New Rules of Engagement: Adapting for Growth in Alternatives
As the investment industry environment transforms faster than ever before, alternative asset managers’ ability to adapt their business models is being tested to the extreme.
Institutional investors now outweigh high-net-worth individuals as a source of hedge fund capital, and they continue to grow their allocations in other unlisted assets 1. This influx of institutional money puts new demands on alternative managers.
These sophisticated clients are intensely focused on how fees are assessed, how investments are run and how risk-adjusted performance is reported.
Further, as the alternatives sector expands, the days of light-touch regulation are over. Regulators have the alternatives sector firmly in their sights, driving managers to restructure funds and rethink how they communicate and report to clients. As regulatory pressures grow, fast-evolving technologies present both opportunity and risk: robotic automation and artificial intelligence (AI) can drive operational efficiency and enhanced investment insight — but they will challenge late adopters.
According to State Street research, more than half (52 percent) of alternative asset managers fear they will need to overcome significant operational inefficiencies to sustain growth for their firms.2 And 69 percent recognize that if they don’t improve operational agility, their competitors will be better-placed to capture growth opportunities. The environment is changing fast and only those that adapt at pace will thrive in it.
No room for complacency
Driven by the need for better long-term returns and portfolio diversification, institutions have increased their bets on alternative assets over the last two decades. Since 1997, average allocations to real estate and other alternatives by pension funds in seven of the world’s largest pension markets has risen from 4 percent to 24 percent.3 And the total assets managed by the world’s 100 biggest alternative managers reached $3.6 trillion in 2016, up 3 percent from 2015.
Against the backdrop of this impressive trajectory, 58 percent of alternative managers are confident that they will achieve their growth objectives over the next year. Future growth is far from guaranteed, however.
The global hedge fund industry saw net outflows of $102 billion in 2016 as performance and fee concerns drove some institutional investors to pull their capital.4 The growing dominance of institutional money in the alternatives market means that managers will need to work harder to find opportunities as global competition for high-quality assets intensifies. And the complexity of the regulatory environment is increasing the challenge of meeting investor needs.
With regulation governing liquidity risk and regulatory focus on investment fees cited as the two biggest perceived macro-environmental threats to their growth prospects over the next five years5.
Though institutional investors’ appetite for alternatives is increasing overall, there are distinct hurdles to greater illiquid holdings for some investors. In the pensions market, for example, illiquid holdings may limit pension funds’ ability to undertake buy-in and buy-out transactions, while rule changes in markets such as the UK are increasing demands from scheme members for lump-sum pay-outs. Alternative managers will need a detailed understanding of individual client pressures to allay such concerns.
Meanwhile, regulations such as the Alternative Investment Fund Managers Directive (AIFMD), Markets in Financial Instruments Directive II (MiFID II) and Dodd-Frank continue to increase the cost of compliance for hedge funds and private equity and real asset (PERA) firms as they require more detailed reporting both to regulators and investors.
The growth shortfall
These considerable challenges mean alternative managers will need to reconfigure their operating models and develop new competencies if they hope to capture the growth opportunities on the horizon.
According to State Street research, there are three main areas of critical importance for the long-term growth of the alternatives sector, including their:
- Ability to extract meaningful insights from data
- Ability to manage technology risks
- Having a strong governance framework in place
Developing sophisticated investment and risk analytics is a key concern for alternative managers as they seek to deliver better yields, uncorrelated returns and effective risk management. And as their environment becomes more tightly regulated – and institutional investors seek closer control over the management of their assets – alternative managers recognize that stronger governance will be necessary. This means putting robust processes and controls in place at both the fund and firm levels, and ensuring clear separation of responsibilities between front-, middle- and back-office personnel.
Playing by new rules
As a whole, the alternative asset management sector boasts a healthy growth trajectory over recent years. But with more capital coming into the sector, the ability of hedge funds and PERA firms to adapt their operating models has never been so profoundly tested.
Our research finds a sector that is bullish about its growth prospects, but aware of the significant challenges that lay in store. Leading managers appear to be rewriting the rules for engaging investors – working toward more customized solutions. Whilst forging integral partnerships with providers that can help them fulfil their growth ambitions and ensure they have a strong governance and risk management framework.
Robert Keogh, Senior Managing Director, Head of Alternative Investment Solutions EMEA, State Street
1 Preqin, Hedge Fund Manager Outlook, June to December 2017
2 State Street, A New Climate for Growth: Adapting Models to Thrive is based on a survey of more than 500 institutional investors and asset managers worldwide, focused on these institutions’ priorities for growing their assets, businesses and improving their investment performance over 1-5 years. Based on this survey’s results it highlights key conclusions that outline the strategies and models necessary to achieve these growth aims.
3 Global Pension Assets Study 2017, Willis Towers Watson
42017 Preqin Global Hedge Fund Report, Preqin
5 Alternative asset manager respondents include hedge funds, fund of hedge funds, private equity and real estate funds