Raising the Bar
Frank Napolitani of EisnerAmper highlights how the alternative investment industry continues to evolve.
Hedge funds are designed to dampen volatility in down markets and participate in up markets, thus creating a smoother return profile over business cycles. They are not intended to outperform index funds during a bull market, yet the expectation remains that a long/short equity hedge fund with net exposure of 0%-30% should outperform a long-only index in a bull market. When evaluating a diversified portfolio with traditional assets of equities, bonds, alternatives and cash, a diversified portfolio of hedge funds continue to provide value from a risk/reward perspective.
Recent underperformance of hedge funds has driven management fees down from the standard 2% to, on average are approaching 1.6% for long/short equity hedge funds and even further (< 1.5%) for a strategic or founder’s class for early investors participating in a new launch.
Hurdle rates or “preferred returns” in private equity, venture capital and real estate funds prior to the incentive fee or “carried interest” remain a mainstay in those fund structures. Many institutional investors that make up the asset base of these funds also invest in hedge funds. Given the current underperformance of hedge funds, we anticipate hurdle rates will become a more popular practice for hedge funds in order to further align interests with investors. Currently, the fund manager is participating in a portion (e.g. 20%) of the first dollar of profits. If a hurdle was instituted, say the US 10-year treasury bond, as a risk-free rate of return, that the fund manager would not participate in the incentive fee unless net performance exceeded this hurdle rate, thus further aligning the fund manager and the investor’s interests.
Strategic or founder’s capital
With underperformance in hedge funds overall, it remains a difficult capital raising environment for portfolio managers that are eager to go into business for themselves and launch a hedge fund. Of the new launch activity that we have witnessed in 2016, over 60% of the managers are obtaining some form of strategic or founder’s capital to seed their new funds. These seed deals will range in size from $25m to $100m, with a combination of discounted fees, a two to three year lockup and revenue share of both, the management and incentive fee for a defined period of time. The additional expenses related to managing an institutional quality hedge fund in a regulated environment have caused some managers to postpone their launches as they are unable to raise a minimum level of AuM to support the operation. Although the bar remains fairly low to start a fund, the ongoing expenses to run the business have a direct effect on the minimum AuM required to support the business and we anticipate this will continue to increase.
Illiquidity premium – “achieving the magic 8%”
For years, many pension plans have used 8% as the target rate of return for their investments. Due to the significant losses many investors suffered during the credit crisis in 2008 coupled with a low interest rate environment, the current outlook for equity performance is in the vicinity of 4% to 6%.
Given the negative outcomes which suspended redemptions instituted by many hedge fund managers during 2008, the immediate trend that followed was a demand for greater liquidity. Prior to 2008, a very high percentage of hedge funds had a hard lockup of at least one year. Post 2008, the concept of a “soft lockup”, where a penalty (e.g. 2%-4%) was imposed upon the redeeming partner if they chose to redeem prior to their 12 month anniversary, is payable to the fund to offset any performance slippage the fund encounters from liquidated securities to honour the redemptions gained traction and is now the standard.
Given the underperformance the industry has experienced, investors have become more willing to invest in less-liquid strategies which can potentially garner greater returns. These strategies may include, but are not limited to, lending to private equity sponsors for leveraged buyouts (LBOs) and stressed/distressed corporate securities in both developed and emerging markets, specialty financing of art/antiquities, and stressed/distressed mortgage backed securities, etc. Many of these strategies provide an opportunity for double-digit (or greater) returns, but require more patience and a longer -term view from the investors, including the ability to stomach short-term volatility and a lack of liquidity to achieve these returns.
Fund structures: multi-series platforms
There has been increased discussion amongst multi-family offices (MFOs) and outsource CIOs (OCIO) about incorporating alternative fund structures including Cayman segregated portfolio companies (SPC) and Delaware series LLCs. These structures have a number of benefits to both the investor and the fund manager, each of which are outlined below:
For the investor:
- The ease of completing only one set of subscription documents
- The flexibility to diversify investments across multiple strategies on the fund sponsor’s platform
- The flexibility to rebalance investments within the platform, based on the underlying liquidity of the investment strategy.
For the manager:
- The ease of having one platform with the ability to add different classes or “cells” to the platform to introduce new, different strategies that may have differing investment characteristics and liquidity
- The flexibility to allow investors to rebalance their investments amongst the platform, versus having a single strategy fund which may cause the investor to withdraw completely
- Each class or cell is separately ring-fenced from each other and in the event a class or cell is impaired, investors will only have recourse against the single class or cell that they are contracted, not the entire platform.
The popularity and growth of the outsourced CIO (OCIO) model continues to increase with both, institutional investors and family offices. These investors outsource their investment programme to a third-party investment and operations team that has full discretion and focuses on managing their portfolio across both traditional and alternative asset classes.
The OCIO structures the portfolio based on the client’s stated goals and risk tolerance and will rebalance the portfolio within these guidelines. The OCIO’s continue to be large allocators to the alternative investment space given their expertise in complex securities/strategies and resources to support these investments. The investors find the OCIO model attractive as they often lack the internal investment/operations talent, risk management capabilities, and the ability to make faster allocation decisions.