INVESTMENT MANAGEMENT                     Beyond the credit crisis:                      the impact and lessons learnt for...
AcknowledgementsThis report, produced by KPMG International in cooperationwith the Economist Intelligence Unit, examines i...
Beyond the credit crisis: the impact and lessons learnt for investment managers	Respondents by geography                  ...
About the research |About the researchBeyond the credit crisis: the impact and lessons learnt forinvestment managers was w...
| Executive summaryExecutive summarySince the summer of 2007, banks have suffered significantlosses as a result of one of ...
Executive summary |Executive summary, continued  	There is a widespread feeling that fund management   firms need to re-ev...
| Executive summary  KPMG comment  While the fund management sector has not been as badly affected as the banking  sector ...
Complex instruments and strategies |Complex instrumentsand strategies: investmentmanagers take the plunge© 2008 KPMG Inter...
| Complex instruments and strategiesDespite what some of the political                                          a large Lo...
Complex instruments and strategies |Complex instruments and strategies:investment managers take the plunge, continued© 200...
| Complex instruments and strategies                                                                            47%       ...
Complex instruments and strategies |Complex instruments and strategies:investment managers take the plunge, continuedstrat...
| Complex instruments and strategies       KPMG comment       Investors have had a bad time in the structured finance mark...
Credit crisis exposes risks of complex strategiesCredit crisis exposes risksof complex strategies12© 2008 KPMG Internation...
| Credit crisis exposes risks of complex strategies                                                                       ...
Credit crisis exposes risks of complex strategies |Credit crisis exposes risksof complex strategies, continued    Other co...
| Credit crisis exposes risks of complex strategies                                                                       ...
Investment managers reveal holes in their risk processes |Investment managersreveal holes in theirrisk processes16© 2008 K...
| Investment managers reveal holes in their risk processes                                                                ...
Investment managers reveal holes in their risk processes |Investment managers reveal holesin their risk processes, continu...
| Investment managers reveal holes in their risk processes                                                                ...
Rating agencies and investment banks criticized |Rating agenciesand investment bankscriticized over transparencyof product...
| Rating agencies and investment banks criticized                                                                         ...
Rating agencies and investment banks criticized |Rating agencies and investment banks criticizedover transparency of produ...
| Rating agencies and investment banks criticized                                                                       “	...
Time for a rethink on risk |Time for a rethinkon risk24© 2008 KPMG International. KPMG International is a Swiss cooperativ...
Beyond the credit crisis: The impact and lessons learnt for investment managers
Beyond the credit crisis: The impact and lessons learnt for investment managers
Beyond the credit crisis: The impact and lessons learnt for investment managers
Beyond the credit crisis: The impact and lessons learnt for investment managers
Beyond the credit crisis: The impact and lessons learnt for investment managers
Beyond the credit crisis: The impact and lessons learnt for investment managers
Beyond the credit crisis: The impact and lessons learnt for investment managers
Beyond the credit crisis: The impact and lessons learnt for investment managers
Beyond the credit crisis: The impact and lessons learnt for investment managers
Beyond the credit crisis: The impact and lessons learnt for investment managers
Beyond the credit crisis: The impact and lessons learnt for investment managers
Beyond the credit crisis: The impact and lessons learnt for investment managers
Beyond the credit crisis: The impact and lessons learnt for investment managers
Beyond the credit crisis: The impact and lessons learnt for investment managers
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Beyond the credit crisis: The impact and lessons learnt for investment managers

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This report, produced by KPMG International in cooperation with the Economist Intelligence Unit, examines in detail for the first time how the fund flows, returns and reputations of investment managers have been impacted by the credit crisis and the economic conditions of the past 12 months.

It is based on the survey of 333 senior executives from across the global fund and investment management community, in March and April 2008. Respondents were based in fund or investment management firms, institutional investors, private equity funds, hedge funds and real estate funds.

References within the report to “mainstream fund management firms” or “fund managers” are based on a filtered sample of respondents that excludes either alternative investment funds (private equity funds and hedge funds) or fund managers’ keyclients (institutional investors).

A range of organization sizes were represented: 58 percent had assets under management of at least US$1billion; and nearly one in four (23 percent) had assets of at least US$50billion. Geographically, about one-third (31 percent) were based in North America, 29 percent in Western Europe, 23 percent in Asia Pacific, with the balance from the rest of the world. The respondents themselves were very senior: 41 percent of participants were C-level executives, 35 percent were in SVP/VP or director positions, or were heads of business units or departments, with the balance from other management positions.

Supplementary to the survey results, in-depth interviews were also conducted by the Economist Intelligence Unit with 16 senior asset managers, hedge funds and industry experts.

