JPM Cap Intro 2011

2011 Investor Sentiment Report
Regeneration: Entering a Period of Sustainable Growth
This report is published by J.P. Morgan Prime Brokerage For further information, please contact: Chris Kapsaroff, Global Equities Client Strategy chris.kapsaroff@jpmorgan.com 212 272 1740 Louis Lebedin, Global Co-Head of Prime Brokerage louis.lebedin@jpmorgan.com 212 272 8582 Andrea Angelone, Global Co-Head of Prime Brokerage andrea.angelone@jpmorgan.com 44 207 779 2647
Table of Contents
Executive Summary Introduction Letter Overview: From Retrenchment to Sustainable Growth I. The Case for Hedge Funds (and Institutional Capital) Investor Allocations in 2011 Hedge Fund Performance, Cumulative and Risk-Adjusted The Increasing Importance of Hedge Funds for Pensions Investment Priorities
1 3 4 6
II. Regeneration Three-Phased Cycle Hedge Fund Net Asset Flows Institutional Investors Making the Largest Allocations Ever Cash Positions, Redemptions and Investment Durations Investor Exposure by Strategy III. Proceeding with Caution Fund of Funds and Consultants - Blurring the Lines Investment Priorities Track Record Increased Due Diligence Greater Liquidity and Risk Transparency Interest in UCITS and Managed Accounts IV. Balance of Power Shifting of Power between Investors and Managers Renegotiations and Redemptions V. Looking Ahead Overview of the J.P. Morgan CIG: Institutional Investor Survey, 2011
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20
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2011 InVESTOR SEnTIMEnT REPORT
Executive Summary
We believe that the hedge fund industry is entering the third phase of a three-phase cycle, one that will be characterized by moderate but sustainable growth, an increased concentration of assets to established managers and a stronger control environment. The first phase began with the sharp retrenchment of 2008 and continued through the redemption-plagued months of early 2009. The second was a period of extensive reallocation that we saw over the course of late 2009 and 2010. The third phase will, in our view, see significant capital inflows to the largest funds, with a greater willingness on the part of investors to place capital with established managers in emerging investment vehicles. We also expect to see established managers grow by acquisition as they seek smaller, standalone managers who have been successful but have not been able to grow enough to move to the next level. For institutions, the hedge fund investment thesis still holds. Institutional investors have indicated that they are seeking superior risk-adjusted returns and diversification from their hedge fund investments [J.P. Morgan Asset Management Alternative Assets Survey, 2010]. For the most part, they are happy with the results they are getting. Institutions now allocate more assets than ever before to the hedge fund segment; they are more comfortable with hedge fund strategies and better able to shape the terms of their relationships with managers. Institutional investors appear to be investing with more conviction. The great reallocation of 2010 has begun to wind down. In 2008, 90% of our respondents had some portion of their capital locked up or gated. By the end of 2010, that figure had fallen to 66%. Investors now appear to be deploying new capital to the hedge fund segment. Overall, 95% of respondents indicated that they would be increasing their allocations to hedge funds in 2011, and many are now willing to place capital with smaller funds. Strong asset flows in the first quarter of 2011 appear to be bearing this. But they also remain cautious. In an effort to make more informed investment decisions, institutional investors demanded improved transparency, liquidity and control in 2009. Overall, institutional investors performed more due diligence, required more thorough risk transparency and requested shorter lock-ups and more frequent redemption periods. However, the required level of liquidity appears to depend on investor type and geographical location. For example, only 11% of North American respondents required monthly redemption withdrawal periods, versus 38% in Asia and 39% in Europe. Risk transparency seems to be critical to almost all institutional investors as 94% of respondents require at least summary information from hedge fund managers on a regular basis. The implications for hedge fund managers have not changed. When looking to select a hedge fund manager, our respondents ranked Experience/Pedigree of Manager, Investment Strategy, Performance/Track Record and Risk Management as the most important criteria for allocation. We think that these results reaffirm investors singular focus on performance. Assets flowed to the largest, most professionally managed funds. As established managers who had opened up to new investor capital in 2009 have begun turning away investors, our respondents indicated that they had a growing interest in smaller and newer funds, particularly by family offices, fund of funds, consultants and wealth management companies. Several important areas of tension between institutional investors and hedge fund managers persist. Over the past several years, we have seen the power relationship between investors and hedge funds evolve. Large investors pensions, endowments and foundations, in particularhave demonstrated the ability to drive change with the largest impact on smaller hedge funds. Our analysis of hedge fund managers confirms that the majority of funds responding to these demands were primarily smaller or newer managers. However, through follow-up conversations, we found that larger funds did succumb to investor demands when large allocations were on offer. As investors reallocated into larger, better performing funds in 2010, they also strengthened the position of what were already the most powerful managers. Our studies show that these managers, many of whom have actually turned away investors, are much less likely to give investors the kind of transparency and liquidity that they seek. Moreover, top performers report that their management and performance fees remain where they were before the crisis. The roles of consultants and funds of funds are evolving. Since the first quarter of 2010, we have witnessed hedge fund net asset flows grow by over $55 billion. Over the same period, fund of funds net asset flows fell by nearly $11 billion. We believe that this signals a shift away from investors use of fund of funds vehicles as they begin placing capital directly into funds as opposed to placing money with fund of funds. The J.P. Morgan Capital Introduction Group: Institutional Investor Survey, 2011 (known from here on forward as CIG: Institutional Survey 2011) revealed that investors expect to hire consultants for investment expertise, while 9% of fund of funds expect to start providing advisory/consulting services in 2011.
Introduction Letter
In the first quarter of 2011, J.P. Morgans Prime Services Capital Introduction Group completed its survey of more than 300 of the worlds leading institutional investors. Participant responses were thought-provoking and suggested that their behavior in 2011 will differ from 2010 in important ways. In order to further test our central hypotheses, we also incorporated findings from original studies performed by the Prime Services and Asset Management divisions of J.P. Morgan, as well as those published by selected third parties. This report describes our analysis and findings. Last year, we argued that changes in investor sentiment were driving a major shift in the allocation of institutional assets among hedge funds that would redefine the competitive landscape. We think the results of this years survey confirm that the great reallocation that we posited in the 2010 report happened and has largely run its course. Institutional investors appear to be cautiously optimistic. Hedge fund managers have responded to investor demands in some constructive ways. In our view, the hedge fund industry is now entering the third phase of a three-phase cycle, one that will be characterized by moderate but sustainable growth, an increased concentration of assets to established managers and a stronger control environment. We hope that hedge fund managers, investors and other market participants find this report useful. We welcome any comments that you may have regarding our views. Best regards, Louis Lebedin Andrea Angelone
Prime Brokerage
Overview: From Retrenchment to Sustainable Growth

