The Future Of Alternative Investments

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This text examines the forces driving today’s alternative investment industry and considers where these may take the industry in the coming years, focusing on the core asset classes of private equity buyouts, hedge funds and venture capital. Alternative investment has matured over the last 30 years and is gradually becoming part of the mainstream financial industry, garnering greater attention and acceptance from both regulators and the general public. However, it is also entering a period of considerable growth and change due to the influence of macroeconomic drivers, post-crisis financial industry regulation, and two critical industry trends: the increasing sophistication of institutional investors and the rise of retail investors as an important source of capital.

The most fundamental macroeconomic driver is the rise of emerging market economies. They generate new investment opportunities and serve as an increasingly important source of capital. At the moment, most emerging market capital flows into alternatives via sovereign wealth funds (SWFs), but the growing number of high net worth individuals in emerging markets – and their openness to alternative investing – will soon become important. Demographics in the developed world are also critical, as the rising tide of pensioners is leading to a growing funding gap in retirement systems. With the leading central banks likely to keep benchmark interest rates near zero for the foreseeable future – ensuring low returns from fixed-income investments – many pension funds are increasing their allocations to higher return alternative investments.

Meanwhile, post-crisis regulatory reforms intended to improve the stability of the global financial system are creating both challenges and opportunities for alternative investors. Bank capital, liquidity and collateralization reforms have discouraged banks from holding many alternative assets on their books and from lending short-term money to fund some alternative investments (e.g. hedge fund strategies). New regulations aimed directly at the investment and alternatives industry are also requiring firms to improve their infrastructure, transparency and texting and are speeding up the maturation of the industry. However, the cost and complexity of the new laws is creating barriers to entry for the industry which may reduce innovation in ways that drag down the long-term returns available to investors critical to society, such as pension funds. Institutional investors are presently the main supplier of capital for alternatives, and their growing confidence and investment capabilities after investing over multiple economic cycles – a complex phenomenon known as “institutionalization” – is a key driver of many future trends in the industry.

The process has helped to increase both the size of the industry and its importance to wider society. However, an even more fundamental change in the retirement sector, the shift from defined benefit to defined contribution pensions (where investments are controlled by individuals), may lead to a significant influx of retail capital into the alternatives sector. This “retailization” trend will be a key driver of growth in the alternatives industry in coming decades, and not just for the current incumbents. Traditional financial services, led by asset managers and banks, will also dramatically expand revenue streams associated with providing access to alternative investments or related products. In turn, regulators will face the challenge of crafting laws that protect investors from unwise investments, while still permitting them to access the returns and diversification benefits associated with alternative products.

The balance of power between investors and alternative investment firms is shifting in the face of both institutionalization and retailization, leading to the convergence into five core business models defined by both the source of capital (institutional or retail) and the degree of asset specialization:

— global alternative asset managers will build global platforms offering a wide range of products, but will also invest in creating alpha for large institutions (e.g. through developing in-house operating teams to run target firms)

— specialists (region/industry) will rely on a comparative advantage in generating alpha for institutional investors within a niche investment segment

— retail alternative asset managers will focus less on alpha creation and more on their ability to master complex retail regulations and provide access to large numbers of retail investors

— start-up firms will sidestep the challenge of raising capital from institutions by offering a distinct value proposition to high net worth and retail investors

— funds of funds will need to develop new products in order to maintain support from institutional investors, but retailization may enable them to expand into retail products as well

While some firms may choose only one of these business models, others may develop more complex strategies. For instance, global alternative asset managers may be also tempted by the retail market and seek to expand into the retail asset management space, leveraging their brand and market position. This tendency may be heightened for the firms that have IPO’d, since publicly listed firms are much keener to increase their assets under management (AUM). In addition, traditional asset managers may become retail supermarkets with strong product offerings in the alternatives space, competing directly with pure-play alternative investment firms. Ownership and governance models may have significant repercussions on a firm’s choice of business model. Changes in the industry’s business models will also drive new capabilities and relationships. First, the growth of retail interest in alternatives will require new distribution channels, direct or through other financial intermediaries. Second, on the institutional investor side, the growing sophistication of some larger investors will lead to a more complicated set of relationships, especially for private equity and infrastructure financing.

Keen to increase returns and gain more control over their investment strategies, many institutional investors are now developing:

— direct investing capabilities in one or more asset types by creating their own investment teams (and thus disintermediating alternative investment firms entirely). However, the skills required for this approach mean that it will only be adopted by a minority of large institutions.

— co-investing capabilities, whereby firms also invest directly, but alongside a traditional fund investment and with the help of the fund manager. This reduces investment costs and avoids the need to develop full direct investing capabilities, but institutions must be able to react quickly to co-investment opportunities and ensure that the interests of all parties are aligned in order to avoid the problem of adverse selection, something that many may find challenging.

— joint ventures with alternative investment firms, whereby traditional one-off investments in a fund are replaced by a permanent, legally distinct partnership. This offers greater investment flexibility for institutions (e.g. over timing the sale of particular assets) and reduces investment costs, but it is a practical option mainly for very large institutional investors.

— separately managed accounts, based on the traditional mutual fund mandate model, appeal to a wider range of institutions, and offer significant flexibility through separating the ownership and the management of the assets (unlike a traditional co-mingled fund). This gives institutions more control and transparency over investments and allows them to change the management team without selling the assets.

Each of these models offers institutional investors a slightly different set of advantages, e.g. in terms of investment costs, control over investment decisions, and the internal capabilities required to put the model into action. That said, many institutions will retain a cornerstone strategy of investing through alternative investment managers as they are constrained by size, organizational set-up, or governance constraints. This conservative strategy will be seen as a safe bet until the long-term returns from the innovative models mentioned above are established.

The alternative investment industry is deeply embedded in the global financial system and economy, with investment decisions affecting capital markets, companies, and individuals across the world. This stands in stark contrast to its origins. The industry has grown from a handful of private investors making relatively small investments in companies and start-ups, to one that covers a wide array of asset classes and encompasses thousands of firms managing and investing trillions of dollars globally on behalf of institutional and individual investors alike. It not only survived the financial crisis, but emerged stronger and more important to stakeholders than ever before. The new economic and regulatory environment is impacting relationships with capital providers, while new business models are fundamentally challenging the competitive landscape. The goal of this text is to provide readers in the global investment and financial services industries with a perspective on the future of the alternative investments.

The text is broken into three parts:

First, we identify and assess the macro level trends that will affect the alternative investment ecosystem. These will include the rise of emerging markets, structural changes to retirement systems, and monetary policy amongst leading central banks.

Second, we will focus on the industry-level drivers of an increase in institutionalization, the rise of retailization, and changes to the regulatory climate.

Third, we will analyse these trends and provide an outlook on how the industry may evolve over the coming decade. We will identify the business and investment models that successful alternative investors and capital providers will employ to navigate the changing ecosystem. For the sake of clarity, we will use the nomenclature below to describe capital providers and alternative investors:

LPs (Limited partners): Asset owners that provide capital to alternative investment firms or divisions to invest on asset owners’ behalf

GPs (General partners): Firms that deploy capital in companies or securities on behalf of LPs/capital providers (such as private equity buyout or venture capital firms, or hedge funds)

Institutional investors: A subset of LPs comprised of institutions that invest capital with GPs (such as pension funds, endowments and foundations, and financial institutions)

Retail investors: A subset of LPs comprised of individuals that invest capital with GPs (such as high net worth or non-wealthy individuals or family offices)

Investors: An inclusive term that includes both GPs (who invest in securities and companies) and LPs (who may invest with GPs or directly in securities or companies)

To be continue...