As published on hedgeweek.com, Wednesday November 13, 2019.
With more investors increasing allocations to private equity and other alternative asset classes, largely at the expense of traditional hedge fund offerings, alternative fund managers are examining their strategic priorities and focusing on how to develop products and prepare their business for a rapidly evolving future.
That’s according to the 2019 EY Global Alternative Fund Survey When focusing on the future, where do you look?
The 13th annual survey (formerly the EY Global Hedge Fund Survey) found that overall allocations to alternative investments haven't changed, but the competition is intensifying between asset classes. Continuing a multiyear trend, assets under management (AUM) allocated to hedge funds decreased by 7 per cent, while allocations to private equity increased by 7 per cent.
The survey also identified expanded interest in private credit and real estate offerings. This shift in allocations has impacted the strategic priorities of alternative managers. Private equity managers have every reason to enact ambitious capital-raising strategies and continue to identify growth as their top priority. Hedge funds are more muted on their growth agenda and are increasingly focused on talent and cost management.
While hedge funds and private equity represent the majority of allocators' alternatives portfolios (33 per cent and 25 per cent, respectively), investors report 23 per cent of their assets allocated to real estate and 19 per cent to private credit, infrastructure and other alternative asset classes.
Given the competition, 69 per cent of hedge fund managers and 71 per cent of private equity managers list asset growth as a top priority. Recognising they need the right people in place to achieve this goal, talent management is a close second, with 62 per cent of hedge fund managers and 56 per cent of private equity managers listing this among their top three priorities. From here, priorities diverge.
Hedge funds are more focused on reigning in costs than their private equity peers. Half of hedge fund managers ranked cost management and rationalisation high among their priorities, while just 29 per cent of private equity managers ranked this a top priority. As interest in private equity shows no signs of abating, 43 per cent of private equity managers report a priority of enhancing middle- and back-office processes and technology to support the explosive asset growth they are receiving, and 24 per cent of private equity managers prioritise investor reporting to meet the needs of new clients, quadruple the number of hedge fund managers (6 per cent) who see this as a priority.
Amid increased investor demand for customisation of strategy and nontraditional offerings, alternative fund managers continue to diversify products, with hybrid credit and ESG products as several of the trendsetters.
Hedge fund and private equity firms continue to diversify their product offerings, despite the operations, technology, talent and investor acceptance challenges they pose. Hedge funds offering or planning to offer co-investment vehicles more than doubled from 21 per cent to 58 per cent in the last year. Another 37 per cent of hedge fund managers currently offer or plan to offer illiquid credit, private credit, CLOs and senior debt in fund structures, 17 per cent currently offer or plan to offer real assets and infrastructure and 16 per cent currently offer or plan to offer real estate. Private equity managers are equally bullish on these product offerings, with 41 per cent offering private credit vehicles, 23 per cent providing real estate products and 22 per cent offering exposure to real estate.
Managers are also continuing to focus on driving growth within their existing strategies, although the structuring considerations and customisation continue to be challenged by investors. The majority (79 per cent) of hedge fund managers have been more successful increasing AUM in their existing offerings rather than in their new products. Despite this, more than half of managers (60 per cent) find success in launching new products, including separately managed accounts (SMAs), for existing clients and new clients. Investors' demand for SMAs continues to grow for several reasons, and managers reported an increase in their firm assets comprised by SMAs from 25 per cent in 2018 to 32 per cent in 2019. Furthermore, 39 per cent of hedge fund managers anticipate growth in the proportion of their firms' assets that will be included in SMAs in the next two years, as compared to their views of their comingled offerings, where 24 per cent of managers expect future asset growth but 20 per cent expect asset declines.
Entering the next decade, diversifying into products that are environmentally and socially responsible is crucial, as 29 per cent of investors are already investing or planning to invest in socially responsible funds, and nearly two-thirds of these investors (63 per cent) say that managers' ESG policies have a critically important impact on their decision to invest.
Managers are hearing the call. The number of hedge fund managers currently offering ESG products is just 19 per cent, but that number is expected to increase by approximately 50 per cent over the next two years. Not only are alternative asset managers launching new product sets, but also embodying what it means to be good "corporate citizens." The majority of private equity firms have adopted environmental and social responsibility policies (66 per cent with another 8 per cent planning to adopt), and even though they are further behind, half of hedge funds have adopted or plan to adopt these policies.