In last years report, we described a hedge fund industry that, on the surface, appeared to have rapidly rebounded from the financial crisis and was positioned for a period of sustained growth. The major hedge fund indexes showed better riskadjusted return characteristics than most asset classes, and by the beginning of 2010, net flows had begun to turn modestly positive. Our survey confirmed that institutional investors would continue to take a leading role in the hedge fund industrys repair, with 91% reporting they intended to increase their allocations to the segment over the course of 2010. Within the hedge fund asset base, however, we believed that a massive reallocation of capital was underwayone that we felt would have important implications for the types of hedge funds that would be successful in the future. By our estimates, more than a third of the hedge fund asset base was in motion by mid-2010. What was driving this tectonic shift in the structure of the industry? In our view: differentiated performance. A relatively small number of the most professionally managed funds outperformed hedge fund indices while maintaining liquidity for investors, while during the same period, large numbers of smaller, less adeptly managed hedge funds underperformed or failed entirely. Over 600 funds liquidated in 2010, more than double the 10-year average leading up to the financial crisis. This shows that there is still a very high level of attrition among funds [HFR Year End 2010 Industry Report]. We found that institutional investors had begun to manage their positions far more aggressively. In all, 89% of the respondents to our institutional investor survey last year said that they had redeemed some portion of their hedge fund investments, while many more indicated that they would have redeemed but were still locked up in poorly
Sources of Capital for new Allocations to Alternatives (2010) % responses of total respondents 72% 49% 77%
performing vehicles as of the date of our survey. We found that as these investors freed up captive capital, they quickly reallocated it to the managers that had proven their ability to perform through the cycle. We believe that industry asset flows bear this thesis out. From late 2009 through 2010, net inflows to the hedge fund segment were positive but well below the average inflows of the 10 years leading up to the crisis. However, the concentration of assets with the largest hedge funds increased significantly during this period. In 2004, hedge funds managing more than $1 billion in assets accounted for 65% of the industrys global asset base. By the fourth quarter of 2010, that figure had surged to 84% [Hedge Fund Intelligence, Global hedge fund assets up 11% in 2010and back above $2 trillion]. Our survey responses for 2010 also bear this thesis out: 75% of respondents cited redemptions as a source capital for their new hedge fund investments, and most of their investments were directed toward the largest managers. In last years report, we maintained that the implications of our findings for hedge fund managers were clear. Riskadjusted performance mattered above all else; it was the #1 selection criteria for investors. We also found that top performing managers often had investors competing for a limited number of allocations, enabling those managers to have greater leverage in negotiating terms around liquidity and transparency. Size also mattered. The largest funds generally proved to be more scalable, more controlled and more attractive to investors from a performance perspective. Running multiple strategies within a fund family, but not within a specific fund, also helped to improve performance and attract capital from investors seeking diversification. Finally, professionally operated funds that employed institutional caliber controls and were capable of managing multiple prime brokers were most likely to attract investors. This years report is based on the J.P. Morgan Prime Services Capital Introduction Groups survey of 363 of the worlds leading institutional investors. The primary research was conducted over the course of the fourth quarter of 2010 and first quarter of 2011. In order to test additional hypotheses and better explain certain trends, we also incorporated data from J.P. Morgans hedge fund benchmarking survey [J.P. Morgan Consulting Group Client Benchmarking Survey] and analysis from J.P. Morgans Asset Management division, as well as select third party studies.
Reallocated Capital from Other Asset Classes
New Capital
Redeployed Capital from Returned Redemptions, Lifted Gates, etc.

Figure 1
Source: J.P. Morgan Capital Introduction Group: Institutional Investor Survey, 2011
We believe that the hedge fund industry is entering the third phase of a three-phase cycle, one that will be characterized by moderate but sustainable growth, an increased concentration of assets to established managers and a stronger control environment. The first phase began with the sharp retrenchment of 2008 and continued through the redemption-plagued months of early 2009. The second was a period of extensive reallocation that we saw over the course of late 2009 and 2010. The third phase will, in our view, see significant capital inflows to the largest funds, with a greater willingness on the part of investors to place capital with established managers in emerging investment vehicles. We also expect to see established managers grow by acquisition as they seek smaller, standalone managers who have been successful but have not been able to grow enough to move to the next level. Other key findings include: For institutions, the hedge fund investment thesis still holds. Institutional investors have indicated that they are seeking superior risk-adjusted returns and diversification from their hedge fund investments [J.P. Morgan Asset Management Alternative Assets Survey, 2010]. For the most part, they are happy with the results they are getting. Institutions now allocate more assets than ever before to the hedge fund segment; they are more comfortable with hedge fund strategies and better able to shape the terms of their relationships with managers. Institutional investors appear to be investing with more conviction. The great reallocation of 2010 has begun to wind down. In 2008, 90% of our respondents had some portion of their capital locked up or gated. By the end of 2010, that figure had fallen to 66%. Investors now appear to be deploying new capital to the hedge fund segment. Overall, 95% of respondents indicated that they would be increasing their allocations to hedge funds in 2011, and many are now willing to place capital with smaller funds. Strong asset flows in the first quarter of 2011 appear to be bearing this. But they also remain cautious. In an effort to make more informed investment decisions, institutional investors demanded improved transparency, liquidity and control in 2009. Overall, institutional investors performed more due diligence, required more thorough risk transparency and requested shorter lock-ups and more frequent redemption periods. However, the required level of liquidity appears to depend on investor type and geographical location. For example, only 11% of North American respondents required monthly redemption withdrawal periods, versus 38% in Asia and 39% in Europe. Risk transparency seems to be critical to almost all institutional investors as 94% of respondents
require at least summary information from hedge fund managers on a regular basis. The implications for hedge fund managers have not changed. When looking to select a hedge fund manager, our respondents ranked Experience/Pedigree of Manager, Investment Strategy, Performance/Track Record and Risk Management as the most important criteria for allocation. We think that these results reaffirm investors singular focus on performance. Assets flowed to the largest, most professionally managed funds. As established managers who had opened up to new investor capital in 2009 have begun turning away investors, our respondents indicated that they had a growing interest in smaller and newer funds, particularly by family offices, fund of funds, consultants and wealth management companies. Several important areas of tension between institutional investors and hedge fund managers persist. Over the past several years, we have seen the power relationship between investors and hedge funds evolve. Large investors pensions, endowments and foundations, in particularhave demonstrated the ability to drive change with the largest impact on smaller hedge funds. Our analysis of hedge fund managers confirms that the majority of funds responding to these demands were primarily smaller or newer managers. However, through follow-up conversations, we found that larger funds did succumb to investor demands when large allocations were on offer. As investors reallocated into larger, better performing funds in 2010, they also strengthened the position of what were already the most powerful managers. Our studies show that these managers, many of whom have actually turned away investors, are much less likely to give investors the kind of transparency and liquidity that they seek. Moreover, top performers report that their management and performance fees remain where they were before the crisis. The roles of consultants and funds of funds are evolving. Since the first quarter of 2010, we have witnessed hedge fund net asset flows grow by over $55 billion. Over the same period, fund of funds net asset flows fell by nearly $11 billion. We believe that this signals a shift away from investors use of fund of funds vehicles as they begin placing capital directly into funds as opposed to placing money with fund of funds. The J.P. Morgan Capital Introduction Group: Institutional Investor Survey, 2011 (known from here on forward as CIG: Institutional Survey 2011) revealed that investors expect to hire consultants for investment expertise, while 9% of fund of funds expect to start providing advisory/consulting services in 2011.
Prime Brokerage
I. The Case for Hedge Funds (and Institutional Capital)

Institutional investors have been steadily increasing their overall level of investment in hedge funds segment for years. In 1999, 46% of hedge fund capital flows were sourced through institutions. By 2009, institutions accounted for the majority of the assets in the space [IFSL, Hennessee Group LLC]. A study by the research firm Preqin in the first quarter of 2011 highlighted the pivotal role that institutional investors now play in the industry. Nearly half of the hedge fund managers they surveyed reported sourcing more than 60% of their capital from institutions; 28% reported sourcing more than 80% of their capital from institutions [Preqin Hedge Fund Manager Study, Feb. 2011]. In Q1 2011 alone, pension funds allocated $18 billion to hedge funds; Pensions & Investments magazine reports that the combined total of net inflows and pending searches is the highest in four years with institutional investments back to pre-2008 levels.
Average % of Hedge Fund Capital from Institutional Investors by Manager AUM (2011) 67% 53% 32% 47% Global Composition of Hedge Fund Capital Flows 100% 80% 60% 40% 20% 0% 54% 1999 Institutional Investors
Source: IFSL, Hennessee Group LLC
46%
56% 74%
44% 2005 Individuals
26% 2009
Figure 2
Hedge Funds Expecting to Open a new Fund in 2011
59% 45%
61%
61%
68%
Opening a New Fund <$250 MM $250499 MM $500999 MM $19.9 BN >$10 BN 100 80

