Alternative Investment Industry Outlook for Q1 and Beyond in 2018

INTRODUCTION

Following a positive 2017 for both hedge funds and private equity including 12 months of outperformance for hedge funds and the best year for private equity investments and exits, investors globally, including various institutions, family offices and high-net-worth individuals, are on track to continue allocating to alternative investments this year. Yet the positive momentum doesn’t go without continued investor concerns -- more specifically for hedge funds, both their fees and performance. Additionally, with respect to hedge fund launches, long/short equity strategies still continue to dominate. However, continuing on from 2017, the industry now has new dedicated strategy categories due to the plethora of new launches focused on cryptocurrency, artificial intelligence and alternative risk premia.

INVESTOR OUTLOOK

Alternative Asset Preference

Institutional investors globally continue to express interest in alternatives. According to a Preqin report from the end of last year titled “Hedge Fund Spotlight,” private equity and real estate had the most assets, where 56% of investors had exposure to both these asset classes, followed by hedge funds (46%), and then natural resources (38%), private debt (34%) and infrastructure (33%).

Hedge Fund Spotlight  

Capital introductions professionals from both boutique and top-tier prime brokerage firms told EisnerAmper that investors across the globe look to maintain hedge funds in their portfolios. They said that one common theme amongst allocators in the U.S., Europe and Asia was a preference toward non-U.S. strategies, given they feel those regions, including Europe, Asia and emerging markets, present more attractive investment opportunities in the current market environment. More specifically, they noted that family offices globally favor non-U.S. managers focused on long/short equity or activist investing.

Additionally, EisnerAmper learned of the following allocator preferences specific to the below mentioned continents:

• In the U.S., various investor groups are seeking multi-strategy managers and niche/ differentiated strategies. In addition, there continues to be a strong favoritism to sector-focused managers in health care and technology, media and telecommunications (“TMT”).
• In Europe, there is a strong demand for liquid alternatives.
• In Asia, just like the U.S, there is a consensus toward favoring differentiated strategies. In addition, investors there are interested in deploying capital to those who have the ability to add short-side alpha instead of just using shorts for hedging.

Private Equity Perspective

Investors will continue to allocate capital to private equity funds, with the majority of it going to fewer yet larger funds, according to Pitchbook. Further, managers continue to take advantage of the positive fundraising environment and launch follow-on funds to their predecessors, which are expected to have even more assets.

“Private equity continues to ride the wave after setting fundraising records in 2017, and market conditions suggest that this trend is likely to continue throughout 2018 despite certain large institutional investors beginning to proceed with caution,” said Elena Newman, partner in EisnerAmper’s Financial Services Group. “Also, the pro-business elements of tax reform should help maintain the buoyancy of an active, though high-priced, deal-making environment. In this environment, a manager’s operations and ability to leverage rapidly-advancing technology to meet investor demands will be a competitive advantage.”

INVESTOR CONCERNS

Investors concur that looking ahead this year, their biggest concerns include performance and fees for hedge funds.

The Preqin report revealed that investors were concerned about hedge funds’ three-year performance and, in addition, had a negative outlook on managers’ performance in general.  Over the past three years, the majority of investors surveyed (70%) said portfolios’ performance fell short of expectations. Only 20% said they met expectations.

Regarding fees, the report stated that 50% of investors are looking to change hedge funds’ fees, driven by returns relative to cost.

Philip DeRosa, managing director in EisnerAmper’s Connecticut office, said he continues to see clients’ and prospects’ fee structures, in an effort to accommodate allocators, move from the traditional ‘2/20’ to a typical management fee (1.25-1.50%), incentive fee (still about 20%), and – because of the underperformance in the hedge fund industry – to a hurdle rate.

“Since at least the last quarter of 2017, we continue to see managers’ fees move in this direction to meet investor demands who can determine whether or not they can outperform either a risk-free rate or a benchmark rate.”

LAUNCHES

In the first quarter of 2018, EisnerAmper has seen a continuation of new launches focused on long/short equity strategies.  They are a combination of generalist and sector focused strategies including TMT and financial services.

“Long/short equity managers still dominate the landscape of launches that I see,” said Jaclyn Greco, manager in the firm’s Financial Services group. “In addition to some very large launches with $1bln+ planned for Q2 and Q3 this year, we’re seeing more and more fund managers launching with the use of separately managed accounts (“SMA”) allowing investors greater transparency and control.  The size of these SMAs has been as low as $10mm and as high as $400mm with some of the larger SMA allocators”

Additionally, the industry has defined new categories of hedge fund strategies due to the abundance of launches focused on alternative risk premia, cryptocurrency/blockchain and artificial intelligence, which began in 2017. These strategies have also garnered lots of investor interest.

“2017 saw the rise of cryptocurrency funds with the West Coast dominating this trend,” said Eugene Tetlow, manager in the firm’s Financial Services Group based in San Francisco. “So far in 2018, cryptocurrencies and Bitcoin in particular have been off to a slow start.  It will be interesting to see how this emerging asset class fares and whether we see a continuation in the growth of crypto funds or a correction in the market. 

CONCLUSION

If the first quarter is any indication of how 2018 should play out, then hedge funds and private equity firms should both fare well this year on the heels of increased investor inflows, especially dedicated to the newest strategies in bitcoin and AI. However, concerns will continue to persevere with respect to hedge funds justifying their fees, especially in terms of their performance.

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