Dave Racich, Partner, Ernst & Young LLP and Co-leader, EY Global Hedge Fund Services, says: "Investors of the next decade are more socially and environmentally conscious than they were in the last decade. They demand customisation, transparency and accountability. They also are more comfortable with and desire a number of offerings that years ago would have been considered nontraditional, but are increasingly becoming more common as part of alternative managers' product arsenal. But, ultimately, they desire investments that will deliver strong returns. Managers able to heed these demands and diversify their offerings are poised to succeed."
While talent management has garnered meaningful focus by alternative managers and progress has been made, significant work needs to be done in terms of achieving diversity in the front office.
Recognising the impact that having the right people makes on positive investment returns, nearly all investors (86 per cent) note that talent management programs play a key role in their decision to invest. Over the past year, investors' focus on succession planning nearly doubled from 23 per cent to 40 per cent. Hedge funds appear most sensitive to retention issues with 43 per cent of hedge fund managers ranking retention as a top priority compared to only 29 per cent of private equity managers. With hedge fund growth and performance generally more lacklustre compared to private equity, being able to retract and compensate key performers is a challenging business issue.
While private equity firms are ahead of their hedge fund peers, improving gender diversity necessitates continued progress. Only 30 per cent of alternatives firms have set diversity targets and just 2 per cent of all alternative fund managers report having a greater than 50 per cent proportion of women employees in the front office. Eighty-eight percent of hedge and private equity funds report their front office leadership team as comprising 30 per cent or less of women. Progress has been made outside of the front office, as 78 per cent of private equity managers report to have at least 30 per cent of their back-office roles filled by women and half of hedge funds have 30 per cent or more gender diversification.
While alternative asset managers feel they don't have challenges in recruiting younger talent, retention proves to be a more significant challenge. Most managers have initiatives to attract and retain young talent, such as improving office amenities (64 per cent of managers), allowing relaxed dress codes (61 per cent) and adding the flexibility to work from home (52 per cent).
Natalie Deak Jaros, Partner, Ernst & Young LLP and Co-leader, EY Global Hedge Fund Services and Co-leader, EY Americas Wealth & Asset Management Services, says: "Increasing diversity is not only the right thing to do, it's strategic, as diversity in backgrounds is linked to supporting better investment decisions and more efficient business operations. The entire alternatives industry has a way to go to build a balanced workforce. The managers who accelerate progress are not only role models to the industry, but are creating a competitive advantage."
Alternatives managers are utilising data as a competitive advantage, and while private equity firms are further behind in devising formal strategies for maximising data utility, they are catching up.
As managers increasingly face a reality where they have to find cost savings and efficiencies, the ability to better leverage data created internally is crucial, and those who do not maximise its utility will be at a competitive disadvantage. Despite the amount of data they generate, just over half (57 per cent) of the largest hedge fund managers (over $10b) have a formal data strategy in place, while under half (44 per cent) of the smallest firms report to have a strategy in place. Private equity peers are further behind. Over half (56 per cent) of the largest private equity firms do not have a formal strategy, and that number jumps to 86 per cent when referring to the smallest shops.
Managers not only lack strategies, but dedicated resources as well. Whereas at the largest organisations, data management is viewed as a full-time job, just 21 per cent of the smallest firms have a CIO/CTO.
Private equity managers have historically trailed their hedge fund peers in using next-gen data and artificial intelligence (AI) as part of the investment process, but the gap is closing, as managers are increasingly seeking out new data sources as part of their investment process.
Now 35 per cent of private equity managers use nontraditional data, on par with the 42 per cent of hedge fund managers using this type of data. Making strides, private equity firms leveraging AI within the investment process tripled from 2018 to 2019 with a jump from 5 per cent to 15 per cent.
With the proliferation of data comes concerns surrounding keeping the information safe and secure. Only 39 per cent of investors are confident that alternative fund managers have adequate cybersecurity protocols in place, whereas the majority (82 per cent) of fund managers feel they are extremely well prepared. This confidence by managers is buoyed by the fact that the majority of managers have increased their cybersecurity budgets over the past two years, some upwards of 50 per cent. Given the variance in severity of cybersecurity breaches, few investors note they would definitely redeem investments if a breach occurred, but rather they would base their decision on the type of information that was compromised, how it was handled by the manager and the steps the manager would take to remediate the issue.
Alex Birkin, EY Global Wealth & Asset Management Advisory Leader and EY EMEIA Wealth & Asset Management Industry Leader, adds: "Data is a double-edged sword. We are seeing sophisticated managers harness the power of their data to improve investment decisions and run the business more efficiently. But to prevent data from being a manager's downfall, it demands quality assessment and safeguarding."