At a time when the world is grappling with zero inflation, near-zero interest rates and oil prices at a 12-year low, one could be forgiven for thinking that the alternative investment funds (AIF) industry might be supercharging in reverse.
If anything, however, the opposite is true. The AIF brand continues to build and attract new investors.
Retail AIFs are on the rise thanks to the liquid alternatives revolution and total AUM in the AIF industry is forecast to reach USD13 trillion by 2020, accounting for 40 per cent of the investment fund industry's assets and 70 per cent of its revenues, according to Deutsche Bank.
Against this backdrop, one of the key themes that permeated CAIS 2016 was how managers can continue to improve the alignment of interests with their LPs. It remains an issue of intense debate but one thing is certain: failure to do so will hold the alternatives industry back from fully reaching its potential and optimising the AIF brand.
This is a big risk, with technology giants such as Google, Apple and PayPal making vast strides in electronic payment platforms. These companies thrive on data analytics and providing a unique user experience. It will not be long before they expand into financial services, utilising their technology to give investors a unique customer service experience; something the Millennials will be only to happy to embrace.
Using technology to enhance transparency
The challenge, and indeed the opportunity, is for today's fund management community to use the vast amounts of data at their disposal to improve communications with LPs.
One aspect that is enhancing the manager/investor relationship, and improving the level of transparency, is technology. Better IT systems and tools, Big Data solutions, and the increased flow of data are all contributing to a richer ecosystem. As KPMG's Anthony Cowell commented: "The world has changed and we have with it. It is more interconnected, more volatile and more unpredictable than ever before. We've entered an era of transience – continuously fluid global markets."
That said, a careful balance needs to be struck between being transparent, but not so transparent that it risks diluting performance and eroding a manager's edge.
Providing a private equity perspective, Sean Donohue, Head of Valuations, Apollo Global Management LP, said at CAIS 2016 that investors were getting smarter and more involved in the valuation process. "They are no longer just taking the GP's word for it. There are more due diligence meetings. They want to understand the differences in valuations between a target company with 8x EBITDA and a comparable company that has 10x EBITDA," said Donohue.
With a growing appetite for more and more data, it is clear that investors are looking to use it to evaluate asset managers and get a tighter grip on the performance attributions of all their alternative investments.
Improve the channel of communication
Technology can go someway to addressing the transparency point, but at a time when alternative fund managers are launching multiple products across multiple jurisdictions to establish a global business model, the art of communicating effectively to different investor types is becoming a vital skill.
"Alternatives must develop a trusted brand that goes beyond the metric of performance," said Andrew Bastow, Vice President and Head of European Structuring and Regulatory Affairs, AQR Capital Management. "In my opinion, managers need to develop global localised communication skills. It is becoming increasingly incumbent upon managers to solve issues and provide customised, outcome-based solutions for investors. I also think embracing regulation is a means of enhancing the alternatives brand. Make it your strategic advantage."
Of course, different investors have different preferences when it comes to the level of communication and transparency they expect from prospective fund managers.
Donald Lindsey, CIO, American Institutes for Research, said that he would always want to know what percentage of a manager's net worth was invested in a fund before committing capital.
"A manager will behave differently if they have 100 per cent of their net worth invested in the fund compared to a manager who has 25 per cent invested, said Lindsey, who added: "If, when conducting my due diligence, a manager doesn't tell me about their investment process because it is `proprietary', I'm going to walk away. What is it that motivates a fund manager? What gets them out of bed in the morning? Is it to make money? Is it profit? Is it simply to do a good job for his investors?"
Knowing how to deal with different investor expectations, different demands on fees, different liquidity lock-up provisions, is no easy task for AIF managers. It becomes a plate spinning exercise. But as Bruce Zimmerman (pictured), CEO and CIO, University of Texas Investment Management Co., commented during CAIS 2016: "You have to be honest and say that you may not be suitable to all investors. Sovereign wealth funds might have lower return hurdles compared to a public pension fund. So managers cannot be all things to all men. They have to think carefully about the type of investors they want to attract."
