Growing capital inflows and a larger, more diverse investor base create the needed conditions for the alternatives industry to mature. As discussed, demand for alternative assets is growing - institutional investors' allocations to alternatives sit between 20% to 25% with private capital receiving a greater share.3
But more than just experiencing the right conditions, managers must feel the push to follow through in their practices to actually realize industry maturation. Regulators, a broadening alternative asset investor base, and the increasing congestion of the manager landscape are all applying different categories of pressure.
Cash is flowing into alternative investments at a record rate, and the field is becoming increasingly crowded with new private fund launches and opportunities. From 2010 to 2020, the number of private equity funds roughly doubled4. Though hedge funds had a shakeout in 2020 as the first-quarter market drop was the fatal blow to many already-underperforming funds, the sector has seen healthy performance since, and the conditions should be improved for hedge fund startups this year.
To cut through the clutter and stand out to limited partners (LPs), general partners (GPs) are turning to emerging investment and distribution strategies. But the quest to set oneself apart comes with its own challenges surrounding one's existing investor base. If managers choose to engage with any of these alternative investing trends, they'll have to be prepared to communicate with their original investors about their plans - ensuring them that new products, funds, or distribution strategies won't take away attention and resources from their original approaches.
As investor allocations to private capital increase so do LPs' appetites to gain greater insight and visibility into their GPs' investment process and operations.
This trend has been led by larger LPs who have requested customized processes and specific accommodations. In turn, this has resulted in more segregated mandates, carve outs and side pockets, parallel investments, side letters with different terms, and joint ventures for large LPs, along with more complexity for GP operations. As large investors seek greater customization, GPs are often managing LP relations approaches as they go, creating multiple service models, varying expectations, and increasing difficulty in tracking and reporting systematically.
The industry is also still figuring out how to meet LPs' transparency expectations. Due to a lack of well-defined standard reporting and analytics practices within the private capital industry, data portability and asset class comparability within their portfolios can become a significant challenge for LPs. Fintech vendors have identified this opportunity and are developing solutions that lean on artificial intelligence (AI) and machine learning to help LPs pull transparency data from GP statements. While this removes the pressure from GPs to some degree, it also highlights the opportunity they face to better anticipate their LPs' needs.
Ultimately, investors are seeking the kind of investment experience we're all accustomed to as consumers - rather than relying on quarterly or monthly statements per individual fund, they want to be able to log in to a digital platform and quickly see a real-time view of their portfolio of alternative investments, as well as perform their own analysis within the same tool. In addition, they seek more standardized, consumable and combinable reporting to help them paint a clearer picture of their entire portfolios, liquid and alternative investments alike. As a result, managers face the opportunity to anticipate these LP needs and equip their back-office operations with robust investor-facing technology that meets these needs.
At the same time, increasing regulation, as well as greater scrutiny as the industry grows, means more attention and focus must go to governance and compliance. Managers need good resources to help with objectives such as:
Financial centers are actively developing their legal and regulatory framework to build competitive advantage while adopting international best practices.
Recent global developments indicate a growing focus on private capital and a drive to build a flexible but well-governed regulatory framework which gives managers and investors the requisite information and protection. This is no longer a niche market for a few sophisticated participants - it is realigning to a much broader community of investors and a deeper product set.
Variable Capital Companies framework was introduced in Singapore at the beginning of 2020 which is already starting to be used by private capital managers.
The Hong Kong Limited Partnership Fund bill - which is attractive as a flexible private fund structure and offers a competitive alternative to other locations - was passed in July 2020 and took effect August 2020.
The region is actively exploring passporting whereby funds based in one jurisdiction can be actively promoted in other participating countries similar to that in place in the EU.
Luxembourg has seen significant success from the flexible Reserved Alternative Investment Fund regulation for private capital managers which was launched in 2016 and is now well established for private capital funds.
Ireland has enacted the Investment Limited Partnerships (Amendment) Bill 2020 which paves the way for significant growth across Ireland's private equity infrastructure, renewables and real estate offerings.
The UK regulator has introduced new rules governing funds which invest in inherently illiquid assets ("FIIAs") designed to reassure investors and aligned to private capital and real estate.
Guernsey's Private Investment Fund (PIF) regime introduced in 2016 offers an expedited route to market for eligible funds and is set to be enhanced with two new models, removing the requirement for manager involvement.
U.S. defined contribution plans take a step toward welcoming alternative investments thanks to a Department of Labor communication. While it will still be a slow and steady journey, managers interested in making their funds available to retail investors through DC plans will have to plot out their transparency measures carefully to comply with standards necessary in DC plans.
Cayman introduced a dedicated private funds law which requires new registration and ongoing oversight obligations which include asset verification and cash monitoring.
