In March, Deutsche Bank’s Hedge Fund Capital Group presented a closer look at the current status of the hedge fund industry in its “2010 Alternative Investment Survey” report (see press release).  The report focuses on responses from 606 investors.  42% of the respondents were Fund of Funds, 21% were asset management companies, 12% were family offices/high net worth individuals, and the remaining group consisted of corporations, foundations and endowments, insurance companies, investment consultants, private banks, and private and public pensions.

This article summarizes the 2010 outlook from investors and the increasing relevance of the seeding business.  In particular, it presents the strategies being favored/disfavored, regional markets being favored/disfavored, predicted allocation amounts, and other information related to due diligence and reasons for investing in hedge funds.

For the most part, investors are optimistic about 2010 and money is flowing back into the industry.  Strategies for this year reflect concerns about the lack of transparency and protection in uncertain markets in 2008 and 2009.  Investors are making choices that ride on renewed confidence in the industry and that favor reduced volatility.

Investors

Investors Generally Optimistic for the Future

Investor sentiment about how the hedge fund industry will fare in 2010 has greatly improved.  In 2009, 41% predicted net asset outflows of over $150 billion and 30% predicted outflows of over $200 billion.  In contrast, 73% of investors surveyed this year predict net asset inflows of over $100 billion and fewer than 2% are predicting outflows.  Consistent with those percentages, investors are also predicting a positive 2010 performance on the leading indices (S&P500, MSCI World, and MSCI EM).

Favored and Disfavored Strategies

Surveyed investors predict that some of the best strategies for 2010 are global macro, equity long/short, distressed, and event driven.  In fact, equity long/short makes up the largest portion of hedge fund assets.  51% of investors plan to add assets to this strategy (an increase from 31% in 2009), 38% plan to maintain their assets in the strategy, and 5% plan to reduce assets.  Event driven also performed very well in 2009 with 42% of surveyed investors now planning to add assets to this strategy and 41% planning to maintain their assets.  Investor interest in merger arbitrage has also jumped greatly from 6% intending to increase exposure to 26% in 2010.  While 29% of investors planned to reduce exposure in 2009, only 4% now seek to reduce exposure.

The strategies that are anticipated to perform the worst in 2010 include cash, volatility arbitrage, CTA, convertible arbitrage, market neutral, and asset backed securities.  Market neutral was one of the worst strategies for 2009 when other strategies were bouncing back.  The percentage of investors seeking to add assets to this strategy has decreased from 26% in 2008 to only 17% this year.  In terms of cash allocation, only 3% of investors plan to increase exposure (a drop from 13% last year), 43% plan to maintain their assets, and a whopping 32% plan to reduce their assets.

Regional Allocations

Overall, investors predict that the Asia region (excluding Japan) will perform the best in 2010 and the Western European region will perform the worst.  This year, 45% of investors plan to invest in Asian (excluding Japan) funds–a significant jump from only 18% in 2009.  Interest in investing in Chinese and Japanese funds is high compared with other countries.  The percentage of investors that do not plan to allocate to each country is 22% and 23% respectively. In contrast, 52% of investors do not plan to allocate in Russia, 44% do not plan to allocate in Eastern and Central Europe (excluding Russia), and 37% of investors do not plan to allocate in India.

Surveyed investors expressed a similar interest in the Emerging Markets, with 38% wanting to increase exposure, 38% wanting to maintain exposure, and only 6% wanting to reduce exposure.  These findings are in response to the strong 2009 returns after a rough 2008 that saw many Emerging Market funds close.  In contrast, investors anticipate the Western European region will not fare well–with 56% seeking to maintain their current assets, 23% seeking to increase exposure, and 12% seeking to reduce exposure.

Hedge Funds

Investors are increasingly investing in hedge funds.  In fact, 76% of consultants surveyed indicated that their clients were increasing allocations to this investment vehicle.   When asked what the main benefit of investing in hedge funds was, 68% of the investors surveyed indicated that hedge funds provide “better risk adjusted returns.”  This benefit is particularly valuable in a volatile and uncertain market.   “Diversification,” which was previously the number one answer, remains a close second.

Amount Currently Invested in Hedge Funds

Currently, over 50% of surveyed investors still manage less than $1 billion in hedge funds.  The Hedge Fund Capital Group expressed concern about this figure, explaining that more than $1 billion AUM is often necessary to build the institutional infrastructure for greater investments and to perform vigorous due diligence.  On the other side of the range, the number of investors with under $100 million invested in hedge funds is decreasing.  The Hedge Fund Capital Group explains that these funds have likely simply shut down due to the economy and inability to attract institutional investors, pension funds, endowments, and other larger investors.

A majority of surveyed investors have track records of investing in hedge funds for longer than five years (only 17% have less than 5 years), with nearly all of those with 15 or more years of experience based in North America, compared with their European and Asian investor bases.