LPs need to align with their trustees
For all its complexity and sophisticated trading strategies, alternative fund investing still comes down to personal chemistry. It is, ultimately, a relationship-based business. And with more institutional dollars flowing in, the more incumbent it is upon managers to engage with investors as partners, and move away from the mindset of `Trust us, we're the experts. We'll update you next quarter on the fund's performance'.
Gerald Alain P. Chen-Young is Vice President and CIO, UNCF, Inc, where he manages three investment portfolios totaling USD1 billion. As well as ensuring there is an alignment of interests between manager and LP, he thinks there also needs to be an alignment of interests between the LP and its trustees. "I would not hesitate to invite managers that we invest with to speak directly with our investment committee. I also believe that the investment mandate is key, making sure that there is an alignment of cash flows across the lifecycle of the investment strategy," said Chen-Young.
This is especially important for investors who increasingly rely on alternative fund managers to deliver liability-driven investment solutions.
Performance is still king
Improving the dialogue with end investors will help to add lustre to the AIF brand but this is not to suggest that investors will be satisfied by merely feeling more involved in the investment process. At the end of the day, performance is still king. It is fundamental to supercharging the alternatives brand, especially given the lean pickings that hedge funds, in particular, have offered in the last couple of years.
Spiros Maliagros, President of Tiedemann Investment Group, summed this up succinctly, saying: "From our perspective, it is getting the best risk-adjusted exposure for the opportunities that the manager is looking to achieve, communicating that clearly to investors, delivering on that premise and making sure that performance is exactly what the investor was looking for."
In his mind, the AIF brand will also improve with continued investor education, particularly as fund managers proliferate the number of investment products across offshore structures, onshore regulated structures, managed accounts, funds-of-one etc. This involves identifying market opportunities and then working with investors to align their interests. It is a much more consultative approach.
"What are they looking for in their portfolio? What are the opportunity sets they care about? What are the regulatory structures they need to invest effectively in alternatives? That helps build long-standing relationships. We have some investors that have stayed with us for three decades because we engage with them on what matters most," emphasised Maliagros.
This underscores precisely how important relationships are in this industry.
Better alignment of fees
One final aspect of the manager/investor relationship, and where a misalignment of interests remains a significant issue, is fees.
The `F' word is still a source of huge debate, and will likely roll on for some time. One could argue that fees are fully justified. Fund managers are profit centres not cost centres: does an investor really benefit by paying 1/15 to a manager returning 3 per cent annualised compared to an investor paying 2/20 to a manager returning 10 per cent?
But regardless of whether fees are justified or not, getting improved transparency on how and where those are calculated will further strengthen relations; particularly in private equity funds where it is not always known how many expenses are incurred before the net return is calculated.
Adi Divgi is President/CIO, at EA Global LLC, a single-family office. Speaking at CAIS 2016, he said that he felt measures had been taken to improve transparency on fees but "there is still a large disconnect between managers and investors and there's still a lack of standardisation. With hedge funds, it is still quite disparate in terms of what investors are paying. Sometimes they include transaction costs, other times they do not and are added on top. It is up to the LP to keep pushing on this but also for GPs to allow transparency to be disseminated across the industry."
One potential way of arriving at an appropriate fee structure is to bring the investor in at the product development stage. "That is symptomatic of innovation today – what do you as a manager do well, and how can you deliver that in a better way to investors? Even if it means doing it for lower fees," suggested Michael Rees, Managing Director, Neuberger Berman, DYAL Capital. He added: "Investors realise that managers can't deliver purely alpha returns in an USD8 trillion industry, they understand there's going to be a mix of beta and alpha."
Given the relatively muted level of performance, particularly in the hedge fund space, over the last few years, going forward fees will need to be more closely aligned with performance. As one manager commented at CAIS 2016, "in order for alternatives industry to flourish those alignments of interests will be vital."
