Annual Hedge Fund Investor Survey: What the evolving investor landscape means to an emerging manager
Once again, Global Prime Partners and Bougeville Consulting joined forces to prepare this third annual survey for Hedgeweek. We spent the back end of last year compiling and analysing feedback, thoughts and remarks gathered from the world of hedge fund investors, with a view to anticipating trends in the demand for hedge fund products.
We are aware of existing surveys, many of which we have seen, and we have decided to complement, rather than compete with, them: not only does this differentiate our output; it also ensures that:
Clients at an early stage of their business developments – and who will not yet have appointed the service providers who typically carry out those surveys – still have access to information that is useful to them
We, as service providers, have a thorough understanding of our clients’ needs and are in a sound position, not only to execute projects on their behalf, but also to provide input into their business plans, taking into account industry developments – including allocators’ demand for hedge fund products
Global Prime Partners (GPP) is a boutique Prime Broker, focusing on servicing clients with AUM generally under USD300m. It is important for GPP to understand the potential for success of the firm’s clients, not just in terms of investment performance, but also as far as AUM growth and stability of assets are concerned – to be able to provide better service, build more durable relationships, and, ultimately, forecast profit.
Bougeville Consulting assists hedge fund managers with their business strategies. This consists in providing the ground work – including research into the various costs and benefits – to enable clients to make decisions relating to opening new businesses, offering new products, or developing new strategies. We provide support with the operational and commercial angles and strive to ensure our clients meet their own clients’ expectations.
In order to produce information that is original, actionable and useful beyond the short term, we have decided not to form a sample of investors who would answer a series of questions in a quantifiable way, but, rather, to recollect and look at what hedge fund allocators have been saying to us over the recent period, as we kept meeting them for the purpose of doing our jobs. We have found that the most useful pieces of information often appeared when there was no pre existing frame, during the course of conversations. This has allowed the provision of more qualitative insight. While others have established facts, we took this opportunity to test, interpret and order those facts in relation to each other for the purpose of explaining and engaging.
Our findings can be articulated around three angles:
Emerging managers are quantitatively less in demand, but they have a broader range of options: During the course of our first survey two years ago, we had found that 70% of respondents said they were open to investing in emerging managers in principle, while our follow up exercise the next year revealed only 25% had done it in practice. In reality, a variety of models hide behind those numbers
The line dividing hedge funds and their investors is no longer clear cut: Entities that have traditionally invested in hedge funds are creating their own platforms, while successful hedge funds effectively act as platforms to emerging portfolio managers they bring in house. Feedback from investors reflects these converging models, and should be factored into any analysis of investor appetite, especially for smaller managers
Europe is emerging as a fertile ground: European allocators are planning to increase their share of hedge fund investment to a larger extent than their US or Asian counterparts. We have asked those concerned to what extent this related to AIFMD, to improvements in the economy, and what that meant in terms of their ongoing commitment to this industry
Smaller funds: how do they fit in?
All the studies and surveys we have read point to an increase in the overall size of assets invested in hedge funds over the next twelve months. While this finding may be dismissed as self-serving – after all, many surveys are compiled by the sell-side – we believe this possibility is overall highly likely.
Those studies, however, make it clear that this increase is, of course, not uniform or indiscriminate:
• Equity strategies – especially long/short and event driven ones – are still in favour, due to the recent performance of the stock market rather than as a result of any specific forward looking insight. CTAs are still to some extent suffering from the shock investors received when they realized even the “best student in class” could be fallible
• What is new though, is the reshuffling of the relative allocations among investors:
1. Pension funds – We have spoken with a few of those and the withdrawing from hedge fund investments by one such large investor attracted a lot of publicity recently. Our view is still that, overall, hedge fund investments by pension plans are to be maintained, which this is supported by quantitative data we have read in existing surveys. However, in Europe at least, these allocations are happening in more direct ways, with hedge fund selection being brought in house in many cases, when they were previously delegated to third parties (funds of funds, whether acting independently or part of bigger groups – e.g. from within private wealth managers). It is also worth mentioning that there is a diversity among the pension funds we have spoken with, partly due to the current stage of sophistication they have reached in terms of their hedge fund selection capability: pension funds that only recently started to analyse funds directly have expressed a preference for less complex and less risky products, and even, in some cases, for long only products
2. Private capital – The institutionalisation of the hedge fund industry was reported extensively over the past few years, and has forced hedge fund managers to build, and to present to investors, actual businesses, of which their investment strategies constitute one part. This trend was compounded by recent regulatory developments, the substance of which seeks to be in line with the interests of hedge fund investors. We have now, however, got to a point where private investors (including family offices, wealth managers, and high net worth individuals) are starting to increase their hedge fund investments. We view this as in continuity, rather than in contradiction, with the trend previously observed: certain private investors may now feel more comfortable investing in products that have become more robust and transparent, whose managers have an incentive to articulate a longer term vision, and in the context of an economy that shows signs of improvements, thus creating an interesting feedback loop in favour of those who were the initial hedge fund supporters
3. Reshuffling by geography – As will be discussed in another section, European investors are planning to allocate more capital to hedge funds as compared with investors in other regions. While this can be viewed to be part of bigger changes happening in Europe, approaches to hedge funds and their strategies vary from country to country within Europe: while funds of hedge funds have encountered difficulties in Europe (as opposed to the US) they are still a way German investors (e.g. smaller pension funds) access hedge funds – when they do so at all; and, if investing in distressed asset strategies is still controversial in Europe, Scandinavian investors are proving to be the most adventurous in that respect
• Finally, we have observed a trend towards an increased concentration within our industry: investors are again overall becoming larger (whether as a result of organic growth or because they have merged with other entities). They are, therefore, more likely than before to invest in larger funds: investor AUM sizes to some extent dictate the sizes of their hedge fund investments, which, in turn, has an impact on the minimum size they will require their investment targets to be, since they do not want to represent over a certain share of a fund’s AUM
So, what is a smaller fund to do?