Hedge Fund Managers

Since 2008 and in part due to the market, investors have been reducing the number of managers they use.  They have also started disfavoring portfolios that are too diverse due to the fact that due diligence requirements are now more costly and timely.  In addition to reducing the number of managers investors place their money with, investors are also preferring to place their money in larger hedge funds with AUMs of over $1 billion.  Those investors focused on managers with smaller AUMs are generally based in Asia or Europe.

Allocations

In 2009, most investors made 5-10 initial allocations.  Those investors who made over 10 initial allocations in 2009 were concentrated in Europe–a total of 54%.  But in terms of follow-on allocations, U.S. based investors led the pack, with 50% making over 30 follow-on allocations.

Redemptions

Despite generally positive performance last year, investors are continuing to make redemptions–the Hedge Fund Capital Group explains this as a result of those managers who have not performed during the market bounce or those that froze assets and their investors are only now able to begin redeeming.  The investors that have made the most partial redemptions–30 or more in the last year, were primarily fund of funds and private banks.  This finding is consistent with the perception that these investors are performance chasers.

Available Cash to Allocate

Compared with 2009, surveyed investors are generally holding less cash.  50% of investors are either fully invested or only holding 0-5% cash.  But the good news is that 29% have 10% or more cash available for investment.

Following up on the previous findings, surveyed investors are confident for 2010.  Those that predict they will be fully invested in the next six months increased from 18% to 21%.  Those that predict they will hold 0-5% cash increased from 32% to 39%, demonstrating a goal of investing more.

Hedge Fund Managers

Challenges and Assessing a Manager

In terms of the biggest challenges investors faced in 2009 and 2010, “selecting and monitoring manager” posed the biggest challenge, with “lack of transparency” also ranking highly.  This year, “investments frozen with a manager” was a new category and also ranked very high.  When assessing a hedge fund manager, investors used to cite the 3Ps: performance, philosophy, and pedigree.   While those qualities continue to be important, investors have increasingly focused on risk management and transparency.     This reflects greater caution and less reliance merely on manager pedigree.  Performance ranks first, risk management ranks second, and philosophy ranks third in terms of importance.

Length of Due Diligence Process

The due diligence process has gotten more costly and timely.  For most investors–over 50%, need 3-6 months to conduct due diligence of a manager.  This statistic is consistent over the last three years.  The percentage of investors who can complete this in less than 3 months has increased slightly and so has the percentage of those who need 7-12 months.

Seeding Business

The institutionalization of hedge fund investing is making it increasingly difficult for new launches to attract investors. While a minimum of $50 million AUM was once sufficient, the critical minimum is now $100 million.  Emerging managers are therefore increasingly turning to the seeding business “to overcome the hurdle of reaching the critical size to gain visibility and profitability.”  17% of the investors surveyed seed managers.  The majority of seeders are U.S. based–59%, with 30% in Europe, 9% in Asia, and 2% in Australia.  Funds of funds are the primary investors that seed, with asset management companies and high net worth individuals following.

45% of fund of funds seed managers, followed 26% of asset management companies and 17% of family office/high net worth individuals.

There are three seeding business models: (1) revenue split, (2) equity split, and (3) platform.  Under the revenue split model, seeders provide capital in exchange for participation in management and incentive fees.  Nearly half of seeders surveyed use this model.  Seeders provide capital in exchange for equity ownership and generally take active partnership role under the equity split model.  19% of seeders surveyed adopt that model.  Finally, under the platform model, established hedge funds and financial institutions provide capital and “turnkey” solutions in exchange for profit share.  Only 9% of seeders surveyed adopt the platform model.  Before a manager turns to the seeding business, it should consider the support offered by the seeder, including the form of operations, risk management, marketing, strategic assistance and business development, and compliance and legal support.  In addition to providing funding, well-respected seeders can also provide reputational capital.

For the most part, the average seeding ticket ranges from $25 million to $75 million, with fewer under $10 million and even fewer greater than $100 million.

Consultants

6% of the surveyed investors consider themselves to be investment consultants.  The findings show that there has been an increasing presence of such consultants in the hedge fund industry.  These firms serve as the “bridge between investment managers and pension funds.”  The largest percentage of the consultants’ client base is the family office/high net worth individuals, followed by government funds, and fund of funds.

Hedge fund investors are also more frequently turning to consultants to perform extensive due diligence.  These investors do not have the resources to perform increasingly rigorous due diligence and rely on consultants.

****

Other related hedge fund law articles:

• Hedge Fund Investors
• Institutional Investors and Due Diligence Requests
• Hedge Fund Service Providers

Cole-Frieman & Mallon LLP provides comprehensive hedge fund start up and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.