Hedge funds face up to their success

Source : Paperjam News

Author : Josephine Shillito

The market will urgently need to upgrade its processes in order to fully seize this potential.

Alternative products - i.e. private debt, real estate, infrastructure, private equity and venture capital - have always attracted large institutional investors such as pension funds and sovereign wealth funds. However, individual investors are gradually venturing into this field in search of the Holy Grail of investment: yield.

For Arnaud Bon, Partner at Deloitte, alternative investments offer an optimal combination of long-term performance and decorrelation with stock markets. They also offer an important psychological component: involvement. "An equity investor doesn't feel he has an impact on the companies in which he holds shares. Alternative investment gives you the feeling of being involved," he says, referring to private debt investments in small businesses and private equity. This increasingly conscious approach to investing is part of a wider trend, and is well reflected in the growing demand for ESG investments.

These assertions are, moreover, substantiated. Private credit yields, according to S&P Global analysts, were 100 basis points higher than syndicated loans in 2020, and European buy-outs, the largest private equity segment studied by European private equity association Invest Europe in its Benchmark 2020 report, delivered an annualized return of 15.06% from inception to the end of 2020, compared with 5.48% for the MSCI Europe index over the same period.

However, these funds are not as easily accessible to sophisticated retail investors as those in the public market. "There's a huge demand from high-net-worth individuals (broadly defined as those with more than $1 million in invested assets) for alternative investments, but supply can't keep up with demand and both sides are very frustrated."

More individual investors

According to Leon Volchyok, managing director in charge of real estate at investment firm Blackstone, HNWI represent a "gargantuan" investment opportunity. "We estimate that HNWIs represent an $80,000 billion market, but only a fraction of that amount is currently invested in the alternative space."

Europe has been quick to seize this investment opportunity, using the European long-term investment fund (ELTIF), a structure that enables professional and retail investors in the European Union to invest in illiquid companies and projects previously reserved for institutional investors.

But such supportive regulation is only part of the challenge. According to market players, alternative investment funds and their service providers will have to review outdated operating procedures if they are to have any hope of attracting and satisfying this new group of investors.

Arnaud Bon explains: "The hedge fund market generally attracts large institutional investors, capable of investing tens of millions and locking them in for at least five years or more. The challenges of dealing with 15 to 20 institutional investors are very different from those of hundreds or thousands of HNWIs".

Know Your Customer (KYC) and Anti-Money Laundering (AML) processes, in particular, are more demanding when applied to a larger and more diverse investor base.

Expanding back-office teams is not the answer. "There are already problems attracting talent to Luxembourg and, in any case, the potential need is greater than the number of people the market is capable of recruiting," says Arnaud Bon. But some solutions are in the pipeline.

Alternative asset supply vehicles

The size of the HNWI market in Luxembourg has not been defined, but private banking clients represent a reasonable estimate of the potential size of this market. According to Luxembourg for Finance, the Luxembourg private banking market has €466 billion in assets under management.

"Whereas fundraising for institutional investors was typically an individual exercise, we're seeing wealth managers with private banking clients partnering with fund managers and setting up an alternative asset feeder vehicle." These vehicles can accommodate 70 to 80 high-net-worth investors, significantly reducing processing difficulties for alternative asset managers.

"The number of investors per feeder fund continues to grow," says Peter Wilson, managing director of ScalingFunds, a technology provider to the hedge fund industry that uses DLT (Distributed Ledger Technology) to streamline the operational processes of alternative investment funds. "Historically, 99% of alternative investment funds were held by institutional investors, such as pension funds and family offices, but, today, you see many individual investors with over €1 million in cash investing via feeder funds in alternative investment funds."

Private banks are now seeing the opportunity of feeder funds to offer their clients exposure to alternative assets. Some are even creating their own feeder fund structures, says Peter Wilson. "It's a smoother process and quicker to bring to market."