While the global financial crisis and the ongoing uncertainty plaguing global markets have undoubtedly had a major impact on the alternative investment industry, another driver of change has been the increased “institutionalisation” of the industry resulting from, post crisis, institutional investors such as charitable foundations, pension funds (in both the public and private sectors), university endowments and insurance companies now being the leading allocators to hedge funds.
While individuals accounted for 54 per cent of all capital invested in hedge funds in 1998, this proportion decreased to 23 per cent by 20111, and it is now estimated that institutional investors account for 57 per cent of the industry’s total assets under management2.
This growing participation of institutional investors in alternative investments has impacted the industry in a number of ways. This article sets out some key trends and explores how the industry has reacted to this increased institutionalisation.
Increased due diligence and transparency
Institutional investors are demanding in terms of due diligence pertaining to managers, counterparties and service providers, as well as in terms of transparency as to portfolio positions and trading.
Either directly or through the use of operational due diligence consultants, institutional investors will thoroughly evaluate all aspects of a manager’s business practices, policies, procedures and operations before allocating capital to that manager.
Requests for investment management proposals and due diligence questionnaires have become longer and more detailed and investors are asking for greater disclosure regarding the quality of management controls and processes, the existence of assets, price verification procedures and the effectiveness of risk and compliance policies.
In addition, institutional investors are routinely demanding insight into portfolio positions and decision-making processes. The importance institutional investors are attaching to such factors as they relate to managers is illustrated by the fact that, for the first time, investors responding to the annual Goldman Sachs Global Hedge Fund Investor Survey ranked operational robustness as equally important as performance track record in allocation decisions.
These demands, combined with increased regulatory requirements, have forced many managers to ramp up their head count and infrastructure. While managers are (quite understandably) keen to control the cost of complying with such investor requests and to safeguard sensitive information regarding trading information, they have responded by working with their investors to distinguish what is practical and useful from what is excessive, giving greater insight into their businesses and forging more collaborative partnerships with those investors.
Standardisation of investor reporting
The increased transparency demanded by institutional investors has driven managers to seek out more efficient ways of meeting investor expectations in this area. Responding to requests for information on an ad hoc basis and organising meetings with multiple investors is, of course, time-consuming and a drain on resources.
Managers have therefore started to develop more standardised reporting in order to pre-empt the most common requests and to enable them to respond more quickly to investor demands. The “operational due diligence day”, on which selected institutional investors are invited to hear presentations, is becoming more commonplace.
Managers are also themselves becoming more demanding of third-party service-providers. In particular, administrators are now under pressure to make available online reporting portals giving easy access to the information investors value most, such as existence and price verification of assets.
Standardising reporting in this way has helped to enhance investor trust in that information is readily available without the need for investors to request it, further enhancing the spirit of collaboration between managers and investors. The greater availability of standardised information has also allowed investors to devote more time to assessing the more idiosyncratic aspects of the manager’s business.
Industry bodies have assisted by developing tools to familiarise managers with investor expectations: the Hedge Fund Standards Board’s list of standards sets out a framework of transparency, integrity and good governance, with one of its stated aims being to facilitate investor due diligence.
Meanwhile, the Alternative Investment Management Association (AIMA) has published a paper setting out investor views, expectations and preferences on a variety of important operational and organisational issues. AIMA has also developed a series of due diligence questionnaires which provide a framework for a basic level of information which investors can then supplement with additional questions addressing their own bespoke requirements.
The increased operational infrastructure demands of institutional investors and the new regulatory environment have created barriers to entry and have made life more difficult for smaller managers.
In addition, the institutional investors who now represent the clear majority of capital invested in the hedge fund industry are more likely to allocate to larger managers: 87 per cent of managers with 100 or more employees who responded to the 2012 KPMG/AIMA Global Hedge Fund Survey indicated an increase in pension fund assets as a proportion of their overall assets under management since 2008, and 80 per cent of those larger managers indicated an increase in other institutional assets over the same timeframe.
The combined effect of these factors is that the bigger managers are getting bigger. A recent Pertrac study identified 60.6 per cent of the total assets under management reported by single manager hedge funds were concentrated in funds managing more than US$1 billion in assets3.
The world’s largest hedge fund manager manages more than US$80 billion and the bottom two hedge fund managers among the top ten in the US alone each have more than US$20 billion in assets under management4.
Perhaps related to this growing tendency for institutional investors to allocate capital to larger managers is the growing allocation to smaller managers by high net worth individuals and family offices. 74 per cent of managers with less than 25 employees who responded to the same KPMG/AIMA survey indicated an increase in assets from high net worth individuals, while 65 per cent of those smaller managers reported an increase from family offices.
This bifurcation of the industry has been in progress for a number of years but, as these figures show, has become more pronounced in the years since the financial crisis.
Liquidity terms and fees
As a consequence of the liquidity difficulties experienced by many funds at the height of the crisis, many investors are now seeking not only enhanced transparency but also more investor-friendly liquidity terms and are resisting the use of lock-ups, suspension and side-pocket provisions and the like. The use of side letters is becoming increasingly common and endowments and pension funds in particular will often insist on enhanced liquidity terms.
Although there has been some pressure to reduce fees, this has been more of an issue for new managers as opposed to the large, established ones.
Increased fund governance
Proper fund governance is an ongoing hot topic. In order to reduce the potential for conflicts of interest between the fund (and its investors) and the manager, institutional investors invariably demand independent directors, whose presence on fund boards is now the default position: the Hedge Fund Standards Board recommends that, in most cases, the preferred model would involve a majority of independent directors. Investors are also alert to ancillary issues such as the number of directorships per director and the frequency of board meetings.
There is also an increasing trend to engage larger third-party administrators as a check on valuation and custody and the larger administrators are acquiring an increased market share of assets under administration. The role of the administrator is also changing: certain administrators are offering a greater range of services, including advanced risk, regulatory and reporting services.
Post-Lehman Brothers, industry assets are becoming increasingly spread among the different prime brokers and it is increasingly common to see managers diversify risk in this area by engaging multiple prime brokers. This has benefited investors in that the fund’s risk is no longer concentrated with a single broker, while the fund also has access to a wider pool of liquidity for any financing or leverage needs it may have.
The increased presence of institutional investors in the alternative investment marketplace is leading to some degree of bifurcation of the industry between, on the one hand, large managers with sophisticated infrastructure servicing institutional investors and, on the other hand, smaller managers catering to family offices and high net worth individuals. Another consequence has been an increased level of investor engagement in areas like transparency, investor reporting and liquidity terms.
Meanwhile, the preference of institutional investors for the larger, more established managers has seen those managers grow even bigger.
Historically, the alternative investment industry has been an innovative and adaptable one. And although the smaller managers may face challenges in attracting the institutional capital which now represents the bulk of the assets managed by the industry, it will be interesting to see how they demonstrate these qualities in responding to these trends.
- AIMA’s Roadmap to Hedge Funds (2012 edition), p.21
- 2012 KPMG/AIMA Global Hedge Fund Survey
- Sizing The Hedge Fund Universe: First Half 2012, Pertrac, August 2012
- “The US50”, The Hedge Fund Journal, November/December 2012.