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The New Alts Manager: Expanding an Alts Strategy the Right Way for the Right Reasons
As alts managers plot their COVID comebacks, committing to an asset class expansion requires thorough reflection.
Alternative asset managers are accustomed to acting nimbly in their quest for alpha. In the last several years, this agility has manifested itself in the form of strategy expansion. Formerly pure-play investment shops are eyeing different asset classes and fund structures while considering making the leap into new territory to attract new investors and diversify their returns.
A growing number of alts managers will begin to seriously consider this trend as they seek to bounce back from the COVID-19-fueled downturn, which has produced a surge of redemption requests, slowed deal flow, triggered dramatic downward valuations in high impact sectors (such as transportation and hospitality), and spread uncertainty across the market.
Amidst the current volatility and elevated uncertainty, alts managers should be actively assessing their current footing to respond to new information. As always in the alternatives space, there will be a premium for swift and robust responses by managers. Those who assess their positioning and acquire the right resources in the immediate future will be able to strike quickly and generate returns ahead of their competition.
Notwithstanding the pandemic’s effects, alts managers continually balance their reactive versus proactive efforts to execute their strategies. While the private funds have experienced an extended stretch of outperformance, hedge fund managers in particular have looked to diversify following years of lackluster returns, underperforming the broader markets for the past decade, with the exception of 2018. As a result, investors’ capital began seeping out of hedge funds and into private equity. In 2019, hedge funds made up a third of institutional investors’ alternative investments, down seven percentage points from 2018. Meanwhile, private equity grew to 25% of institutional investors’ alternative investments, up from 18% the year before.1 As a result, more than a quarter of hedge fund managers now have a private equity or venture capital offering.2
Recently, the movement of alternative strategy expansion has been most prevalent in the form of pure-play hedge funds expanding into closed-end private structures – primarily private equity (PE), and private debt, less so in real estate and infrastructure. While there have also been instances of PE shops exploring open-ended fund structures, the inherent imbalance of portfolio versus investor liquidity in this space is a persistent challenge.
However, expanding into new products isn’t a move to take lightly. The emergence of these traditional hedge funds into “hybrid” structures has strong implications for their own operating models, as well as for service providers and other stakeholders. Operations and investor needs can differ vastly between different product types. Deep expertise in the middle- and back-office demands of one specific product type does not necessarily proxy into others, and missteps can be costly. Managers’ time is well-spent understanding the practical demands of the new investment territory they’re considering and their own ability to handle the expansion.
The needs between separate alternative asset classes can differ drastically, and alts managers need to consider those factors when reflecting on whether an expansion is worth the work. For those managers who are seriously considering a multi-strategy approach, there are a few questions they should ask themselves:
- Motive – Managers should deeply evaluate why they’re choosing to expand their strategy. Is it simply to serve as a hedge on returns or do they feel like they have the expertise and capabilities to provide a unique and differentiating offer for new and existing investors through this move? Both may be justified answers, but the reasoning should dictate how a manager leans into the expansion. A credit strategy hedge fund, for example, may develop a complementary closed-end private debt fund while a multi-strategy hedge fund may add pure private markets strategies as a diversification play.
- Implementation – Before diving into an expansion, managers should question whether their new products will feel like a natural and holistic offering or more like a bolt-on strategy. If the manager doesn’t have (or cannot quickly and efficiently muster) the resources to achieve the former, it may not make business sense to expand. The new offering should achieve synergies across operations, investor relations and technology, rather than require a full stack of independent capabilities to support the new strategy.
- Positioning to investors – Managers should also consider the positioning of their potential strategy expansion to both their existing as well as targeted investors. Managers should look to alleviate any potential concerns that existing investors have around the viability of the strategy that they’ve already signed on for as the manager pursues new strategies. Managers should also develop on a promotional strategy that communicates to current investors that the new offering will in no way dilute the quality of the original offering, while still promoting the new strategy to investors new to the firm. In this arena, strategically aligned, synergistic expansions are easier to position and rationalize to investors than diversification-driven, bolt-on efforts.
- Operational preparedness – Before launching a new strategy arm, managers should ensure they have partnered with the right service providers that are able to support the offering and provide advice to the manager from risk-reduction and cost-savings perspectives. Also, from a business resiliency standpoint, managers should ensure the strategy expansion can thrive under current remote work operations and seamlessly transition back and forth under similar circumstances in the future.
This process of reflection and path to a decision on whether or not to expand a manager’s strategic focus will likely occur over an extended period of time. However, if a shop does decide that a new alts offering is a prudent business decision, an important next step is to seek resources that can assist with its execution.
As alts managers enter new territory when expanding their strategies, an administrator can bridge the knowledge and experience gaps. While a good partner can fill a manager’s operational needs, the ideal partner goes beyond that to serve as a guide to the manager in redefining their strategy.
How can alts managers evaluate potential partners to find the perfect fit? Firstly, managers should seek out a provider with the experience to anticipate their needs. As such, the relationship should be less transactional and more consultative. For example, a formerly pure-play shop can benefit from an administrator or solutions partner with deep experience across the alts space, including in matters related to fund structures, regulations and cash management. Recognizing that their administrator is ready and able to support future changes provides a manager assurance that they can execute their strategy and make a successful, sustainable play into “new ground.”
In addition to the ability to advise a manager on the subtleties of new asset classes, an ideal partner should provide a wide breadth of services such as fund administration, custody, prime brokerage, credit, and cash and collateral management, allowing the manager to access a one-stop shop of capabilities as they navigate a new asset class and fund structure. They should also be able to deliver a streamlined experience for the manager, so that if the manager uses multiple services, the administrator is able to communicate cohesively rather than as multiple fragmented teams.
As the lines between alternative asset classes blur, managers who deem expansion the right move for their firms will require appropriate guidance and services to help generate alpha. The drive to diversify alternative investment strategies will pick up steam and the balance will tip in favor of these non-traditional funds, making a transition seem even more appealing. But as discussed, the move into new asset classes isn’t a simple or quick journey. As managers blend their strategies to incorporate new products in separate asset classes, they must have a clear strategy, deploy seasoned expertise and seek out the ideal service providers to assist with their mission. The alts managers that do this successfully are better positioned to navigate through current economic uncertainty and outperform the market and their competitors.
24-hour cycles of trade processing, reconciliations, valuation, profit and loss. Emphasis on agility and minimized latency.
Investor-controlled capital flows (subscription/redemptions), typically on a monthly basis.
Prospect of SMAs and/or side- pockets from large investors.
Strong external influences from portfolio lifecycle events (corporate actions, settlements, collateral, investor activity), with portfolio financing considerations for leverage. Premium on immediacy of cash/FX data and execution capability.
Monitoring of portfolio holdings, complexity of LPAs, waterfall calculations and performance.
GP-controlled capital flows (calls/distributions), timed to portfolio deal transactions. Large LPs may demand co- invest/direct-invest, and/or ongoing ownership options.
Deal-driven cash flow timing; large, short-term credit line availability key to mitigate late/failed calls.
Inherent differences in operational cadences, fund and investor accounting methodologies. Do not over assume synergies.
Investors in both structures will have different sensitivities along the lines of their own shape (asset owners, fund of funds, family offices, etc.). Larger investors will bring special demands for favored terms.
Strong banking relationships are key for credit and financing.
Complex fund structures lend themselves to advanced cash optimization solutions.
1 EY, 2019 Global Alternative Fund Survey, 2019