The Convergence of Consultants and Funds of Funds

Excerpt from Deutsche Bank’s Alternative Investment Survey 2013

DEUTSCHE BANK

As the industry matures and becomes more institutional, it follows that consultants have become one of the most influential groups in the hedge fund investor community. Many consultants have expanded beyond their traditional remit to offer discretionary services for their institutional client base.

At the same time, however, the fund of funds industry has aggressively evolved and expanded its business model to address increasing fee compression pressure, declining assets, and industry consolidation, amongst other challenges. We are seeing more and more funds of funds offering advisory services, bespoke portfolios and outsourced CIO solutions, to name a few, in order to cater to the growing institutional investor base and contribute to their overall portfolio solution. In the wake of several high-profile mergers and business restructurings, a leaner, more focused and more entrepreneurial fund of funds sector is emerging.

In this year’s survey, we continue to observe the evolution and convergence of funds of funds’ and consultants’ business models. The theme of convergence is best demonstrated by the fact that the fund of funds’ and consultants’ client base has become increasingly similar (see Fig.1).

While consultants are known for catering to an institutional clientele, funds of funds have had to make a concerted effort to replace their diminishing private wealth investor base with one that is more institutional in nature. Our survey suggests that they have been fairly successful. On average, the funds of funds respondents in this sample typically have a client split of 52% institutional capital (pensions, insurance,endowments, foundations and government funds), 36% family offices/private banks and 11% from other sources. With a growing institutional investor base, funds of funds are becoming increasingly competitive in their intermediary role between hedge fund managers and the institutional end-allocators.

How can we explain a trend of increased direct investing by institutional hedge fund allocators, as well as understand the stable amount of institutional assets that our fund of funds respondents report? The answer is quite positive – the institutional pie is growing. As more pension plans, endowments, foundations and insurance companies make their first move into hedge funds, leading funds of funds receive inflows that appear to meet the outflows that they are seeing from those that have graduated to direct hedge fund investing. Further, some single managers have capacity constraints, and are unable to accommodate large allocations from institutional investors; funds of funds, however, do not have this capacity issue. Assuming a low interest rate environment for the near to medium term, we expect that inflows to the best funds of funds will continue as a growing number of institutional investors look to their hedge fund investments to deliver consistent returns.

Given the increasingly similar client base, it would follow that funds of funds and consultants develop similar business offerings to meet the needs and objectives of their institutional clients. To that end, we asked funds of funds: “What percentage of new business this year has been for bespoke portfolios and for advisory?” (see Fig.2).

With 36% of end-allocators stating that bespoke portfolios are one of the main benefits of their fund of funds allocation, it makes sense that a significant number (29%) of the funds of funds have seen over half of new business for bespoke portfolios.

It is interesting to note that the demand for advisory is considerably less, with just over two thirds of funds of funds finding it accounts for less than 10% of new business. It is difficult to determine whether this is because the funds of funds have been concentrating their efforts on promoting their bespoke portfolios, or whether the investor demand is simply not there on the advisory side. However, it is noteworthy that funds of funds have indeed begun to offer advisory services as a complement to their bespoke and/or customised portfolio offering.

As much as the funds of funds have been adapting their business models in order to remain competitive, many investment consultants are doing so as well. The number of consultants in our survey who have established a discretionary fund of funds product for their clients has risen from 26% last year to 50% this year (see Fig.3).

To explore this point further, we asked those who replied in the affirmative to determine how their discretionary AUM has changed as a percentage of their aggregate AUM. The answers ranged significantly, but the weighted average was +19%. We expected a year on year increase, but were surprised to see such a significant shift. We expect this trend to continue in 2013.

As evidenced above, the client base and business models of consultants and funds of funds are increasingly overlapping. Another key finding from this year’s survey does not concern the convergence of businesses but rather, a key area of differentiation. Consultants tend to favour traditional, blue-chip managers – well known names that have gained credibility with strong historical performance, robust operational infrastructure and proven business management. Funds of funds often add value by accessing those managers that often fallunder the radar, including niche strategies. The findings in Fig.5 augment this argument.

Many hedge fund managers, in particular the younger, smaller and/or niche funds, often find it a struggle to initiate dialogue with the consultants. This is clearly illustrated by Fig.4 which shows that consultants shy away from hedge funds running less than $100m and that have a track record of less than a year. A reason for this is that consultants are often heavily capacity-constrained, and initiating coverage of a new manager requires a significant amount of man-power. Unless there is enough investor interest to warrant coverage, consultants will typically side-line those funds. With this in mind, it is not surprising to see that 80% of consultants will pass on covering a manager due to a lack of investor interest. Further half of these respondents placed it as the single most important reason for not researching a manager.

It is encouraging, however, to see that only over a quarter of consultants cite a track record of under three years or an AUM of less than $500m as reasons for not researching a manager. Building consultant relationships may require significant time and patience, but they can prove to be amongst the most rewarding.

Despite receiving their fair share of criticism in the press, it is clear that there are a large number of investors who firmly believe in the diversification, resource and educational benefits that a fund of funds allocation can provide. In contrast to consultants, funds of funds seem to be offering value for their clients by accessing niche managers, including smaller or younger funds.

When we questioned end-allocators on the main benefits of their fund of funds investments, almost 60% said ‘access to niche manager’ was the single most important benefit.

As mentioned earlier many funds of funds have moved the discussion with clients away from that around a standardised product, towards creating bespoke portfolios. The above responses would suggest that these tailored solutions have been well received, with over a third of investors choosing the bespoke portfolio option as a main benefit of their fund of funds allocation. The majority of those respondents who chose the “other” category consider diversification to be the main benefit of their fund of funds investments. Their fund of funds allocations enable them to reach an acceptable level of diversification with a smaller amount of capital – allowing scale that small investors would otherwise not be able to achieve. Other benefits that were discussed in the “other” category include access to historically closed funds, leveraging the relationships of the funds of funds and the speed of allocation.

A third of the investors have chosen outsourcing operational due diligence as a main benefit, indicating that funds of funds are possibly offering this as a standalone service, which puts them in direct competition with consultants, another factor that points to the convergence of the activities between these two groups.