13 minute read 19 Nov 2018
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How disruption is reshaping alternative asset management

By

Mike Lo Parrino

EY Americas Financial Services Organization Private Equity Leader

Private equity veteran bringing the broad power of EY to the clients. Relationship builder. Problem tackler. Avid gardener.

13 minute read 19 Nov 2018

Our latest Global Alternative Fund and Investor Survey explores key trends in the industry, including new technology and the changing face of talent.

Sweeping change has taken hold of the financial services industry. Robotics and AI are fundamentally changing the relationship that financial institutions have with end users. The vast proliferation of data is changing the way that institutions ultimately make business decisions. Finally, the skill sets that are needed to drive the business forward are changing the mindsets of those that occupy the corner office, fundamentally changing the way that they conduct business.

You can download our 12th annual Global Alternative Fund and Investor Survey here.

The alternative fund industry now finds itself at that defining moment as well. Alternative asset managers have been busy evaluating how rapid technological innovation, changing demographics, convergence of industries and other factors have been and will continue to reshape their business.

We hope the observations and findings of the survey will help contribute to an ongoing and healthy dialogue that promotes the continued development and advancement of the global alternative fund industry.

  • From July to September 2018, Greenwich Associates conducted 102 interviews 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 under management; and 65 interviews with institutional investors (funds of funds, pension funds, endowments and foundations) representing over $2.7 trillion in assets under management.

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Chapter 1

Key strategic priorities

Similar to last year, raising assets continues to be the top strategic priority for hedge funds and private equity funds alike.

Amid a shifting industry landscape, alternative asset managers continue to juggle a number of pressing strategic business issues, many of which are being influenced, or outright driven by, disruption within the industry. Seismic shifts in technology capabilities, investor expectations related to product offerings and evolving talent profile needs are no longer forward-looking items to address — these are front and center for all alternative managers to deal with today.

Allocation to hedge funds

20%

of investors plan to decrease allocations to hedge funds in 2018, following a multi-year trend.

In many respects, the most common individual strategic priorities identified by managers are all intertwined. With most managers focused on asset growth, the successful combination of employing technology to drive investment returns in the front office while embracing new technologies and outsourcing capabilities in the back office should create an ideal landscape in which alternative investment managers can thrive.

However, infrastructure is needed to support these new tools, and the right talent model is critical to implementing and harnessing the power of today’s technology. Next-generation technology is also becoming a solution to the challenges that managers are facing both in combating margin pressure and in developing an institutional quality middle and back office that investors are coming to expect.

Asset growth and talent management top the list of alternative fund managers’ strategic priorities

Asset growth continues to be paramount for the success of individual managers and the industry as a whole. The fact that it remains the top priority comes as no surprise as it contributes to the successful financial results of managers, which is necessary to provide funding to accomplish many of the other secondary and tertiary priorities referenced here.

Talent management as a clear second priority is a change from prior years. Evolving product development and disruptive technology are forcing managers to re-evaluate their talent model to make certain their people have the right skills to be successful in this digital era.

Interestingly, the priorities between hedge fund and private equity managers are almost identical. This alignment speaks to the fact that each is facing the same issues as their business models continue to converge.

Investor allocations to alternatives remain stable, with hedge funds currently leading the way

The investors within this survey (excluding fund of fund respondents) indicated that, on average, they have almost a quarter of their assets allocated to alternatives, which is relatively unchanged from 2016.

Investors maintain a diverse portfolio of alternatives, with the current lion’s share going to hedge funds, private equity and real estate. Private credit is a smaller, but rapidly growing, component of investors’ portfolios. It also is an asset class that is often an intersection between traditional hedge fund and private equity managers, with each attempting to extend its investment capabilities and operational infrastructure to tap into investor appetite for these products.

Anticipated changes to hedge fund allocations foreshadow challenges in future fundraising efforts

Continuing a multiyear trend, the vast majority of investors expect to keep their allocations to hedge funds flat. However, by a 3:1 ratio, those that do report expected changes are more likely to forecast decreases rather than increases within their hedge fund allocations. This negative outlook has likely been influenced by a number of factors, but the hedge fund industry’s continued lackluster performance relative to perceived high costs, combined with hedge funds comprising such a large percentage of investors’ existing portfolios, is top of mind for many. Many midsize and smaller hedge fund managers are playing a zero-sum game among each other, resulting in some managers winning at the expense of others.

