Can resilience shape a shifting landscape?

Authors
Natalie Deak Jaros

EY Americas Wealth & Asset Management Co-leader and WAM Assurance Leader

Passionate about servicing the industry and community. Celebrates D&I and promotes the recognition of high performing women in the industry. Loves spending time with her husband and two daughters.

Mike Lee

EY Global Wealth & Asset Management Leader

Spirited leader for wealth and asset management. Champion for change. Driven to produce better outcomes and simplify the complex. Passionate about family, friends and sports.

Jun Li

EY Americas Wealth & Asset Management Co-leader

Passionate about diversity and inclusiveness, mentoring and sponsorship. Loves beach vacations with family, relaxing with a good book and watching his young daughter win chess matches.

Ryan Munson

EY US Wealth and Asset Management Partner

Loves servicing the alternatives industry. A top-notch family man. Married to an EY alum with 3 children. Passionate about Buffalo Bills football.

6 minute read 15 Nov 2022

Investors remain interested in alternative funds, and managers focus on traditional strengths while responding to market opportunities.

In brief
  • Investors hold their alternative allocations constant, with some investors increasing their allocations to benefit from short-term market dislocations.
  • Managers focus on traditional strengths, with offerings in illiquid credit, real estate, private equity, venture capital and opportunistic or special situations.
  • Investors are scrutinizing their managers’ talent management programs, with a focus on DEI, as well as their ESG policies, reporting, and investment criteria.
     

Uncertainty, whether sudden or gradual, can bring both opportunities and threats. During 2022, as the alternative fund industry has experienced the ongoing repercussions of the COVID-19 pandemic, instability in global economies, market volatility and central banks’ actions to avoid the threat of recession — even in the face of market decline — investors have continued to see value and remain invested in alternative funds for diversification, risk mitigation and maximization of returns. Of investors expecting to make changes, the majority state they will increase their allocations, with a focus on benefiting from short-term market dislocations and looking for long-term capital growth.

Managers, focused on their traditional strengths while being responsive to opportunities arising in the market, are increasing their product offerings in areas such as illiquid credit, real estate, private equity, venture capital, and opportunistic or special situations. In addition, managers are expanding distribution of their existing products to new customers, such as retail investors, and are incorporating differentiated investing criteria within an existing strategy, such as private market investing within a hedge fund. Exposure to digital assets remains small, as most managers indicated that digital assets comprise less than 2% of their overall portfolios. Plus, managers are offering — and investors are interested in — sustainable and impact investment products and environmental, social and governance (ESG), as many of the largest alternative investors are public pensions, endowments and foundations that have their own environmental and socially responsible commitments and requirements to fulfill.

It comes as no surprise that managers and investors alike identified their top business challenge as responding to the various market risks, with managers and investors viewing public market volatility, changing interest rates and talent management as leading concerns. In addition, both managers and investors expressed recessionary concerns in their 12-month economic outlook, with marginally heightened concerns noted for global economic indicators as compared with those specific to the US economy.

This ongoing marketplace instability has prompted alternative fund managers to think beyond immediate short-term navigation of the global economy and markets. In addition to delivering on their commitments, they are thoughtfully embracing a more long-term view of their overall business to position it for the future. Managers are becoming more active in succession planning and have engaged in or are considering engaging in strategic transactions designed to strengthen long-term business viability, with investors more actively engaged than ever in conversations with managers around their succession-planning strategies.

The ongoing demand on talent has elevated talent management as a major concern for managers and investors alike. To combat the problem, managers are applying a multipronged approach to improve talent retention by increasing compensation, prioritizing diversity and inclusiveness, and expanding flexibility, job roles and responsibilities. The majority of investors reported that scrutiny of their fund manager’s talent programs has increased, with an expanded focus on diversity, equity and inclusion (DEI). And in this post-COVID-19 environment, the industry’s workplace flexibility policies are changing from last year’s practices, with hybrid and remote work being replaced by more structured return-to-the-office work policies.

In addition to the rise of responsible and impact investing and the new market reality, managers need to prepare for the increased number of global regulatory changes and proposals that, if adopted, would require increased reporting responsibilities and the associated costs of compliance. Over half of alternative managers believe that their infrastructure is well prepared and that they are aware of the gaps that need to be addressed. Although larger firms have the resources to effectively meet these increased challenges, the cost of compliance may disproportionately impact smaller and midsized firms.

