Hedge funds and institutional investors have kissed and made up – for now

Kissing and making up is one of the best parts of any relationship gone awry. Resolving differences and moving forward with all the positive things that brought two parties together in the first place is a lot better than holding a grudge or worse.

It’s clear at the moment that hedge funds and institutional investors are in a kiss-and-make-up phase, judging by a plethora of recent surveys and research we have come across and covered, as well as anecdotal evidence noting institutions’ interest and commitment alternative strategies is definitely on the rebound.

But kissing and making up is often not done overnight, nor does it mean that all bygones are bygones, according to JPMorgan’s 2011 Investor Sentiment Report, which plainly notes that several key areas of tension between institutional investors and hedge fund managers continue to persist.

The report, entitled Regeneration: Entering a Period of Sustainable Growth (click here to download), is chock full of positives on how the power relationship between investors and hedge funds has evolved, particularly in the wake of the financial crisis, market meltdown, market melt-up and now less out-of-the-ballpark but more consistent and non-correlated returns.

Indeed, JPMorgan sees the hedge fund industry entering the third phase of a three-phase cycle, one that will be characterized by moderate but sustainable growth, an increased concentration of assets to established managers and a stronger control environment – all things that institutional investors now demand – and are getting.

The reason: because institutional capital has become increasingly critical to hedge fund managers as they become larger. Hedge funds managing $10 billion or more in assets reported that, on average, 67% of their capital originated from institutional sources, according to the survey’s findings. The chart below illustrates what institutional investors deem the greatest benefits of coming back to the relationship.

Meanwhile, nearly half of the hedge funds managing more than $1 billion in assets, the segment most likely to source an overwhelming majority of capital from institutions, plan to add funds in 2011, according to JPMorgan.

So what will this third, let’s-hold-hands-and-skip-through-the-tulips phase look like?

“The third phase will, in our view, see significant capital inflows to the largest funds, with a greater willingness on the part of investors to place capital with established managers in emerging investment vehicles,” the survey notes.

Large investors— pensions, endowments and foundations, in particular—have demonstrated their ability to drive change, with the largest impact on smaller hedge funds, according to the report, which found that while the majority of funds responding to these demands were primarily smaller or newer managers.

At the same time, the report notes that some of the bigger hedge fund fish are also bowing to investors’ demands – especially when a large allocation is dangling in front of them, or the prospect of an additional juicy worm from an already-hooked and baited investor.

But even the best reconciliations have their still-sore spots. On the manager side, there is still hesitancy among larger and more established funds to give investors the kind of transparency and liquidity they seek – for the simple reason that they don’t have to. Moreover, top performers report that their management and performance fees remain where they were before the crisis.

Investors, meanwhile, are playing the jilted post-infidelity wife going for the mink coat and diamond earrings – making significant demands on hedge fund managers.

“Selection criteria is exacting. Due diligence is intense. Investor demands for transparency, liquidity and controls are acute,” notes the report. “We believe that these trends are secular, not simply a hangover from the crisis period.”

The good news is that investors are committed to the relationship for the long term. Some 90% said the duration of their typical hedge fund investment is longer than two years, while most reported that the typical duration is two to five years.

A full 25% of those surveyed said their typical investment in hedge funds is held for more than five years – a marked increase from the 16% that gave the same response in 2008, when redemptions were quite common.

A side note in the report’s findings was on so-called tail-risk product, something that barely existed three years ago but more recently has become a must-have for many institutional investors. Some 35% of respondents indicated that they expect to invest in a tail risk product in 2011 versus 24% in 2010, suggesting investors “will be looking over their shoulders for some time to come.”

There are lots of others reasons to expect that hedge funds and investors will remain a happy item for a long time to come. Survey respondents reported that they have less than 10% of their portfolios in cash, whereas in 2008, 53% had more than 10%, indicating that they have begun to put capital to work.

In 2009, 18% that 75% of their hedge funds had returned to their high water marks. This year, half of the respondents said that at least 75% of the managers that they invested in had reached their high water marks.

In short, hedge funds will likely continue to play “the good wife” as investors continue their march towards making alternatives part of the bigger portfolio picture – at least until they get to a point of irreconcilable differences.

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