Written in cooperation with International Fund Investment, this report is based on surveys and structured interviews conducted globally between February and June 2010. The study has benefited from the participation of 200 respondents across 26 countries, and includes: alternative investment managers with $515 billion under management; administrators with $4.2 trillion under administration; and, institutional investors with $884 billion under management. In addition to the above groups, interviews were also conducted with lawyers and independent directors.
References within the report to alternative investment managers are based on a sample of respondents that invest in either (or a combination of) hedge funds, private equity, real estate, infrastructure and structured products, although the main focus has been on the hedge fund sector.
One of the constants in the alternative investment industry is the presence of change. From its origins to expansion in the 1990s and through the explosive growth of the 2000s, the one thing that the industry could count on was continued change. However, in reality, the basic structures of the alternative investment business were not very different in 2007 than they were in 1997. The industry was a great deal larger but practices and structures remained largely unaltered. Investorsconsidering alternatives, including the world’s largest institutions, had to do so on the manager’s terms, not their own.
Those days are now over. The industry is going through a period of transformational adjustment to a very different and more regulated operating environment. The majority of institutional investors included in the survey intend to increase their allocations to alternative investments in the next three years, with some intending to allocate over 10% of their total assets. As a result, these investors will have a far greater influence over the shape and culture of the industry in the future – they will demand institutional grade controls, increased transparency and flexible product strategies in order to invest their capital. In addition to the credit crisis, events such as Madoff, whilst not a hedge fund, highlighted the need for a robust due diligence process. The influx of more institutional capital into alternatives will result in further substantial growth of the well known, billion-dollar managers.
The desire for more transparency and liquidity is the main driver behind the recent growth in new product structures in hedge funds, including managed accounts and managed account platforms as well as onshore regulated products. Managers are being forced to make adjustments to the new environment, whether they like it or not (and some emphatically do not). For many of them, the frustration of having to review internal procedures and systems, consider different domiciliation options, gear up for more regulation and so forth has a payoff. They believe that this painful and expensive process will enable them to attract many more and different types of investors to their funds.
The paradox of regulation
The results of this survey show that the anticipated increase in regulation is not wanted by the majority of investors, managers or service providers. Despite regulation being widely promoted as a way to protect the investor, it is these investors who are most strongly against it. Few investors believe it will produce any tangible benefits. Some see it as being protectionist to certain jurisdictions and therefore detrimental to the development of the global alternative investment industry whilst others fear that it will inhibit the competitive positioning of investment managers by adding to costs. As a result, many investors in Europe believe it will reduce the number of new start-ups, thereby stalling the industry’s engine of creativity – the production line of boutiques that provide vitality and talent in the future.
Nevertheless, the universal view is that further regulation is on the way. Investors, managers and service providers take a fatalistic approach to this subject. It is viewed as an inevitable consequence of the recent well publicised scandals affecting the industry, combined with the dramatic market volatility in recent months. Furthermore, numerous respondents made the point that alternative investments were in no way responsible for the market crisis. Indeed they were often victims themselves. Nonetheless, managers recognise that they cannot escape from the increase in financial regulatory supervision occurring around the world.
Regulation is coming to the alternative asset management industry on both sides of the Atlantic. The impact of various US regulatory and legislature initiatives, including the so called ‘Volcker’ rule, which proposes a ban on proprietary trading by banks, will likely be considerable for the alternative investment industry, as talent migrates towards boutiques. In Europe, the Alternative Investment Fund Managers Directive (AIFMD) is closer to finalisation. The European Parliament’s Committee for Monetary and Economic Affairs recently voted for the draft directive and the EU Council’s group of finance ministers followed suit on its version of the text.
Managed accounts: theory & practice
Separately managed accounts have always been a mainstay of the investment management industry. Managed account platforms, however, are a relatively new phenomenon.
Using managed account structures as a method of investing in alternative investments, has become considerably more attractive than fund of funds with institutional allocators. Investors surveyed forecast that managed account structures will experience substantial growth. (After direct investment into single manager funds, managed accounts are predicted to see the largest increase in asset allocations over the next three years.)
The control that managed accounts offer investors was mentioned by all those that use, or intend to use, these structures. After control, liquidity (in particular avoiding gates, lock-ups etc) and transparency were the next most popular reasons for turning to managed accounts. As a result, managed accounts are being used almost systematically by large institutions when they wish to make a large allocation to a manager.
However, managed accounts have drawbacks. Their biggest drawback is that they do not provide access to all managers or strategies. They are also difficult to implement for illiquid strategies, like distressed funds, due to increased reporting and administration demands. In addition, investors are conscious of the added costs, resources and responsibilities that are imposed upon them. Only large institutions have the means to employ the staff to implement and monitor a successful managed accounts program. Other concerns included performance diminution and the fact that they place more operational risk on the investor (and less on the manager). In addition to complexities with implementation, capacity constraints are already emerging in the managed account sector and investors are likely to have some difficulty finding the managers they want via these structures. Managers interviewed complain that managed accounts are taking up too much of their time and resources. They are concerned that their own fund investors must come first. Some managers have declined to take on managed accounts and others are imposing limits.
