Institutional Investors Rapidly Shift to Direct Hedge Fund Investing: Citi Survey

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