A New Dawn for Alternative Assets

By Ravi Bulchandani, Managing Director, Barclays Wealth, Barclays (12/01/2010)

I wrote in these pages last year that rumours of the demise of the alternative investment industry were much exaggerated. But it was a close-run thing! The average hedge fund was down between 20 per cent and 25 per cent (but it is worth remembering that this was still better than the public markets); outflows amounted to about one third of hedge fund industry assets; private equity fundraising slowed down dramatically as the valuation on existing portfolios continued to decline; and, investors didn’t want to know. It is encouraging to note that sentiment is much improved and the alternatives sector appears to have found its feet again after an extremely difficult two years. For the purposes of this article, we will focus chiefly on hedge funds and private equity.

Hedge Funds

Optimism Warranted

We remain optimistic about the future of the industry and, furthermore, that  hindsight will show the 2009-2010 period as a great time to have added to alternative investment exposure in portfolios. The smartest institutional investors appear to be taking the same view – outflows from hedge funds have all but ceased and although large, sustained inflows remain elusive, investors are content to leave the profits earned on their hedge fund investment this year to accumulate. Many have not forgotten the reasons they got into hedge fund investments in the first place – the access to skilled managers, pursuing uncorrelated returns, using a wide range of portfolio techniques and tools unavailable to traditional managers - and all this in a structure that leads to strong alignment of interest with investors.

In looking forward, it is also worth looking back. Doubtless, some of the shock that investors felt at the fact that hedge fund investments had recorded negative returns was tempered by the fact that in aggregate the industry had actually done better than many traditional financial asset markets over that period. Perhaps, too, on sober reflection, investors realised that these were not riskless investments, and that in an environment when any risk-taking was severely penalised, it is not surprising that hedge funds suffered.

There may also have been an element of – how shall we put this? – overstating the case on the part of many funds, and particularly funds of funds. The promise of small, positive returns every month – without significant downside – was never particularly credible, and the events of last year have cruelly exposed that fallacy.

We believe, however, that the enduring virtues of funds of funds, the fact that they provided diversification, due diligence and delegated responsibility for portfolio construction and management in an inherently complex space, will probably come back into favour again. Investors are likely to be extremely demanding for the fees that they pay and standards of scrutiny of the value that funds of funds actually add are going to be much higher.


The Balance of Power Shifts

The near-death experience of many hedge funds last year has produced a better balance between investor and fund interests across many dimensions. In the near-term, this is leading to the availability of much better terms for alternatives investors – which they should take every effort to avail themselves of. No longer are hedge funds or private equity firms able to impose longer lock-ups just because they can. There is much greater scrutiny by investors of whether the underlying asset class or strategy warrants a long lock-up. For example, if a long-short equity manager who is focused on large-cap UK stocks demands a long lock-up, investors are likely to charge for the privilege. Conversely, where a strategy demands a longer lock-up (distressed debt, some credit strategies), investors are more likely to accept those if the reasons for the longer lock-up are clearly stated.

Events last year are also likely to lead to greater transparency – investors will demand greater clarity on the risks that the underlying manager is taking, and much greater understanding of the precise attribution of portfolio performance. Hedge fund managers are going to need to show a greater willingness to share their entire portfolios, and investors are likely to be willing to sign up to appropriate confidentiality agreements in exchange.

This increased transparency is likely to go hand-in-hand with an increased investor focus on operational due diligence, with independent administration and custody now likely to become a minimum requirement, as opposed to a “nice to have” .

An increased focus on counterparty and prime broker risk is also likely, with much greater stress testing of business plans in the event of counterparty or prime brokerage failures.

Many hedge funds will also attempt to migrate some strategies to more transparent and regulated delivery structures, particularly those that can be made to conform easily to the UCITS (Undertakings for Collective Investment in Transferable Securities) format in Europe, which has so far posed few barriers to some hedge fund strategies.


Strategy Outlook

It is a well-known feature of equity markets that bear markets do not have the same life expectancy as bull markets. Something similar appears in the hedge fund return data, although the return series is much shorter than for equity and bond markets. If this insight is true, though, we may be on the verge of a very good multi-year period for hedge fund returns. A close look at the hedge fund data supports this view – previous years of flat or negative returns are followed by many years of strong returns. In the current environment, there are grounds for thinking that the devastating decline in hedge fund returns will be followed by some years of good returns. There are both good industry level and strategy-specific reasons for this optimism.


Reasons to be Cheerful

At an industry level, there has been a notable shrinkage of risk capital deployed in the financial markets. Many investment banks have cut back on their proprietary risk-taking activities, bank capital is being deployed to rebuild depleted balance sheets, and leverage levels are significantly lower relative to pre-crisis levels. The near 30 per cent shrinkage in the size of the hedge fund industry also means that many financial market trades that have appealing risk/reward tradeoffs are not as crowded as they once were. Accordingly, opportunities for hedge funds to deploy capital and take risk should be well rewarded. Even though some asset prices have bounced back sharply off their post-crisis lows (eg bank loans), there are still opportunities to earn high returns without deploying high levels of gearing.

Strategy Commentary

At a strategy-specific level, we think that it is likely that traditional long-short equity managers are likely to do well in the next few years. After having been driven mainly by macro and technical factors, equity markets show signs of becoming less randomly volatile, driven more by company and earnings fundamentals with greater stock-specific and sector predictability. As such, managers who are focused on primary research may well have a sustainable edge. Managers who are experts in dealing with the aftermath of recessions, such as credit-focused and distressed players, may also do well. The high spreads available for “event pricing” may favour event-driven managers, although activist investing will be trickier for hedge funds in still volatile markets that will be unwilling to reward the promise of corporate performance improvement until it actually occurs. Managers who are skilled at interpreting macroeconomic data and the impact of policy on markets will do well, and trend followers may recover their poise after a difficult 2009 when few clear trends were apparent. All in all, hedge fund managers are likely to find 2010 full of very interesting opportunities.


Private Equity

Private equity firms will find an equally interesting environment for investment – the challenge here will be that investor inflows and sentiment are unlikely to improve until there is a more sustained improvement in the availability of leverage, and greater visibility on exits by portfolio companies. Highly-leveraged buy-outs  are likely to remain scarce for some time. But opportunities still exist for those who are able to deploy less leverage, as well as for operators who have added value through managerial, logistical, strategic and process improvements at portfolio companies rather than focusing merely on financial engineering. Private equity companies in this category lucky enough to have some powder dry from funds raised in late 2007 and 2008 are likely to deliver excellent returns from investments made in 2009 and 2010, although any investments made in 2006 and 2007 (when valuations were stretched and leverage plentiful) are likely to be problematic.

History is on the side of those investors bold enough to invest in private equity in 2010, as historical returns show that recessions and their immediate aftermath have proved to be an excellent time to invest in the asset class. But we believe it is going to be as important as ever to be selective in the choice of sectors, as in the choice of managers.

Two strategies that have been out of favour for a long time – secondary investing and early stage or growth investing – are likely to perform well. Many investors are still unwilling and/or unable to continue to meet capital calls on funds that have shown declines in portfolio values from companies hit hard by the recession, and they will be anxious to dispose of these. We believe that funds specialising in the analysis of partially-funded private equity should find plenty of value.

Finally, the intersection of a long drought in early-stage investing (the number of specialist players here has continued to decline) with the dislocations in funding created by the recession should mean an abundance of opportunities for early-stage and growth investors, particularly those that are able to tap into the wave of innovation, expertise and incredibly motivated young businesses in emerging market economies.