The Rise of Hedge Fund Coinvestments
While co-investing has been a staple of the private equity industry for many years, it is a more recent and growing trend in the hedge fund industry. We believe that hedge fund co-investments are an important tool to increase the total return of portfolios, while limiting correlation to traditional asset classes and hedge fund strategies.
Why are we seeing growth in hedge fund co-investment opportunities?
Prior to the global financial crisis the hedge fund industry experienced strong inflows. Many hedge funds enjoyed relative freedom to pursue niche opportunities and put less liquid investments into side pockets. In recent years, industry inflows have been more limited and investors have been more restrictive on permissible investments, particularly less liquid situations. As a result, hedge funds, outside of mainstream liquid strategies such as equity long/short and global macro, have had less discretionary capital available to deploy. This has coincided with regulatory changes that have decreased bank and insurance company willingness to invest in non-traditional asset classes, creating more opportunity for alternative forms of capital to fill that void. The end result has been an increase in established hedge funds seeking co-investment capital for discrete opportunities that do not meet the liquidity, concentration or asset class guidelines of their main funds.
From the investor’s perspective, fees, transparency and correlation are key focal points when it comes to hedge fund allocations. In our view, co-investments have the potential to provide improvement on all three fronts. Furthermore, they can provide a way for investors to target specific exposures and risk/return profiles that meet their investment objectives.
In short, we believe co-investments offer a clear and self-sustaining value proposition to hedge fund managers and investors. For managers, co-investments represent a new form of capital that enables them to participate in high-conviction opportunities that, absent co-investment capital, they would not be able to pursue. For investors, co-investments offer a means of direct access to differentiated sources of return with potentially bespoke risk/return profiles as well as attractive fees, transparency and control rights.
How do hedge fund co-investments differ from private equity co-investments?
The primary difference is the universe of managers from which co-investments are sourced. Co-investing is a mature concept for private equity firms. Indeed, many private equity managers have established and often contractual processes for how co-investments are allocated among existing clients.
Co-investing is a newer concept for hedge funds. Most hedge fund managers do not have a long list of existing investors with whom they have traditionally partnered on such investment opportunities. At the same time, most hedge fund allocators are not equipped to make decisions about co-investments. As a result, these opportunities tend not to be as heavily trafficked as private equity co-investments and there tends to be greater potential for tailoring implementation strategies.
Another important difference is the breadth of investment strategies accessible through each of the two categories. Private equity co-investments typically involve control private equity positions that are subject to the same factors that influence valuation of public equities. Hedge fund co-investments represent a diverse array of asset classes, liquidity profiles and risk. They can be “risk-on” or “risk-off” and everything in between. They can range from publicly traded equity and debt to non-traded investments, such as litigation finance and reinsurance, which have no correlation to traditional assets classes. For this reason, we would generally expect that hedge fund co-investments would have lower correlation to global equities than private equity co-investments. Hedge fund co-investments also tend to have shorter holding periods than private equity co-investments.
How are hedge fund co-investments sourced?
Today, sourcing is entirely dependent upon having access to a robust network of idea-generators. The most obvious sourcing channel comes from hedge fund managers with whom an investor has existing primary fund investments. However, it is increasingly common for hedge fund managers to solicit co-investment capital directly from allocators with whom no primary fund relationship exists. This is happening because few hedge fund managers have existing investors with active co-investment programs and managers recognize co-investments as an opportunity to broaden their client base and support future business growth.
What are the key barriers to entry?
While we believe there are many potential benefits to making co-investments, there are challenges as well. Broadly speaking, we see four key barriers to entry:
Sourcing: Having a wide network of existing hedge funds—idea generators—and a pipeline for new ones is critical. The greatest advantage in this space comes from the luxury of choice, having access to a wide range of potential opportunities and being selective.
Analysis: Co-investing requires integrating a hedge fund manager due diligence framework with asset-specific underwriting. Many hedge fund investors are not structured or resourced to support this two-pronged approach.
Execution: Co-investing requires efficient decision making, often over the course of mere days. In addition, legal documentation and vehicle structuring must be accomplished far more rapidly than is required in traditional fund investing.
Capital Flexibility: Co-investments are often presented because the hedge fund manager has constraints on size and/or liquidity that prevent inclusion of these ideas in a main fund. Investors must have the mandate and appetite to be flexible around these parameters in order to maximize their opportunity set.
