thing is for certain: Pressure from regulators won’tabate anytime soon. This year will bring increasedemphasis on managing the compliance burden in amanner that integrates governance, controls, supervision,operations, and technology. A dedicated chief complianceofficer is recommended for firms that have registered orplan to register with the SEC in 2013. A chief financialofficer or chief operations officer might have been able tohandle the added responsibilities before, but those daysare clearly over.5 “BofA Tallies Costs of Form PF Filing,” The Hedge Fund Alert, March 28, 2012, 1/BofATallies.pdf.6 “More Than 1,500 Private Fund Advisers Registered with the SEC since Passage of the Financial Reform,” U.S. Securities and Exchange Commission, October 19, 2012, http://www.sec.gov/news/press/2012/2012-214.htm .7 U.S. Securities and Exchange Commission, October 9, 2012, nce-exams.pdf .8 Timothy Spangler, “Dodd-Frank’s Fate Unclear with Changes at Top of SEC,” Forbes, November 28, 2012, of-sec/ .2

Competing for new assets withtargeted strategiesDespite the increased scrutiny from regulators, theindustry’s AuM broke through the 2 trillion barrierand may be poised to rise even higher as institutionalinvestors shift more of their investments towardrisk-driven classifications and expand the pie of theiralternative asset allocations.Still, we recognize the near-term growth outlook isnot that rosy. The industry’s relative underperformanceduring the last few years has some investorsquestioning the value add of hedge funds and theyare exerting downward pressure on fees as a result.“Two-and-twenty” is no longer sacred, and feeflexibility is becoming the new normal.For certain, some hedge funds will inevitably generateoutsized returns in 2013 and offset these kinds ofpressures, but the search for alpha will likely remainelusive for most. As such, we do not expect theindustry to snap out of its lull overnight.Nevertheless, we do believe certain hedge fundsare positioned to grow opportunistically in 2013,particularly those that offer investment strategiesemanating from emerging global trends.What’s new for 2013The balance of power may firmly remain in the hands ofinvestors, but we believe this will be an area of opportunityfor hedge funds in the coming year, specifically those withdiverse investment capabilities and robust operationalinfrastructures. For example, we expect certain big-ticketinstitutional investors with dry powder and focusedinvestment priorities to increasingly seek customizedsolutions in 2013. These could include bespoke investmentor co-investment strategies, and might require tailoredreporting capabilities and managed account platforms.These opportunities favor large hedge funds in particular.Additionally, resolution of challenges tied to the JOBS Actmay give hedge funds access to high-net-worth individualsthrough wealth management platforms. Congress intendedfor the law to help lift advertising restrictions on theindustry, and it will likely pressure the SEC to rule on hedgefunds’ responsibilities for verifying qualified investors.A positive ruling could reshape the way hedge funds marketand attract new assets.With the hedge fund industry maturing, competition isintensifying from traditional and non-traditional assetmanagers in the industry. New entrants are acceleratingindustry convergence by blurring the lines in some casesbetween hedge funds, private equity funds, and mutualfunds. Hedge funds are also playing a part in this evolution,with some funds pursuing new investment strategies anddistribution channels involving private equity, mutual funds,and other domestic or foreign registered products suchas UCITS.We expect these diversification strategies to continue in2013, with some firms also expanding geographically,into emerging or even frontier markets, or into new assetclasses such as European credit. Alpha opportunities mayalso be found in certain asset classes like real estate ordistressed debt.For those hedge funds that are not interested in expandinginto a diverse mix of strategies, we see other opportunitiesin 2013. For instance, we believe certain emergingmanagers will revert to the industry’s entrepreneurial rootsby generating alpha through niche strategies such asstructured credit, frontier market debt, or other illiquid fixedincome instruments.If 2013 turns out to be as challenging as the previous fewyears, expect more interest around the topic of succession.If the past is any indication of the future, then we may seemore large, well established hedge fund founders pass thebaton on to the next generation of managers, leaving ayounger, less road weary group to deal with demandinginvestors and regulators.Bottom lineLarge hedge funds are in some cases better positionedfor growth in 2013 by being able to leverage broadbased competitive advantages across investments,distribution, and operations. However, in an industry whereperformance ultimately drives success, scalable smallermanagers and niche hedge fund strategists should haveplenty of opportunities in the year ahead.2013 Hedge Fund Outlook 3

