Private equity and other alternative investments are gaining favor among allocators at the expense of hedge fund managers, which are facing challenges from market conditions and changing investor preferences, according to EY’s annual global alternative fund survey, which was previously called the EY global hedge fund survey.

A fifth of investors said they planned to decrease allocations to hedge funds in 2018, continuing a multi-year slowing of allocation appetite for hedge fund products, while a third of investors planned to increase allocations to private equity and only 9% to decrease them in the next three years.

“Alternative asset managers are grappling with a whirlwind of changes, and they can either act now to address industry disruptions — ranging from technological innovation to products and competition from new players — or admit defeat and lose competitive market share,” Natalie Deak Jaros, co-leader of EY’s global hedge fund services, said in a statement.

“In order for alternatives to stay ahead, they need to appease investor demand for customization, implement technology that augments investment decisions, and hire the proper talent to both manage technology and bring outside thinking to the traditional financial services mindset.”

(Related: Often Ignored, Closed-End Funds Have Some Big Advantages)

Greenwich Associates conducted 102 interviews during the third quarter with hedge funds, representing over $1.1 trillion in assets under management; 103 interviews with private equity firms, representing nearly $2.2 trillion in assets; and 65 interviews with institutional investors, representing over $2.7 trillion in assets.

Increased Competition

EY reported that hedge fund and private equity managers are increasingly competing with one another to tap into investors’ desire for nontraditional products. A majority of investors surveyed said they were increasingly allocating to such offerings, including private credit, real estate and real assets.

Forty-six percent of private equity managers and 35% of hedge fund managers reported having a private credit offering. In addition, three in 10 hedge fund managers said they offered a private equity product, and two in five private equity managers had hedge products.

EY said the diversification of product offerings was directly resulting in convergence as managers across all strategies develop expertise and branch out to a variety of alternative offerings.

The survey found that besides demanding nontraditional products, allocators increasingly want to be more active partners with their managers, and to have a voice on investment decisions and operational matters.

More than one-third of investors said they planned to increase their behavior as “active LPs,” and 32% said they would continue to build out investment capabilities to replicate the strategy internally without the assistance of a third-party external manager.

Not only that, but investors are becoming more active partners with their managers in demanding that product offerings be tailored to their needs. The survey found that more than a third of hedge funds were responding to this growing demand for customization by increasing or planning to increase the number of separately managed accounts and funds of one they offer.

EY noted that these offerings appease investor demands, but create operational headaches for alternative asset managers.

Hedge Funds Embrace AI

Hedge fund managers are rapidly embracing artificial intelligence in the front office, with 29% reporting using AI, compared with just 10% in last year’s survey. The same is true for next-generation data, as 70% of hedge fund managers are using, or expect to use alternative data within their investment process.

According to EY, managers view the use of nontraditional data and/or AI as an opportunity to enhance their investment process and differentiate themselves in a competitive landscape.

“Not only do managers clearly see the benefit of AI and alternative data in helping them gain a competitive edge, but investors are actively seeking out managers that are exploring new innovations to deliver alpha,” Dave Racich, co-leader of EY’s global hedge fund services, said in the statement.

“Not long ago, we were only talking about quantitative managers utilizing these techniques; however, we continue to see increased adoption and use cases across all strategies.”

The AI adoption rate among private equity firms is much lower, with three quarters of respondents saying they did not use AI and had no intention to do so, according to the survey. EY noted, however, that many larger private equity managers are investing in big data to help identify investment opportunities while providing analysis into pricing trends that guide buyout negotiations.

In the back and middle office, both hedge funds and private equity continue to invest in technology solutions, the survey found. However, the sophistication of the technology investments is more pronounced with hedge fund managers who are ahead in using AI and robotics to automate a variety of processes.

Thirty-four percent of hedge fund managers said they have made back-office investments in robotics, which are resulting in more timely and accurate reporting, compared with only 1% of private equity managers who reported using this technology.

Talent Management Priority

According to the survey, talent management has emerged as a key concern for alternative managers. More than 40% of hedge fund managers and 50% of private equity managers cited talent attrition as one of the industry’s top three risks.

In both the front and the back office, nearly half of managers said they had changed the type of talent they were looking for compared with five to 10 years ago. Hedge funds look for talent with data and analytics experience, while private equity funds steer their personnel searches toward gender and cultural diversity.

The prioritization on talent does not necessarily translate to institutionalization of this very important function, EY said. Some 60% of hedge fund firms and more than half of private equity ones said they did not have a formal talent management program in place.

This finding is at odds with investor preferences. Sixty-eight percent of allocators said a formal talent program was an important influence on their investment decision.

“The ability to navigate the talent landscape has never been more critical for asset managers,” Mike Lo Parrino, private equity leader of EY Americas’ financial services organization, said in the statement. “Firms need to integrate technology skill sets with traditional finance professionals, which can be a challenging balance to achieve.”

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