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Transcript of "Beyond the credit crisis: The impact and lessons learnt for investment managers"

  1. 1. INVESTMENT MANAGEMENT Beyond the credit crisis: the impact and lessons learnt for investment managers July 2008 FINANCIAL SERVICESAUDIT ß TA X ß A D V I S O R Y
  2. 2. AcknowledgementsThis report, produced by KPMG International in cooperationwith the Economist Intelligence Unit, examines in detail forthe first time how the fund flows, returns and reputationsof investment managers have been impacted by the creditcrisis and the economic conditions of the past 12 months.  It aspires to go further than this though. It investigateshow, in the light of the challenges presented by the credit crisis,fund management firms are managing the increasing complexityof the instruments they use and the strategies they adopt.  Our foremost thanks go to the 333 respondents from57 countries who answered our online survey and the16 executives who gave us their time for interviews.  We would also like to thank members of the editorialboard and other colleagues around the world who have helpedus in carrying out this research, in particular Shiana Saverimuttu,Freddie Hospedales and Mireille Voysest from KPMG in theUK and Phil Davis and James Watson from the EconomistIntelligence Unit.Wm David Seymour Tom Brown James SugliaPartner and Global Head of Partner and European Head of Chairman of KPMG’sInvestment Management Investment Management Global AlternativesKPMG in the US KPMG in the UK Advisory Commitee KPMG in the US© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  3. 3. Beyond the credit crisis: the impact and lessons learnt for investment managers Respondents by geography Contents31%based in North America Page 2 About the research29% 3 Executive summarybased in Western Europe 6 Complex instruments and strategies: investment managers take the plunge23%based in Asia Pacific 12 Credit crisis exposes risks of complex strategies17% 16 Investment managers reveal holes in their risk processesrest of the world 20 Rating agencies and investment banks criticized over transparency of productsEditorial Board  24 Time for a rethink on riskChaired by Tom Brown KPMG in the UKBill Dickinson KPMG in the UKJohn Hermle KPMG in the USGerold Hornschu KPMG in Germany 28 The way forward: where canColin Martin KPMG in the UK investment managers add value?Patrick McCoy KPMG in the UKPaul McGowan KPMG in IrelandRichard Pettifer KPMG in the UK 33 Challenges ahead: the keys to successCara Scarpino KPMG in the USElmar Schobel KPMG in Germany 34 ContactsAndrew Schofield KPMG in AustraliaAnthony M Sepci KPMG in the USWm David Seymour KPMG in the USAndrew Stepaniuk KPMG in the Cayman IslandsJames Suglia KPMG in the USDavid A Todd KPMG in the UKAndrea J Waters KPMG in Australia The views and opinions expressed herein are those of the survey respondents and interviewees and do not necessarily represent theAdditional contributions views and opinions of KPMG International or KPMG member firms. The information contained herein is of a general nature and is notColin Ben-Nathan KPMG in the UK intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information,Antonia Blake KPMG in the UK there can be no guarantee that such information is accurate as of theMarcus Sephton KPMG in the UK date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professionalSteven Tait KPMG in the UK advice after a thorough examination of the particular situation. © 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  4. 4. About the research |About the researchBeyond the credit crisis: the impact and lessons learnt forinvestment managers was written in cooperation with theEconomist Intelligence Unit and is based on their survey of333 senior executives from across the global fund andinvestment management community, in March and April 2008.Respondents were based in fund or investment managementfirms, institutional investors, private equity funds, hedge fundsand real estate funds. References within the report to in Western Europe, 23 percent in “mainstream fund management Asia Pacific, with the balance from firms” or “fund managers” are the rest of the world. The respondents based on a filtered sample of themselves were very senior: respondents that excludes either 41 percent of participants were alternative investment funds C-level executives, 35 percent were (private equity funds and hedge in SVP/VP or director positions, funds) or fund managers’ key or were heads of business units clients (institutional investors). or departments, with the balance A range of organization sizes from other management positions. were represented: 58 percent had Supplementary to the survey assets under management of at results, in-depth interviews were least US$1billion; and nearly one also conducted by the Economist in four (23 percent) had assets of at Intelligence Unit with 16 senior least US$50billion. Geographically, asset managers, hedge funds about one-third (31 percent) were and industry experts. based in North America, 29 percentParticipating countriesArgentina Chile Germany Israel Mexico Russia Sweden United KingdomAustralia China Ghana Italy Netherlands Saudi Arabia Switzerland United StatesAustria Colombia Greece Japan New Zealand Serbia Thailand of AmericaBahrain Czech Republic Hong Kong Kenya Nigeria Singapore Trinidad and VietnamBelgium Denmark Iceland Luxembourg Pakistan South Africa TobagoBrazil Egypt India Macedonia Peru South Korea TurkeyBulgaria Finland Indonesia Malaysia Poland Spain United Arab Canada France Ireland Mauritius Portugal Sri Lanka Emirates Respondents by business type44% 20% 13% 23%Mainstream fund managers Alternative investment managers Investors OtherPlease note that with the graphs illustrated, not all answers add up to 100 percent because ofrounding or because respondents were able to provide multiple answers to some questions.© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  5. 