• A question of definition – In our survey last year, we had said that the 70%-25% conundrum could be solved in two ways: by asking investors “how small is small?” (i.e. what is the minimum AUM size of a hedge fund in which they would actually invest?), and by drawing lines between different types of investors, some of which are actually committed to smaller sizes. As far as the first point is concerned, existing surveys echo our findings of two years ago. One of them says 75% of their sample would invest in smaller managers “theoretically”, while another survey places the average “minimum AUM threshold” at around $200 mn. While our experience tells us this is high for a fund starting up, it is fair to assume that individual responses are not concentrated around that mean but are more evenly distributed. Besides, if the proportion of investors willing to invest in funds with AUM under $500mn has gone down slightly – actual numbers depend from survey to survey – allocators who said they would look at smaller funds have become more flexible in some of their criteria (e.g. length of track record they require)
• Calibrating risk – Last year, we showed that whilst few investors actually invest in smaller funds, those who do, paradoxically, provide investment of relatively “better quality”, thus creating an “all or nothing” situation for start up managers. As a result of conversations we have had this year, we can make this statement even more precise, by developing some form of matrix to analyse investors’ approach to size as they relate to risk: those investors committed to funds of smaller sizes (e.g. large endowments, with long term horizons and proprietary assets) are more likely to invest in funds with higher risk profiles (since they can absolutely afford the losses and are not willing to trade off potential returns, the very reason why they are committed to smaller managers in the first place). This can be counterintuitive for an emerging manager desperate to reduce the risk of its strategy, in an attempt to lure investors that are reluctant because of the small size it will be starting up with. Existing surveys do point out to private investors prioritising higher return over downside risk, with the opposite being true for institutional investors; however this fact applies to all hedge funds, without any distinction according to size, and we believe some nuance is de rigueur as far as smaller managers are concerned
Redefining the playing field
As mentioned, a disappointing reality often lies behind the headline numbers of 70-75% of investors willing to invest in emerging managers. However, more options than before are now offered to emerging managers, as a result of the blurring of the line between hedge funds and their investors.
• “Just 150 people hold the fate of the investment management industry in their hands”, a recent Financial Times article said, to highlight the fact that “only a small number of decision makers control the fortunes of the UK fund management industry […] threatening the livelihood of many asset managers”. While this is one explanation for the majority of investments being directed to a smaller number of larger funds, a fact we have explained above, this idea of horizontal consolidation also reinforces the “all or nothing” approach that has emerged: the lucky few emerging managers who will have managed to secure an allocation are likely to start on more solid grounds than when, arguably, flimsier investors might potentially have invested in them more easily before; and, in the context of allocations being so rare, securing an investment also means eliminating competition from those who won’t get any investment at all
• This horizontal consolidation is the sign of an industry becoming more mature. With this comes the need for hedge fund managers to build real businesses, as opposed relying solely on their investment strategies, and also the need for product differentiation. We already discussed the former point at length in our survey a year ago and it is, in fact, the very raison d’être of the business we created. Alternatives to creating “real businesses” exist in two forms that are expected to get some traction over the next few months:
1. Established hedge funds and investors have started to converge around creating operational platforms from which an emerging manager with a strong investment strategy will be able to work, effectively becoming the equivalent of an in-house portfolio manager. While hedge fund managers acting as umbrellas for, and allocating capital to, would-be hedge fund managers have existed for a while, those who traditionally acted as allocators now performing such functions is a new trend (and is a form of vertical consolidation within our industry).