And while currently not directly impacting funds managed by alternative managers, the SEC’s increased climate disclosure proposal for public companies has contributed to an overall trend of increased investor scrutiny of managers’ corporate ESG policies and investment criteria. In response to this increased scrutiny, managers are developing ESG policies and implementing governance structures to set policy and embed ESG into their investment decision-making processes. Meeting investor ESG policy and reporting requirements is becoming increasingly important, as 26% of investors decided in 2022 not to invest with a manager because of inadequate ESG policies, a five-point gain from 2021. This increase should serve as a warning for managers to take investors’ demands for appropriate ESG policies and reporting seriously. Managers who neglect this trend may lose out on investor interest and capital allocations.

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Chapter 1

Most investors are holding their alternative allocations constant

Alternative fund managers and investors say responding to market risks is their top challenge, as managers focus on long-term growth.

During 2022, we experienced a combination of macroeconomic, geopolitical and regulatory headwinds that challenged financial markets in a way unseen perhaps since the global financial crisis of 2007–08. Significant market declines across almost all asset classes resulted from the ongoing repercussions of the COVID-19 pandemic, instability in global economies, central banks’ actions to address rampant inflation, and geopolitical conflicts. 

It comes as no surprise that managers and investors alike identified their top business challenge as responding to the various market risks, with managers and investors viewing public market volatility, changing interest rates and talent management as leading concerns. In addition, both managers and investors expressed recessionary concerns in their 12-month economic outlook, with marginally heightened concerns noted for global economic indicators as compared with those specific to the US economy.

This year’s survey results reflect the strength of investors’ appetites to invest in alternative funds, with managers (especially more established ones) continuing to pivot to diversifying product offerings and expanding their business models. The majority of investors surveyed expect to hold their alternative allocations constant, but of those expecting changes, most state they will increase their allocations in the next three years. Private credit was identified as the largest expected beneficiary, as many investors believe that this period of rising interest rates and deteriorating economic conditions will create a credit cycle that allows for interesting and lucrative investment opportunities in this space.

male and female designers working on digital tablet in tree shaped office space
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Chapter 2

Alternative fund managers pursue strategic transactions

Alternative fund managers view their primary goal as aligning with a strategic partner who will be additive to the business moving forward.

The ongoing economic instability, coupled with an industry that continues to mature, has prompted a significant increase in the number of alternative fund managers who are adopting a more long-term view of their overall business positioning. The industry’s maturation can be illustrated by managers’ pursuit of strategic transactions with both internal and external partners. Their goals are twofold: to provide short-term resources to see the business through this economic cycle, and to solidify the long-term strength and viability of their business, including preparing for succession and transference of control.

Deal value is always a key consideration, but the top factor identified by 51% of managers considering potential transactions is aligning with a partner who will be additive to the business moving forward. This may come in various forms: supplying financing to allow the business to pursue long-term growth objectives; providing relationships the partner may make available to the firm; or dispensing strategic insights and advice the partner may be able to lend to the business. Also significant is ensuring that the firm culture remains intact and that employees continue to have opportunities.

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Chapter 3

Alternative fund managers view talent retention as a top concern

The alternative fund industry’s workplace flexibility policies are changing in 2022 to more structured return-to-office work practices.

In the current competitive talent environment, alternative fund managers have to be laser-focused on talent management, and 75% reported that talent retention is their primary goal, with hiring, recruiting and onboarding talent and ensuring an inclusive culture their second and third top talent management priorities. And as talent management continues to play a much larger role in investors’ evaluations of their managers, over 55% of investors stated that relative to two to three years ago, scrutiny of their fund managers’ talent programs and policies has increased.

No conversation around talent management would be complete without a discussion about how the industry is returning to work post-pandemic. The industry’s workplace flexibility policies are changing, with more structured return-to-office policies becoming the norm. With such policies resembling a pre-COVID-19 working environment and structure, firms’ management styles need to balance competing stakeholder expectations around in-person engagement with employee flexibility desires.

