Alternative fund managers demonstrated resilience in adapting to the new Covid-19 reality

Despite extreme levels of market volatility, increased trading volumes and disruptions to society due to Covid-19, alternative fund managers have persevered, and even exceeded, performance expectations from investors.

Nonetheless, managers continue to face challenges in addressing important areas of focus, including environmental, social and governance (ESG) products, and diversity and inclusion (D&I), according to the 2020 EY Global Alternative Fund Survey.

In times of change, does accelerated adaptation present obstacles or opportunities? – the 14th annual survey (formerly the EY Global Hedge Fund Survey) – reveals that total allocations to alternative investments remain relatively unchanged; however, the competition between asset classes continues to intensify. Following a multiyear trend, allocations to hedge funds shrunk again to just 23 per cent in 2020, compared to 33 per cent in 2019 and 40 per cent in 2018. Investments in private equity and venture capital remained stable at 26 per cent, while investments in private credit increased from 5 per cent to 11 per cent as many market participants anticipate Covid-19 initiating a credit cycle that will create opportunities for these managers.

A shift in alternative products is not the only change this year. Hedge funds have been expanding their offerings, or tapping into new markets, such as private asset classes in particular, via a variety of unique structures. More than 40 per cent of hedge fund managers are currently offering co-investment vehicles or best-idea portfolios, and, additionally, almost 20 per cent of managers are creating side pockets, which allow investors an election to participate in illiquid investments within a broader portfolio.

Another area of explosive growth is special-purpose acquisition companies (SPACs), with a nearly threefold increase in the amount raised in SPACs compared to 2019. Managers have found these types of permanent capital structures to be an attractive way to raise capital, acquire companies and fast-track them toward the public markets. While a number of managers are sponsoring these deals, traditional activist managers have been particularly represented in these transactions.

Hedge fund managers expect that Covid-19 market volatility will drive a significant interest in active management, with over half of hedge fund managers (52 per cent) surveyed believing that the impact of Covid-19, and the related market volatility, will increase investor interest in active management. To note, nearly one-third (30 per cent) of investors responded that the Covid-19-related market volatility has, in fact, increased their interest in actively managed alternative investments.

Alternative funds demonstrated resilience as they dealt with, and continue to grapple with, the fallout from the Covid-19 pandemic, with technology being a significant driver of this success.

The alternative funds industry rose to the occasion surrounding the Covid-19 pandemic in terms of investors' expectations and managerial performance. Investors generally felt that their alternative fund managers either met or exceeded their performance return expectations, with 58 per cent of hedge fund investors and the majority (81 per cent) of private equity investors noting that their managers met or exceeded performance expectations during the market volatility that occurred as a result of the pandemic.

Investor marks were even higher when they assessed the operational aspects and client service functions of their alternative fund managers during the pandemic. Over 90 per cent of allocators stated that their managers met or exceeded their client service expectations across a variety of dimensions, including risk management, business updates and investor reporting. Further, 80 per cent of allocators said that the remote environment resulted in minimal or no disruption to the engagement and due diligence of existing and prospective manager relationships. On the heels of the success of this remote working environment, alternative fund managers expect that one-third (32 per cent) of back-office and middle-office professionals will work remotely after conditions normalise and that 28 per cent of front-office professionals will as well. This speaks to the efficiency and resiliency that each group has demonstrated, but also to the evolving expectations of employees wishing for greater flexibility in their work locations.

Ryan Munson, Wealth and Asset Management Partner at Ernst & Young LLP, also notes that, given everything that has transpired in 2020, it is a testament to the alternative fund industry that managers were able to quickly pivot operations, minimise disruption to investor engagement and deliver performance during periods of extreme market volatility. These actions and results highlighted the value of alternatives in preserving and growing investor capital in the most challenging of markets.

Covid-19 has accelerated many of the digital trends that we've seen over the past several years, which have become critically important for alternative managers. Investors are reasonably satisfied with their managers' efforts to embrace technology and data. Hedge funds, in particular, were reviewed favourably, since over half (53 per cent) of investors surveyed felt that the hedge fund industry was ahead of the curve from a technology perspective relative to other financial services. When considering credit and private equity, this number drops to 30 per cent and 28 per cent, respectively. For example, one-quarter (24 per cent) of hedge fund managers are using, or plan to use, advanced data to predict investor behaviour, and one-third (35 per cent) are doing so to analyse their own internal operations.

Despite these advancements, there is room for improvement when it comes to automating certain functions. Similar to advanced technologies, hedge funds are further along in the automation journey in all key functions, including fund accounting, treasury and valuation.

The marketing and investor relations functions have largely maintained their status quo as a manual-intensive process. Although a high-touch personal experience is needed, that experience can be enhanced by technology and meaningful investor reporting. Particularly given the challenges that this environment has posed with creating new relationships, and the acknowledgment that existing relationships are becoming more bespoke and expecting of an enhanced client experience, managers cannot afford to neglect the transformation needed.

"Covid-19 has served as a catalyst in the alternatives industry, especially in terms of how firms use technology to facilitate remote working and to create efficient systems that enable productivity," says Alex Birkin, EY Global Wealth & Asset Management Consulting Leader and EY EMEIA Wealth & Asset Management Industry Leader. "Hedge funds are the clear frontrunners as they were early adopters of outsourcing and continue to leverage next-generation tools such as machine learning, robotics and blockchain technology to keep up with their evolving, complex business operations."

