Institutions playing catch up
Fund of hedge funds (FOHF) are receiving increased attention and capital from institutional investors. This demand is driven by institutions’ appetite for hedge funds and the recognition that FOHF are the appropriate vehicle for channeling this interest. How large is this demand? How is this growth changing the FOHF industry? This article addresses these two issues.
FOHF currently allocate about $100bn (E101bn ) of capital in the US. As Exhibit 1 indicates, FOHF intermediate about one-fifth of all hedge fund investing. This percentage has been increasing since 1998 (following a decline after the Long Term Capital crisis) and is again at an all-time high level.
Institutions probably account for no more than one-fifth of FOHF capital. This relatively meagre percentage reflects an historical aversion to hedge fund investing (though endowments and foundations segment are a notable exception). Some institutions remain categorically opposed to hedge fund investing; many others have been doing more talking and studying than investing.
There are, however, a number of compelling reasons to believe that institutions’ demand for hedge funds will grow steadily and that FOHFs will match and likely exceed this pace:
o Alternative investments are becoming mainstream. Non-traditional asset classes are being systematically incorporated into investment programmes.
o The return environment. The recent poor performance of both traditional equity and fixed income markets (and the prospect of a continued lower return environment) highlights the appeal of absolute return and risk-controlled strategies.
The fund of funds structure is sensible. The majority of institutional investors have neither the resources for evaluating hedge funds nor the allocation to appropriately diversify their investments. As most traditional institutional investment consultants have not been able to develop these advisory services, FOHF are logical vehicle for investing. (FOHF have become the de facto consultant for hedge fund investment strategies.)
This increase in demand seems to have started. In 2002, there has been a dramatic increase in institutional mandates for hedge fund strategies.
Thus, overall demand for hedge funds is becoming more institutionalised. The combined demand from institutions, including FOHF, is reaching parity with direct retail investing. (These institutions accounted for less than 20% of hedge fund investing a decade ago.)
It is important to note that a flood of institutional money may have two important detrimental effects. First, as market inefficiencies become more fully exploited, these inflows may suppress returns. Many investment strategies appear to be already reaching such capacity constraints. Second, the market will likely contain greater risks because managers may be tempted to move beyond their core skills in order to maintain target returns. Reduced returns and increased risk may partially dampen future demand.
To date, clients’ requirements of FOHF managers have been relatively minimal. For example, referrals and personal relationships, rather than formal marketing practices, have dominated new business development. Also, client service activities are fairly minimal with the majority of client interaction handled by the intermediating broker or salesperson.
There has also been relatively little effective demand for a rigorous investment process. To illustrate this point, it is helpful to consider the FOHF value chain. From an investment standpoint, we identify five primary FOHF activities:
o Sourcing and screening: identifying a relatively focused list of qualified hedge funds from a total universe of some 6,000 managers.
o Due diligence: conducting an in-depth analysis of the hedge fund managers identified in the screening process. During this step, FOHF must evaluate all aspects of the individual firms, including the effectiveness of the investment strategy, strength of the investment process, soundness of operations, quality of investment professionals, and durability of business management.
o Placement: getting the desired managers to accept capital. As a manager’s capacity is often limited, gaining access is sometimes challenging.
o Portfolio construction: actively balancing the FOHF portfolio to meet client requirements in terms of expected return and risk exposure.
o Ongoing monitoring: assessing all of the fund’s underlying managers to ensure that they are staying within their product goals, strategies, and skill sets.
Until recently, much of the perceived value of FOHF managers has been in placement. That is to say, investors have relied on FOHF managers to put money with desirable hedge funds. Cynics refer to this limited business model as a ‘dating service’. Portfolio management has meant little more than diversification and risk management little more than qualitative feedback – “we are in constant contact with our managers”.
With relatively unsophisticated clients, this FOHF business model has persisted. It has been profitable because the resources that are required to support these activities have been fairly minimal.