How is alignment typically achieved with the hedge fund manager
Generally speaking, alignment is achieved in two ways. It can come from assurance that a manager has “skin in the game”, investing personal capital alongside that of external investors. And it can come through fee structures that are akin to “sweat equity”. There are a wide range of fee structures (including no fees), but structures are typically skewed toward realization-based incentives over a performance hurdle whereby a manager is only compensated if the investment achieves the investor’s objectives.
What is the role of co-investments in client portfolios? What are the trade-offs?
We believe the primary role of hedge fund co-investments in client portfolios is to potentially increase expected return. Secondary benefits may include improving transparency, reducing average fees and introducing targeted exposures that are not correlated to existing allocations.
The trade-offs are that co-investments are resource-intensive and require quick response times. In addition, they can have higher risk and wider distributions of outcomes than traditional fund investments. Finally, co-investments may require more onerous contractual liquidity.
In our view, hedge fund co-investments have a distinct role to play in well-balanced portfolios, offering important diversification benefits to traditional asset classes as well as hedge funds and opportunistic investments. We believe that hedge fund co-investing will reach the level of adoption currently found in private equity, leaving significant runway for growth in the years ahead.
In a fraught world, policy makers cannot allow partisan divides to get in the way of crucial reforms. By drawing on successful strategies employed elsewhere and adapting to current needs, governments can—and must—do better.
Rarely has the need for effective government been greater than now—and rarely has the ability to produce it been more constrained. After the recent wave of storms and disasters—both natural and financial—the need for leadership and a concerted response from national capitals is acute. Adding to the pressure, many governments are managing the implications of an unprecedented degree of fiscal and monetary intervention. They are preoccupied with the urgent tasks of getting banks to lend again and demonstrating fiscal credentials to the bond markets. The crisis mode of the past few years endures in several countries, while in others there is no more than cautious optimism.
Leaders must confront long-term, fundamental questions too: from the size and role of the state to how best to stimulate growth; from profound and surging demographic imbalances to tackling growing unemployment and welfare bills; from deciding on the extent and nature of regulation necessary to protect the public to forging a new relationship between citizens and government services. Thus, many governments confront a daunting paradox: an expanded set of major policy imperatives in a constrained and almost precarious fiscal position.
On these subjects, however, there is little agreement. The policy debate is becoming more polarized at arguably the worst possible time. There is a real risk that in the face of big choices and much disagreement, paralysis reigns. Leaders thus spend their energy on policy fights and battles for the hearts and minds of the public—at the expense of making progress.
It is in times like these that government matters most.
Our research shows it is possible to make huge strides in addressing critical challenges, even without resolution of the many ideological and policy dilemmas. From government spending to tax collection, education improvement to health outcomes, and welfare reform to job creation, we see the potential for meaningful improvement, to do more and better with less. What is needed is government management by design, built to fit these difficult times: government that identifies the most critical, solvable problems, reorganizes where necessary to deliver the right solutions, and abandons the tools and approaches that no longer work.
In this effort, governments can draw heavily on the mission-driven mind-set of employees—a real comparative advantage for the public sector over the private sector. Too often leaders insufficiently tap into this valuable asset. And leaders can do far more to mine information on what is working elsewhere. International peers, often trying to solve exactly the same problems, provide invaluable road maps and lessons. Unlike the private sector, where companies spend millions of dollars trying to understand secret competitor strategies and replicate them, the public sector is an open environment, and thereby easier to mine for successful practices and lessons learned.
Government by design
Political leaders rarely campaign for office on a platform of government effectiveness. For some it fails to capture their imagination or, they suspect, the imagination of voters. For others, tackling the bureaucracy is perceived as high risk and low reward compared with passing new laws in the legislature. Yet few succeed without achieving some reform. Many departing presidents, prime ministers, and cabinet secretaries reflect on how the engine of government itself was at the very heart of their successes or failures.
What it takes
To truly transform government requires fresh thinking and a substantial investment of both resources and political capital: business-as-usual or modest or occasional improvement is inadequate. Those that have achieved sustainable and significantly higher levels of government performance did so by explicitly designing and executing multiyear reforms that push beyond everyday initiatives designed to improve management capability. In our research, we identify 40 such programs that have been enacted around the world in the past two decades. There were a number of objectives these programs were designed to achieve: significant fiscal consolidation, better outcomes across multiple public services, and economic growth (exhibit).