With nearly double the number of investors saying that they invest in ESG products, alternative fund managers must determine a path forward for offering socially responsible products and simultaneously managing their own internal ESG policies.

Allocators are increasingly focused on ESG products and socially responsible investing, but they also wish to partner with managers who prioritise their own internal ESG policies. As the survey shows, almost half (49 per cent) of investors are currently investing in ESG products, which is almost double the number of investors including ESG products in their portfolios in 2019 (26 per cent). Further, over a quarter of allocators are required to allocate to socially responsible products, nearly double from the prior year. Much of this trend is being driven by investors outside of the US, with the majority (84 per cent) of all investors in Europe either currently being required or expecting to be required to invest in ESG products in the next two years.

As a result, socially responsible investing continues to prove to be a promising avenue for growth. However, as the survey shows, alternative managers are not keeping up with the demand. Just one in five managers offer ESG products, which remains unchanged from 2019, and just under half of managers have been able to systematically include ESG risk factors in their investment process. Those who can mobilise and launch products in the ESG space will have a competitive advantage, since nearly all investors (88 per cent) ask managers how ESG is incorporated into their investment decision-making.

Separate from products, nearly three-quarters (70 per cent) of investors reported that an alternative manager's internal ESG policy is critically important when deciding whether to invest. This is a tremendous increase from 2019, with just 27 per cent reporting this as critically important. Private equity funds are further than their hedge fund peers, since almost 64 per cent of private equity managers currently have an ESG policy, while only half of hedge fund managers have one.

"Much of the initial historical progress we've seen from an ESG standpoint has been outside of the US, but with increased investor demand for these products and for their managers to be good corporate citizens, we believe this is a tipping point moment where all managers irrespective of geographic location will step up to address this issue," says Natalie Deak Jaros, EY Americas Wealth & Asset Management (WAM) Co-Leader and WAM Assurance Leader. "We are seeing some response to these expectations, particularly with the emergence of ESG frameworks and scoring, as well as broader inclusion of ESG risks into the investing process."

Talent management remains a top concern for alternative fund managers, while continued focus on social justice and equality shine a light on D&I.

Despite both prioritising talent management, hedge funds and private equity firms have different approaches. Both say that improving productivity and engagement is a top priority, with 42 per cent and 31 per cent, respectively, ranking this as the number one priority. From here, priorities diverge.

Private equity firms have prioritised increasing gender representation, with more than half (56 per cent) reporting this as a top three priority and one quarter (24 per cent) placing it as a top priority. Additionally, more than half (52 per cent) of managers reported increasing ethnic minority representation as a top three priority. Implementing strategies to increase gender and ethnic diversity were ranked lower on hedge fund managers' list of priorities, with 26 per cent of managers reporting increasing gender representation and 18 per cent reporting increasing ethnic minority representation as a top three priority.

Investors, on the other hand, are keenly aware of the need for more diversity. Nearly all investors note that a manager's D&I policies play a role in their decision to invest. Coupled with the fact that 69 per cent of investors believe that increased diversity leads to positive performance, it's not surprising that 57 per cent of allocators specifically ask to review the actual diversity composition of their managers' workforce.

While awareness is important to achieving more diversity, there's significant room for growth, given that the majority of alternative fund managers (68 per cent) have informal, or no, D&I policies and that, when comparing hedge funds and private equity firms, 42 per cent and 26 per cent, respectively, have no formal plan. Almost two out of three managers (62 per cent) promote awareness and provide training on bias and inclusion (59 per cent) as part of their D&I initiatives. From there, there are large drop-offs, with a minority of managers reporting sponsoring diversity groups, interview training, setting diversity targets and other initiatives. Additionally, front-office roles continue to have a significant lack of diversity. More than half of hedge fund managers (56 per cent) and 39 per cent of private equity firms have less than 10 per cent of women in front-office positions, which is almost entirely unchanged from 2019 (53 per cent for hedge funds and 35 per cent for private equity).

An ethnically diverse organisation is also critical to an organisation's success, and an area of focus for investors. Compared to gender diversity, underrepresented minorities make up an even smaller percentage of alternative fund managers' workforces. Two-thirds of hedge fund managers (65 per cent) and more than three out of four (78 per cent) private equity firms reported less than 10 per cent of front-office employees that are underrepresented minorities. The back office proves to be slightly further along than the front office for both hedge fund and private equity managers, but the vast majority of managers indicated that they have back-office teams with 30 per cent or less minority representation.

"There are a number of reasons that diversity at alternative fund managers is critical, but investor behaviour and expectations are near the top of the list," said Dave Racich, Partner, Ernst & Young LLP and Co-leader, EY Global Hedge Fund Services. "As this year's survey shows, most investors feel that their own organisations are more diverse than their fund managers', and virtually all (96 per cent) investors want to allocate more to female- and minority-led firms. Now is the time for alternative fund managers to step up and critically examine how they are thinking about talent attraction, development and retention to ensure a more diverse workforce. The experiences and knowledge from these individuals will prove to be fruitful in generating new ideas that ultimately benefit the manager and its investors."