Aura looks at how hedge funds need to understand and respond to sovereign wealth funds’ concerns and priorities.
Certain themes emerged during the discussions including the consensus that after a period of disappointing returns, sovereign investors now appear more bullish on hedge funds’ prospects. But to gain allocations, hedge funds need to understand SWFs’ concerns and priorities, and articulate how changes in the hedge fund industry address them.
Hedge Funds are Evolving
The idea that hedge funds lack adequate governance structures, have poor controls and weak risk frameworks is outdated – and was always an unfair generalisation. But the sector’s historical lack of transparency remains ingrained in many investors’ minds and needs to be challenged by asset managers.
When talking to SWFs, hedge funds need to emphasise their similarities with the broader asset management industry. In co-mingled funds, hedge funds necessarily protect portfolio secrecy; it is their prime intellectual property (although there is daily transparency in managed accounts). However, most hedge funds now produce account risk factor statements and detailed data to enable clients to manage risks and asset allocation – SWFs welcome this transparency.
Institutionalisation is Attractive
Hedge funds are changing in other ways that are a selling point for SWFs. Recent headlines1 herald hedge fund growth of $2.5 trillion in the coming years, while others note that few new funds are being created. The two facts are not contradictory: the sector is growing and barriers to entry have increased, largely as a result of regulatory changes. However some of those barriers, such as in EMEA the revised Markets in Financial Instruments Directive (MIFID II) and Alternative Investment Fund Managers Directive (AIFMD), are easier to manage than fund managers may think.
Evolution is being accelerated by hedge funds’ average lifespan of just 5-7 years. With few new entrants and a diminishing pool of surviving funds, a transformation is occurring. Hedge funds were traditionally entrepreneurial vehicles, often spun out of banks or asset managers. Now they are becoming mature and more institutionalised, making them more appealing to SWFs.
In light of these structural changes within the hedge fund industry, those hedge fund managers seeking SWF mandates should emphasise their firms’ stability and maturity. There is strong investor interest in succession strategies given that many funds have in the past been started by, and centred around, an individual. Hedge funds should be ready for prospective investors to make numerous visits to a hedge fund and talk to multiple team members to understand the firm’s culture and mind set.
Being in Control Matters
The ways that investors, including SWFs, access hedge funds is changing. While co-mingled UCITS funds remain popular with some investors, there is growing interest in separately managed accounts. These can replicate existing funds or may involve a manager being given a specifically adapted mandate.
Managed accounts are attractive for SWFs for many reasons. They offer daily transparency, facilitate a bespoke fee structure and ensure that other investors do not determine SWFs’ liquidity. Perhaps most importantly, they allow clients to set investment controls, including limits on borrowing or the use of environmental, social and governance (“ESG”) screens for investment.
ESG investment is becoming an increasingly large component of the investor universe and is especially important to many SWFs, such as Norway’s $1 trillion wealth fund, given their typically long-term outlook. Managed accounts allow investors to tailor portfolios to their specific ESG requirements. Given the breadth of ESG definitions, it can be challenging for hedge funds to demonstrate their ESG credentials: membership of bodies such as the United Nations-supported Principles for Responsible Investment (PRI) is valuable.
New Fee Models are Attractive
Hedge funds’ pricing models are shifting – in ways that are welcome to SWFs. Historically, the hedge fund industry charged 2-and-20. But this structure is changing, with management fees of 1%, or even 75bp depending on the asset class, becoming more common.
Low cost products such as ETFs increasingly appeal to investors in search of beta but investors are willing to pay for alpha (with an agreed beta stripped from performance); in such circumstances, a “1 or 30” structure is becoming more common. Additionally, funds should emphasis clawback and high watermark features to reassure SWFs that they only pay for performance (such features now typically extend to management fees).