Many midsize and smaller hedge fund managers are playing a zero-sum game among each other, resulting in some managers winning at the expense of others.

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Chapter 2

Impact of front-office technology

Technology and data are profoundly changing how asset managers execute their strategy in the front office.

While disruption is occurring everywhere within alternative asset managers’ operations, perhaps nowhere is it more noticeable than in the front office where technology and data are profoundly changing how asset managers execute their strategy.

AI adoption

74%

of private equity managers do not expect to use AI. But only 40% of hedge fund managers still hold that expectation.

Various studies estimate that 90% of the data in the world has only been created in the last two years. Harnessing this information to identify investment opportunities and create investment theses is paramount to successful investment programs.

Artificial intelligence and machine learning are more often being used by managers across asset classes and investment strategies to make actual investment decisions. Automation of various facets of the investment process is being embraced, and managers who are able to complement their operations with these tools are gaining significant competitive advantages.

The impact of artificial intelligence on front-office models is significant

In the past year, we saw 300% growth in the use of artificial intelligence (AI) in the front office among hedge fund managers and 100% growth in the proportion that expect to use AI in the near future.

Hedge funds have embraced these capabilities more quickly as their investment strategy of analyzing large volumes of securities and economic data lends itself more to leveraging software and machine learning as part of the trade analysis and execution process.

By contrast, most private equity managers have not yet identified business cases to justify investing in AI. We expect that as private equity managers become more comfortable with its functional ability, we will see exponential growth as we are currently witnessing with hedge fund managers.

Use of big data continues to proliferate

The majority of hedge funds either use or are evaluating “next-gen” data for use cases in their investing — a material increase from two years ago. During 2018, only 30% of hedge fund managers did not expect to use next-gen data in their investment process, a decline from almost 50% who made that statement just two years ago.

Private equity managers are further behind in their use of next-gen data, as the use cases for private equity may be more limited. Currently, nearly half of private equity managers do not use, and do not expect to use, next-gen data in the future. However, like the shift that gradually occurred for hedge fund managers, we expect private equity to follow suit.

Use cases and availability of next-gen data continues to grow

Next-gen data is increasingly available from traditional market data vendors — a trend that can have the unintended consequence of accelerating the commoditization of data sources that were novel just a few years ago.

Many managers see the greatest value in data sets that are coming directly from specific sources: satellite imagery firms, credit card processors, etc. There is added value, which often makes this data more expensive, in information that has not yet been widely disseminated by the broader market.

Nearly 60% of hedge funds who use next-generation data are doing so to support their fundamental approach. The adoption rate among private equity managers is lower, but increasing as these managers continue to progress on the digital journey.

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Chapter 3

Talent and growth

Attracting and retaining talent has never been more difficult — or more important — to a manager’s short- and long-term success.

The immense demand for talent and, specifically, for people with different skill sets than traditional pure finance backgrounds, coupled with a rapidly different generational profile of talent with different desires, are landing a one-two punch that is significantly disrupting alternative asset manager talent programs.

Talent attrition

40%

of hedge fund managers and 50% of private equity managers cited talent attrition as one of the industry’s top three risks.

Across the front, middle and back office, alternative asset managers recognize the need to be hiring individuals who have the ability to interact with the advanced technology solutions that are being used. Data scientists, engineers and programmers are just some of the nontraditional backgrounds that more frequently are supporting, working alongside and leading managers’ operations.

As a result of the changing talent needs, attracting and retaining talent has never been more difficult — or more important — to a manager’s short- and long-term success.

Given the cost and potential disruptions caused by hiring and downsizing, alternative managers are increasingly turning towards contract employees to fill skill/resource gaps in operational roles.

Talent profiles are rapidly changing to keep pace with industry needs

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. Technology advancements, product development expansion, and the realization that different and diverse points of view will drive better investment decisions are just some of the reasons for this massive pivot about how managers think about their people.