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Chapter 4

Alternative fund managers expand their product offerings

Institutional investors with environmental and socially responsible commitments increase their investments in SMAs and impact funds.

“Expanding your strengths” could be the catchphrase for alternative fund managers this year, as they currently offer or plan to offer products across hedge, private equity, credit and real estate, similar to the offerings they reported three years ago. A notable exception relates to private equity’s expected incursion into opportunistic and special-situation investments. One-third of private equity managers anticipate increasing these offerings, with a smaller number of investors indicating they too would increase their allocations to take advantage of expected market dislocations.

Awareness is growing among companies, investors and shareholders that for businesses to remain viable, they must think about and manage their impact on the planet and society in new ways. This includes managers being responsive to investors’ expectations of increased integration of ESG and sustainability across their corporate policies and investment portfolios.

Many of the largest alternative investors are public pensions, endowments and foundations that have their own environmental and socially responsible commitments and requirements to meet. With 14% of investors required to invest in these products and 29% anticipating being required to invest in these products in the next two to three years, this relatively new trend is expected to continue to grow, with governance and climate risk being top areas of interest, followed by human rights and DEI.

Investors are gaining exposure to these socially responsible offerings via a variety of products, including socially responsible funds or separately managed accounts (SMAs); funds that have some portion of their assets dedicated specifically to investing to address ESG issues; and impact funds. Investors are typically accessing these structures via traditional asset managers, but this presents an opportunity for alternative fund managers, as expanding their ESG offerings is part of their growth agenda.

Businessman sitting in cafeteria working at laptop
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Chapter 5

Investors increase scrutiny of alternative managers’ ESG policies

Investors expect alternative managers to increase integration of ESG and sustainability across corporate policies and investment portfolios.

As output from the global regulatory pipeline begins to increase, the SEC and other global regulators have rolled out several significant proposals that affect the alternative fund industry ranging from regulations on private funds to reporting private fund activity, and from ESG disclosures for investment advisors and investment companies to climate-related disclosures. The proposals have contributed to a recent trend of increased investor scrutiny of managers’ ESG-related corporate and investment policies and processes. Hedge fund and private equity managers alike are responding to the increased pressure by developing corporate ESG policies. Some 57% of firms have a governance structure, and 53% have embedded ESG into their investment decision-making.

Although most managers are providing their ESG policies and procedures upon request, investors want increased transparency in reporting to demonstrate that their managers are meeting their ESG requirements. It’s interesting to note that 56% of private equity managers provide reporting on these initiatives, as do 19% of hedge fund managers.

While managers continue to evolve how they manage their corporate ESG polices and investor communications, meeting investor ESG requirements is gaining significance. In 2021, 20% of investors decided not to invest with a manager because of inadequate ESG policies. This rose to 26% in 2022 and should serve as notice for managers to not get complacent. Investor ESG demands continue to be highly evolving, and what may have been appropriate to an investor in the past may no longer be adequate.

Summary

With increased regulatory reform on the horizon, alternative fund managers are preparing their operations and infrastructure to meet their growing compliance burden. And with investors increasingly scrutinizing fund managers’ talent management programs and ESG policies, investments and reporting, managers are responding by taking measures to improve talent retention and prioritize DEI. In tandem, they’re developing ESG policies and governance structures to set policy and embed ESG into their corporate governance and investment decision-making.

About this article

Authors
Natalie Deak Jaros

EY Americas Wealth & Asset Management Co-leader and WAM Assurance Leader

Passionate about servicing the industry and community. Celebrates D&I and promotes the recognition of high performing women in the industry. Loves spending time with her husband and two daughters.

Mike Lee

EY Global Wealth & Asset Management Leader

Spirited leader for wealth and asset management. Champion for change. Driven to produce better outcomes and simplify the complex. Passionate about family, friends and sports.

Jun Li

EY Americas Wealth & Asset Management Co-leader

Passionate about diversity and inclusiveness, mentoring and sponsorship. Loves beach vacations with family, relaxing with a good book and watching his young daughter win chess matches.

Ryan Munson

EY US Wealth and Asset Management Partner

Loves servicing the alternatives industry. A top-notch family man. Married to an EY alum with 3 children. Passionate about Buffalo Bills football.