Shift to private capital continues as investors thirst for returns

Peter Sanchez, Northern Trust

As global investment markets became more efficient and persistent low interest rates saw returns dry up, institutional investors have been turning to alternative assets in their efforts to generate performance. Since traditional hedge fund investments have often not fully lived up to their promises in the past decade, managers in the space are looking to offer access to other alternative assets, such as private capital, in their attempts to fulfil investors’ needs.

There are three primary reasons driving investors to allocate to alternatives. The first is that they hope to generate returns uncorrelated to the markets, then they aim to diversify their portfolio and also mitigate the volatility of their performance.

Although hedge funds were designed to meet these objectives, it turned out that many did not make the grade; the hedge fund market underperformed the broader market nine out of the last 10 years. As a result, there has been a move from hedge funds into private capital – which includes private equity, private debt, real estate, real estate debt and infrastructure.

Peter Sanchez, CEO of Northern Trust Hedge Fund Services outlines this trend: “Institutional investor allocations have been edging steadily towards private investments. In 2019, hedge funds made up a third of institutional investors’ alternative allocations. This was down from 40 per cent in 2018. Concurrently, private equity grew to account for around 25 per cent of institutional investors’ alternative investments – up from 18 per cent in the prior year *.

“So, the trend is clear. Hedge fund managers who have not succeeded in differentiating themselves in terms of the core principals of correlation, diversification and volatility, could now find that competitive edge in private capital structures.”

But switching from only running a pure hedge fund to offering private capital investments to clients comes with a few key considerations.

Operational and communication divergence

Managers looking to make this change need to first make sure they are aware that operationally, a private capital fund is quite different from a hedge fund or a long only structure. Also, the investor expectations when investing in a private capital fund can diverge considerably from what hedge fund managers are accustomed to. These requests tend to revolve around tenure, fees, returns and transparency. 

In addition, just because a manager has deep expertise in multiple strategies across the hedge universe, doesn’t necessarily mean that same expertise can be transferred smoothly to the private capital world.

One of the fundamental questions a hedge fund manager looking to offer private capital structures should ask is whether this signifies a complete change in strategy or whether it is more of a bolt-on to what they currently have in place.

Sanchez explains the significance of both approaches: “A holistic change makes it hard for a manager to justify their current strategy and what they originally invested in. You’re going to have to be fairly convincing on why you’re adding this strategy that is completely different and potentially not aligned with the existing strategy the investors bought into. In addition, the new strategy may have different operational requirements the investor may not be open to understanding or accepting if the new strategy is completely and holistically different to the existing one.

“Choosing the bolt-on route on the other hand allows the manager to justify the rationale of branching out because the strategy in and of itself wouldn’t have changed. Rather, the tenure or the length of the investment changes which sees the manager offering new terms to their investors.” 

Best placed for private capital transfer

Not all hedge fund managers can make the shift to offer private capital. Those best placed to offer this bolt-on structure are managers in the credit arena which is prevalent in the hedge fund space; funds investing in distressed loans, bank loans or corporate loans.

Sanchez gives further detail: “Fund managers looking to diversify their credit strategies can set up closed-ended funds, which are typically private equity or private capital structures, to complement what they already have in their open-ended Master Feeder structure which invests in credit. 

“Both structures – the closed and open ended – will accommodate credit structures. By making this change, an open-ended hedge fund investing in distressed debt can now offer clients a much longer-term investment. It might give them the ability to invest directly in a particular asset rather than a portfolio. This is an ideal example of a bolt-on because the manager is carrying over some of the characteristics and aspects of a private capital fund onto the existing credit strategy they are running within an open-ended master feeder hedge fund structure.”

Although hedge fund managers running credit strategies can more easily adapt to offer private capital investments, the addition of such streams comes with unique operational requirements.

“The operational needs of a private capital structure are considerably different. Managers will need to understand the specific requirements around accounting, cash management and the timing of investments because these are all different within a private capital structure. This is a significant shift from the subscription and redemption process in the traditional hedge fund space,” notes Sanchez.

