Private capital aims are altering the HF industry for good

As investors clamored this past spring for opportunistic strategies, the media wrote the hedge fund industry’s obituary (again) and the pandemic raged — a shift was underway as managers boosted their private capital offerings.

The private capital moves are not new, but just like all trends related to COVID-19 the timeline and activity sped up to meet the pent-up demand, according to observers.

According to Peter Sanchez, head of Northern Trust Alternative Fund and Omnium Business Services, roughly 25% of their hedge fund clients offer some sort of private capital fund structure and he expects this percentage to grow as more hedge fund managers look to cater to investor demand.

“There’s been less launches on the hedge fund side, but more on the private capital side,” he said of launch activity so far this year. “Both are launching opportunistic strategies and looking at buying assets on the cheap due to COVID.”

Pure-play hedge funds have been expanding into closed-end private structures, with private equity being the most predominant, alongside private debt, real estate and infrastructure. According to Northern Trust, the emergence of traditional hedge funds into hybrid structures has implications for operating models, as well as for service providers and other stakeholders.

The considerations for alts managers include the alpha versus liquidity of the strategy, the shifting investor landscape and the practical realities of executing the business strategy.

The allure to getting into different strategies via closed-end offerings is a way for hedge fund managers to become more opportunistic in nature, said Sanchez. It also adds diversity to the overall hedge fund population that tends to rely more on long/short equities than credit strategies historically.

The waterfall-based fees on a specific investment also has its charm for investors looking to know specifically what they are paying for beyond a traditional management and incentive fee structure. The boost to hedge fund firms is that the calculation of the return on a set strategy is also done over a longer period of time and the assets are locked-up for a longer time period as well.

According to a recent Ernst & Young survey, hedge funds accounted for one-third of institutional investors’ alternative investments in 2019, which is down seven percentage points from 2018. At the same time private equity grew to 25% of institutional investor’s alternatives holdings, which is up from 18% the year before.

The survey found that more than a quarter of hedge fund managers have private equity or venture capital offerings. This offering expansion serves as a hedge on overall returns and access to new capital, according to Northern Trust.

Sanchez said that one of the broad themes his team has seen is the flexibility and openness to accommodate investor needs through the structuring of separately managed accounts, funds of one and of course private closed-end offerings.

Co-investments too remain popular too among hedge fund firms and private equity managers. Investors who know they bring crucial capital volume often for co-investments and other separate account structures so that they can invest directly rather than using the fund as a vehicle for the investment. This leads to great alignment too over fees.

Lastly, all these structural changes to fund offerings are leading to huge changes in how the hedge fund operating model works.

Operational concerns include fund and investment valuation as well as accounting and the establishing of a waterfall fee schedule. While a fee schedule focused on realized gains appeals to investor, it requires deep experience and knowledge of private equity operations, according to Northern Trust.

Sanchez said the change in operations just like the long-term strategies emerging from the pandemic are likely to last well beyond the time frame for a global vaccine – and therefore permanently reshaping the hedge fund industry.

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