Four emerging trends shaping managers' products, strategies and distribution decisions
Transitions to hybrid alternative strategies
As some alternative asset managers encounter the pressure of an increasingly crowded market, many have eyed a hybrid approach as a way to differentiate themselves to investors.
Many pure-play hedge funds have expanded into closed-end private structures – private equity being the most predominant, alongside private debt, real estate and infrastructure. For many hedge fund managers, this serves as a hedge against the performance of the hedge fund industry itself, which has been outperformed by the S&P 500 for the vast majority of the past decade. Meanwhile, institutional investors’ allocations to private equity have grown to 26% in 2019 and 2020, up from 18% in 2018. On pure-play private equity side, some shops are exploring open-ended fund structures, but the inherent imbalance of portfolio versus investor liquidity is a persistent challenge.
The journey to a new alternative investment strategy is neither quick nor simple. As managers try their hand at new alternatives strategies in order to stand out from the pack, they must have a clear path forward, the right expertise, and a plan to transparently communicate the change with their existing investors.
The rise of SPACs
Special purpose acquisition companies, or SPACs, are blank check companies that exist solely to raise capital from investors. These publicly listed SPACs sell shares and hold investors’ money over the course of two years, during which they must acquire another company or return the capital at the end of the period. As their use has trended upward recently, they’ve begun to compete for GPs’ time and resources, while also adding to their exit options for investments.
SPACs originated in the 1990s but skyrocketed in popularity in 2020. In 2016, SPAC IPOs raised $3.5 billion, while in 2020 SPAC IPOs raised $66 billion – making up nearly half of the U.S.’s 2020 IPO activity. This SPAC boom was brought on by pandemic-fueled volatility in public markets. GPs saw opportunity in opening SPACs and merging with companies while markets were down, knowing that if the acquired company can make it through the pandemic, they’d see impressive returns over time.
However, this investment vehicle poses key risks and concerns for managers and their investors. If a long-time private equity manager decides to foray into the SPAC space, it could encounter a learning curve when it comes to shareholder relations if it’s accustomed to communicating only with experienced institutional investors on the private market side.
Managers who choose to build out a SPAC offering while maintaining their traditional alternative assets will also have to consider how to provide transparency to their investors about the returns and benefits of the SPAC’s operations, as well as the manager’s time and priorities. If they fail to keep their alternative asset investors in the loop with their new SPAC ventures, they may risk losing goodwill or alienating their broader investor base.
A growing embrace of secondary market transactions
With more and more capital injected into the private capital sector leading to a greater number of deals occurring, the secondary market will continue to see increased activity. This is further egged on by GPs’ and LPs’ growing motivation to actively manage their alternative investment portfolios, making the secondary market more attractive and inviting to more investors, as well as by spikes in demand for liquidity brought on by managers seeking additional exit options during the pandemic.
As the secondary market becomes more active simply due to a broader shift toward private capital investing and a desire to actively manage their illiquid portfolios, the industry has seen an embrace of specialist secondary fund strategies, as well as an absence of exits occurring at significant discounts.
To a smaller yet still significant degree, managers’ desire for longer holding periods while needing to give original investors liquidity within the fund's legal life also drives secondary market activity. This gives way to more special purpose acquisition secondary transactions where GPs will team up with large LPs and purchase a holding out of its original fund and offer existing fund investors the choice of liquidity or rolling their investment over into the new vehicle.
Expanded distribution with U.S. defined contribution plans
In June 2020, the U.S. Department of Labor issued a communication clarifying the use of private equity assets in DC plans. The DOL concluded that a “plan fiduciary would not, in the view of the Department, violate the fiduciary’s duties under section 403 and 404 of ERISA solely because the fiduciary offers a professionally managed asset allocation fund with a private equity component as a designated investment alternative for an ERISA covered individual account plan in the manner described in this letter.”
Outside of the U.S., other countries have long embraced the addition of alternative assets in retirement plans. Australia, for instance, has widely embraced alternatives for superannuation plans, particularly for large sponsors with a high employee count, offering risk tolerance needed for illiquid assets. And on both of the core challenges of alternatives in DC plans – frequent valuation and liquidity – Australian superannuation plans have found a way to work with alternative asset managers.
However, until now, the U.S. had not received clear direction on including alternative assets in DC plans, and the DOL’s communication could open alternatives to a new market of investors. It is important to note this will be a slow and steady journey – not an opening of the floodgates. Building new and complex investment options into DC plans often falls to HR professionals, unlike DB plans which are almost solely overseen by experienced investment professionals. With this new kind of target audience, managers will have to finetune their strategy, partners, sales approaches and communication style if they want to be involved in this market.