Dozens of governments have undertaken ambitious programs to remake themselves.
Analyzing these programs and interviewing the leaders involved reveals a valuable set of lessons for other government leaders facing major challenges. The first is being clear and ambitious about what the government is trying to achieve. Many transformations achieved what appeared to be impossible targets. Sweden, for example, moved from an 11 percent deficit to a fiscal surplus in the 1990s, having been close to default and an International Monetary Fund (IMF) bailout. A second lesson is the need to make big—not incremental—shifts in the amount of time, energy, and resources required. On average, the programs in our sample lasted for six years, with a staff of 1,300 involved in each.
Fit for purpose
Beyond this clear focus and investment of time and resources, government by design also means investing in those capabilities needed for success. Some of these are common and enduring across the public, private, and nonprofit sectors, such as employing best practices in technology and operations, organization and human resources, and budgeting and finance, as well as operating across geographic and stakeholder boundaries and making use of large data sets for better performance and policy. Other capabilities will be specific to the government sector, including risk management in regulation and client differentiation for welfare-to-work interventions.
Increasingly, the intense pressure for reform, combined with a new operating environment, makes innovation a critical capability. In many areas, government agencies around the world are reimagining how services are delivered (for example, through one-stop shops and e-portals) by providing greater data availability and through mobile services that allow citizens to get instant help and support. They are also migrating to a new paradigm where nonstate actors—private companies, nonprofits, and citizens themselves—play an increasingly important role in designing and executing policies and services.
Finding answers to the solvable management questions
Governments that are willing to reform and build these crucial capabilities are better able to achieve major breakthroughs in the most fundamental policy areas, even in the absence of new policy or legislation.
Take fiscal management, arguably the most daunting of all issues today. According to the IMF, most governments in countries that are members of the Organisation for Economic Co-operation and Development (OECD) need to improve their deficits by 4 percent or more of GDP to achieve long-term debt targets.1 Of course much of this involves policy debate. Entitlement reform, public-spending reductions, and increased taxation are highly charged political issues. However, operational reforms designed to improve efficiency can make a meaningful difference now and set the stage for more successful policy implementation over time.
In particular, spending reviews undertaken agency by agency—even if initially focused only on noncore functions such as technology, procurement, or travel—can yield meaningful savings that will increase credibility and flexibility as fiscal constraints increase. Similarly, improved tax collection, drawing on international best practices, can produce real revenue growth within the existing tax structure.
A number of governments are taking a more strategic and evidence-based approach to achieving fiscal sustainability by launching multiyear spending reviews. These reviews help to establish priorities and clear paths to deficit reduction. Almost without exception, the spending reviews uncover huge opportunities for improving effectiveness, decreasing costs, and increasing revenue by improving the efficiency of administrative, noncore activities. To size the prize, consider that our global bench-marking research indicates that operational expenditures represent 35 to 40 percent of total government expenditure; on average, 19 percent of GDP for OECD countries. Within that operational expenditure, roughly a third is spent on overhead functions, representing 6 to 7 percent of GDP in OECD countries.
To date, we have reviewed ten countries that have conducted such spending reviews during the past five years and discovered that there is currently little standardization in approach. Several governments have imposed top-down spending cuts, from the center to agencies, while others have developed a bottom-up understanding of the potential savings opportunities. Of those using a bottom-up approach, New Zealand and Denmark have used clear baselines and intragovernment or external benchmarks to estimate the savings potential—even though this is clearly an opportunity to drive success.
Drawing on benchmarks from different governments, we estimate a potential to save 5 to 10 percent of operational costs through overhead categories without compromising core programs. This represents a savings in the range of 0.3 to 0.7 percent of GDP—some 10 percent of the adjustment that countries are required to make in order to achieve their long-term debt targets. This is a significant contribution, given that it requires no compromise on core programs, no reduction in social programs, and no additional costs to taxpayers. And it ultimately sets the stage for better policy implementation in the future.
Meanwhile, as governments grapple with increasing social obligations and projected declines in the relative size of labor workforces, tax administrations are under even more pressure to collect every dollar of tax payable. They need to ensure that every dollar they spend collecting taxes yields the maximum benefit for citizens. Tax administrations also have broader significance: the interface and effectiveness of a tax administration often becomes a watermark of public confidence in a government.