SWFs are defined by their cautious approach to investment given their stewardship of public funds. However, the changes taking place in the hedge fund sector, including improved transparency, institutionalisation and the growth of managed accounts are making it significantly more attractive to such investors. The key to success is to engage with SWFs to help them understand the implications of the industry’s evolution and the benefits the asset class can deliver to them.
Fund of Hedge Funds Services
There is a role within the alternatives firm C-suite that is widely held, often overlooked, and massively underestimated. The role touches every corner of the organization but is difficult to contain within a job description.
The role touches every corner of the organization but is difficult to contain within a job description. It is both critical and undervalued, and more than ever, one that can make or break the success of your hedge or alternative investment fund.
If this sounds troubling, that’s because it is. Meet the Chief of Everything But Investment - the COEBI.
The role of the Chief Operations Officer (“COO”) has expanded – and in some ways, stretched to the point of breaking due to a number of converging trends. Regulation has become more complex and challenging to implement. Technology and security issues are a concern for every financial institution. Global geopolitical uncertainty caused by events such as Brexit threatens to shift entire operational frameworks.
These changes are so prevalent and demanding that the COO title no longer captures the scope of what the COO of an Alts business actually does. The role has silently and dangerously morphed into COEBIs and they represent perhaps both the greatest opportunity and the greatest risk for a hedge fund.
COO = COEBI
The fund management industry today is faced with unprecedented competition, volatile markets, greater demands for transparency, and increasing resistance on fees. The pressure from all directions have led to an intensifying need for firms to better manage expectations, reduce costs, lower risk and ensure stability. These responsibilities have landed squarely in the lap of the COO.
Historically, the COO held relatively prescriptive roles tied to the operational and technical needs of the organization. Today, these same areas have experienced the most disruption due to technological innovation and data modernization, which can be either a risk or opportunity depending on the size and resources of the firm, and one the COO must be able to manage.
Today, the role of a modern alternatives firm COO may include collaborating with internal risk teams to streamline client and regulator communications, making the call to recruit specific talent or investing in technologies to meet competitive shortfalls, responding to data and cybersecurity breaches, or working with service providers to streamline processes.
In general, as alternatives firms evolve to meet modern challenges and derive more sophisticated strategies, COOs have been the organizational driver to identify problems and find solutions, moving from a once execution-focused role to a more strategic one.
Success of COEBI = Success of Firm
Unfortunately, the COO role is one that defies easy definition to begin with. Despite being one of the most central and connected leaders within an organization, there is no clear career path to becoming a COO. In order for the COO/COEBI to succeed, the individual needs diversity of experience, which is inherently both a strength and a weakness – a strength because it gives them immense adaptability, but a weakness because they are less likely to be truly an expert “Chief of Everything.” Since there is no specified training or standard for a COO, it is even less likely they will be prepared as a COEBI.
Your COEBI could be acting as the negotiator to demanding stakeholders and partners, the decision maker on HR matters and innovation challenges, the spokesperson in times of crisis, and the expert for both legal and IT consultation. These individual roles are daunting enough on their own, not to mention that now they may depend on the ability of a single individual.
Therefore, the success of your COEBI is imperative because whether they are seen as the leadership unicorn or the chameleon, their actions have exponential impact on their firms, both positive and negative.
Support Your COEBI!
As a COO - likely unsuspectingly - morphs into a COEBI, they might not have the resources, background or bandwidth to successfully address and solve the business challenges of the modern alternatives business. In other words, the greater the demands, the higher the risk of the COEBI becoming a point of weakness for the fund - and the consequences all the more dire.
What, then, can management do? First, the C-suite must recognize the importance of the COEBI and find ways to support their work, including outsourcing administrative and operational burdens. Second, firms should carefully evaluate who is holding the role, and whether the role should actually be held by a more built-out team -- i.e. instead of a singular individual, perhaps there should also be a Chief Technology officer and a Chief Compliance Officer, among others.
The more you can empower and recognize the role of the COEBI, the better you can ensure that the COEBI is set up for success, not failure, as the pressures rise.