Addressing fee pressure throughoperational streamliningThe combination of limited top-line growth andoperational cost creep has put many hedge fundsin the prickly position of grappling for productivitygains. Compliance costs are rising, institutionalinvestors are increasingly seeking customizedservice levels, and alpha generation has grown morechallenging. We see 2013 as a year in which hedgefunds consolidate these efficiency gains while diggingdeeper into their organizations looking for morecost-cutting opportunities.What’s new for 2013We believe hedge funds will increasingly turn tooutsourcing, process efficiencies, enhanced datamanagement, and technology solutions to help alleviatethese operational strains in 2013. These strategies will beparticularly important to those hedge funds that patchedtogether temporary fixes to deal with new complianceburdens in 2012, while postponing the implementationof long-term solutions.Outsourced service providers will likely play a growing rolein support of data-intensive regulatory-driven initiatives(e.g., Form PF reporting) and compliance programs. Middleoffice functions such as trade processing or corporateactions processing, or even certain activities like collateralmanagement that are closer to the front office, couldalso be prime outsourcing candidates. While retainingoversight responsibilities in-house, hedge funds will turn tonew outsourcing models that transfer resource-intensiveoperational, regulatory, and technology activities to externalpartners with scale advantages. This approach will helpcomfort those who fear losing control through outsourcingrelationships while alleviating significant cost pressures andincreasing fee transparency with fund investors.4The industry’s views on technology will also continue toevolve, as more chief information officers embrace creativeways to reduce costs and risks by better integrating serviceprovider connectivity, enhancing risk analytics, leveragingdata management, and offloading certain commoditizedtrading activities, among other opportunities. Hedgefunds both small and large are increasingly scrutinizing theescalating costs of market data. Larger hedge funds withinternal operational infrastructures will arguably benefitmore from this technology rethink, but smaller funds willbe able to generate technology-driven efficiencies eitherdirectly or through service provider relationships. Hedgefunds lacking a streamlined data warehouse may adoptspecialized bolt-on systems to help them address theinflexibility of legacy technologies in dealing with increasingdemands from regulators and investors. Others will migrateto cloud-based software solutions, given the increasedsophistication and security protections they offer for frontand back-office functions.Bottom lineThe increasing regulatory burden, combined with investorpressure to provide greater transparency and reduce fees,amounts to a new operating reality for hedge funds.It may be difficult for all but the largest funds to justifythe investments needed to sustain an institutional-gradeoperation while confronting increasing operationaldemands. Ongoing industry consolidation is oneramification of this difficulty. But we believe that some maybe able to alleviate this pressure and level the playing fieldby turning to partnership strategies that incorporate a blendof outsourcing and technology.

ConclusionThe hedge fund industry faces no shortage of challenges,but we see its current struggles as a form of resistancetraining. Hedge funds are being forced to invest in theirinfrastructure to shoulder the growing strain of regulatoryand investor demands. When those demands lessen,hedge funds will emerge as stronger and more structurallycapable of winning investors’ confidence.In the meantime, the industry will have to do what it canto manage the added burden while delivering alpha. Wesee cause for optimism in this respect. Leading head fundsare getting ahead of regulatory uncertainty by fortifyingtheir compliance policies, procedures, and personnel.Others are adjusting to downward pressure on revenueby instituting new fee structures and exploring newdistribution channels. And many more are tapping processefficiencies and technology solutions to streamline theiroperations.We have every confidence that these changes — and moreto come — will position the industry to effectively managethis increasingly dynamic and challenging environment inthe year ahead.The question now is whetherhedge funds can find alpha withthe extra weight of increasinginvestor and regulator demands.2013 Hedge Fund Outlook 5

ContactsIndustry leadershipCary StierVice ChairmanU.S. Managing Partner, Asset Management Services GroupDeloitte LLP 1 212 436 [email protected] DoughertyAsset Management Tax LeaderDeloitte Tax LLP 1 212 436 [email protected] LemayAsset Management Audit and Enterprise Risk Services LeaderDeloitte & Touche LLP 1 617 437 [email protected] SpenserAsset Management Consulting LeaderDeloitte Consulting LLP 1 212 618 4501pmspens[email protected] WeismanAsset Management Financial Advisory Services LeaderDeloitte Financial Advisory Services LLP 1 212 436 [email protected] SchubertChief Advisor, Asset Management Services GroupDeloitte Services LP 1 203 708 [email protected] EckenrodeExecutive Director, Deloitte Center for Financial ServicesDeloitte Services LP 1 617 585 [email protected] Center wishes to thank the following Deloitteprofessionals for their contributions to this report:Michael ChungDirectorDeloitte & Touche LLPKarl EhrsamPrincipalDeloitte & Touche LLPRob FabioPartnerDeloitte & Touche LLPJeannie LewisPrincipalDeloitte & Touche LLPRahul BagatiSenior AnalystDeloitte Services LPHeadquartered in New York City, the Deloitte Center for Financial Services provides insight and research to help improve the business performance of banks, private equity, hedge funds,mutual funds, insurance and real estate organizations operating globally. The Center helps financial institutions understand and address emerging opportunities in risk and informationtechnology, regulatory compliance, growth, and cost management. The Center brings a financial services integrated view to Deloitte and its network of member firms, each of which is alegally separate and independent entity that provide audit, consulting, financial advisory, risk management, and tax services to select clients.With access to the deep intellectual capital of 193,000 people worldwide, Deloitte serves more than one-half of the world’s largest companies, as well as large national enterprises, publicinstitutions, locally important clients, and successful, fast-growing global growth companies. To learn more about the Center, its projects and events, please visit us at www.deloitte.com/us/cfs.This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professionaladvice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business.Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor.Deloitte, its affiliates, and related entities shall not be responsible for any loss sustained by any person who relies on this publication.Copyright 2012 Deloitte Development LLC. All rights reserved.Member of Deloitte Touche Tohmatsu Limited

According to a Hedge Fund Alert article, Bank of America estimates, some large hedge funds spent upwards of 500,000 just in completing a first-year Form PF.5 What’s new for 2013 With more than 1,500 new pri