This trend is playing itself out in both the front and back office, where nearly half of managers reported that they have changed the profile of talent they are looking to hire relative to five to ten years ago.

Managers are seeking diversity and data/analytics expertise

As they evolve their workforce, hedge fund and private equity managers have slightly different priorities.

Hedge funds, where data and analytics are more heavily utilized as part of the trading process, are seeking out candidates with data analytics experience, as well as those with coding/programming skills.

Private equity managers, on the other hand, are most focused on gender and cultural diversity, particularly in the front office. These firms view a more diverse organization as critical to being able to better source, evaluate and manage new investment opportunities.

Contract workers are seen as an increasingly viable solution to complement a full-time workforce

As firms grapple with the increasing costs of hiring and retaining talent, many are looking for cost-efficient ways to scale up or down rapidly depending on business needs. Given the cost and potential disruptions caused by hiring and downsizing, alternative managers are increasingly turning towards contract employees to fill skill/resource gaps in operational roles. This trend has been enabled by the increasing use of technology, which has reduced the need for “institutional” knowledge among their employees.

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Chapter 4

Innovating beyond fee pressure

The disruptions impacting the non-investment operating model are nearly as dramatic as what is playing out in the front office.

The disruptions impacting the non-investment operating model are nearly as dramatic as what is playing out in the front office.

Prioritizing cost management

50%

of allocators feel cost management should be the top priority for their managers.

The innovation and disruption impacting the non-investment operating model are nearly as dramatic as what is playing out in the front office. Managers are innovating operations that both pass the rigor of due diligence prerequisites as well as the manager’s own needs, while also being scalable and aligning fees with investors. Customized fee models are being deployed that deviate significantly from the “2 and 20” model that is widely referenced in media reports but that is less used in practice.

Technology is being used to perform tasks that would have required a small army of people in the past. Outsourcing capabilities from service providers continue to become more sophisticated. All of these levers provide opportunities for managers to combat fee pressure while modernizing operations that are responsive to this technologically advanced era.

Investors want alternative managers to embrace innovation focused on cost management

Investors are clear where they would like managers to focus: cost management. Fee pressure and the analysis of performance relative to cost continue to dominate many of the industry conversations. While many of the other priorities here have an indirect impact on investor returns, costs have a direct correlation. As such, it is not surprising that a majority of allocators want their managers to be more innovative in cost management, with nearly 50% indicating this should be the top priority.

After costs, investors have a number of areas they would like their managers to focus including the importance of talent and leadership succession and adoption of technology.

Investor satisfaction with fees is not improving

Likely exacerbated by strong market performance among non-alternatives and alternatives performance (particularly among hedge funds) that has varied but broadly been mediocre, there has been no improvement in investor sentiment towards the fees they pay their alternative fund managers. Nearly 40% of investors say they are not satisfied at all with the fees of the industry. This comes even after years of industry concessions on fees, some of which have been influenced by the preponderance of lower-cost alternatives that continue to resonate well with many in the investor community.

When asked what the most important expense drivers were in their decision to invest with a manager, investors said roughly 45% of the decision was driven by management fees and 30% of the decision was driven by performance fees. Trading and operating costs made up the remainder.

Fee structures are rapidly evolving

Amid investor dissatisfaction with traditional flat fee models, many managers are responding via customization of fee structures that are more palatable to investors. Nearly 60% of hedge fund and private equity managers alike have adopted, or are considering, some non-traditional fee offering in an attempt to attract investor capital.

Of those managers utilizing nontraditional fee structures, the most common approach for both groups is implementing a hurdle rate before charging performance. Whether the hurdle is a fixed percentage or pegged against a benchmark, managers appear open to designing the incentive fee in a manner that more closely compensates managers for alpha generation. The similarities in approach between hedge funds and private equity diverge after this top response.

Summary

This year’s Global Alternative Fund and Investor Survey sought out the points of view of both hedge fund and private equity managers, as well as institutional investors who allocate to both asset classes as well as broadly across alternatives. Download the full report (pdf).

About this article

By

Mike Lo Parrino

EY Americas Financial Services Organization Private Equity Leader

Private equity veteran bringing the broad power of EY to the clients. Relationship builder. Problem tackler. Avid gardener.