Source: Preqin Hedge Fund Manager Study, February 2011 Figure 3 60
Not Opening a New Fund 90%
>$1 BN
<$1 BN
Source: J.P. Morgan Consulting Group Client Benchmarking Survey 54% 51%
Institutional capital has become increasingly critical to hedge 20 fund managers as they become larger. Hedge funds managing 0 $10 billion or more in assets reported that, on average, 67% of their capital originated from institutional sources. The importance of institutional investors is likely to increase in 2011. Analysis by J.P. Morgans Prime Brokerage business concluded that nearly half of the hedge funds managing more than $1 billion in assets, the segment most likely to source an overwhelming majority of capital from institutions, plan to add funds in 2011, and Preqin found that 84% of its respondents expect to increase the proportion of their capital base sourced from institutional investors.
40
39%
38%
48%
Figure 4
20% Distribution of net Asset Flows by Firm8% AUM Tier, 2010 11% 10% 7% 9% 2% 2% 1% 44.7 North America Europe Asia Monthly Quarterly Semi-annually Annually No preference
10% Middle East and Latin America
3.3
2.2
2.4 (2.8)
5.6
<$100 MM
$100 250 MM
$250 500 MM
$500 MM 1 BN
$15 BN
>$5 BN
Source: HFR Year End 2010 Industry Report
Figure 5
50
Are institutional investors getting the results theyre looking for from their hedge fund investments? After all, investors could simply be chasing returns by rotating capital into hedge funds because they performed better than other asset classes. Hedge funds are an expensive way to generate returns, and the investor/manager relationship can be complex. If institutional investors find themselves dissatisfied with the results of their forays into the space, there could be another major wave of redemptions. Through primary research, we have found that institutional investors mainly seek two things from their hedge fund investments: superior returns per unit of portfolio volatility and diversification into less correlated asset classes. Through follow-up conversations, some managers have increasingly mentioned capital preservation as a high priority. This feedback is consistent with the larger stress on diversification and reduction of volatility [J.P. Morgan Asset Management, Alternative Assets Survey, 2010]. It appears that hedge funds
have delivered, though some strategies and managers have performed better than others. Looking at returns of pension fund portfolios for the one-, three- and five-year time horizons dating from June 2010, Preqin found that hedge funds generally outperformed their expectations on a total return basis. More importantly, returns for the 12 months ending June 2010 exceeded the expectation by an average of 365 basis points. Because these returns were measured in the midst of a major reallocation of assets, they include trailing data from underperforming funds that were later redeemed and, therefore, probably dampen overall returns. A comparison of the cumulative returns of major hedge fund indexes to those of major stock and bond indexes confirms the point. A look at returns from the 12 months ending December 2010 shows that 19 out of 25 hedge fund strategies outperformed the major stock and bond indexes on a risk-adjusted basis.
Institutional Investors Greatest Advantages of Investing in Hedge Funds (% of respondents) 73% 63% 51%
Median Returns of Public Pension Plans by Asset Class as of June 30, 2010 20% 15% 10% 5% 0% -5% -10% -15%
1 Year Fixed Income
3 Years Hedge Funds Listed Equity
5 Years Private Equity
Volitility of Returns
Returns
Diversication
Figure 6
Real Estate
Total Investment Portfolio

Figure 7
Source: J.P. Morgan Asset Management, Alternative Assets
Source: Preqin Hedge Fund Manager Study, February 2011
Cumulative Returns, 20072010 130 120 110 100 90 80 70 60 50 40 Jan-08 S&P 500 May-08 Sep-08 Eureka Hedge Jan-09 Euro Hedge May-09 HFRI Sep-09 DJ/CS HF Index Jan-10 May-10 MSCI World Sep-10 Barclays Govt/ Credit Index Bond
Figure 8
Source: Indices
100
Prime Brokerage
HFRI Index Risk Return Comparison, 2010 20 15 10 5 Return (%) 0 (5) (10) (15) (20) (25) 0 5 10 Standard Deviation (%)
Source: HFR Year End 2010 Industry Report Figure 9
Short Bias RV: Multi Asset-Backed Yield Alts EM: Global Conv Arb FI Corp Reg D E-D Emerging Markets RV Tech/HC EH DJ/CS HF FWC EM: Asia ex-Japan Distressed Macro: Sys Div Quant/Drectnl Barclays Govt/Credit Macro EM: LatAm FOF Merg Arb EqMktBNtrl Energy EM: Russia S&P 500 MSCI World EAFE
15
20
25
For institutional investors capable of securing stakes in top performing hedge funds, a number of compelling investment opportunities exist. For hedge fund managers, the institutional investor base represents an increasingly crucial source of capital. The opportunity for high quality managers could be enormous. A Pensions & Investments/Towers Watson survey in the fourth quarter of 2010 shows the total assets of the worlds 500 largest institutional investors at nearly $62 trillion [Pensions & Investments/Towers Watson World 500: The Worlds Largest Money Managers, 10/18/2010]. But allocations to hedge funds remain relatively small. The percentage of public pension fund investments in hedge funds, for example, has nearly doubled since 2007, but it still remains at only 6.6% of their total portfolios. Hedge fund managers face a number of significant challenges when dealing with institutional investors. Overall, however, we believe that institutional investors are helping to make the hedge fund segment more transparent, effectively controlled and likely to deliver superior risk-adjusted returns (more on these points to follow). In our view, the case for hedge funds remains a strong one from the perspective of most institutional investors. The case for institutional capital from the perspective of hedge fund managers has become convincing as well. 130
120 110 100 90 80 70
Public Pension Fund Allocations to Hedge Funds, 2007Present 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% Q4 2007 Q4 2008 Q4 2009 Q4 2010 Q1 2011
Figure 10
6.5% 5.7% 6.0%
6.6%
3.6%
Source: Preqin Hedge Fund Manager Study, February 2011
60 50 40
North America Monthly Quarterly
Europe Semi-annually Annually
Asia No preference
Middle East and Latin America
II. Regeneration
We believe that the hedge fund industry is entering the third phase of a three-phase cycle, one that will be characterized by sustainable growth, increased concentration of assets and a stronger control environment. The current cycle began in 2008, with the retrenchment in global markets. Hedge funds assets declined by 31% between the second quarter of 2008 and the first quarter of 2009. In the aggregate, they outperformed most asset classes. Overall, hedge funds provided better total returns than equities and better risk-adjusted returns than bonds throughout the crisis. Still, from the third quarter of 2008 to the fourth quarter of 2009, investors withdrew over $329 billion [HFR Third Quarter 2009 Industry Report]. In previous studies, we found that much of the capital outflow was driven by high net worth investors that required liquidity for a variety of reasons, not all of them related to the performance of their hedge funds positions. By the second half of 2009, the hedge fund asset base was sourced primarily from institutional investors and high net worth individuals that took a longterm view. The fact that many institutional investors saw hedge funds as an attractive investment class does not mean that they were particularly satisfied with the hedge fund position that they actually held. This brought about the second phase of the current cycle: reallocation. Over the course of late 2009 and early 2010, we believe that more than a third of all hedge fund assets were in motion [Tectonics: Shifting Investor Sentiment and the Implications for Hedge Fund Managers, J.P. Morgan Prime Brokerage, September 2010]. Most of the capital in flight during this period did not appear to be new money coming into the hedge fund space but rather, existing capital being shifted from managers that underperformed during the crisis to those that outperformed. From the first quarter of 2009 through the fourth quarter of 2010, hedge fund assets increased by $586 billion, a growth of 44% [HFR Year End 2.0 2010 Industry Report]. However, all of that growth came 1.8 from manager performance; investors pulled out1.6 net of a 1.4 1.2Industry $76 billion during this period [HFR Year End 2010 1.0 Report]. Capital flows turned positive in the second half of 0.8 2009, but since then, quarterly new investment 0.6 been has 0.4 0.2 modest, averaging 3.5% of global AUM versus the 20002008 0.0 average of 10.4% [HFR Year End 2010 Industry Report]. Entering 2011, we believe that institutional investors are cautiously optimistic about, and increasingly demanding of, the hedge fund segment. This year, 95% of CIG: Institutional Survey 2011 respondents said that they intend to make new allocations
Three-Phased Cycle: The Hedge Fund Environment, 20082011P
Retrenchment Reallocation Regeneration 2.2 2.01 2.0 1.88 1.93 1.92 1.77 1.8 1.72 1.67 1.65 1.54 1.60 1.6 1.41 1.33 1.43 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 2008 2008 2008 2008 2009 2009 2009 2009 2010 2010 2010 2010 2011 2011
$ Billions
Figure 11
Global Asset Inflows/Outflows, 20002010 250 200 150 100 50 (50) (100) (150) (200) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: HFR Year End 2010 Industry Report Figure 12
Average inows of total assets 10.4%
to hedge funds in the coming 12 months. This figure increased from 88% in 2009 and 91% in 2010. The average size of hedge fund allocations has already begun to increase; the percentage of CIG: Institutional Survey 2011 respondents making average allocations of at least $25 million improved from 18% in 2008 to 32% in 2010. Pension, endowment and foundation managers, as well as large insurers, were the investors most likely to make these large placements. The majority of CIG: Institutional Survey 2011 respondents indicated that they plan to increase the number of hedge funds they invest in over the next 12 months as well. Interest was particularly strong among pension, foundation and endowment managers, 71% of whom indicated that they will increase the number of hedge funds into which they have made placements. Additionally, we found that many of the largest pensions, particularly in North America, remained significantly underfunded and see hedge funds as a way to build back
250 200 150 100 50
$ Billions
Average inows of total assets 3.5%
10 | Prime Brokerage
Percentage of Respondents Intending to Allocate to Hedge Funds (20092011E) 88% 91% 95%
Percent of Hedge Funds Subject to Gating or Lock-Up Provisions (20082010) 90% 84% 66%
45% 31% 2009 Increasing Total Allocation 2010
53%
2011 Expected 2008