5. | Executive summaryExecutive summarySince the summer of 2007, banks have suffered significantlosses as a result of one of the biggest crises ever to hitthe financial services sector, the so-called credit crisis.So far, banks have been the focus of attention as bearingthe brunt of the credit crisis impact. But what of the fundmanagement sector? This report asks how fund managershave been affected by the credit crisis – and what strategiesthey are adopting in response. Some of the key findings within the report include: Investors do not have the same Trust in fund managers has fallen enthusiasm for complex as a result of the credit crisis. instruments as fund managers. Fund management firms have Increasing complexity defines the suffered a degree of fallout from fund management industry today. the credit crisis, although nothing This survey of fund management nearly as severe as the banking and investment professionals reveals sector. Well over half of mainstream that 57 percent of mainstream fund fund managers say investment management firms use derivatives returns have fallen and about the in their portfolios. The figure is even same proportion report falling higher within large mainstream fund subscriptions. But the damage management firms: nearly one-third potentially goes further than short-60% of those with assets of at least term losses in funds: six out of ten US$10billion use derivatives to respondents believe trust in fund a major extent. Even more fund managers has been eroded due managers (61 percent) now manage to the effects of the credit crisis. hedge fund strategies, which in manyof respondents believe trust in fund instances are complex. The surveymanagers has been eroded due to also found that half of mainstreamthe effects of the credit crisis fund management firms manage private equity strategies, nearly half manage asset-backed securities and more than one-third manage collateralized debt obligations (CDOs). Fund managers still believe that with the exception of CDOs, all the above strategies and asset classes will rise over the next two years. On the other hand, 70 percent of the investors who answered the survey say that the credit crisis has reduced their appetite for complex products. © 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  6. 6. Executive summary |Executive summary, continued There is a widespread feeling that fund management firms need to re-evaluate what kind of business they are conducting and the risks they are running. Lack of skills and experience is Risk management, valuation Making fund management a key concern. There is evidence, methods and governance successful in the future requires in the light of the credit crisis, that structures are all being shaken up. a renewed focus on the client some aspects of fund management There is a widespread feeling that proposition. The credit crisis will require urgent attention. The skillsets fund management firms need to sharpen the minds of fund managers: of staff, for instance, have to some re-evaluate what kind of business in a time of increasing uncertainty degree failed to keep up with growing they are conducting and the risks and investor conservatism, they sophistication. One in five fund they are running. Four out of ten need to demonstrate their added- managers that have invested in firms surveyed for this report say value proposition. The concern is complex financial instruments, such they have already formalized risk that investors will reject further as derivatives, CDOs or structured frameworks in the past two years as innovation, particularly if it involves products, admit to having no in-house a result of managing more complex complex strategies and instruments. specialists with relevant experience. strategies, with a similar number As mentioned previously, 70 percent Investors are at greater risk still, with planning to do so over the coming of investors say the credit crisis has about one in three of the institutions two years. Valuation methods have reduced their appetite for complex investing in such instruments saying come under intense scrutiny during products. The fund management they have no in-house expertise of the credit crisis and a third of firms industry will need to prove the these. Rating agencies are seen as have reviewed this activity, while doubters wrong by developing providing little support: one third of a further third will do so in the next products and services that perform the respondents agree that rating two years. An even higher proportion, well over the cycle and in changing agencies provide an accurate 38 percent of respondents, have economic environments. All-weather assessment of whether an instrument reviewed governance arrangements strategies, lifestyle funds, insightful will default and just 1 percent of – particularly relevant in the cases of asset allocation advice and sound respondents think rating agencies are funds that used risky instruments to risk management and governance very accurate in predicting defaults. enhance returns on supposedly low practices are all likely to be at a volatility funds – and a further quarter premium in the coming months will do so in the next two years. and years.20% 65% 70%of managers that have invested incomplex financial instruments admit of firms surveyed say they have already formalized risk frameworks of investors say the credit crisis has reduced their appetite forto having no in-house specialists with in the past two years or are planning complex products by a majorrelevant experience to do so in the next two years or moderate extent© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  7. 7. | Executive summary KPMG comment While the fund management sector has not been as badly affected as the banking sector by the credit crisis, the landscape has changed and many investment management firms should re-position themselves in the new environment. It is clear that derivatives will continue to become more and more important in the investment management environment. Successful firms need to embrace the use of derivatives in their products in order to enhance performance with acceptable risk parameters. Derivatives have become the tools of the trade, they cannot be uninvented. However, the use of derivatives and investment in complex products requires an upgrade in the sophistication of how investment management firms are run. In particular, the following areas should be addressed: People Risk management Customer propositions There needs to be a migration While many investment As the credit crisis has unfolded, of experienced people from the management firms have developed investor confidence has taken a hit investment banks to investment sophisticated risk management and their appetite for investment management firms, especially in programs, there is a shortfall risk has been diminished. It is not derivative operations and risk across the industry in investment that long ago that investors were management. The requirements risk management capabilities, badly burned by the bursting of the of a derivative operation are so especially where firms are using tech bubble. The fund management fundamentally different from complex instruments and strategies industry has been criticized for being running a long-only business in their funds. Analysis of complex too product-led and not sufficiently that it is very difficult to develop products, scenario and stress customer-focused. In order to rebuild sufficient skills in-house. testing, price validation and liquidity investor confidence and attract Incentive plan design needs risk management