A distinction between traditional hedge funds and private capital investments is the way managers communicate with their investors. Sanchez elaborates: “In private capital, the investor is investing directly in specific investments and their terms are related to those investments. In the hedge fund world, you invest in a fund and a portfolio and investors don’t necessarily get into the detail of what exactly is in that portfolio. Therefore, the communication strategy is vastly different.”

Another consideration managers need to be aware of is the expectation to provide institutional investors with the opportunity for co-investment. “This has been a hot term in the private capital world. What it means is that an investor buys into an asset, such as a building or a business, through the private capital fund while also investing in that same asset independently. The benefit to the investor is their fees are reduced because they’re only paying fees on the portion of their investment that goes through the fund. While at the same time, they’re able to take a greater concentration of the investment through this set up,” Sanchez outlines.

Hybrid synergy

According to Sanchez, managers playing on the edge of hybrid strategies will have better synergy with private capital fund structures: “This is generally in the credit space; fund managers who have traditionally been branded as hedge funds but have diversified to include some type of hybrid model which includes private capital structures. These managers have an awareness of closed-ended fund structures, of capital structure capabilities and accounting.”

So, he says a credit fund manager would probably be more ready to move into private equity or private capital because of their experience with the hedge private capital structures over the years in credit strategies. “A typical long/short fund which is only used in the open-ended master feeder structures and simple public securities investments will have a much more difficult time when it comes to addressing those operational needs. They will also be less aware of the potential pitfalls around institutional investor expectations related to private capital investments,” Sanchez cautions.

In order to avoid making a misstep in this regard, managers considering this move should talk to their peers and create a dialogue with people in the private capital industry. Sanchez also speaks of the importance of having access to an alternative fund administrator: “Fund administrators servicing this space used to be called hedge fund administrators. Now they’re now called alternative fund administrators because they’re not only servicing hedge funds but also private equity firms, real estate firms and private debt funds. Therefore, if you choose to add private capital structures to your offering, you need to make sure your service providers have the expertise to guide you in terms of both the operational requirements and the investor expectations.”

Practical challenges

In terms of practical differences private capital investment brings to the table, the primary challenge centers on valuation, which is less straightforward than traditional hedge fund managers may be accustomed to. Sanchez says: “In the hedge world, most of the valuations are serviced by pricing vendors around the asset classes, like OTCs, futures, equities and bonds. In the private capital world, most of that is done through discounted cash flows. Then there are valuation firms that look at financial statements and carry out an independent valuation assessment based on the financials and cash flows of the particular investment, taking into account comparables.”

Waterfall and accounting needs around private capital structures are also a potential hurdle. “Managers need to be aware of these investments having carried interest and different fees based on realised and unrealised P&Ls. The accounting around this is very sophisticated which could be a challenge,” Sanchez points out.

Additional complexities revolve around rationalising non-correlated returns. In the hedge fund world, investors buy into a portfolio and get a return based on that portfolio. In private capital however, they could be investing in a specific asset and therefore their return is based on that sole investment which brings with it unique complexities around terms and fee structures.

In fact, Sanchez indicates managers will have to have different investment negotiation terms: “Institutional investors are going to want their terms and fees based on crystallised probability rather than unrealised P&L. In the hedge world however, managers get paid incentive fees or get paid on both realised and unrealised P&Ls.”

Bottom line

The impetus for managers to diversify their business and generate return for their clients is not about to fade any time soon. Market data further underscores the move away from hedge funds towards private capital as institutional investor appetite for the latter continues to rise. 

The challenge lies in undertaking this shift in a way that is beneficial to all involved, both from an investment perspective and on an operational dimension.

On the investment side, managers need to aim for their new venture to generate uncorrelated returns, to diversify their portfolio and mitigate volatility. While operationally, they need to ensure they have the right skill set and expertise in place as well as the support of specialist third party partners.

 

*(https://vaioe.at/wp-content/uploads/2019/11/2019_Global-Alts-Fund-Survey_FINAL.pdf)

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