Figure 13
Increasing # of HF Investments
2009
2010
Figure 14
their asset base. More than two-thirds of consultants, an increasingly important market participant, indicated that they would also be increasing the number of funds that they placed with. Investors are positioned to act. Fewer now find themselves invested in hedge funds that have redemptions suspended or gated. In the CIG: Institutional Survey 2011, 66% of respondents reported that some percentage of their portfolio was subjected to these provisions, but nearly 90% had less than 10% of their capital held up. More than 80% of CIG:
Institutional Survey 2011 respondents reported that they have less than 10% of their portfolios in cash, whereas in 2008, 53% had more than 10%, indicating that they have begun to put capital to work. In 2009, 18% of CIG: Institutional Survey 2011 respondents reported that 75% of their hedge funds had returned to their high water marks. This year, half of the CIG: Institutional Survey 2011 respondents said that at least 75% of the managers that they invested in had reached their high water marks.
Investors Making Average Allocations to Hedge Funds Greater Than $25MM 32% 22% 18%
120 90
100 80
2008
60 30 0 120 90 60 30 0
60
2009 Family O ce
2010 Endowments, Foundations and Pensions Consultant Bank

Figure 15
Other
Wealth Manager
Insurance Company
Fund of Funds
20 0
40
11
Respondents Hedge Fund Holdings Gated or Under Redemption Suspension in 2010
Cash Positions as a Percent of Total Portfolio (2010)
Greater than 25% Gated or Suspended 2% 1025% Gated or Suspended 10% 110% Gated or Suspended 54% 0% Gated or Suspended 34%
Greater than 50% Cash 1% 2550% Cash 3% 10-25% Cash 14% 5-10% Cash 29% Less than 5% Cash 52%
Figures 16 and 17
How are investors acting on their sentiments? We found that the majority of them are taking a long view. Overall, 90% of CIG: Institutional Survey 2011 respondents reported that the duration of their typical hedge fund investment is longer than two years. Most reported that the typical duration is two to five years. However, 25% stated that their typical investment in hedge funds is held for more than five years. This shows a marked increase from the 16% that gave the same response in 2008, when redemptions were quite common. We also found that investors with more experience investing in hedge funds tend to make larger placements. In the CIG: Institutional Survey 2011, investors with more than 10 years of experience managing hedge fund positions accounted for only half of our respondents, but 70% of the assets placed. Conversely, those with fewer than three years of experience placed only 2% of the capital. In all, 48% of CIG: Institutional Survey 2011 respondents with more than 10 years of experience reported that the size of their average hedge fund investment was larger than $25 million. For those with one to three years of experience investing in hedge funds, only 6% reported an average allocation of more than $25 million. No respondents with less than a year of hedge fund investing experience made placements larger than $25 million. As we have found in previous research, investors responding to the CIG: Institutional Survey 2011 had disparate views on which strategies they will be allocating toward in the coming months. There were, however, four overarching themes. First, 100 respondents clearly identified several strategies of interest; 80 between 20% and 25% indicated that they will increase their allocations to macro, event driven, emerging markets and60 fundamental long/short managers, and 17% slated managed40 futures for increases. These figures are roughly similar to 20 what respondents said last year, though the number saying they would allocate more to managed futures strategies 0
Typical Duration of Investment (20082010) 100% 80% 60% 40% 20% 0% 10% 2008 Greater than 5 years 25 years 12% 2009 12 years
Figure 18
16%
+3%
19%
+6%
25%
74%
69%
65%
10% 2010
Hedge Fund Investing Experience by number of Respondents and AUM Invested 100% 51% 22% 17% 1% 9% HF Investing Experience by # of Respondents Greater than 10 years 13 years 710 years Less than 1 year
Figure 19
100% 70%
18% 10% 2% HF Investing Experience by AUM in HFs 46 years
90%
decreased by a meaningful amount year over year. Second, 54% respondents generally agreed that they will reduce their 51% 48% 39% 38% allocations to two types of strategies in particular. Managers running multiple20% strategies within a single fund will likely 11% 10% 8% 7% 9% receive substantially less capital 1% year, as nearly a quarter this 2% 2% of CIG:North America Institutional Survey 2011 respondents indicated that Europe Asia
Monthly Quarterly Semi-annually Annually No preference
10%
Middle Ea Latin Am
12
Prime Brokerage
Respondents Increasing/Decreasing Exposure by Strategy (2011) -25% Macro Event Driven Emerging Markets Long Short Equity: Fundamental CTAs/Managed Futures Credit Strategies: Corporate Credit Commodities Credit Strategies: Structured Credit Long Short Equity: Sector Multi-Strategy -24% Fixed Income Arbitrage Long Short Equity: Market Neutral Long Short Equity: Quantitative Long Short Equity: Long Biased Convertible Arbitrage Options Arbitrage Long Short Equity: Short Biased Unhedged Equity: Long Only Fund of Funds -10% -4% -10% -5% -2% 2% 2% 1% 4% -12% -11% -4% -6% 6% 6% -9% -8% -22% -5% -19% -6% 11% 10% 10% 9% 9% 8% 8% 7% 17% -20% -19% -10% -8% 20% 22% -15% -10% -5% 0% 5% 10% 15% 20% 25% 25% 24% Net % Change +6% +14% +14% +1% +11% -11% +5% +1% +1% -15% -4% -3% +3% 0% -4% -1% 0% -2% -9%
Figure 20
they would be reducing their allocations to these types of funds, while only 9% said that they would increase. We may very well see these multi-strategy funds lower their performance or management fees in order to prevent these capital outflows. Respondents also generally agreed that they would be reducing their allocations to fund of funds, something that we think will have important implications for consultants. The third theme derived is that investors are likely to maintain their current geographic allocations,
which have remained fairly constant over the course of the past three years. The final theme is dissonance. A quarter of respondents stated that they plan to increase their allocation to macro strategies, but 19% said that they plan to decrease. Fundamental long short, one of the four most popular strategies for new allocations among respondents, is likely to have an equal number of investors redeeming. In fact, every strategy can expect to see capital outflows to some degree.
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III. Proceeding with Caution