are all key areas to long-term savings, successful firms to evolve to take more account of focus on in funds as well as fund of should focus on a much clearer long and short-term performance fund treasury structures. Another explanation of how products will as well as risk and investor important lesson learned from the perform and on much greater levels satisfaction: at the level of the experience of the credit crisis is the of investor assurance about firm as well as the individual. For importance of treasury and credit governance and risk management. most organisations this will require risk management (and how to best On their side investors need to a significant shift in organizational manage surplus cash in fund understand the risks and features behavior and strengthening of structures) as well as liquidity risk of what they have invested performance management process management (and how to best in or permitted their investment and systems. manage extreme redemption managers to invest in. While retail scenarios). The area of treasury investors enjoy a much greater and investment risk management is degree of regulatory protection, where we expect to see significant ‘caveat emptor’ or ‘buyer beware’ investment and increased focus very much applies to institutional within investment management investors. Reliance on rating agencies firms in future. is not enough. Proper analysis and risk assessment is required. On the other hand, firms will also need to pay more attention to customer demands, i.e. if clients want simple products that is where the client proposition needs to be focused. © 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  8. 8. Complex instruments and strategies |Complex instrumentsand strategies: investmentmanagers take the plunge© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  9. 9. | Complex instruments and strategiesDespite what some of the political a large London-based investment firm,and media circles say, fund managers says: “We think investors are tiringdo not set out to confuse investors. of funds that are highly correlated toWhile complexity exists, it is typically markets.” The firm runs US$1billion inthe by-product attempts to enhance five single strategy hedge funds andthe offering, through improved risk two fund of funds, and has justcontrols, protection of capital or launched a new hedge fund, managedenhancement of returns. in Hong Kong. The new fund invests This report considers complex in very different sub-sectors from ainstruments to be those that are illiquid traditional long-only strategy. Theyin nature and hard to value using include directional strategies, tacticalconventional valuation measures. trading, long-short, market neutral andComplex strategies are taken to be event-driven tactics. It is typical ofthose that, again, may be illiquid or hard larger, institutional-focused fund firmsto value. But they may also be innovative that have responded to investors’ 51%and not widely understood across the demands and attracted significantinvestment spectrum and by investors assets in non-core investment areas.of either institutional or retail variety. Derivatives are also a significantBy definition, complex instruments growth area, with 57 percent of firmsand strategies are understood by a surveyed for this report saying theysmall number of people and this, in use derivatives in their portfolios of mainstream fund managers runturn, increases the risks associated (see Chart 1). The figure is slightly long-short funds of the 130/30 typewith their use. higher (61 percent) within mainstream Such instruments are worthy fund management firms and muchof special attention, given that higher within larger ones (74 percent):increasing complexity defines the nearly one-third (29 percent) of thosefund management industry today. with over US$10billion in total assetsThis survey of fund management say they use derivatives to a majorand investment professionals reveals extent. Derivatives are used in a varietythat a substantial majority (61 percent) of fund strategies including fixedof the mainstream fund management income, money market and somefirms that responded to this survey – equity strategies, such as the 130/30-encompassing fund and investment type vehicles that balance a gross longmanagers, retail fund managers and position of 130 percent of assets withreal estate funds – now manage a 30 percent short position. Just overhedge fund strategies which in many half (51 percent) of mainstream fundinstances are complex. This rises to managers run long-short funds of the71 percent of fund managers with over 130/30 type.US$10billion in total assets. The head of wealth management Many have invested significantly at an Asia-based bank says: “130/30in building up a hedge fund capacity, in funds are another way for talented fundthe belief that investors will increasingly managers to demonstrate their skills.demand funds that deliver returns in If the risks are well communicated toall weathers. The rise in hedge fund investors and well understood they canassets from US$1,000billion in 2005 be a great product.” But he cautionsto US$2,650billion at the end of 2007, that specialized skills are needed.according to HedgeFund Intelligence, “The ability to buy the right stocksa data provider, bears out this belief. is a valuable skill, but shorting certainlyThe head of alternatives distribution at requires additional capabilities.” © 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  10. 10. Complex instruments and strategies |Complex instruments and strategies:investment managers take the plunge, continued© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  11. 11. | Complex instruments and strategies 47% of respondents in Asia Pacific expect that the use of derivatives will increase in the next two years. This was the highest percentage among respondents Derivatives have a number offunctions. Some of these are practical,such as to offset cash drag – thenegative impact on performance causedby holding cash to meet demand forredemptions. Assets held in exchange-traded derivatives that match thecharacteristics of the portfolio can bequickly cashed if there is a suddendemand for redemptions. Derivatives are widely used in fixedincome portfolios to seek extra yield oras protection against certain economicand portfolio-specific events. A wealthmanagement head says: “They can,for instance, neutralize the risks of animminent central bank decision thatcould affect the value of governmentbonds in a portfolio.” Derivatives are alsothe building blocks of ‘overlay’ strategieswhich allow dynamic asset allocationwithout having to incur the costs ofbuying and selling underlying assets. But hedge funds and derivatives arejust part of the picture. The survey alsofound that 50 percent of mainstreamfund firms manage private equityassets, 42 percent use asset backedsecurities and 37 percent managecollateralized debt obligations (CDOs).With the exception of CDOs, exposureto all these strategies and asset classesare expected to rise over the next twoyears. For example, far more (26percent) of North American investmentfirms plan to increase their exposure toderivatives, compared with those whowill decrease their exposure (3 percent).The same story plays out for hedgefunds: 34 percent of North Americanfirms will increase investment here,while just 8 percent will back away. In Western Europe, the market fortraditional equity funds should inch up:24 percent of firms say they willincrease investment here, nearly asmany as the number of firms that willreduce investment (21 percent). Bycomparison, demand for more complex © 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  12. 