In this quest, tax administrations can learn a great deal from one another. But our in-depth research at federal tax administrations in 15 OECD countries uncovered wide variability not only in the performance of tax authorities across countries but also within countries across different functions—submissions processing, examinations, collections, and taxpayer service.
We estimate that, in aggregate, the tax administrations in our study can collect an additional $86 billion in direct tax revenues if they adopt the practices of the top third. Four major design elements stand out as avenues for achieving improvements: proactive demand management that smooths tax collection across the year and avoids the end-of-year bottleneck, sophisticated taxpayer segmentation to prioritize which taxpayers to target with which approaches, streamlined operations, and rigorous performance tracking. And these savings apply only to direct taxes.
Beyond undertaking spending reviews and improving tax collection to manage the operating budget, governments have a major opportunity to take an end-to-end capital-management approach to their balance sheets at both the agency and government-wide level to improve fiscal health. This includes identifying and measuring material risks, incorporating the knowledge of risk into operations, and ensuring the integrity of the internal assessments over time. Even simple approaches to changing the inflow of accounts receivable or outflow of accounts payable can yield meaningful improvements.
Along with fiscal management, unemployment dominates the landscape across most of the OECD. Here, too, exist fundamental differences in ideology and vision on how to solve rising unemployment risk stasis. Stimulus programs and other legislative actions to increase growth and create jobs may or may not get through legislatures, but other government interventions to improve demand, supply, and the matching of skills to jobs can significantly improve the jobs picture.
Many governments are now adapting vocational education to better fit employment prospects, for example, by involving employers more closely in both its design and delivery. Employment agencies are doing a better job of matching supply and demand by improving their market information and by producing more comprehensive, specific, and up-to-date data on vacancies, job seekers, and required qualifications. They are also segmenting the job-seeker population to better understand which segments can be processed in quick and automated ways and which merit deeper intervention and support.
Regulation and enforcement
After a series of catastrophic events, government bodies that protect the public—such as industry regulators, law enforcement, and disaster-preparedness agencies—are being more closely scrutinized with regard to their actions, their impact, and their overall effectiveness. But they are not necessarily receiving larger budgets. In stark terms, society is asking whether regulators are most effectively anticipating the next threat and protecting the public. As with unemployment, the policy debate on this issue can become quickly polarized around the trade-off between more protection for the public and consumers and the potentially negative impact of more aggressive regulation for economic growth.
Agencies can make great progress by focusing on optimal resource allocation and redesigning how they organize and plan. They can place more emphasis on outcome-based regulation and on predicting, preparing for, and mitigating “tail risk.” The most significant assaults on the public’s sense of safety and security have come from events that previously seemed unlikely. Tail events are difficult to predict because they often require multiple things to go wrong. Examples include the attacks of September 11, Hurricane Katrina’s damage to the New Orleans levees, the financial crisis of 2008–09, and the recent earthquake and tsunami in Japan and the nuclear-power-plant meltdown that followed. But better risk-based systems can improve governments’ ability to prevent and respond to such events.
Core public services
In fact, across core public services—in areas such as infrastructure, education, health care, and policing—government by design can also enhance outcomes and manage costs. In these areas, the political discourse is often dominated by significant and legitimate ideological differences. Despite that, governments that focus on what really works operationally in driving outcomes can reap gains. Governments that systematically embrace the latest proven project-management approaches and tools can dramatically improve the value of infrastructure investments, at the same time reducing errors and time to completion.
In education, for example, school systems can learn from peers at a similar stage of evolution or performance about the right levers to use for improvement—be it better use of pupil data, revision of standards and curricula, or a deeper professionalization of teaching careers. Likewise, the escalation of health care costs across all systems is provoking significant political debate. Yet the best systems are already beginning to make progress in health care productivity through a number of steps, such as the prediction of patients most at risk and the adoption of subsequent prevention strategies, delivery of care at home and in capital-light settings rather than in hospitals, and technology innovations to boost clinician effectiveness and efficiency. Government services can and should build on examples of success around the world.
There is a real prize for governments that can make progress even as the policy and fiscal environments threaten to thwart action. But to win, governments must adapt to fit the challenges of today, in part by applying best practices from around the world.
In challenging times, the government we need is rarely the government we inherit. Instead, government must be deliberately designed and managed to make progress on solvable problems.