Institutional Confidence a Year On

Have investors recovered from the crash?

AMY BENSTED, MANAGING ANALYST, PREQIN

At the end of Q3 2009 Preqin’s analysts surveyed more than 50 institutional investors with known activity in hedge funds to garner their thoughts on various issues key to the industry today. Preqin carried out a similar survey in October 2008 – just as the global financial markets crashed. In this article we examine investor confidence at the cusp of a new decade and evaluate institutional sentiment in 2009 as compared to 2008. We surveyed a variety of institutional investors including private and public sector pension funds, endowment plans, family offices, foundations and insurance companies. The survey also encompassed a large cross section geographically with investors based in Europe, North America, Asia as well as the rest of the world.

Investor satisfaction and confidence
Institutional investors are, on the whole, more satisfied with the returns of their hedge fund portfolios today as compared to a year ago. In 2008, just under 40% of all surveyed investors were dissatisfied with their hedge fund investments following returns which had not met expectations – this figure today stands at around 27%. As shown in Fig.1, 62% of investor surveyed in 2009 stated that return expectations have been met, and a further 11% stated hedge fund returns have exceeded their expectations.

prequin1

Although the industry as a whole was successful in outperforming public markets following the crash, a significant proportion of investors remained dissatisfied with their investments in hedge funds in 2008. In addition, investors that were satisfied and dissatisfied alike were seeking redemptions from existing investments in order to rebalance other distressed areas within their portfolios. In some cases investors in the more successful strategies have found themselves over-exposed to the asset class, and as a result have been making redemptions in order to rebalance.

As a result, many hedge funds disappeared altogether and the industry shrank considerably from $1.93 trillion at its peak to approximately $1.3 trillion today (source: Hedge Fund Research). Today returns are back in positive territory and some strategies have been producing their strongest performances for five years or more. This bounce back has helped to restore some of the institutional confidence that was lost in 2008 with 73% of investors stating that they are satisfied with hedge funds returns in 2009 – up from 62% in 2008.

In addition, institutions are once again investing in the asset class following the temporary suspension of activity at the endof 2008 and we have recently witnessed new investments made by institutions such as Alaska Retirement Management Board and New Zealand Assets Management.

prequin2

Fig.2 shows that 66% of institutional investors are either confident or very confident that their hedge funds meet their investment objective. There still remains a degree apprehension in the asset class following the disappointing returns, high profile scandals and gating of capital which characterised the end of last year.

However if returns remain strong and managers have learnt from the lessons of the crash then investor confidence in the asset class should be restored to pre-2008 levels.

As a result of the increased investor satisfaction, there is once again a net positive balance of investors planning to increase their allocations to the asset class (see Fig.3): 29% of the investors surveyed plan to increase their investments, compared to only 20% planning to decrease them (and the balance of 51% intend to maintain their investment at current level).

prequin3

Among the institutions planning to reduce their investments in hedge funds, it was interesting to note that in some cases this was due to short-term liquidity reasons. One European foundation told Preqin that it was cutting some hedge funds from its portfolio “unwillingly …because of their outperformance, hedge funds’ relative proportion of the total portfolio now exceed the maximum allowable by the board so I am forced to redeem to bring its percent in line with the strategic allocation”.

What are investors looking for in hedge fund managers?
Fund transparency has replaced fund performance as the greatest consideration for investors when selecting new hedge fund managers (see Fig.4). Risk management and firm reputation have also grown in importance to hedge fund investors following the high profile hedge fund scandals which have dogged the industry in the past 12 months. Last year the performance record of a fund was the most important criteria institutional investors used when assessing new hedge fund opportunities, however investors now are more conservative in their reasons for investing in hedge funds, with most choosing these vehicles for portfolio diversification and to improve the risk/return profile of their portfolio rather than to produced outsized returns (Fig. 5).

prequin4

prequin5

Just under half of all investors surveyed stated that they have not altered what they search for in hedge fund managers since the market crisis at the end of 2008 (see Fig.6). Of the investors which have altered their search criteria for new investments, 52% are now looking for increased liquidity and a third look for more transparency at fund level. Whereas fees are a key issue for institutional investors they do not specifically set out to invest in funds which charge lower fees, preferring instead to negotiate fees with funds which exhibit characteristics which are more important to them such as greater liquidity and transparency.

prequin6

Institutional fee debate
In 2008 institutional investors were more neutral in their opinion on the matter of hedge fund fees – with 53% of investors surveyed last year stating that fees charged were acceptable, though 33% stated that these fees were acceptable only as long as return expectations were met. It is clear that today institutional investors are becoming increasingly disillusioned on the subject of fees (see Fig.7): an investment officer at a prominent US public pension fund told Preqin that he did not understand why “hedge fund managers should be paid like rock stars”. Several other prominent hedge fund investors (notably CalPERS) have publicly called on hedge fund managers over the course of 2009 to reduce their management and performance fees and the decline of hedge fund fees has been a buzz topic in 2009.