Imposing limits on managed accounts could become a badge of honour with successful, well known managers in the future. Pre market crisis, finding capacity with such well regarded managers, those that were often technically closed, was a concern for large investors. Post crisis, a variation of this problem could reappear within the managed account universe. Hence, direct investment into alternative investments is forecast by investors to increase more quickly than investment via managed accounts over the next three years.
Changing structures for allocators
The way in which institutional investors currently access alternative investments will change in the next three years. At present, investors generally allocate capital to alternative investments through funds of funds, managed accounts, indexed products or direct investment. Institutional investors with the requisite resources are now moving to a hybrid allocation model. A clear trend in favour of single manager funds and managed accounts is emerging as allocations to funds of funds diminish.
Fund of funds did not have a good market crisis, say their investors. Their raison d’être to reduce market risk through enhanced diversification failed to materialise when it mattered most. Whilst large institutional investors favour a hybrid model of single manager funds and managed accounts, smaller institutional investors have more limited allocation options and fund of funds will remain their gateway to the industry. A number of these investors note that larger fund of funds are proving to be adaptable and innovative; some have enhanced their communication with investors and provide a far more customer centric experience.
Fund of funds managers with assets in excess of $5 billion have the resources to expand into managed accounts and to diversify their offerings in other ways. In 2010 and beyond, the best of these large, multi purpose operations are likely to continue to expand into new areas (offering investors different structures and strategies). Convergence and divergence across strategies and structures will drive consolidation. Recent mergers in the hedge fund industry, including that of two well known firms in the business, both with assets in excess of $5 billion, are an example of this. This is widely expected to lead to a further wave of M&A activity. There is always a possibility that something similar to the ‘merger mania’ that gripped the custody industry in the 1990s could be replicated amongst today’s independent alternative asset managers.
The supply side of the alternative investment industry has changed considerably in recent years. Prior to the credit crisis, questions were raised regarding the availability of talented managers who could generate alpha at a rate demanded by investors. Currently, there is significant amount of capacity available to manage funds, with only two in five managers operating at or near full capacity.
Our interviews revealed evidence of a next generation of talent migrating from brand name investment houses to set up new businesses. Whilst the industry continues to institutionalise, the allure of reward, creativity and freedom on offer from the boutique sector will always attract alpha generators. Hence, the number of boutiques will continue to thrive, although in capital terms, they will represent a far smaller proportion of the industry. The pace of change may be impacted further by the proposed ‘Volcker’ rule in the US, as proprietary traders are forced out of the mainstream. The future choice for investors looks bright – the difficulty will be finding the star in all the mediocrity (see Fig.3 & Fig.4).
Single manager funds lead
As investor appetite for absolute returns continues to grow, over three in five managers expect that single strategy hedge funds will be the main route to market, with the majority of them expecting returns of between 11-20%. This data is confirmed by investors who are increasingly searching for direct investment into funds.
Expectations for returns favour private equity, single strategy hedge funds and structured products, although it is unlikely that we will see a significant increase in the latter before the next year. Whilst investors have short memories, they will likely not forget the term collateralised debt obligation (CDO) in a hurry. The events in recent years, however, have not caused the structured product industry to close, and a number of larger managers have expressed a desire to ramp up their collateralised loan obligation (CLO) businesses when the market fundamentals change. Our interviews suggest that investors are regaining confidence in the sector and are beginning to search for innovative products, with a growing interest in higher risk bonds and other investments such as art funds.
Hedge fund and private equity products are preferred by managers – an indication, perhaps, that investors have short memories and are willing to try again, albeit under new and improved terms.
From our interviews, it is clear that the funds of funds industry is at a crossroads. Transparency, liquidity, alignment of interests and customer centricity are all changes which the industry is making. Many managers commented that they lost sight of investors and with that the trust between investor and manager was broken. The surviving fund of funds brand names will continue to thrive as institutional investors have limited opportunities with which to access talent. For the smaller funds of funds, there needs to be a mindset change towards the investor, and improvements in communication will be essential. Nonetheless, we are likely to see stronger asset growth from managed account platforms in the next three years asinvestors seek more control and transparency in their investments.
The majority of institutional investors intend to increase their allocations to alternatives in the next three years. Institutional allocations to alternatives are diverging as what might possibly appear, at least superficially, to be contradictory trends.The days of uniform swings to alternative asset classes by allocators are over – at least for the time being. The largest institutions are increasing allocations to alternatives, whilst those at the other end of the scale are, at most, just maintaining the small presence that they took when they first invested in alternatives a few years ago. Some institutions are pulling out of hedge funds altogether (although maintaining an interest in private equity and other alternative asset classes).
The key differentiators today are resources and experience. Large institutions are of sufficient size to facilitate running a successful alternative investment program that is adequately resourced, should they wish to do so. The biggest pension funds interviewed are adding staff as they build up their own in-house expertise. In some cases their knowledge base is now considerable. With their acquired expertise they are increasingly investing directly in alternative investments and are using managed account structures.