Investors expect the roles of consultants and fund of funds to continue evolving. We found that large investors have begun to increasingly use consultants to help them invest directly into hedge funds. In 2010, new capital invested directly into hedge funds totaled $55 billion. Fund of funds investors saw capital outflows of $11 billion during the same period. Despite the fund of funds outflows, we believe that the sector will continue to play an important role in the industry, but in order to regain its dominance, it will need to deliver services and performance that rationalizes the extra layer of fees. We have already seen a trend as fund of funds begin to blur the lines with consulting firms and offer additional services. Nearly half of the fund of funds managers we surveyed launched advisory
Fund of Fund vs. Hedge Fund Industry net Asset Flows (Q2 2009Q4 2010) 13.8 1.1 (3.3) 2.5 (11.9) 13.8 19.0 9.5 0.3 (2.0) 13.2 1.8
(32.2) (42.8) Q2-09 FoF Flow Q3-09 Q4-09 Q1-10 Q2-10 Q3-10 Q4-10
Industry Flow
Figure 21
Fund of Fund Respondents that Act as an Advisor/Consultant (2010) Expect to Start Providing Advisory/Consulting Services in 2011 9% No 43% Yes 47%
Respondents Who Use a Consultant (2010)
Expect to Start Using One 1% Yes 17% No 82%
Figures 22 and 23
services by late 2010, and 83% of them charged a separate fee for consulting services. In some cases, we have seen fund of funds managers offer the advisory services for free. However, we also found that less than 10% of investors used fund of funds for advisory services. In our view, hedge funds are well positioned to increase their share of global investment capital. However, the institutional 20 investors that we think will be allocating the vast majority of the new capital are making significant demands on hedge 6
-8 -22 -36 -50
fund managers. Selection criteria is exacting. Due diligence is intense. Investor demands for transparency, liquidity and controls are acute. We believe that these trends are secular, not simply a hangover from the crisis period. Overall, we think that institutional investors will drive improvements through the upper tiers of the hedge fund industry. We also think that these trends will drive additional costs and behavior changes into the space.
14
Prime Brokerage
We have found that over the past three years, institutional investors consistently stress the same criteria when selecting hedge funds in which to allocate: the managers experience, pedigree and performance history, in addition to the specific strategy employed. Investors cite a number of other issues as being highly important to them, such as risk management, transparency, lock-ups and fees. However, the decision to allocate does appear to come down to whether the manager has demonstrated the ability to deliver high quality returns and whether the strategy employed fits the investors overall portfolio. We found that for institutional investors, a hedge funds prime broker is not a top priority in manager selection. However, it can be a reason not to allocate. Nearly half of CIG: Institutional Survey 2011 respondents indicated that they would decline investing in a hedge fund because of the managers choice of prime brokers. Two-thirds responded that they would decline investing because of a managers choice of administrator. Increasing numbers of CIG: Institutional Survey 2011 respondents have stated their willingness to invest in smaller funds. In 2010, fund of funds, family offices and wealth management companies were the segments most likely to invest in managers with less than $100 million in assets. Overall, 69% of CIG: Institutional Survey 2011 respondents indicated that they would be willing to invest in startup hedge funds, though most said that they would do so selectively. In follow-up conversations with investors, we found that many were interested in smaller funds primarily because the largest managers were beginning to close. Some investors felt that they were being crowded out of certain hedge fund investment opportunities by large institutions, particularly pensions, endowments, foundations and insurance companies that were willing to make substantial placements. Many investors have concentration limits, and these large institutions are often forced to focus their efforts on the largest managers. Not surprisingly, 43% of respondents to the CIG: Institutional Survey 2011 who made average investments of more than $250 million stated that they required a hedge fund to manage assets of more than $1 billion before they would consider making an allocation. A secondary but important motivation for many investors was the opportunity to take a large stake in a newer vehicle in its early years, when investing experience suggests it should have its strongest returns [The Performance of Emerging Hedge Fund Managers, Rajesh K. Aggarwal (University of Minnesota) and Philippe Jorion (University of California/Davis) working paper, January 2008].
Top Priority When Selecting a Hedge Fund Manager, 2010

YoY % Change 0%
Experience/Pedigree of Manager Investment Strategy Performance/Track Record Risk Management Drawdown Statistics Transparency Lock-up Provisions % of Liquid Net Worth of Manager Invested in the Fund Leverage Other 10% 20% 30% +1% 40% +3%
+2% -2% -1% +1% -3% -1% -2% +4%
Figure 24
Investors Willing to Invest in a Start-Up Manager (2010)
Yes 10% No 31% Selectively 59%
Figure 25
Minimum AUM Required to Invest in Fund (20092010) 40% 30% 20% 10% 0% $0 MM 2009 $50 MM 2010
Figure 26
37% 25% 27% 15% 27% 24% 13% 14% 8% 4%
4%
2%
$100 MM
$250 MM
$500 MM $1,000 MM
Hedge Fund Performance by Age of Fund 12% 10% 8% 6% 4% 2% 0% 02 years Average Return Average Alpha
Figure 27
10.08%
9.15%
2.71% 0.38% 3-9 years
Source: The Performance of Emerging Hedge Fund Managers, 2008
| 15
Interest in investing in smaller funds, however, does not appear to have translated into interest in developing untested managers. Performance and pedigree still matter. So does the maturity of the fund. Only 40% of CIG: Institutional Survey 2011 respondents indicated that they would be willing to invest at inception, and just under half require a minimum of one years track record to even consider investing. When the responses are considered in the context of asset weighting, the environment for less tested vehicles becomes more challenging. The majority of pensions, foundations and endowmentswho control the lions share of the assets and make the largest placementsrequire that the managers they allocate to have at least two years of performance history. Additionally, we have found that while many investors are willing to make placements in small or start-up funds, those funds are likely to be managed by experienced managers and not new entrants.
Minimum Track Record Required to Make Investments (2010)
Greater than Six Months to Complete Due Diligence by Investor Type (2010)
30% 20% 23%
31%
17% 12%
18%
Bank
Fund of Funds Consultant
Insurance Family O ce Wealth Endowment, Company Management Foundation Company and Pension Figure 28
Minimum Track Record Required to Make Investment by Endowments, Foundations and Pensions (2010)
3 years or more 17% 2 years 19% 1 year 13% 6 months 11% Fund Inception 40%
Greater than 2 years 63% 1 year 3% 6 months 3% Fund Inception 31%
Figures 29 and 30
On average, most respondents said that they spent three to six months on due diligence; nearly 20% said that they spent 6 to 12 months. The majority of respondents reported that 35 they increased the depth and breadth of their due diligence 28 rather than the frequency. A clear majority increased due diligence out of concern over operational issues. The average 21
14
number of due diligence questionnaires fielded per month by J.P. Morgans Prime Brokerage Group increased by 250% between 2008 and 2010. Responding pensions, endowments, foundations and wealth management companies were significantly more likely to spend over six months on due diligence than other investors.
Investors Willing to Lock-Up for More than Two Years (20082010) 49% 46% 45%
Average Time to Complete Due Diligence (20072010)
7 0
22% 14%
2007 Greater than 1 year 612 months
2010
2008
Figure 31
2009
2010
Figure 32
16
Prime Brokerage
Investors continue to stress the importance of liquidity. More than half of our respondents would not commit to a lock-up period of over one year. Sentiment varied greatly by segment, however. Nearly 75% of endowments, pensions and foundations respondents indicated they would accept lock-ups of over two years, while other segments were less willing to make comparable commitments. Most responding investors require liquidity quarterly, and only 22% require it more frequently. Liquidity requirements vary by region. Only 11% of North American investors reported that they require monthly
Required Liquidity (2010)
liquidity, compared to 38% for Asian investors and 39% for Europeans. More than 15% of North American investors were willing to accept semi-annual or annual liquidity, and 20% said that they had no real preference. In follow-up discussions with investors outside of North America, more accessed hedge funds through fund of funds platforms and had the need to manage heightened asset/liability mismatch risk. Additionally, the fallout from the Madoff scandal has been particularly impactful on investor sentiment outside the United States.
Longest Acceptable Lock-Up Period (2010)
No Preference 15% Monthly 22% Quarterly 53% Semi-annually 5% Annually 5%
None 6% 6 months 6% 1 year 43% 2 years 28% 3+ years 17%
Figure 33
Figure 34
Respondent Base (2010, based on number of respondents) Planning to Invest via Managed Accounts Planning to Invest via UCITS
Yes 29% No 71%
Yes 27% No 73%
Figure 35
| 17
Managed accounts and UCITS structures offer investors platforms with the potential to satisfy their requirements for increased liquidity. Interest in both, however, has been limited. In 2009, nearly 40% of our respondents indicated that they planned to invest in managed accounts in the coming year. Less than 20% actually did. At the end of 2009, 34% of our respondents said that they intended to invest in UCITS in the coming year. Only 19% did. Many of the more experienced investors polled said that while frequent liquidity was attractive, they were concerned that constant changes in the capital base
Managers Intending to Launch a UCITS Strategy in 2011
managed accounts, the mismatch becomes obvious. Assets in both managed accounts and UCITS have increased in recent quarters; UCITS experienced a substantial one-year growth in 2010 with total assets under management increasing 198% to $90.5 billion [Absolute UCITS]. While this surge in AUM is significant, the total asset base remains relatively small when compared to a total hedge fund asset base of $2 trillion. While we believe that these assets will continue to grow, we also believe that the total allocations to these improved liquidity vehicles will likely remain modest in comparison to the hedge fund segment as a whole. Transparency continued to be an area of intense focus for investors as we entered 2011, but the degree of transparency required differed greatly depending on investor type. Overall, we found that a meaningful percentage of respondents increased their transparency requirements from moderate to high, meaning that they required position-level detail on a recurring basis. Only 6% of respondents surveyed stated that they required nothing more than quarterly or monthly letters. Among these respondents, consultants and fund of funds, not surprisingly, were significantly more likely to require high levels of transparency. Both, for example, reported that they required high levels of transparency at double the rates that wealth management companies, insurers and family offices did. The majority of those that were more likely to invest directly, or via a fund of funds or consultant, reported that they required moderate levels of transparency.
Risk Transparency Required by Respondents (2010)
81%
14% 4% Yes No Possibly 1% Currently Have One

