Hedge Fund to Family Office: Continuing Trend or Past its Prime?

Posted on July 30th, 2017

For the last several years, converting a hedge fund to a family office was a popular transition. George Soros, Stanley Drunkenmiller and many other high-profile hedge-fund kings returned outside investments, packed up their suitcases of money and trotted down the yellow brick road to become a family office.

Increased competition, downward pressure on fees and lagging returns relative to other asset classes certainly put the squeeze on hedge funds. But it was the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 that pushed some hedge funds to pull the plug and go the family office route.

Survival of the Fittest

Signed into law in response to the financial meltdown of 2007-2008, Dodd-Frank changed the playing field by repealing the “private adviser exemption” granted under the Investment Advisers Act of 1940. It required that hedge funds and other private fund advisors register with the SEC as well as meet the more stringent requirements for transparency and reporting of Dodd-Frank.

Family offices fared better. Thanks to the “family office rule,” which became effective in 2011, single family offices and some multi-family offices that met certain requirements were exempt from having to register with the SEC as investment advisors.

This exemption provided a “loophole” that enabled family offices to avoid the onerous reporting and related compliance costs that Dodd-Frank required. Combined with other market conditions, the family office rule sparked some hedge funds to rethink their business. According to a recent article in the Wall Street Journal, approximately three dozen hedge funds converted to family offices since 2011.

Running a hedge fund is challenging. Operational costs are high, competition is fierce and delivering stellar returns is difficult in the current low interest-rate environment. High fees along with underperformance relative to other asset classes don’t help. One very bad year can be just enough to put a firm over the edge. Just ask Seneca Capital, SAB Capital, BlueCrest, JAT Capital and other well-know hedge funds that threw in the towel in 2015 (a bad year for hedge fund performance by all markers) to become a family office. But will this trend continue?

Ripe for Change

The once steady stream of hedge fund to family office conversions is looking more like a trickle nowadays as some of the drivers have changed.

For one, hedge funds have had 7 years to adapt to Dodd-Frank and figure out whether they would sink or swim under its onerous filing and reporting requirements. The light regulatory hand of the current administration is unlikely to burden firms with additional requirements particularly since the very fate of Dodd-Frank is still in question.

Hedge funds are also getting back on track. The Preqin All-Strategies Hedge Fund benchmark indicates that overall, hedge fund returns are on the rise and performance in 2017 is thus far better than expected. Although fund returns still lag that of other asset classes, the rosier outlook may provide a much-needed boost of investor confidence and help stem the outflow of capital. Tired of high fees and disappointing returns, investors had been reallocating their portfolios away from hedge funds and into private equity, real estate and other asset classes. A predicted rise in short-term rates in 2017 may also help since hedge funds typically outperform fixed-income investments when rates go up.

In addition, anti-money laundering requirements around Know Your Customer and beneficial ownership are slowly chipping away at the halcyon days of privacy for high net-worth individuals. As family offices grow in number and in the sheer volume of wealth they control, they may be faced with more reporting and compliance obligations --a fate that hedge funds now know well.

Whether operating as a hedge fund, fund administrator, single family office or multi-family office, FundCount software provides the accounting, investment analysis and reporting flexibility to meet your changing needs.