12. Complex instruments and strategies |Complex instruments and strategies:investment managers take the plunge, continuedstrategies is rising much faster. Indeed, compared with 10 percent who will40 percent of firms will increase the reduce theirs (see Chart 2).use of derivatives, while just 7 percent However, according to surveywill cut back. The same is true for respondents, the use of CDOs will fallinvestment in hedge funds: 44 percent considerably: just 9 percent will increaseplan to increase use of those, far more investment in that asset class, whereasthan those who will reduce exposure 17 percent plan to reduce exposure. But(9 percent). In the Asia Pacific region, experienced market observers argue thatwhere fund penetration overall is lower, CDOs are resilient vehicles. The deputytraditional equity funds have still to fulfill chairman of the asset managementtheir potential. Far more firms (41 percent) division of a Swiss investment bankwill increase exposure to these than says CDOs have run into problemsthose who will pull back (8 percent). But before and made a subsequentthis will be accompanied by an increase resurgence. “This situation is not new –in the number of investment firms using it is the assets backing them that havederivatives (47 percent increasing changed,” he says. “In 1998 it wasexposure, with 5 percent decreasing). emerging market debt and in 2001 itSimilarly, 43 percent will increase was Enron bonds. You can’t blame theinvestment in hedge fund assets, vehicles themselves for this.”KPMG commentOne of the main factors behind the growth of complex financial instruments in recentyears has been the search for yield by investors. In order to generate the required yieldfor investors in a market where funding was readily available, product developers turnedto increasingly complex structured financial instruments. An example of such a productis the ‘CDO squared’ (a structured credit vehicle that invests in other structured debtnotes). There is no doubt that over the last decade there has been the demand for suchinstruments. It is still unclear as to whether growth in this market will return and if sowhether the design of the instruments will have to change. What is clear, however, is that funds are increasingly using derivatives as part oftheir investment strategies. What has been highlighted by the credit crisis and its effecton structured credit products is how important it is to fully understand the pricing andrisk of such investments. Funds that should be successful are those that have differentiatedinvestment strategies (i.e. there may be demand for an allocation to a specialist structuredcredit fund, but investors should not expect money market funds to invest in such products).In addition, those funds that can provide transparency of the underlying valuation risk willmeet the increased investor demand to understand the risk in their portfolio.10© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  13. 13. | Complex instruments and strategies KPMG comment Investors have had a bad time in the structured finance market and very few new structured finance-related transactions are currently being carried out. We do not expect the markets to return for a while and whenever that happens, the transaction volume will be lower and the structures should be less complex and easier to understand. Improved transparency is required for the market to pick up, but exactly what changes need to be made remains to be seen. It is interesting that existing transactions had disclosure documents that were hundreds of pages long with lots of information about the transaction and its risks. Yet the transparency from these documents did not prevent the credit crisis from happening. The road ahead needs to be a move to simplify and standardize what information is needed to make better investment decisions. Market participants need to work together on this. The subprime sector of the market probably has the most questionable future of any of the other asset classes. It has suffered a material public image hit related to this crisis and, as a result, many people feel this sector will not return until 2010 at the earliest. Some parallels are being drawn to the manufactured housing securitization market that collapsed back in 2000/02 and has subsequently never recovered. However, subprime credits will always exist, giving the sector a fighting chance to return to some semblance of its former self. It will be interesting to see developments emanating from the rating agencies that help design securitization structures, as one benefit from this crisis has been an overwhelming amount of data points related to default behavior and the facts and circumstances surrounding this behavior. It is likely that rating agencies will enhance models to incorporate these behavioral tendencies as well as build in forward-looking aspects to their models like home price appreciation origination patterns in the industry, and possibly monitor primary market trading activity. 11© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  14. 14. Credit crisis exposes risks of complex strategiesCredit crisis exposes risksof complex strategies12© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  15. 