Figure 36
Source: J.P. Morgan Consulting Group Client Benchmarking Survey
would negatively impact performance. Additionally, responding investors in all regions acknowledged that these more liquid vehicles were only suitable for specific, fairly straightforward strategies. Another significant impediment appears to be structural. In all, 25 to 30% of responding investors indicated that they were interested in making placements in these more liquid platforms in 2011. Less than 5% of hedge fund managers indicated that they planned to launch a UCITS strategy in 2011. For fund managers, the operational complexity and increased expenses associated with these strategies make them attractive only when they garner very substantial placements. Many managers that we spoke with indicated that they would consider launching a UCITS or a managed account offering only if they could place substantially more than $100 million into it. With 83% of our responding investors stating they intend to invest less than $25 million in separately
90.0 67.5 45.0 22.5 0.0
Limited (monthly/quarterly letters only) 6% Moderate (summary information on a regular basis) 61% High (position level detail on a regular basis) 33%
Figure 37
18
Prime Brokerage
Risk Transparency Required by Investor Type (2010)

90% 80% 80% 75% 70% 64% 58% 60% 55% 50% 44% 44% 41% 40% 32% 31% 30% 20% 18% 20% 11% 11% 10% 7% 4% 4% 0%
Bank Consultant Endowment, Family O ce Foundation and Pension Fund of Funds
Transparency Levels for Investor Reporting Across All Funds

Most Transparent Least Transparent 78% 73%
73%
20% 7%
35% 19% 22% 19%
Insurance Wealth Company Management Company
Current Holdings
High
Moderate
Limited
Figure 38
Historical Holdings (1 month prior)
Historical Holdings (3 months prior)
Current Top 10 Winners & Losers
Portfolio and Risk Attributes
Performance Attribution
Source: J.P. Morgan Consulting Group Benchmarking Survey
Figure 39
In conversations with investors, we consistently found that they viewed the lack of transparency to be a critical impediment to growth in the hedge fund segment. For many strategies it makes sense to restrict liquidity; too much liquidity can damage returns. But the continued lack of transparency, from the perspective of our investors, was something that they found to be less easy to accept; the technology is too widely available. Additionally, a hedge fund managers ability to deliver a reasonable level of transparency is often viewed by investors as a general barometer for their overall control environment. From discussions with individual investors, we found that one of the main reasons why investors are asking managers for current and historical holdings is their concern over assets that could be illiquid and problematic if another financial crisis were to occur. Overall, a third of our respondents reported that they required high levels of transparency, but only 20% of the managers we polled said that they provided it. We turned to our hedge fund managers to find out more about the kinds
of transparency they were providing. The primary determinant of high transparency appeared to be the perceived, or actual, need for the manager to provide it, in order to attract a critical mass of institutional capital. Half of the emerging managers that we polled provided high levels of transparency. They were the most willing to provide position-level data by a substantial margin. They were also the managers with the least assets and most were seeking to raise additional capital. A third of mid-sized credit funds and a quarter of credit funds managing $150 million to $500 million in assets reported providing current holdings transparency to investors. Credit funds can be particularly complex, and we were somewhat surprised that so many managers provided high levels of transparency. From discussions with managers, we knew that most of these funds were also seeking to raise capital as well. 80 three Far fewer credit fund managers in the Billion Dollar Club were two 60 seeking new capital, and less than 13% of them reported that one they were providing high levels of transparency. Long/short 40
20 0
Most Transparent Reporting Option by Fund Category: Current Holding Frequency

$0150 MM Emerging Managers $500 MM$1 BN Credit $5 BN+ Multi-Strategy $150500 MM Credit 29% 20% 13% 10% 7% 0%
60 30 0 120 90
50% 33% 25%
90 80 70 60 50 40 30 20 10 0
90 80 70 60 50 40 30 20 10 0
$110 BN Long/Short Equity $1 BN+ Credit $500 MM$1 BN Long/Short Equity $15 BN Multi-Strategy $150500 MM Long/Short Equity
three two one
ve four three
Figure 40
two
one
| 19
equity managers are probably the ones whose strategies most lend themselves to transparency, yet 80% of these managers with between $1 billion to $10 billion in capital did not provide investors information on current holdings. When we looked at the type of information that managers were providing, we found that nearly two-thirds gave investors performance attribution reporting and nearly 80% published portfolio and risk analytics. These types of reports are challenging to produce in a timely and accurate manner when facing off against multiple prime brokers. We saw the high incidence of report provision in these two areas as consistent with a trend that we had identified in previous years, namely that hedge fund managers were increasingly investing in middle office technology in order to complete the value chain between their portfolio managers and traders. Less than a third of managers we surveyed were providing other types of information, such as historical holdings or winning and losing positions. We found one additional response to be particularly striking. In 2010, 24% of CIG: Institutional Survey 2011 respondents indicated that they purchased a tail risk product. This suggests
that nearly a quarter of institutional investors bought in to an investment strategy that barely existed three years ago. Moreover, 35% of our respondents indicated that they expect to invest in a tail risk product in 2011. The hedge fund segment may be poised for a period of sustainable growth, but investors, it appears, will be looking over their shoulders for some time to come.
Respondents Invested in a Tail Risk Product (20102011P) 35% 24%
2010
2011P
Figure 41
IV. Balance of Power

