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Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
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As we discussed in last year’s hedge fund industry survey, there
are a number of managers with assets closer to the $3-$5 billion
range and above that have opted to limit their capacity and
close to additional investors near and above that AUM band.
These managers are concerned about their ability to absorb
continued inflows and effectively deploy capital in their core
hedge fund product. Yet, these managers are seen as having
additional capacity in the long-only side of their portfolio.
Increasingly, many of these participants are beginning to
manage long only money alongside their hedge fund, but in
private structures that have been initiated almost exclusively
at the request of existing investors.
Both sets of these managers are found in what we showed was
the bifurcation zone in last year’s hedge fund industry survey.
These are the most mature hedge funds, where it is a logical
next step to begin thinking about their strategic development.
Smaller hedge funds are still growing, and as such risk losing
their focus if they look beyond their core product.
Our interviews in Asia highlighted a further set of hedge fund
managers that were actively looking to diversify their product
offerings, namely, much smaller hedge fund firms that needed
“long-only accounts to keep the lights on”. We interviewed
several APAC hedge fund firms with significant long-only
or other product offerings that were added to their product
arsenal over the last few years. In many instances, these
products were created at the request of existing investors.
The reality for most Asian hedge funds has been that since
the Global Financial Crisis it has been difficult to raise hedge
fund capital and that in order to afford the steadily growing
fixed costs of this business, they had to be flexible and open to
reverse inquiries from clients for long-only SMAs, etc.
New Products Show Inverse Relationship Between
Fees and Potential Asset Pools
Chart 28 illustrates the span of product innovation we
encountered across this year’s hedge fund participants.
There are three main considerations managers discussed
when determining where they are best suited to create new
product offerings.
First, managers need to decide whether they will look for
extended opportunities in alpha strategies or whether they will
look at traditional actively managed product to capture beta
returns. Second, managers must determine which audience
they wish to pursue—the traditional institutional and high net
worth hedge fund audience or the broader retail audience.
Finally, managers must determine the trade-off they are willing
to accept between fees and asset pools, as there is an inverse
relationship between these two factors. Strategies likely to draw
the highest fee potential are those that have the most limited
AUM pools and, conversely, those that have the largest AUM
pools are likely to command significantly lower fee structures.
Products with the highest fee potential are those being
explored by hedge funds in a secondary convergence zone
on the opposite end of the investment spectrum. These
are typically activist managers looking to identify offerings
that blur the lines between hedge funds and private equity
offerings, or they are credit managers offering structured
illiquid products built around assets with an associated cash
flow as well as an alpha opportunity. These products are clearly
focused on the traditional hedge fund audience of institutional
and qualified high net worth investors. These products require
deep investment expertise to structure and hedge and a
substantial infrastructure to cover the set-up, administration,
and accounting. While fees on these products are high, the
lock-up and payout on incentive capital is often long-dated at
3 years or beyond.
“ Hedge funds that have grown are offering follow-on
products. They are looking to diversify their product mix to
be more profitable,”
– Institutional Fund of Funds
“ You’ll often see someone who started a successful long/
short fund and then carved out their long book. Then they
might hire a credit group. This product proliferation stage
raises more red flags for us than anything. Is it a dilution?
Is the goal now about asset raising?”
– Institutional Fund of Funds
“ It’s only been in the last couple years that we’ve started
seeing the hedge funds starting to offer long-only product.
For one key guy, he’s out of capacity in his hedge fund but
there’s lots of room on the long-only side,”
– Outsourced CIO
“ Few APAC assets managers can survive on hedge funds
assets only”
– <$1 Billion Hedge Fund