Agecroft Partners See Strong Trends In Hedge Fund Capital Raising for 2010
Agecroft Partners has observed several dominant and emerging trends regarding capital flows into the hedge fund arena I thought you might be interested in hearing about. These trends identified through conversations with more than 200 hedge fund organizations and 1000 institutional investors during 2009 include (1) continued improvement of capital flows; (2) increased competition; (3) increased importance of marketing; (4) extension of the due diligence process; and (5) segmentation of the hedge fund marketplace by investor type. These trends are explained below.
Continued Improvement of Capital Flows: The past 16 months witnessed unprecedented changes in the hedge fund industry with assets off 40% from their peak levels and industry revenues down approximately 70%. The environment was worse for fund raising where we estimate that new flows were likely down 95% from peak levels for the 4Q08 and 1Q09. The asset raising environment slowly improved during the 2nd and 3rd quarter, with a significant increase in the 4th quarter. However, it was still down an estimated 60% to 70% from the peak. During each successive quarter in 2010, we expect hedge fund capital inflows will continue to improve. A major driver of this renewed growth will be a gradual yet substantial increase in allocations made by pension funds.
Increased Competition: While asset flows had been a fraction of their previous highs, 2009 saw a significant increase in competition as many hedge funds, previously closed to new investors, began to market their funds. This trend will continue throughout 2010 as many leading hedge funds strive to return to their previous asset peak. The asset raising environment in 2009 was also affected by the development of a large secondary market for hedge funds, where investors could buy into many hedge funds at a large discount to NAV, as well as receive the benefit of investing below the high-water mark. Secondary funds should not be as big a factor in 2010 as discounts to NAV narrow. Finally, while there was a ‘flight to safety’ by institutional investors to larger hedge funds with strong brands in 2009, this trend should reverse itself as investors seek out smaller and more nimble alpha generators.
Increased Importance of Marketing: Due to the aforementioned increased competition, and the dynamic changes occurring amongst the major investor types, marketing and branding of hedge funds plays a more crucial role today than in the past. While most institutional allocators were stable investors throughout the crisis, high net worth individuals led the redemption wave and created liquidity problems for many hedge funds and hedge fund of funds, along with their underlying investors. Hedge funds will be more focused on their investor demographics in the wake of 2008. The resulting landscape features institutional investors as the preferred client, controlling a greater market share of hedge fund allocations. This trend will continue as pension funds significantly increase allocations to hedge funds. These changes highlight the need for a professional, proactive and knowledgeable sales force able to sell a fund’s specific attributes to an appropriate mix of investors.
Extension of the Due Diligence Process: The due diligence process of hedge fund investors is longer, more focused and deeper than ever before. Institutional investors typically require three to five meetings before making an investment decision. Their process focuses on multiple evaluation factors including: (1) organizational quality, (2) investment team, (3) investment process, (4) risk controls, (5) operational infrastructure, (6) terms and (7) historical performance. The weighting of the various attributes varies among investors, but the trend, particularly in the wake of the Madoff scandal, is toward longer due diligence and increased focus on areas of operational due diligence and risk management policies.
Marketplace Segmentation by Investor Type: The hedge fund marketplace consists of many different segments each displaying a unique profile with regard to the following factors: (1) decision-making structure, (2) length of due diligence process, (3) evaluation factors utilized, (4) average duration of investment and (5) impact on capital flows in the hedge fund industry. Next we will highlight the trends in hedge fund allocations by major investor types.
Pension Funds: The average pension fund portfolio allocates approximately 2.5% to hedge funds. Although it is still only a small fraction of the allocation of the top endowments, this percentage represents a significant increase from ten years ago. We anticipate that pension funds will gradually increase allocations to hedge funds during the next decade, approaching 15% of their asset base. Furthermore, we estimate that 90% of pension funds that allocate to hedge funds currently use a fund of hedge funds structure. However, over time we expect an increasing number of pension funds to choose direct access to managers as they acquire more knowledge and experience of hedge funds. Smaller pension funds will continue to use fund of funds. In addition, rather than separating hedge funds out as a separate asset class, we expect many pension funds to use hedge fund managers within their existing equity and fixed income buckets as a best of breed solution. During the recent crisis, pension funds were the most stable investor in hedge funds and will continue to be a sought-after investor by managers.
Endowments and Foundations: During 2009, endowments and foundations redeemed well below industry average. Primarily liquidity issues, as opposed to less favorable long-term opinion on the merits of investing in hedge funds, drove these redemptions. The endowment and foundation space is a bifurcated market comprised of organizations with more than $1B AUM and those with less than $1B AUM. Many of the larger endowments and foundations are fully allocated to hedge funds and will continue (in some instances) to favor a portfolio allocation of more than 50% to managers. Although we do not underestimate the positive impact that endowments and foundations have had as early adopters of hedge funds, the growth in this space is limited given current, already large allocations. The primary opportunity in this space is, as we see it, takeaway business, where a new manager will replace an existing manager. For endowments and foundations with less than $1B AUM, we anticipate growing portfolio allocations to hedge funds up from an estimated 10-25% overall. We also anticipate an increase in reliance on access to hedge funds through consultants for smaller endowments and foundations.
Fund of Hedge Funds: 2009 saw significant contraction in hedge fund of funds assets. The crisis of 2008 did not treat all fund of hedge funds equally. Some fund of funds experienced significantly fewer redemptions relative to peers due to a variety of factors including, (1) higher concentrations of institutional clients, (2) avoiding extreme leverage, (3) low Madoff exposure, (4) outperforming peers and (5) proactively educating clients on appropriate comparative benchmarks. While we expect the absolute dollar amount invested in funds of funds to increase with the expansion of assets in the hedge fund industry, the market share of funds of funds should decrease as increasing numbers of institutional investors go ‘direct’ to single managers.
The hedge fund of funds industry also consolidated throughout 2009—a trend we expect to continue. Some larger funds of funds ceased operations due to (1) Madoff exposure, (2) poor performance or (3) strategic decisions by a parent company. Larger competitors with greater distribution capabilities also acquired some smaller funds of hedge funds. As funds of funds continue to consolidate, opportunities will arise for smaller firms to differentiate themselves.
Consultants: The institutional hedge fund consultant market place has seen explosive growth as more institutional investors begin to go direct. Most of these firms saw few redemptions from their client base in 2009, while seeing the number of clients expand. This trend will continue well into the future, with increased competition from traditional institutional consultant firms and fund of fund organization that create separately managed portfolios for large institutional investors.
High Net Worth Investors: Generally, high net-worth investors fall into two categories: institutional and non-institutional. The first group, categorized by high sophistication, portfolio stability and endowment style approach to investing, constitutes a desirable investor. Many among this group operate from a family-office structure or spend a majority of their time independently evaluating hedge fund managers. The second category, characterized by less sophistication and fewer resources, tends to chase performance, and utilize a follow the herd mentality to investing. Unfortunately, we believe that this group bears primary responsibility for redemptions from both hedge funds and hedge fund of funds in the recent crisis. A large percent of assets controlled by this latter group have left the hedge fund space and we anticipate their return to be a lengthy process. The return of this capital will likely involve the engagement of advisors and consultants.
Conclusion: Agecroft Partners expects the hedge fund industry is moving toward a period of sustained growth driven by institutional investors that will increasingly adopt a more institutionalized process for evaluating hedge fund managers. The majority of assets will flow to a small percentage of managers representing firms characterized by: (1) strong distribution, (2) clear comprehension of nuances among investor segments, (3) strong brand, and (4) consistent high-quality marketing messages.