Institutions have begun to change the nature of the larger relationships that hedge fund managers have with their investors in important ways, reflecting a shift in the relative power held on either side of the capital equation, but one that has been unevenly realized. Over the course of the past two years, the majority of institutions have successfully renegotiated some portion of their agreements with at least one of their hedge fund managers. This has been particularly true of investors that make large placements. However, as the great reallocation played out over the course of 2010, capital shifted to the largest hedge fund managers with the most attractive performance characteristics. These managers have proven to be much less likely to make significant changes in order to accommodate investors. Our 2009 and 2010 studies depict an industry in flux. We believe that increasing influence of the largest institutional investors will continue to drive change through 2011, but they will come up against some immovable objects in the form of very large hedge funds that have no shortage of investor interest. In 2010, 37% of responding investors reported that they renegotiated management fees and 25% said that they renegotiated performance fees. Overall, 87% indicated that they redeemed from a hedge fund. We think that two things stand out about these responses. First, nearly half of our responding investors making average placements of between $25 million to $100 million were successful in renegotiating core terms with at least one of their hedge fund managers. Only 21% of responding investors whose average placements were between $1 million to $5 million were able to win similar concessions. In follow-up conversations with these investors, we found that most used a period of subpar, but not poor, relative performance as an
Respondents Who Renegotiated the Management Fee with Hedge Fund Managers (2010)
opportunity to reprice the relationship. They extracted other concessions as well, such as reduced lock-ups and improved liquidity. Smaller investors were not nearly as successful in convincing even underperforming managers to move in their direction on terms. The second aspect of these responses that we felt significant was that the leading reasons for redemptions were related to poor or erratic performance. In 2010, as in 2009, the overwhelming majority of respondents redeemed because their hedge fund investment underperformed. Another leading reason was style drift, which was also performance related. Considerably further down the list were liquidity-related issues, but these only became material when the manager was underperforming and the investor was trying to exit. Issues like lack of transparency and inadequate communication were down the list as well. Investors wanted liquidity, transparency and controls. But they wanted performance even more. We found that the largest investors have been successful in convincing many hedge fund managers to provide improvements in these areas, but the change was concentrated amongst the ranks of the smaller and/or underperforming managers.
Respondents Who Redeemed from a Hedge Fund (2010)
No 13% Yes 87%
Figure 42
Respondents Who Renegotiated the Performance Fee with Hedge Fund Managers (2010)
Yes 37% No 63%
Yes 25% No 75%
Figures 43 and 44
| 21
One of the significant impacts of reallocation in 2010 is that the relative strength of the largest hedge fund managers increased. Industry statistics showing increased concentration are clear, and we found similar results in our polling data. In all, 48% of hedge funds managing over $1 billion in assets that we surveyed stated that they added funds in 2010; only 8% said that they subtracted funds. Many of these large managers also opened existing vehicles to new investors. More than 85% of these hedge fund executives indicated that their management fees were still above 1%; over half charged 2% or more. Performance fees remained in the 20% range for roughly 85% of these same managers, and 7% charged even more. As we discussed earlier, most of the largest hedge funds have done little to increase transparency and liquidity.
Hedge Fund Performance Fee Structure (2010) 85% 82%
Hedge Funds Adding or Subtracting Funds in 2010 65% 47% 24% 8% Added Funds >$1 BN <$1 BN
Figure 45
45%
11%
Subtracted Funds
Neither
$1 Billion+ Hedge Fund Management Fee Structure (2010) 38% 34%
16% 8% 7% 20% 7% Other 12% 9% 3% 0.5% 1.0% 1.5% 2.0% Other
Less than 20% >$1 BN <$1 BN
Figure 46
Figure 47
It does appear, however, that they made significant efforts to improve controls. More than 80% of hedge funds managing $1 billion or more in assets that we surveyed indicated that 80 they employ a chief compliance officer. More than 95% of these managers said that they had either already 70 registered with the SEC or are planning to register. Most will argue that 60 there is room for improvement, but most also say that they 50 have seen real progress. Improving the control environment requires real investment on the part of hedge fund managers.
However, it also delivers real benefits in a market where managers often run multiple strategies in multiple regions and face off against multiple prime brokers. Which brings us back to the core issue: by rotating so much capital into the largest hedge funds, investors have bought into hedge funds with superb track records, but they have also shifted the balance of power in many core relationships over to the manager.
40 30 20 10 0
100 80 60 40
40 35 30 25 20 15
22
Prime Brokerage
V. Looking Ahead
When looking to 2011, CIG: Institutional Survey 2011 respondents said that they expect three types of trends to develop. The first are changes that investors themselves expect to drive. In all, 79% of our respondents expect to see increased transparency in the coming year, with 58% predicting more due diligence on investors in a fund. Institutions were sanguine about their ability to cause significant change to the terms of their broader relationships with hedge funds, but primarily with the smaller ones. Over 90% stated that they did not see longer lock-ups as likely to happen, and 53% expected fees to decrease. However, investors were demonstrably unsuccessful in extracting term and fee changes from the large, top performing hedge funds where they were allocating the overwhelming majority of capital. Moreover,
Hedge Fund Trends for 2011
Increased Regulation Increased Transparency More Due Diligence on Investors in a Fund Lower Fees Consolidation More Money Allocated to Managed Accounts Decreased Leverage More Money Allocated to UCITS Longer Lock-Ups 0% 7% 20% 40% 60% 80% 100%
Figure 48
our respondents confirmed that they felt they could rebalance the terms of their relationships with hedge funds, but only where the managers were new, small or underperforming. Responding investors also expect to see changes that come about as indirect effects of their actions. More than half said that they expect to see increased consolidation in the hedge fund segment. Nearly 70% of our respondents anticipate hedge fund leverage to increase or stay at current levels. Throughout much of 2010, hedge fund indexes were highly correlated with major equity market indexes. We believed then that investors seeking superior risk-adjusted returns and diversification would, at some point, begin to pressure their managers to act with more conviction. That appears to be happening now, and we believe that the concomitant uptick in the leverage of J.P. Morgans Prime Brokerage clients is a good indicator. The final type of change that responding investors think will be seen in 2011 is regulatory. Overall, 86% of our respondents said that they expect increased regulation over hedge funds. Investors that we spoke with separately on this topic indicated that regulatory changes were likely to be generally complementary to the trends that investors hoped to drive. They also stated that they have little ability to predict what these changes may be at any detailed level.
86% 79% 58% 53% 52% 37% 31% 26%
in follow-up conversations with responding investors, we found that they seemed to be happy to pay for performance and make concessions on terms if the manager actually delivered. Overall,
| 23
Overview of the J.P. Morgan CIG: Institutional Investor Survey, 2011