As the FOHF client base becomes increasingly sophisticated, a new business model is emerging that will acheive prominence. The strength of this model is that it fits all the criteria of a ‘complete’ firm: balanced excellence in investment management, distribution, and business management. (For a full description of the complete firm, please see our June 2000 report Success in Investment Management: Building and Managing the Complete Firm). Some may prefer to call it the ‘institutionalisation of FOHFs’ because the professional standards more directly apply to the institutional segments; these standards, however, are applicable to and will ultimately be demanded by the high net worth market as well.
With regard to distribution, FOHFs are beginning to recognise the need to dedicate resources to these specialised activities. Penetrating the emerging institutional demand for hedge funds will require FOHF managers to work extensively with and provide ongoing education to a sponsor’s investment professionals. Complete FOHF firms will transform themselves from opportunistic networkers to systematic marketers.
Complete FOHFs must have an equally robust process for investments. To maintain their own returns while continuing to increase capacity, FOHFs must increasingly expand their coverage of managers. As illustrated in Exhibit 2, we call this the ‘T-effect’. (Its depiction resembles an architect’s t-square or inverted letter “T”.) Within each investment strategy, to gain additional capacity, FOHFs must increase the number of firms they assess and monitor. To preserve returns, FOHF managers will also be compelled to review a broader range of investment strategies.
Portfolio construction and risk management are also emerging as distinguishing capabilities for sophisticated FOHF clients. Leading risk management capabilities have begun to include periodic security-level analysis of each individual manager and the aggregate position of the entire fund. This analysis includes not only an integration of leading risk management packages but also proprietary modeling and data collection. To support the transparency required for superior risk management, extensive use of separate accounts is becoming essential.
The future resource requirements of the complete FOHF are therefore significant. To effectively compete, it will not be uncommon for complete FOHF to have 50 to 100 employees – a substantial increase from today’s staffing levels.
If leading FOHFs require substantially more people and bigger investments in technology, the minimum number of assets under management to be financially viable will be substantially higher than it is today. Rough estimates are that this minimum threshold for complete FOHFs will be at least $1bn, relative to the $50m to $200m required for simpler FOHF business models. If one factors in salary escalation and any reduction in average fees, this break-even point rises even higher.
We expect that the flow of institutional capital will be concentrated on a smaller number of complete FOHF. Over the next several years, we would expect to see the global league tables dominated 10 to 15 leading firms. These managers are likely to oversee between $5bn and $10bn in assets under management. Given the current market size and projected growth, this group is likely to have over 60% market share, a greater concentration than exists today.
This consolidation has significant implications for would-be market entrants. Starting with little or no FOHF capabilities today, it will be very difficult to organically build a complete FOHF. Therefore, financial services firms without current capabilities but with substantial aspirations must entertain either an acquisition or a strategic alliance. The past two years have seen several FOHF purchases and more are likely to follow. To date, alliances have been difficult to structure, either due to fee-sharing issues or to would-be distributors developing an interest in building their own FOHF capability. Going forward, the scale requirements of a complete FOHF should make alliances more likely, perhaps using partial equity ownership to align interests.
We do believe that more modest FOHF business models can remain quite profitable for their principals. However, these more modest firms will be under enormous competitive pressure from the larger FOHF for institutional capital. They will face questions about the depth of their resources and vulnerability to loss of one or two key individuals. Success will hinge upon either outstanding performance or an intensely loyal set of client relationships.
FOHF make for an appropriate vehicle for most institutional investors. Institutions, however, will require a more robust FOHF business model. Enhancing both the distribution and manufacturing elements of FOHF management will require significantly more resources than are currently employed. As a result, assets under management will consolidate with ‘complete’ FOHF providers.
Christopher J Acito is a principal at Casey, Quirk & Acito LLC, a strategy consulting firm for the investment management industry. CQA’s research, including two papers on the FOHF industry can be obtained from www.cqallc.com