November 2011

ALTERNATIVES: Confidence boost

Leg-upHedge funds received negative publicity throughout the financial crisis, but Michael Hornsby and Kerry Nichol of Ernst & Young say investors are now demonstrating renewed belief in the alternative investment industry.
Investors generally allocate money to alternative investment funds, such as hedge funds and real estate, in order to diversify their portfolio, access potentially enhanced returns, and benefit from the greater flexibility to focus on a specific investment theme, such as clean energy in the private equity sector. Funds of alternative funds offer investors further portfolio diversification and access to specialist asset managers. A fund of funds will typically have between ten and 80 underlying funds. Historically, they have been a popular choice among small and medium-sized investors as well as larger investors who wanted to enter unfamiliar markets they are unwilling or unable to enter via single funds. Funds of funds offer immediate diversified access to a variety of strategies, managers and markets. An optimal portfolio allocation for the average investor might include a 20% allocation to alternative investments and an 80% allocation to a diversified global securities portfolio. Studies have shown that combining assets which have a low correlation with each
other, such as gold, private equity, and bonds, allows a reduction of risk without necessarily sacrificing returns. According to a recent Investment Intentions Survey conducted by the European Association for Investors in non-listed real estate vehicles (INREV), respondents indicated that they had allocated about 18% of their portfolios to alternatives, 9% thereof to real estate. The 2010 Russell Survey found that, on average, institutional investors allocated roughly the same portion of their alternatives portfolio to real estate and hedge funds, slightly less to private equity, and a small portion to commodities and infrastructure. Alternative investment funds, however, have their disadvantages. These include:
• Higher levels of risk
• Lower levels of investor protection because of the lower levels of regulation
• Lower levels of transparency
• Lower levels of liquidity: for example, divestments may only be possible at certain times
• Higher levels of costs: fees in alternative investment funds are generally higher than in traditional investment funds. Investors in funds of funds may pay fees at two levels – at the fund of fund level and at the underlying fund level Less pay, reduced talent
The financial crisis brought with it challenges for the alternative investment fund industry. For example, many managers of open-ended funds implement restrictions on redemptions simply to survive. Ernst & Young’s 2010 global hedge fund survey, Restoring the balance (conducted in association with Greenwich Associates), found that managers had increased liquidity and reduced management and incentive fees in an attempt to retain and attract capital. But this had a negative impact on their ability to retain and attract talent as reduced fees have resulted in key talent being paid less. Investors continue to ask managers to alter compensation models, moving away from pure cash compensation towards either holding more equity interests in the fund vehicles themselves or in the general partnerships/ management companies, or by the introduction of a deferred compensation model with a claw-back mechanism. Investors underline the need for an increased level of transparency, with approximately 40% of investors surveyed seeking full portfolio transparency. Investors ranked largest holdings, asset class and portfolio volatility, liquidity and risk information among the most important information. Surprisingly, counterparty risk or stress testing were not identified as being key information by investors; however, this could be interpreted as being “a given” post-Lehman. Alternative Ucits boosted
Traditionally, alternative asset classes have been accessible primarily to sophisticated, well-informed or institutional investors. Post-2008, investors have been focusing on transparency and liquidity, but also looking for brand recognition, investment diversification, and substantial levels of regulatory and governance oversight. Alternative Ucits funds meet these requirements, yet still offer exposure to some alternative fund strategies. Consequently, such funds have seen increased interest. Some of the alternative Ucits’ growth has also been driven by alternative managers wishing to broaden their investor base, benefiting from the opportunity to distribute the Ucits within Europe and internationally, some by traditional managers wishing to offer their investors a wider range of products and take a share of the higher return hedge fund market. Not being limited to institutional investors,alternative Ucits have allowed retail investors “a piece of the pie” in terms of higher returns and the exposure to alternative fund strategies. Regulatory impact
Regulation is one of the key challenges for the alternative asset management industry. Regulatory developments in Europe, such as the Alternative Investment Fund Managers (Aifm) directive, Solvency II and over-the-counter derivatives regulation are expected to raise barriers to entry and increase the costs of doing business. Set to become applicable in mid-2013, the Aifm directive will have a profound structural impact on the alternative asset management industry both in Europe and internationally. While the main focus is on managers, the directive will not only impact European Union and non-EU managers, but also EU and non-EU domiciled alternative investment funds, the service providers to these funds and their investors. Being a regulatory response to address some of the challenges highlighted during the financial crisis, the Aifm directive introduces a number of requirements regarding transparency for investors, remuneration of managers, periodic disclosure requirements to investors on assets subject to special arrangements arising from their illiquid nature and liquidity management obligations, governance, and minimum capital requirements. However, the key question will be how investors react to products compliant with the Aifm directive. Three comments can be made in that respect. First, many institutional investors are themselves subject to requirements limiting the amounts that they can invest in less regulated products – regulatory or self-imposed. Second, the Aifm directive marketing provisions may severely limit European investors’ access to non-Aifm directive compliant products from 2018, when national private placement regimes may be phased out and replaced by the passport regime as the only way to market alternative investment funds within Europe. Third, compliant products offer investors a new level of regulatory comfort. From a global perspective, the directive is likely to become, for many investors, a minimum standard on governance, compliance and transparency. We believe that investors will welcome this, facilitating the establishment of a globally recognised alternative investment fund brand that could become the parallel to the Ucits brand for non-Ucits products. On the other hand, the directive is expected to increase the compliance burden, increase operating costs and as a result reduce the risk/return competitive advantage offered to investors. We believe that, in response, many asset management groups will opt to offer their current and future investors a range of products comprising those subject to higher levels of regulation, such as the Aifm directive, as well as unregulated ones. Therefore, many will consider setting up parallel regulated and unregulated alternative funds. Delivering promises
Institutional investors are planning to increase their alternatives allocation by 5% over the next two to three years. To retain and attract capital, alternative investment managers will need to ensure that they deliver on their promise of consistent superior performance, while continuing to meet the challenges of regulation and investor expectations, without morphing back into the broad traditional investment fund industry. Michael Hornsby is the real estate leader, and Kerry Nichol is partner, asset management, at Ernst & Young, Luxembourg ©2011 funds europe

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