15. | Credit crisis exposes risks of complex strategies “ eople will undoubtedly save more P and invest in less risky products.” A Managing Director at a large US-based money management firm While complex strategies are with AAA ratings – the kind that pension appealing to fund managers and funds were most exposed to – accounted their clients in low-yield, low volatility for 1,000 of these downgrades, more environments, the inherent risks than any other ratings class. Structured sometimes only become apparent in investment vehicles (SIVs) have turbulent markets. The credit crisis also suffered from the credit crisis. which began in early summer 2007 In January, for example, Victoria Finance, and continues – albeit in an evolved a US$6.8billion SIV run by Ceres Capital form – today has proved the undoing Partners, had its credit rating cut by of a number of complex strategies Standard Poor’s to D, its lowest level. and instruments. Some hedge funds, particularly those Structured credit vehicles containing with high exposures to asset-backed CDOs and credit default swaps (CDSs) securities and derivatives, have also have been some of the highest-profile experienced losses. Of these, Peloton casualties. CDSs had seemed fairly Partners, the London-based simple instruments – they were firm, gained the most notoriety. The insurance against a company defaulting company’s flagship ABS hedge fund on its debt obligations. But the side- enjoyed an impressive year in 2007, effects were unanticipated by many returning 87 percent to investors, and investors. For instance, years ago, an assets under management grew to4,485 investor buying US$100million of a US$3.5billion. But within a matter of company’s bonds would have sought a few weeks in January it collapsed. to avoid that company going bankrupt, A Financial Times commentator and since that would devalue the bonds. financial markets author says: “Their But if the investor bought CDSs as fatal bet appears to have been a bigThe number of downgrades of CDOs insurance, there would be an incentive position in synthetic asset-backedfrom January to April 2008 alone for the investor to support bankruptcy securities that had to be forciblyaccording to Morgan Stanley rather than restructuring if the company liquidated when some banks tightened had financial difficulties, since a default their credit terms.” He believes certain would trigger the derivative and pay themes are at the core of many hedge all the money back. Similarly, investors fund collapses: high degrees of leverage; selling credit protection through CDS concentration in a relatively narrow asset may be exposed to unanticipated credit class; and liquidity problems brought risk if they enter into a CDS assuming on by an unforeseen deterioration in that the underlying company is less market conditions. In other words, he likely to default than it really is. views hedge funds exhibiting those According to Morgan Stanley characteristics as fundamentally flawed research, from January to April 2008 from a risk perspective. Yet some hedge alone there were 4,485 downgrades of funds have profited handsomely from the CDOs, leading to a fall in their value in credit crisis. New York based Paulson the secondary markets. Just over 4,000 Co bet heavily against subprime assets of these downgrades were on CDOs and its three funds returned between of asset-backed securities. Tranches 130 percent and 650 percent in 2007. 13© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  16. 16. Credit crisis exposes risks of complex strategies |Credit crisis exposes risksof complex strategies, continued Other complex strategies that have But the damage potentially goes furtherlost out in the credit crisis include the than short-term losses in funds. Six out“enhanced” money market funds that of ten survey respondents believe trustinvested in hedge funds and CDOs to in fund managers has been eroded dueincrease returns. Some fixed income to the effects of the credit crisis (seefunds adopted the same strategy and Chart 4). A managing director at a largesuffered similar consequences. Private US-based money management firm,equity activity, too, has been heavily says: “People will undoubtedly saveimpacted and large leveraged buyout more and invest in less risky products.”deals are now a rarity (although mid- Intriguingly, investors themselvesmarket deals have remained buoyant). are less inclined to rush to judgment.Ultimately, the crisis spilled over into In all, 47 percent of institutional investorsequity markets as doubts surfaced over say their trust in fund managers hasthe ability of banks to finance economic been eroded. While this figure is high,growth, with Western markets falling it does mean many investors do not10 percent and more in the first quarter blame fund managers for losses orthis year. that the managers have succeeded Fund management firms have also in safeguarding their clients’ assets orfelt the impact of the credit crisis. Well managing these relationships. There is,over half (60 percent) of mainstream seemingly, opportunity for fund firmsfund managers say investment returns with talented managers and stronghave fallen (see Chart 3) and about the processes to prove their mettle in thesame proportion report falling aftermath of this crisis. But many ofsubscriptions. them will need to adapt in the coming By comparison, only 45 percent of months and years if they are to succeed.hedge funds and 44 percent of privateequity funds say returns are down.Although a much smaller set ofrespondents, the trend among realestate fund respondents appeared farworse: two-thirds say returns have beenimpacted – far more than in any otherasset class.14© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  17. 17. | Credit crisis exposes risks of complex strategies KPMG comment With the benefit of hindsight we can now see that, even though they may have followed what was thought to be good market practice at the time, a number of funds did not have an adequate valuation governance structure for managing the valuation risk inherent in illiquid, structured products. For funds where illiquid assets were not core, there was often little fundamental analysis performed of the products that they acquired, instead reliance was placed on the analysis performed by the rating agencies and sales materials. Consequently, when the crisis struck, these funds found it hard to quantify the level of risk they were exposed to, as a key risk metric used was the proportion of the portfolio invested in AAA-rated assets. It is now recognised that funds may need to perform a more thorough analysis of all new structured products, including assessing the most appropriate valuation technique, or source of valuation information and outlining contingencies for what happens in the event that the primary source of pricing information becomes unavailable. The work that has been done by the Hedge Fund Working Group (in the UK) and the Presidents Working Group (in the US) has set out some broad principles for hedge funds with respect to valuation governance, which should be considered by all fund managers that invest in illiquid assets. 15© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. No 15member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  18. 18. Investment managers reveal holes in their risk processes |Investment managersreveal holes in theirrisk processes16© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  19. 