This years research was conducted over the course of the fourth quarter of 2010 and first quarter of 2011. When constructing the respondent universe, we focused on investor quality and demographics (i.e., investor type, location and years of experience). Our goal was to facilitate the assembly of a forum for a balanced group of thought leaders. We were fortunate to be able to involve many of the worlds leading institutions in this effort. At the time of the survey, the respondents had placed $0.7 trillion into the hedge fund segment. The respondents were geographically diverse, with 24% coming from Europe, 17% from Asia and 56% from Canada and the United States. Geographic segmentation proved to be important in evaluating the surveys results, as investors in different regions expressed divergent views on a number of important topics. Survey participants also represent a mix of levels of experience in, and exposure to, hedge fund investing. In all, 88% of respondent assets invested in hedge funds were controlled by investors who reported at least seven years of experience in the space. We included a significant number of investors who were newer to hedge funds. These respondents were identified using the same quality and demographic screens as the more experienced investors who had placed the lions share of the capital into hedge funds at the time of the survey. The perspectives of the newcomers proved to be important, as they represent the largest source of potential capital inflows and often had views that differed from those of more experienced responding investors on several important points. Approximately 40% of respondents disclosed they had more than $1 billion invested in hedge funds at the time of the survey. The remaining 60% consists of investors from a broad spectrum of placement sizes and includes responses from several high quality investors with very little, but high potential, exposure to hedge funds.
Hedge Fund Investing Experience (2010, based on AUM in Hedge Funds)
Less than 1 year 1% 13 years 9% 46 years 17% 710 years 22% Greater than 10 years 51%
Figure 49
Respondent Base (2010, based on number of respondents) Investor Types Insurance Co. 3% Consultant 5% Other 6% Wealth Mgmt. 6% Bank 7% Endowment, Foundation and Pension 10% Family O ce 19% Fund of Funds 44%
Geographic Location Middle East and Latin America 3% Asia 17% Europe 24% North America 56%
Figure 50
Notes:
| 25
Notes:
Notes:
IMPORTANT DISCLAIMER These materials (Materials) have been prepared by J.P. Morgans Prime Brokerage business (JPM PB) for informational purposes only. No research department within J.P. Morgan Chase & Co. was involved in the preparation of or data collected for these Materials. Primarily, these Materials are intended to serve as JPM PBs analysis of survey responses collected by J.P. Morgans Prime Services Capital Introduction Group (CIG) from institutional hedge fund investors that participate in J.P. Morgans Prime Services Capital Introduction Program (the CIG Program). The number of institutional hedge fund investors represented in these Materials is smaller relative to the size of the institutional hedge fund investor marketplace, and these Materials are not intended to represent the views of the institutional hedge fund investor community at large. Although these Materials are derived from sources believed to be reliable, these Materials have not been verified for accuracy or completeness by J.P. Morgan Chase & Co. or by any of its subsidiaries, their respective affiliates, successors, assigns, agents, or by any of their respective officers, directors, employees, agents or advisers (collectively, J.P. Morgan), and J.P. Morgan does not guaranty these Materials in any respect, including but not limited to, their accuracy, completeness or timeliness. Information for these Materials was collected and compiled during the stated timeframe. J.P. Morgan has no obligation to update any portion of these Materials. Past performance is not a guarantee of future results. These Materials may not be relied upon as definitive, and shall not form the basis of any decisions contemplated thereby. It is the users responsibility to independently confirm the information presented in these Materials, and to obtain any other information deemed relevant to any decision made in connection with the subject matter contained in these Materials. J.P. Morgan makes no representations (and to the extent permitted by law, all implied warranties and representations are hereby excluded), and J.P. Morgan takes no responsibility for the information presented in these Materials. These Materials are provided for the intended users use only, and no portion of these Materials may be reproduced or distributed for any purpose without the express written permission of J.P. Morgan. None of the information presented in these Materials shall constitute, or be construed as constituting or be deemed to constitute an offer to buy or sell or a solicitation of an offer to buy or sell any securities. The CIG Program operates through J.P. Morgan Clearing Corp., J.P. Morgan Securities Ltd, J.P. Morgan Markets Limited, J.P. Morgan Chase Bank N.A., Singapore Branch (JPMSB), J.P. Morgan Securities (Asia Pacific) Limited (JPMSAPL) and J.P. Morgan Securities Japan Co., Ltd. (JPMSJ). J.P. Morgan does not charge or receive fees for introduction services provided through the CIG Program. The CIG Program does not provide capital raising, placement agent, referral, solicitation or equivalent services (Placement Services) to funds, their related investment managers, general partners, managing members or their equivalents that participate in the CIG Program (Manager Participants). The CIG Program also does not provide investment recommendations or endorsements of any kind (Advisory Services) to eligible prospective institutional investors participating in the CIG Program (Investor Participants), including in relation to Manager Participants, recommendations or endorsements of their services, products, investments or investment strategies. Placement Services and Advisory Services may, however, be provided by J.P. Morgan businesses unrelated to the CIG Program. Information presented in connection with the CIG Program may not be suitable for any and all institutions. Under all applicable laws, including but not limited to, the U.S. Employee Retirement Income Security Act of 1974, as amended, or the U.S. Internal Revenue Code of 1986, none of the information presented in connection with the CIG Program shall constitute, or be construed as constituting or be deemed to constitute investment advice, and J.P. Morgan is not acting as fiduciary for any purpose. An investment in a hedge fund is speculative and involves a high degree of risk, which each investor must carefully consider. Returns generated from an investment in a hedge fund may not adequately compensate investors for the business and financial risks assumed. An investor in hedge funds could lose all or a substantial amount of his or her investment. While hedge funds are subject to market risks common to other types of investments, including market volatility, hedge funds employ certain trading techniques, such as the use of leveraging and other speculative investment practices that may increase the risk of investment loss. Other risks associated with hedge fund investments include, but are not limited to, the fact that hedge funds: can be highly illiquid; are not required to provide periodic pricing or valuation information to investors; may involve complex tax structures and delays in distributing important tax information; are not subject to the same regulatory requirements as mutual funds; often charge higher fees and the high fees may offset the funds trading profits; may have a limited operating history; can have performance that is volatile; may have a fund manager who has total trading authority over the fund and the use of a single adviser applying generally similar trading programs could mean a lack of diversification, and consequentially, higher risk; may not have a secondary market for an investors interest in the fund and none may be expected to develop; may have restrictions on transferring interests in the fund; and may affect a substantial portion of its trades on foreign exchanges. 2011 JPMorgan Chase & Co. All rights reserved. J.P. Morgan is a marketing name for the prime brokerage business of JP Morgan Chase & Co. and its subsidiaries worldwide. Clearing and custody services are provided by J.P. Morgan Clearing Corp. (JPMCC) and J.P. Morgan Securities Ltd (JPMSL). Access to financial products and execution services is offered through J.P. Morgan Securities LLC (JPMS). JPMCC and JPMS are each separately registered broker dealer affiliates of JP Morgan Chase & Co., and are each members of FINRA, NYSE and SIPC. JPMSL and J.P. Morgan Markets Limited are authorized and regulated by the FSA. JPMSAPL is licensed and regulated by the Securities and Futures Commission of Hong Kong. JPMSB is regulated by the Monetary Authority of Singapore. JPMSJ is registered and regulated by the Financial Services Authority in Japan. All of the foregoing entities are subsidiaries or affiliates of JPMorgan Chase & Co. and are included in the JPMorgan family of companies. Product names, company names, and logos mentioned herein are trademarks or registered trademarks of their respective owners.

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2011 Investor Sentiment Report

Regeneration: Entering a Period of Sustainable Growth

2011 InVESTOR SEnTIMEnT REPORT

2011 InVESTOR SEnTIMEnT REPORT

Overview: From Retrenchment to Sustainable Growth

Reallocated Capital from Other Asset Classes

Redeployed Capital from Returned Redemptions, Lifted Gates, etc.

2011 InVESTOR SEnTIMEnT REPORT

I. The Case for Hedge Funds (and Institutional Capital)

44% 2005 Individuals

Hedge Funds Expecting to Open a new Fund in 2011

Opening a New Fund <$250 MM $250499 MM $500999 MM $19.9 BN >$10 BN 100 80

Not Opening a New Fund 90%

10% Middle East and Latin America

Source: HFR Year End 2010 Industry Report

2011 InVESTOR SEnTIMEnT REPORT

1 Year Fixed Income

3 Years Hedge Funds Listed Equity

5 Years Private Equity

Total Investment Portfolio

Source: J.P. Morgan Asset Management, Alternative Assets

Source: Preqin Hedge Fund Manager Study, February 2011

6.5% 5.7% 6.0%

Source: Preqin Hedge Fund Manager Study, February 2011

North America Monthly Quarterly

Europe Semi-annually Annually

Middle East and Latin America

2011 InVESTOR SEnTIMEnT REPORT

Source: HFR Year End 2010 Industry Report

Average inows of total assets 10.4%

250 200 150 100 50

Average inows of total assets 3.5%

45% 31% 2009 Increasing Total Allocation 2010

2011 Expected 2008

2010 Endowments, Foundations and Pensions Consultant Bank

2011 InVESTOR SEnTIMEnT REPORT

Respondents Hedge Fund Holdings Gated or Under Redemption Suspension in 2010

Cash Positions as a Percent of Total Portfolio (2010)

18% 10% 2% HF Investing Experience by AUM in HFs 46 years

2011 InVESTOR SEnTIMEnT REPORT

III. Proceeding with Caution

Source: HFR Year End 2010 Industry Report

Respondents Who Use a Consultant (2010)

Expect to Start Using One 1% Yes 17% No 82%

Top Priority When Selecting a Hedge Fund Manager, 2010

+2% -2% -1% +1% -3% -1% -2% +4%

Investors Willing to Invest in a Start-Up Manager (2010)

Yes 10% No 31% Selectively 59%

37% 25% 27% 15% 27% 24% 13% 14% 8% 4%

2.71% 0.38% 3-9 years

Source: The Performance of Emerging Hedge Fund Managers, 2008

2011 InVESTOR SEnTIMEnT REPORT

30% 20% 23%

Fund of Funds Consultant

Greater than 2 years 63% 1 year 3% 6 months 3% Fund Inception 31%

Average Time to Complete Due Diligence (20072010)

2007 Greater than 1 year 612 months

No Preference 15% Monthly 22% Quarterly 53% Semi-annually 5% Annually 5%

None 6% 6 months 6% 1 year 43% 2 years 28% 3+ years 17%

Yes 29% No 71%

Yes 27% No 73%

2011 InVESTOR SEnTIMEnT REPORT

14% 4% Yes No Possibly 1% Currently Have One