Agecroft Partners has observed several dominant and emerging trends regarding capital flows into the hedge fund arena.
The trends were identified through conversations with more than 200 hedge fund organisations and 1,000 institutional investors during 2009.
They include continued improvement of capital flows; increased competition; increased importance of marketing; extension of the due diligence process; and segmentation of the hedge fund marketplace by investor type.
The past 16 months witnessed unprecedented changes in the hedge fund industry with assets off 40 per cent from their peak levels and industry revenues down approximately 70 per cent. The environment was worse for fund raising where Agecroft estimates that new flows were likely down 95 per cent from peak levels for the 4Q08 and 1Q09.
The asset raising environment slowly improved during the second and third quarter, with a significant increase in the fourth quarter. However, it was still down an estimated 60 per cent to 70 per cent from the peak. During each successive quarter in 2010, Agecroft expects hedge fund capital inflows will continue to improve. A major driver of this renewed growth will be a gradual yet substantial increase in allocations made by pension funds.
While asset flows had been a fraction of their previous highs, 2009 saw a significant increase in competition as many hedge funds, previously closed to new investors, began to market their funds. Agecroft says this trend will continue throughout 2010 as many leading hedge funds strive to return to their previous asset peak.
The asset raising environment in 2009 was also affected by the development of a large secondary market for hedge funds, where investors could buy into many hedge funds at a large discount to NAV, as well as receive the benefit of investing below the high-water mark. Agecroft says secondary funds should not be as big a factor in 2010 as discounts to NAV narrow. While there was a flight to safety by institutional investors to larger hedge funds with strong brands in 2009, Agecroft says this trend should reverse itself as investors seek out smaller and more nimble alpha generators.
Due to increased competition and the dynamic changes occurring among the major investor types, marketing and branding of hedge funds plays a more crucial role today than in the past, says Agecroft. While most institutional allocators were stable investors throughout the crisis, high net worth individuals led the redemption wave and created liquidity problems for many hedge funds and hedge fund of funds, along with their underlying investors.
Agecroft says hedge funds will be more focused on their investor demographics in the wake of 2008. The resulting landscape features institutional investors as the preferred client, controlling a greater market share of hedge fund allocations.
The due diligence process of hedge fund investors is longer, more focused and deeper than ever before, says Agecroft. Institutional investors typically require three to five meetings before making an investment decision. Their process focuses on multiple evaluation factors including organisational quality, investment team, investment process, risk controls, operational infrastructure, terms and historical performance. The weighting of the various attributes varies among investors, but the trend, particularly in the wake of the Madoff scandal, is toward longer due diligence and increased focus on areas of operational due diligence and risk management policies.
The average pension fund portfolio allocates approximately 2.5 per cent to hedge funds. Although it is still only a small fraction of the allocation of the top endowments, this percentage represents a significant increase from ten years ago. Agecroft anticipates that pension funds will gradually increase allocations to hedge funds during the next decade, approaching 15 per cent of their asset base.
