Alternative investment managers were evolving in the context of changing market conditions even before the Covid-19 pandemic, although the virus has speeded up the process.
What is emerging is an alternatives landscape where pure-play hedge funds will be rare. That is one of the conclusions of a new study by Northern Trust, The Shape of the New Alternative Asset Manager.
Early on, the study’s authors observe that hedge fund managers have in recent years delivered only “lackluster returns, with the market outperforming then for the entire first decade [of the millennium] with the exception of 2018.” And even in 2018, the edge that hedge funds demonstrated over the S&P 500 was unremarkable. A loss of 4.05% for the former vs. a loss of 4.38% for the latter.
Not unsurprisingly, lackluster performance has meant that investor money, especially that of institutional investors, which was previously committed to hedge funds, has gone elsewhere—namely private equity.
Going Where the Money Goes
There is a parallel movement in the retail world. More than half (57%) of North American LPs believe significantly more retail money will go into private equity in the next five years.
In response to that development, some hedge funds are following the money. One quarter of hedge fund managers now have a private equity or venture capital offering.
Increasingly sophisticated limited partners are driving some of this diversification. The larger and more sophisticated LPs want choices. They may want direct involvement in PE deals, so that they are co-investors with the fund rather than just part of the fund. This gives the LPs greater control and lower overall fees.
Bolt-on or Integrated?
For the alternatives managers who want to give the LPs what they want in the present demanding climate, it’s not as easy as just whipping up something new in the back room. The report cautions that managers must “have a clear strategy, deploy seasoned expertise, and seek out the ideal service providers to assist on their mission.”
Will new PE/VC offerings be bolt-ons or integrated parts of the new whole? What are the available synergies that might be exploited in integrating them? Managers need to consider integration as it relates to operations, investor relations, and technology and might consider a unified strategy that can benefit from information arbitrage. A credit strategy hedge fund, for example, and a private debt fund might usefully be combined.
There is reason for concern about current investors. When investors is a formerly pure-play hedge fund shop learn there is a plan to add PE, they may wonder, “Am I on a ship that, in the view of the captain, needs rescue?” The simplistic bolt-on approach will be the hardest to explain—an integration/synergistic approach can be presented as an improvement, not a rescue mission.
Also, as mentioned above, having the right service providers is critical for the operational readiness of such an expansion. Left to navigate the new seas on its own, managers might “struggle to maintain their original strategy and alpha-generating opportunities.” (Northern Trust of course is not completely disinterested in making these observations.)
Both Sides of the Bridge
But let us conclude, as the paper does, by looking briefly at the issue of cash-flow management. This turns out to be very different on the opposite sides of the hedge fund/PE fund bridge.
Private equity funds have capital flows (calls or distributions) that are timed to portfolio deal transactions. This involves deal-driven cash flow management. Sometimes, for example, the call will go out for capital within the LPs’ commitment, but the cash will be slow coming back, creating a crunch for the GP. To deal with such circumstances, the GP needs a short-term line of credit.
All this is very different from the cash-management issues that arise in hedge funds, where the flow (by subscription or redemption) is investor-driven, typically on a monthly basis. As Northern Trust observes, bringing both systems under the same roof meld different accounting conventions and even “cadences.” One must seek synergies, but one cannot assume them!