Alternative fund managers need to rethink their approach to tech, talent and fees if they want to stay ahead of the pack in this increasingly competitive field
Investors have had to trust their assets to an unconventional world for more than a decade. Since the crash of 2008, they have endured the lowest interest rates in living memory and unrivalled volatility in equities.
Such uncompromising times call for an alternative to the traditional listed equities and corporate and government bonds. In the hope of diversification, investors are turning instead to hedge funds, private equity, infrastructure and real estate.
Lumped together for convenience under the label ‘alternatives’, these assets – and there are other more esoteric ones in the group too, including timber, gold and wine – have attracted billions from all over the world as investors seek a way to ensure they get some bang for their buck.
Assets under management (AUM) in the alternatives space have hit all-time highs consistently since 2008. According to Preqin’s The Future of Alternatives report, published in October 2018, private equity, private debt and infrastructure achieved all-time fundraising records amounting to $8.8trn AUM at the end of 2017. The figure is projected to reach $14trn by 2023.
The Channel Islands have benefited commensurately from these international trends. Jersey recorded inflows of more than £200bn last year – the highest recorded figure to date in hedge fund assets under administration.
According to the Monterey Insight Jersey Fund Report 2018, the value of Jersey-domiciled fund assets originating from the US grew by almost 150% and the number of Jersey funds with US promoters increased 165%. Meanwhile, Jersey-domiciled fund assets with Japanese promoters have increased five-fold over the same time span.
The islands’ high levels of regulation, sophisticated administration infrastructure and proximity to mainland Europe make them attractive locations to domicile an alternative fund. However, much as with fund performance itself, past glories do not mean that the future is without its challenges.
Like so many other industries, from food delivery to public transport and energy, alternative funds are subject to disruption. Fund managers and their administrators and advisers must keep pace if they are to survive.
The robots are coming
Clearly, technology creates both challenges and opportunities for alternative fund managers. EY’s 2018 Global Alternative Fund Survey found a 200% increase in the use of artificial intelligence (AI) by hedge fund managers in the past year.
AI and machine learning are more often being used by managers across asset classes and investment strategies to make actual investment decisions. The automation of various facets of the investment process is being embraced, and managers who can complement their operations with these tools are gaining significant competitive advantages.
Matt Wood, Director at Altair, says: “Tech is critical to supporting the operations of fund managers who need a specialist solution. Managers can buy this in from specialist providers or access it by outsourcing the administration of their funds to a specialist fund administrator.”
However, the prevalence of AI and machine learning among private equity managers is far lower. The EY report found that ‘most private equity managers have not yet identified business cases to justify investing in AI’.
Nick Stevens, a Partner in the Private Equity Group at KPMG in the Channel Islands, says private equity is far more of a people business than the algorithm-embracing hedge fund world. “What makes private equity work is people with personal connections. It’s about human networks rather than computer ones,” he explains.
Talent strategy
Private equity is not the only alternative asset class that needs to ensure it has the best people at the helm of its funds. The EY survey found that all alternative fund managers ‘are keenly focused on talent management as they attempt to respond to and gain a competitive edge as a result of changing business dynamics’. In particular, they are looking at ensuring teams are fully stocked with experts in their chosen investment fields.
Wood says: “Alternative investment funds may struggle to outperform by being generalist in nature. We see that leaders are recruiting in-house expertise not just in fund management, but they are hiring operational, digital and regional expertise too. In this way, they can provide more value creation opportunities to the portfolio companies in which they invest. In turn, these funds are more sought after by investors.”
The EY survey found that more than two-fifths (42%) of hedge funds and more than half (52%) of private equity managers had changed the educational background and past experience of the employees hired or interviewed for roles in the front office.
Hiring practices are changing in the back office too to combat some of the challenges alternative managers face, particularly in managing the tech revolution.
EY reports that in 2017, just 10% of hedge fund managers reported that they had invested in robotics or AI in the middle and back-office functions. In 2018, a third of hedge fund managers implemented robotics, while one in 10 uses AI.
Fee structures
All this change helps manage some of the escalating costs facing the alternative funds sector. But given that EY reported that more than a third (38%) of clients are unhappy with the fees on offer, providers still have work to do if they are to find the sweet spot between turning a profit and delivering value.
That work is not coming in the form of cuts. The EY survey says 82% of hedge fund managers refused to slash charges. However, there is evidence of an adjustment in fee structures.
There is a willingness by managers to embrace alternative charging structures. Wood offers anecdotal evidence that there is some compromise in this area. “There have been some variations on the typical performance hurdles [over which managers receive fees]. I do see managers go to a money multiple hurdle rather than an IRR [internal rate of return], which is less hard to flatter and influence.”
In private equity, the old 2 and 20 fee structure – a 2% management fee and a 20% performance fee – is stubbornly persistent. “The 2 and 20 model is very old – it’s worked for many decades and it’s here to stay. It does align interests between investors and fund managers,” KPMG’s Stevens says.
The alternative space is dynamic and exciting, and has much to offer an informed investor looking to diversify their portfolio. For managers to survive, however, they will need to continue investing in technology, adding to their talent pool in new and interesting ways and – above all – make sure they remember that when it comes to fees, their clients’ pockets are perhaps not as deep as their own.