19. | Investment managers reveal holes in their risk processes 20% of fund manager respondents admit to having no in-house specialist with relevent experience of the complex financial instruments they have invested inThe fallout from the credit crisis has There is evidence that some aspects backed securities that offered additionalso far only proved disastrous for a of their businesses may require urgent yield over treasury bonds as if they werehandful of hedge fund managers. attention. The skillsets of staff, for ‘cocaine’. Investors are not alone inAnd, as just noted, there is an instance, have to some degree failed displaying such an addiction. A highindication that many investors have to keep up with growing sophistication proportion (40 percent) of fund managersnot lost faith in fund managers. At in fund management. One in five fund say they have bought a product forthe same time, there is a widespread managers who, according to the survey, which they did not have the frameworkfeeling that firms need to re-evaluate have invested in complex financial to assess the risk. While the vast majorityexactly what kind of business they instruments, such as derivatives, CDOs of mainstream fund managers and hedgeare conducting or wish to conduct or structured products, admit to having funds have bought or developed riskand ensure it is in alignment with no in-house specialists with relevant systems, the finding provides evidenceclient interests. They also should experience of them. A similar proportion that these systems have either becomereassess what risks they are (23 percent) of hedge fund managers outdated or were not entirely suited to theknowingly or unknowingly running. admitted the same (see Chart 5). purpose in the first instance. Less than Investors are at greater risk still, with half (42 percent) of fund management about one in three (32 percent) of the firms say they can quantify completely institutional investors that invest in their exposure to complex instruments instruments such as derivatives, CDOs and just one-quarter (24 percent) say or structured products saying they have no they can completely quantify the risk in-house expertise for these. If the fund associated with the exposure (see Chart 6). management industry is to retain the trust The head of sales at a European risk of investors, it would seem imperative for technology provider says: “Firms are it to both develop the necessary skills and developing products using instruments then offer these skills to investors. such as bank debt, loans, derivatives, Alan Greenspan, former chairman which they have not managed before. of the US Federal Reserve, believes They are looking to open up new avenues investors were helpless to resist risky in terms of markets and clients. But this instruments. He has been widely quoted creates a dilemma because cross-asset as saying they became addicted to asset- class cashflows are not easy to track.” 17© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  20. 20. Investment managers reveal holes in their risk processes |Investment managers reveal holesin their risk processes, continued One of the issues is whether fundmanagers are identifying and tackling Chart 6 Answers from mainstream fund managers to the question:the right types of risk. Less than half To what extent does your firm quantify the exposure and risk in(41 percent) of fund managers think their complex financial instruments?principal measure of risk reflects themajority of the risk an investment firm 6% 37% 42% 15%is taking and just 6 percent think this Exposuremeasure completely reflects the actual 6% 53% 24% 16%risk of loss. This rises to 10 percent Riskamong hedge funds, which tend tohave greater experience of managingcomplex strategies. The managers We can’t quantify this at all We can quantify this completelyoften cut their teeth on trading floors We can quantify this in part Don’t knowand have an understanding of bothtrading strategies and the instrumentsused (the aggregated answers from Source: Economist Intelligence Unit survey, March - April 2008 based on responses from fund /investment management firms, real estate funds and retail fund managersall respondents are shown in Chart 7). One of the world’s biggest fundof hedge funds, with US$38billion undermanagement, has a two-tiered approachto managing risk in its portfolios. It hasidentified that its main risks are theprevailing macroeconomic environmentand the selection of underlyingmanagers. So it has developed top-downand bottom-up processes operating intandem. Top-down asset allocationdecisions are taken by an experiencedfour-person investment committee whichhas about 70 years’ experience betweenthem. The firm’s chief executive says:“Top-down views are big creators ofalpha in our portfolios.” The bottom-up process starts witha rigorous quantitative process but isultimately guided by the firm’s abilityto get a close-up view of the managers,having built up relationships with themover two decades of being in the hedgefund business. The chief executive says:“The best managers come from firmswe have known for a long time. They arefrequently spin-outs from existing firms,sometimes second or third generationsof a firm.”18© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  21. 21. | Investment managers reveal holes in their risk processes “ op-down views are big creators T of alpha in our portfolios.” Chief Executive, one the world’s biggest fund of hedge funds KPMG comment Improved risk management has come into greater focus as a result of the market turmoil. Many of the currently employed risk management measures such as value at risk (VaR) or stress testing are backward looking in nature and lack the ability to take in current data or views about the future. For example, in ABS CDOs, one of the key shortcomings made in analyzing the risks in these products was that the underlying mortgage securities were more diversified than they turned out to be. We can now see that the mortgage securities were highly correlated and how sensitive they were to the decline in home prices. That information was not reflected in stress testing. Another area highlighted by the credit crisis is the degree to which companies are subject to model risk. Many companies may be reliant on models to assess their credit risk or value their holdings. Yet these models may not have been validated by an independent party or have the proper risks and controls regarding their use. Federal Reserve Chairman Ben Bernanke recently said in a speech, “No model regardless of the sophistication, can capture all the risk that an institution might face. Those institutions faring better during the recent market turmoil generally placed relatively more emphasis on validation, independent review, and other controls for models and similar quantitative techniques. They also continually refined their models and applied a healthy dose of scepticism to model output.” 19© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  22. 22. Rating agencies and investment banks criticized |Rating agenciesand investment bankscriticized over transparencyof products20© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  23. 23. | Rating agencies and investment banks criticized 86% 88% of respondents think conflicts of interest is a concern in respect of respondents think that lack of understanding of the instruments of rating agencies they rate is a concern in respect of rating agenciesWhile the infrastructure within some asset managers and their clients boughtfund management firms may have products that have been found to beproved with hindsight, insufficient to less than reliable. The originators ofmanage the risks they were taking, the many of the products, the investmentexternal inputs have often been less banks or manufacturers, also come inthan perfect too. Survey respondents for criticism. About one-third (34think that both rating agencies and percent) of fund managers say theybanks may have contributed to the have been sold a product where thelack of understanding of products. risk was under-stated by the originatorAnd yet fund managers and their (see Chart 10). This rises to 50 percentclients alike have come to rely on the among institutional investors.major rating agencies. Respondents to the survey demand Where a vehicle was awarded a rating wholesale changes to the way theof AAA, the market, rightly or wrongly, investment banks do business withtook this to be a firm statement of them. The vast majority of respondentsquality. But in the last 12 months, a series say they want investment banks toof AAA-rated CDOs have been found improve the risk transparency of productsto contain securities that were worth and about six in ten (59 percent) wouldsignificantly less in a distressed market. like investment banks to change theirA managing director of a large US-based remuneration structures to avoid over-investment firm says: “People relied zealous sales tactics (aggregatedblindly on credit ratings and mutual answers from all respondents arefunds blindly bought products.” shown in Chart 11). The investment community has The head of financial systemsbeen stung and this is reflected in the at a European central bank says thesurvey responses, where 35 percent of current bonus system creates anrespondents agree that rating agencies incentive to take risks without beingprovide an accurate accessment of fully accountable for them. “At thewhether an instrument will default upper end, the size of the bonus is not(see Chart 8). Asked why this should limited,” he says. “Higher net profitsbe the case, some 86 percent cite generated by the employee translateconflicts of interest, while 88 percent into higher bonuses. At the lowersay rating agencies fail to understand end, however, the bonus is limitedthe instruments they rate. Other to zero. In other words, any lossescomments include an inability to are borne entirely by the bank and therespond rapidly enough to market and shareholders and not by the employee.”corporate events (see Chart 9). He suggests three ways to improve The Chief Executive of an Indian the bonus system. Firstly, bonusrisk management consultancy says: schemes should be longer term. Instead“The efforts by the rating agencies to of being primarily based on last year’simprove their processes will not do performance, the bonus should takeanything to address the fundamental the performance of several yearsconflict of interest that exists in their into account. Secondly, the level ofbusiness model; as long as companies the average bonus in investmentpay for ratings that investors use, there banking should be reduced in orderwill – from time to time – be crises like to take into account that potentialEnron, subprime and so on”. losses are not borne by the employee. The rating agencies are said to be Thirdly, guaranteed bonuses shouldonly a part of the reason why so many be abolished. 21© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  24. 24. Rating agencies and investment banks criticized |Rating agencies and investment banks criticizedover transparency of products, continued Chart 11 Answers from all respondents to the question: Which of the following would you like investment banks to do differently over the next two years? Select all that apply. 80% Improve transparency of risk associated with products 60% Improve transparency of fees associated with products 59% Change their remuneration model (e.g. make it more aligned to the interest of their customers) 56% Improve transparency of reports (e.g. marketing material prospectuses) 2% Don’t know Source: Economist Intelligence Unit survey, March - April 200822© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  25. 25. | Rating agencies and investment banks criticized “ eople relied blindly on credit ratings and P mutual funds blindly bought products.” Managing Director, US-based investment firm KPMG comment It is expected that the current slowdown may drive a wave of innovation in incentive plan design. We are already seeing some financial institutions shifting the balance of their incentive plans to greater reliance on long-term performance. The issue of symmetry of interests between investors and executives is crucial if management and shareholder interests are to be aligned. Rolling out of deferred annual bonus plans further down organizations could however be challenging, because of risks to participants, which is more of an issue at this level. When reviewing the make up of compensation packages and addressing the mix of salary, bonus and long-term incentives it will be important to strengthen the links between client satisfaction and reward, and risk performance indicators and reward. The idea is to reward against a balanced set of performance indicators not just short-term revenue and profit targets. We believe that reward should include benchmark performance of the sector as a whole and should recognise the value of low volatility. For most organisations this may require a significant shift in organisational behavior and strengthening of performance management process and systems. 23© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
  26. 26. Time for a rethink on risk |Time for a rethinkon risk24© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are offiliated with KPMG International. KPMG International provides no client services. Nomember firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third party, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.

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