prequin7

Today, just 23.9% of institutional investors feel that hedge fund fees at their current level are justified. Approximately 60% of institutional investors feel that hedge fund fees are too high with a further 17.4% of investors surveyed stating that although fees are coming down, they remain too high. Institutional investors are becoming both more aware of their power to negotiate fees as well as increasingly using this power to drive fees down. When Preqin asked institutional investors whether they have tried to negotiate better terms with their hedge fund managers (see Fig.8), we found approximately half of all investors surveyed have tried to negotiate the management fees and performance fees associated with their hedge fund investments, with 62% of those investors which have attempted negotiations being successful! A further 22.2% of institutional investors were considering approaching negotiations with hedge fund managers to reduce the fees charged on their funds. As more investors continue to negotiate the terms associated with their hedge funds we can expect there to be a further consolidation of fees at a level below the standard “2&20” that has been the industry norm for years.

prequin8

Institutional investor opinions on regulation of the hedge fund industry
Regulation of the hedge fund industry has been another key topic in 2009 and over 82% of all investors surveyed felt that the industry needed to be regulated to some degree (see Fig.9).

prequin9

The events of the past 12 months – primarily the extremely high profile Madoff scandal – have affected institutional sentiment on the current regulatory system as well as bringing the asset class to the attention of the general public as a whole. Institutional investors are asking for increased regulation of the industry in order to help safeguard their investments as well as to assist them in making appropriate investment decisions on behalf of their beneficiaries.

Most commonly investors are asking for a limited amount of regulation of the hedge fund industry but for these regulations to be applied to all managers. An investment manager at a large UK insurance company told Preqin: “Regulation can be a good thing and a bad thing. As long as it is not costly or limiting to investors, they would like to see a certain degree of regulation, particularly in regards to fund transparency. However I would not want to see the industry heavily regulated because this could prevent managers from doing their job properly. Too much regulation will change hedge funds from an alternatives fund to a regular fund.”

Most investors recognise the need to regulate the industry and believe sensible and restricted amounts of regulations can be both beneficial to investors as well as to fund managers.

Hedge fund transparency is the key issue that institutional investors would like to see improved through increased regulation. Over 60% of all investors surveyed asked for “increased disclosure of hedge fund holdings”. Most investors surveyed believed that the disclosure of fund holdings to investors should remain confidential in order to maintain the funds’ competitive advantage but felt that the transparency would help them in balancing their portfolios and in monitoring their managers.

The registration of all hedge funds to financial authorities is a sensitive issue and one that has been much debated over 2009. Approximately a third of investors would like to see the registration of hedge funds with financial authorities, although most respondents specified that the registration should be designed to keep the general nature of the industry intact; that is to allow hedge funds to remain alpha producing vehicles which generate uncorrelated returns (see Fig.10). As a large European public pension fund put it “we like the idea of fund registration. There is a fine line between useful regulation and over regulation. Over regulation will negate all benefits of allocating to hedge funds”.

prequin10

Conclusions
Institutional confidence in hedge funds is returning to the asset class following the global crisis in 2008. Investors, who last year lost confidence in hedge funds following disappointing returns and several high profile fund collapses and scandals, are beginning to make new investments in funds and have been more satisfied with their hedge fund performance over 2009 as compared to 2008.

The hedge fund industry has changed: there now are fewer funds and the industry has shrunk to $1.3 trillion (Hedge Fund Research). Institutional investors are now the largest source of capital to the hedge fund manager – providing over 70% of the total assets in the industry – therefore it is vital for managers to understand the needs and demands of these investors if they are to be successful in their search for institutional support.

Liquidity and transparency are the most important considerations for institutional investors. Fund transparency is the key issue that hedge fund investors would like to see regulated, so funds which already provide their investors with this will be very attractive to the institutional investor over the next 12 months. Also those hedge fund managers that are flexible in the terms and conditions associated with their funds will be more successful at gaining institutional support.

The issue of fees has been at the forefront of the hedge fund industry in 2009, and institutional investors are becoming increasingly dissatisfied with the 2&20 structure that has been traditionally implemented. As institutional investors continue to use their collective might to negotiate lower management and performance fee we predict that the industry 2&20 standard will be reduced to a more mutually acceptable level.

ABOUT THE AUTHOR

Amy Bensted is a Managing Analyst for Preqin. She manages Preqin’s Hedge Investor Profiles product, an online database featuring profiles for 2,500 institutional investors in hedge funds from around the world. Profiles include exclusive information on fund type preferences, previous investments, key financial information and direct contact information for key decision makers.