Institutional investors are causing hedge funds to invest in operational infrastructure and increased transparency – a change that puts pressure on smaller funds and leads to a segmentation of the industry, a report by KPMG and AIMA shows.
The report “The Evolution of an Industry” based on a survey of 150 hedge fund management firms worldwide with assets of more than US$550 million found that funds improved their operational infrastructure to support investor transparency and regulatory compliance amid increasing allocations from institutional investors.
Robert Mirsky, head of hedge funds at KPMG in the UK, said “the combination of an increase in regulation, the changing nature of the investor base and the natural evolution of the business has made the industry nearly unrecognisable from only five years ago.”
While the majority of hedge fund assets before the financial crisis came from high net worth individuals and family offices, institutional investor have become the main capital source in the industry since 2008.
Institutional investors, such as charitable foundations, public and private sector pension funds, insurance companies and university endowments, represent 57 per cent of the industry’s assets under management. Seventy six per cent of funds reported increasing investments by pension funds. However, high net worth individuals who made up the majority of investments in the past are still among the largest investors particularly in smaller hedge funds.
The term institutionalisation of the hedge fund industry not only refers to the allocation of institutional capital to hedge funds, but also the continuing investments by hedge funds in operational infrastructure.
“Institutionalisation has been described as the continuing inflow of new institutional capital into the industry, but as this report demonstrates, it is also about the increasing sophistication of operational infrastructure with respect to transparency, compliance and due diligence,” said Andrew Baker, AIMA’s CEO.
The main effect of the influx of institutional money into hedge funds is that managers had to become more institutionalised to respond to investor demands for transparency and due diligence, which are greater when it comes to institutional investors. This meant significant increases in headcount across the industry. At the same time managers said they had to spend more time dealing with due diligence issues since 2008. Ninety per cent of respondents reporting an increased demand for due diligence since 2008 and 84 per cent of all respondents indicated they had increased transparency to investors.
The survey results also show that investor size and manager size are correlated when it comes to investment allocations. Large institutional investors tend to invest with large fund managers, whereas family offices are more likely to invest with smaller funds. Fund of funds, whose allocations are decreasing overall, are the exception and gravitate more towards funds with less than $500 million under management.
Given that a robust infrastructure is the only way to attract larger investors, it is expected that big funds will be getting bigger and barriers of entry to the hedge fund market will increase.
But large investors are not completely ignoring the smaller players. Boutique players continue to demonstrate an ability to evolve and thrive in this changing business landscape, the report noted, citing the example of the emergence of ‘co-opetition’, where managers with different strategies, who would otherwise be competitors, come together to form mutually-beneficial working relationships.
Small and large funds that responded to the survey said they are confident the industry will attract strong inflows of capital over the next years, but they also expect there will be fewer managers in operation.
Since 2008 new money to the industry has come mainly from North America, Asia Pacific and the Middle East. European Union allocations have been flat and those from Switzerland declined.