Whisper it Quietly – the Stealth Movement of Alternatives into Mainstream Asset Management

An issue of perception

Before the crisis of 2008, Alternative providers, more specifically Private Equity firms and Hedge Funds, were largely shrouded in mystery and urban myth. Tales of Fund Managers earning billions, sat on their laptop in the Cayman Islands, or PE funds swooping in on M&A transactions at the last minute as ‘corporate vultures’, were rife. Leverage was the name of the game and stories of personal wealth creation causing a demolition of shareholder value and shattered careers were frequently reported by the mainstream media and business pages alike. The Principals and Founders of these outfits were the modern day embodiment of Gordon Gekko and consequently vilified. From 2005 – 2007, Global Alternatives AUM nearly doubled from $2.9 trillion to $5.7 trillion.

The post crisis environment

In light of recent difficult economic conditions and an increased focus on balance sheet risk and the need for tangible investment returns, “alternatives” as an asset class has once again rotated into prime focus. Genuine ‘alpha’ creation, although not precisely defined, has become the key priority for most Institutional investors. Dusting themselves down admirably from the crisis, and with some vital legislation enacted to govern transparency and perceived riski, Hedge Fund providers, Private Equity Firms and Real Estate players have once again become a more than credible source of returns. At the end of 2011, Global Alternatives AUM stood at a staggering $6.5 trillion, having grown at a 5 year rate of over seven times that of traditional asset classesii.

Recent pressure on fees notwithstanding, the trend is clear – Alternatives Managers and Long Only Investors are increasingly blending into one.

Alternative Managers running “traditional” strategies

The opportunity for niche boutiques to enter the mainstream has not been lost. Deutsche Bank’s prime brokerage division recently surveyed 60 global Hedge Funds with $528 billion AUM and found that over half offered at least one mainstream productiii. An additional 20% of respondents to the survey not currently offering such a product said they would consider doing so in the futureiv. Despite the common misconception, this phenomenon is not an entirely recent development, with many alternatives firms already having established a three year track record in such vehicles.

Further, Deutsche suggests the following combined statistics:

  • Combined total of assets run by alternative mutual funds, $238 billion.
  • Alternative UCITS products, $222 billion.
  • Long-only funds run by hedge fund managers, $177 billion.
  • Total $637 billion, equivalent to over a quarter of the size of the $2.51 trillion global hedge fund industry.

Almost half of the managers who had embraced non-traditional hedge funds said that these products had driven more than 50% of their new business since 2008, according to Deutsche Bank.

How should traditional Asset Managers respond?

Of course having a strong performing product or strategies is vital for any growth. However, regardless of this, many mainstream managers are under pressure, particularly from retail investors, to clarify both product and strategy. Additionally a lack of track recordv and credibility provide added headwind for winning business. Faced with these challenges, the response to date has broadly been twofold:

  • Purchasing a boutique or team lift out
  • Strategic partnerships with niche alternatives managers

The former has provided far more evidence of failure than success as cultural issues and internal conflicts have jeopardised long term integration. The latter circumvents this to a degree, with managers able to ‘stress test’ cultural and strategic fit. However, without an option to purchase either part of or the entire boutique dependent on success, managers can end up serving as a very lucrative distribution arm for the boutique with little in return.

For those wishing to grow capabilities organically, what are the primary challenges? Our feedback suggests that the two biggest factors challenging traditional asset managers and their diversification into alternatives are:

  1. Risk Management
  2. Technical Product Expertise of the Sales force
  3. Overall Understanding of clients’ needs

i) Risk Management

Both retail and institutional investors are demanding far more from compliance, performance reporting and risk management. This is driven in part by the derivatives exposure such strategies employ and has meant that a consideration of a dedicated Chief Risk Officer role is paramount. Institutional investors are also increasingly outsourcing performance management and reporting meaning that asset managers are now competing with consultants in this area.

Responding to this from a hiring perspective has been challenging. A lack of such talent in traditional competitors (experience of dealing with derivatives etc.) has meant a closer examination of other sources of candidates. The two primary areas appear to be Hedge Funds and the sell side Capital Markets teams. A premium is also in evidence for individuals who have previously overseen build outs of reporting infrastructure and systems. Despite an increasing fluidity of workers from ‘buy to sell’ side, issues of compensation and cultural fit are of critical importance for successful outcomes. Search firms who are able to access and have a track record in both areas are well placed to assist clients.

ii) Technical Product Expertise of the Sales force

Articulating alternative strategies and investment methods to clients arguably presents a greater challenge than traditional products. The increased complexity of strategies and depth of consultant and client investigation has meant some firms have sought to bolster their client portfolio or product specialist teams with highly investment literate (often ex investors) talent. Such individuals are often used in a quasi sales role.

Other players have sought new talent from less traditional sources, again including Hedge Funds and Investment Banks. However this strategy is not without challenges. Cultural assimilation and suitability to the buy side are critical. Equally individuals often have to adapt to a decrease in geographical responsibility, given many alternatives managers run a very lean but geographically diverse sales team. Despite the recent pressure on sell side compensation bringing levels closer to the buy side, sales professionals in both Hedge Funds and Investment Banks are often used to formulaic and potentially lucrative  remuneration schemes which reward success but are also a product of the higher revenues achievable within the asset class. For many traditional managers a consideration of a separate compensation structure is needed although this can present obvious organisational problems where the alternatives specialists are part of a larger distribution effort.

Some have chosen to respond by revamping sales training, education and product communication (marketing information etc.) to bridge this perceived shortfall. In our experience, this needs to happen in conjunction with a conscious upgrading of available sales talent.

One trend that has emerged, is a genuine requirement for sales professionals across both traditional and alternatives strategies to approach new prospective clients in a measured and consultative manner rather than being a focused, ‘product pusher’ which can be the perception particularly with higher margin products (i.e. alternatives). Individuals who possess both the technical expertise and emotional EQ to achieve this are highly sought after.

iii) Overall Understanding of clients’ needs

This is a third trend we have witnessed. Interestingly, both retail and institutional investors consider the understanding of client needs as fairly poor for both traditional and specialist managersvi. This trend has meant and will mean an increasing importance on client servicing functions and empathy of the sales force. Those firms with high quality and dedicated client servicing professionals will be well placed to gain market share. Indeed the talent shift witnessed from the consultancy community to asset managers is likely to continue, as specialist client servicing or product specialist roles become required. Firms who can respond to these perceived short comings will be able to differentiate themselves from the majority of competitors.

Conclusion

To conclude, despite the relative headwind and challenges that exist for firms seeking to diversify into alternatives, the investment demand within the asset class seems set to continue.  For long term business success, alternatives could be considered a separate business, and configured as such. Dedicated leadership teams should be earmarked before embarking on a build out, as well as opportunities to leverage existing sales and reporting capabilities.  Scalability of investment capabilities should also be considered.

As this article briefly demonstrates, the arduous path to creating a long term sustainable diversification is not without its hurdles. However for those players who consider the factors above and have a clear and coherent strategy, there is no reason that long term alternatives success is not achievable.

i Chief amongst these in Europe are AIFMD and UCITS.
ii See McKinsey & Co, “The Mainstreaming of Alternative Investments. Fuelling the Next Wave of Growth” - p.5
iii See Deutsche Bank report November 2013 – ‘From alternatives to mainstream:
Hedge funds’ changing role in the asset management industry’.
iv ibid
v A 3 year track record is usually the minimum required from Institutional investors.
vi See Exhibit 7 - McKinsey & Co, “The Mainstreaming of Alternative Investments. Fuelling the Next Wave of Growth”.