Institutional fund managers have undertaken a dramatic shift to direct hedge fund investing following the global financial crisis, according to a survey released Monday by Citi Prime Finance.
The survey is based on in-depth qualitative interviews with some 60 major investors representing $1.7 trillion in assets under management as well as hedge fund managers representing $186 billion in assets under management.
It reveals that pensions and sovereign wealth funds have not only been increasing their hedge fund investment programs but are also allocating directly to hedge funds rather than using traditional funds of funds. Along with this trend, due diligence has intensified and focused on new priorities.
The survey found that hedge funds managing between $1 billion and $5 billion experienced the largest net growth in 2010.
“Fund managers in this range occupy a ‘sweet spot’ for investment allocators, with interest extending as low as $500 million in developed markets and $250 million in emerging markets,” Sandy Kaul, U.S. head of business advisory services, said in a statement. “Above $5 billion we see a bifurcation in the industry among hedge fund managers that are limiting new investment and those that are developing into larger asset management organizations.”
Among other key survey findings:
- Direct allocator hedge fund portfolios are typically small: 20–50 managers. Interviewees usually made only one to four allocations per year, writing few, but large tickets ranging from $25 million to $100 million.
- Partnership is key, with an emphasis on the “partnership” forged between the direct allocator and its selected managers and on the longer-term investment focus of its portfolios.
- Pension and sovereign wealth fund direct allocators have not yet settled on a standard model or approach. Most still look to outsourced CIOs, consultants or fund-of-funds advisors to support their direct allocating efforts.
Due Diligence Shift
In the aftermath of the financial crisis, due diligence has intensified and its focus has shifted. The Citi survey found that before 2008, a manager’s “pedigree” was a primary concern of institutional investors; that is, where the manager’s investment talents had been honed. Investors also focused on
“edge:” the unique skill a manager brought to the game that would likely generate better returns than other managers.
As well, pre-crisis investors wanted to be sure that the manager’s interests were aligned with their own; they wanted the manager to have money in the fund so that he or she would be focused on performance, not maintenance.
Other factors were less important in investors’ allocation decisions: how well the manager ran his business; operational aspects; and stability of service provider relationships. Moreover, the existence of an independent track record was not
always a critical investor consideration. Indeed, producing an independent track record often was not possible as many new managers had spun out of sell-side proprietary trading organizations or had served as portfolio managers within other hedge funds.
Today, the Citi report says, “the ‘footprint’ a hedge fund manager must demonstrate to qualify for institutional money has expanded dramatically. Many of the factors that had been of secondary importance to investors shot up in terms of being instrumental to their allocation decision.”
Take pedigree. Though still a drawing card for institutional investors, most of the survey participants said they would not invest at the outset in spinouts or startups other than through a seeding or farming arrangement—even if the highly credentialed manager brought an auditable, portable track record. The new manager would also have to demonstrate a wide set of supports and infrastructure.
A hedge fund manager’s edge is still one of investors’ top priorities, but now the manager has to demonstrate he or she is really generating alpha and not just posting beta in a hedge fund structure.
Institutional investors continue to want a manager to have “skin in the game,” in the event of a loss to feel the same pain as the investor.
The survey found that the biggest shift in institutional investors’ due diligence priorities has been an emphasis on hedge fund managers effectively running their business. “The non-financial performance of the fund now weighs equally in many investors’ minds to the manager’s returns,” the report says.
Operational due diligence reviews have become the norm, and have become much more probing that before the crisis. Managers are expected to have the right controls and processes in place. One public pension plan told Citi: “We need the comfort of a compliance officer and risk officer. If they are lacking in structure, it’s not worth it for us.”
According to the survey, most investors spend an average of three to six months conducting reviews, not only asking about controls but demanding a demonstration. Many reported that they actually went to a manager’s offices to observe month-end processing and perform tests around trade oversight and cash movements.
Finally, institutional investors need a track record, and they will examine more than just financial returns. They want to understand how the manager behaved during the financial crisis. And, very important, they want to find out how the manager dealt with investor relationships during that period.
A pension plan summed up these concerns: “We look at the intangibles. During tough times, did the manager made good decisions? Did they align with investors? Did they treat their people well? Does their behavior show that they would put their investors first?”