As Brendan Conway aptly observed in Barron’s, late last year, there are “too many hedge funds with too much money chasing too few opportunities.”
Another way of saying this is that the industry has reached maturity, with all of the backaches and burdens that entails. Accordingly AIMA, in conjunction with Barclays Capital Solutions, has produced a new white paper on investor/manager relationships in the hedge fund world that speaks in its own way to this situation.
The paper, The Extra Mile, based on a survey, explores “the changing relationships between hedge fund managers and investors” – especially institutional investors, who it says are “actively pursuing a more direct engagement” with the underlying funds – and it makes Conway’s point, that in these author’s words the hedge fund space is now a “mature industry, one in which the growth of an HF is largely dependent on its ability to take market share from competitors rather than being able to ride the wave of overall industry growth.”
In that context, it isn’t surprising that the (more or less fixed) pool of investors is getting pickier.
One of the big takeaways from the survey is that investors are increasingly sophisticated; they see HFs without any gee-whiz factor as a “way to tailor the risk-return of their entire portfolio.” Sixty-eight percent of those surveyed said they are in at least one partnership with a HF manager that goes beyond the traditional LP/GP relationship.
They are looking for the following in their engagement with the management thereof:
- Access to expertise/skills;
- Customization from the point of view of their investment needs;
- Increased understanding of the goings-on;
- More value for their fees.
Expanding on point (3) there, one investor surveyed said: “We want to know everything good and bad from a manager in order for us to start trusting them and build a strong lasting relationship.”
Expanding on point (4), a representative of a pension fund said, “Flexibility with fee structures tells us that you know our internal constraints and are willing to work with us.”
More broadly, the investors questioned split on whether they regarded fee concessions as an integral aspect of their engagement with managements. Endowments and family offices generally took the view that if net returns are sufficient, the level of fees is not an issue. Also, they are more willing to pay for the incentive part of the fee structure than were some others, and if their attitude was that if they do press for concessions, that’ll involve the flat management-fee portion of the structure.
Public pension funds, the authors observe, are in a different place. They are more fee sensitive, “owing to the disclosures that they have to make on this front.” But they have a trade-off to offer for any concessions they win. Or rather, two possible trade-offs. On the one hand, “[S]everal pensions we spoke to did mention that they are willing to write larger tickets for a meaningful fee reduction.”
On the other hand, they may also be in a position to agree to longer lock-ups in return for a fee break.
Too Much Trouble?
Another takeaway, from the point of view of the HFs, is that such an engagement requires a lot of time and effort, and those commodities have to be budgeted.
“Some HF managers,” the report says, “have made the decision not to seek partnerships for a viable reason,” and this might well be for many of them the best call. How best to handle the circumstances of your own “maturity” is your own call.
For those who do engage in such partnerships, though, the following are the key desiderata:
- Stickier tickets;
- Product development through seed capital from their new institutional best friends;
- Cross-selling opportunities;
- Knowledge sharing;
- Positive references to other investors.
In expounding on these points, the report also presents a brief history of the growth of the institutional component in the hedge fund industry, as illustrated by the graph below [our adaptation of their original).
In the balmy pre-crisis days of 2005, institutional HF assets (the blue portion of each bar) were merely 33% of the total global HF assets.
The ratio of the blue portion of the bar to the over-all bar has increased along with the size of the bars. The blue was 43% of the whole in 2008, 55% in 2010, and 61% in the third quarter of 2013.
In that context, close relationships with the investors are readily comprehensible.
The Survey Sample
The second chart displayed here (also adapted from one in the AIMA/Barclays materials) indicates the split within the survey as to hedge fund strategies involved. Multi-strategies and credit-based approaches dominate.
Why? Well … multi-strategy funds are good partners for institutional investors, the authors of the report observe. Their multiple focuses give them a combination of expertise and flexibility that may not be found elsewhere.
Credit funds are so prominent on that chart because they are likely to have co-investment opportunities available.
In a foreword, Michelle McGregor-Smith, chair of the AIMA investor steering committee, expresses AIMA’s “sincerest gratitude to Barclays.” Aside from her service as a chair, McGregor-Smith has an even more pressing connection to the issue. She is chief executive of British Airways Pension Investment Management Ltd.