Added to which, large institutions generally allocated earlier to alternatives than smaller ones. This has also assisted them in their knowledge base development. With longer track records, they were generally less perturbed by the disappointing performance numbers that much of the alternative investment industry produced during the recent market crisis. It is the largest allocators that report that they are increasing their exposure to alternative investments (see Fig.5).
Smaller institutions, on the other hand, do not have these resources. Some of those surveyed have admitted to being unsure as to which course of action to pursue at present vis-à-vis their alternative investment strategies. Whilst a number of them followed in the footsteps of the largest institutional allocators by diversifying into hedge funds, in many cases they did this in the mid part of the last decade. In other words, not long before the market crisis. Rather than making a long term commitment, their allocations were often done on an experimental basis; in many cases, it was little more than putting a toe in the water. These investors are the likeliest to be concerned with the failure of many alternative managers to consistently generate absolute returns, and report that they will not be allocating more to alternative investments in the next three years.
In the aftermath of the market crisis, it is also the smaller institutional investors that have reviewed their alternative fund investment strategy. Equally, it is those that are in this category that have said that recent events have had consequences for their operational due diligence procedures.
Method of allocation
Our research suggests that there is no single preferred method of allocating to alternatives by investors. Most expect that direct investment into alternative investments will grow the fastest of the available options over the next three years. One interviewee, for example, reported that his organisation has decided to concentrate upon a limited number of funds whilst getting to know their managers and organisational set-up exceptionally well (see Fig.6).
Several major institutions are currently employing a hybrid model in their alternative allocation programs. They use funds of funds but also invest directly in funds. As time goes by, the objective is to increase their direct proportion and to reduce their fund of funds allocation. But for smaller players, there is an acceptance that they have no real alternative to access anumber of managers other than to continue with the fund of funds option. A number of investors made the point that the fund of funds industry “did not have a good crisis”.
Consequently, the larger fund of funds managers are proving to be adaptable and innovative. Therefore, as we move further away from the credit crunch period, it is believed that they could do particularly well in the future. But it is also anticipated that there is likely to be a period of real consolidation amongst the fund of funds managers with assets of much less than $5 billion.
Assets in managed accounts are forecast to increase over the next three years by nearly one in two respondents. The reasons given are the greater transparency, liquidity and operational advantages that these vehicles provide for investors.
After direct investment into hedge funds, managed accounts are predicted to see the strongest increase in asset allocations over this period. The control that they offer investors was mentioned by all those that use these instruments, or intend to use them in the future. A number of the largest institutions now use managed account structures as a matter of routine if they wish to make a sizeable allocation to a manager. Typically, this can be in excess of $100 million.
A Global Investment Manager
Our material outflows ended in February 2009. The financial crisis changed the asset manager and investor landscapes considerably. The continuing uncertainty in markets and the regulatory environment is driving investors to be cautious and therefore ‘manager viability’ and product selection are key. Since before the beginning of the year, as the upturn continues, we are now seeing inflows, but not with the exuberance of old.
There are certainly fewer investment mandates around but those that are worth having are generally bigger, on average, than we have seen in the past. The opportunities that we are seeing are primarily coming from institutions. Notably there are new direct mandates from pension funds. More than 50% of the assets that we manage are now direct mandates from pension funds.
Increasingly, European investors see UCITS and managed accounts products as a ‘must have’ in any portfolio and we are seeing considerable investor preferences switching away from traditional Cayman funds to UCITS platforms. This is especially true for French and Italian funds of hedge funds. Investor due diligence into Cayman funds is more thorough and we have come to expect a longer process than in the past. One client asked about our back-up generators. Clients have a lot more choice among managers offering similar products. They are not in any hurry to allocate capital on the whole and due diligence is becoming a way of differentiating between these managers. It is common for investors to want to see our people one by one – presumably to ensure that we are all saying the same thing. The marketplace for investor assurance services also seems to be growing. We’re seeing increasing numbers of investors use investment consultants for due diligence and frequent e-mail from organisations offering due diligence services.
We are very disillusioned by the developments with the EU AIFMD. Are there any signs that this will add to investor protection? How on earth will it be put into practice in its current form? It is still clear that the Euro-morass do not understand the alternative investments industry, perhaps willfully so and we need enlightened regulators who know what they are doing.
The Hedge Funds Standards Board (HFSB) recommendations, which to a large extent were compiled to pre-empt burdensome regulation on the industry, have not had a noticeable impact with the European regulators or with the investor community. We have not had a single investor ask us if we are signatories to the HFSB, for example.
FIN 48 has been a serious issue for the industry for managers that had not accrued for taxes that may have been due across the different jurisdictionsin which they operate. It took us seven months to decide what to do about it given that there are many different accounting interpretations of the same rule. We have witnessed some material impact in NAVs in some funds. It’s been that serious.
No one is safe from being acquired in the new market conditions. We want a compelling proposition in everything and we are on the lookout. We want to offer a single brand with a diverse product portfolio. Regulatory, fiscal and investor pressure will drive up the barriers to market entry. You want all sorts of people to succeed in this industry. The hedge funds industry has grown largely organically by talented people who have started small and built significant books of business. It is becoming too difficult to set up now and this is disappointing.