Institutional investors are increasingly becoming the main investor of hedge funds. Despite investor confidence improving in recent months, hedge funds will have to adapt their businesses to cater to new demands of this investor type. Amy Bensted, a Preqin senior analyst of the hedge funds business shares valuable insight into the role institutional investors will play in the evolution of the hedge fund industry in 2010 and beyond.
Q. How does institutional investors activity in hedge funds compare to other investor types such as portfolios of high net worths? Will they increase the amount of capital they invest in hedge funds over the next year?
Hedge funds, traditionally the domain of the high net worth individual, have witnessed an increased institutionalisation of the asset class over the past 5 years. Once limited to just endowments, family offices and a handful of pension funds, hedge funds are now being increasingly used by private sector pension funds, insurance companies and sovereign wealth funds. All of which have huge pools of readily available capital for investment. Currently we monitor about 2,500 institutional investors active in hedge funds – and our database has grown by 16% over the past 12 months.
The events of 2008 considerably dented investor confidence in the hedge fund industry: despite their outperformance compared to other types of investments, the failure of many hedge funds to produce the absolute returns they had promised coupled with high profile scandals and gating of assets left some institutional investors disenchanted with the hedge fund industry as a whole in 2008. However over 2009 investors have been more satisfied with their hedge fund investments and as a result are now more confident in their use of hedge funds than they were at the end of 2008. Over 73% of institutional investors are satisfied with hedge fund returns in 2009 up from 62% in 2008, and in turn approximately 66% of all hedge fund investors are either confident or very confident in the ability of hedge funds to perform portfolio objectives.
Last year, there was a significant contraction of the industry , with both high net worth individuals and institutional investors withdrawing capital from hedge funds. However institutional assets were the “stickiest” during this time, and institutional investors have begun to allocate capital back into the asset class over the second half of 2009. This has created a huge shift in favour of the institutional investor in hedge funds and we estimate that 72% of hedge fund assets come through institutional (including funds of funds) means, as of October 2009. A recent Preqin survey revealed that 29% of all institutional investors intend to increase the amount of capital they invest in hedge funds over 2010, with 51% maintaining their existing exposure and 20% decreasing their current exposure. However even some of those investors that are seeking to maintain their current allocation to the asset class are also looking to make investments in new funds as they seek to rebalance their portfolios and to take advantage of the latest opportunities and the best performing hedge fund strategies.
Q. How can hedge funds attract institutional investors?
Fund transparency has replaced fund performance as the greatest consideration for investors when selecting new hedge fund managers. Liquidity is also a key concern – a recent Preqin survey revealed that half of all investors are now looking for more liquidity in their hedge fund portfolios. Risk management and firm reputation have also grown in importance to hedge fund investors following the high profile hedge fund scandals which have dogged the industry in the past 12 months. In 2008 the performance record of a fund was the most important criteria institutional investors used when assessing new hedge fund opportunities, however investors now are more conservative in their reasons for investing in hedge funds, with most choosing these vehicles for portfolio diversification and to improve the risk/return profile of their portfolio rather than to produced outsized returns.
Those funds which can provide the transparency and liquidity as well as having solid back offices will be very attractive to institutional investors in 2010.
Q. Will hedge funds have to reduce their management and performance fees to cater to institutional investors?
Fees has been a huge topic in the institutional world over 2009: with several prominent hedge fund investors (notably CalPERS) having publicly called on hedge fund managers over the course of 2009. Although managers might not reduce the fees as stated on their documents – they will have to be much more flexible in fee negotiations if they are to get some institutional capital.
We surveyed investors in October this year and we found that today just 24% of institutional investors feel that hedge fund fees at their current level are justified. Approximately 60% of institutional investors believe that hedge fund fees are too high with a further 17% of investors surveyed stating that although fees are coming down, they remain too high. Institutional investors are becoming both more aware of their power to negotiate fees as well as increasingly using this power to drive fees down. When Preqin asked institutional investors whether they have tried to negotiate better terms with their hedge fund managers we found approximately half of all investors surveyed have tried to negotiate the management fees and performance fees associated with their hedge fund investments, with 62% of those investors which have attempted negotiations being successful. A further 22% of institutional investors were considering approaching negotiations with hedge fund managers to reduce the fees charged on their funds. As more investors continue to negotiate the terms associated with their hedge funds we can expect there to be a further consolidation of fees at a level below the standard “2&20” that has been the industry norm for years.
Q. What role will institutional investors play in the future success of both emerging and established hedge funds?
Institutional investors are an essential source of capital for hedge fund managers: by obtaining institutional backing emerging hedge funds become established, medium sized funds become large funds and hedge fund managers can have access to a long term source of capital. In comparison to high net worth individuals they have continued to invest in hedge funds through the market crisis and their confidence in the asset class is returning following the events of last year. Those managers which are able to cater to the demands of institutional investors will be the ones which will gain their support in 2010.
* Much of this information comes from the recently published “Preqin Global Hedge Fund Investor Review.” For more information about this review please visit www.preqin.com/hfir