2. Another model has emerged, in the form of a hybrid between a service provider and a hedge fund investor, providing both the infrastructure and some capital for a start up manager to play with. The infrastructure consists in a managed account platform, and, as opposed to the model we discussed in the previous point, the fact that the platform is built on a stand alone basis allows for outside investors to participate also – and hence for the fund to grow while remaining somewhat more independent that if it had been completely absorbed by someone else's business
• Being on a platform provided by either of the above allows an emerging manager to build a track record and not to worry too much about operational matters. From an investor’s standpoint, it allows them to control operational risk instead of leaving it with managers who have little experience of dealing with it, and to create scale. Downsides include the fact that those opening platforms will continue to apply tight selection criteria in an environment where competition for that capital is fierce – thus continuing to make differentiation an important point; and the fact that this solution has an opportunity cost, since those providing both capital and operational support do so at a price
• Finally, we have referred to FoFs losing traction as a result of pension funds gaining expertise in selecting funds, including hedge funds. While this is typically a European feature, it is also a form of industry reorganisation that can benefit investment managers over the longer term. Pension funds will be getting more skilled and confident, and as they are getting under more pressure to create returns to match their liabilities, hedge fund investments should follow. We are still within the early days of this trend though, and current attitudes towards risk aversion and hedge fund sizes still have a long way to go
The year of Europe?
A recurring feature of this year’s existing surveys, which echoes our own experience this year, is the renewed faith in Europe, both regarding European investors’ appetite (including for non European strategies) and the demand for European (and Japanese) strategies and products (whether from European investors or not).
• European investors – When we performed this exercise a year ago, we were at the beginning of the transition period for the AIFMD. The investors we spoke with were uncertain about the extent to which they were allowed – or not – to engage with hedge fund managers. A few wealth managers we spoke with were waiting on the sidelines, waiting for the local regulators to clarify their hedge fund marketing rules. In July this year, the AIFMD came into force, and while many aspects of the new rules are still unclear, some European investors decided that they had waited for long enough. As of today, they are more likely to make new allocations than their US or Asian counterparts – not only as a result of the AIFMD suspense, but also as a result of the improving outlook for the regional economy
• European strategies – Improving outlook is also a reason why managers investing in Europe are among the most popular among investors, whether they consist in European managers per se or in US managers seeking to expand into Europe in order to take advantage of asset prices that are both attractive and “uncrowded” given our lack of experience (e.g. in distressed asset strategies). We had explained elsewhere that US managers have more experience and success in certain strategies, activism being one of them. While some of these successful fund managers have said to us that they had not expanded into Europe because “we already have too much to do in the US”, some have recently started to show a growing interest in our part of the world. These strategies, which we expect will be in demand, are, however, difficult to execute for manager whose fund is below a certain size – which explains why a recent Financial Times article was saying that “activism” could become more a marketing tool on the part of some hedge fund managers than the reality of their strategies
• European products – This is the term by which we would like to designate those hedge fund products that have global investors, do not invest in Europe, and, yet, are incorporated here. At the moment, UCITS products incorporated in Luxembourg are “hot buns” – as another hedge fund consultant told us, thus echoing our own experience so far this year. While part of their success is undoubtedly linked to the regulatory convergence between the UCITS framework and the one now regulating all non UCITS, it is worth noting that the appeal of the “UCITS brand” has started to penetrate the US, where they were not well known until recently
The practicalities (and impracticalities) of investing in smaller managers still mean this is a ferociously competitive space. However, support is at hand and a range of solutions are starting to materialise. Ultimately, we are still in a situation where “the winner takes all”.
Marianne Scordel founded Bougeville Consulting to assist alternative fund managers with their business strategies. This includes providing assistance to emerging hedge fund managers who need to devise and then execute a business plan, and supporting established managers willing to expand into Europe. Prior to this, she worked for Nomura and for Barclays Capital. She is an Alumna of St. Antony's College, Oxford.
iv See http://www.hedgeweek.com/2014/06/18/205027/are-us-hedge-funds-going-flo… in which we report that “US FOFs have not suffered much over the recent period, especially if compared to their European counterparts, the AUMs of which have halved since 2007”, a fact which Keith Black, PhD, CFA, CAIA, Managing Director of Curriculum for the CAIA Association, identified for us.
v Our previous survey was seeking to explain the fact that 70% of investors say they are prepared to invest in smaller funds “in principle”, however, when we checked retrospectively, only 25% had done it “in practice”
vi Financial Times, ‘Just 150 people’ will control UK funds, article by Chris Flood dated June 29, 2014
vii For more information on this, see the article written by Miles Johnson and Harriet Agnew and published in the Financial Times on June 30, 2014, Blackstone plans its own investment platform
ix Financial Times, ‘Activism has become a marketing strategy’, article by James Williams dated August 11, 2014