Alternatives Investors Look for More than Returns

Asia has experienced rapid growth in alternative investments in recent years, fuelled by investors’ search for increased alpha in emerging markets and by institutional players broadening their investment horizons to diversify geographical risk. Assets allocated to hedge funds, private equity and, increasingly, real estate and infrastructure funds have seen significant growth. This has led to alternative assets starting to become part of the investment mainstream.

But what are investor expectations in Asia for alternative investments? How are investible assets likely to be allocated across the different categories, including hedge funds, private equity, real estate, infrastructure and others? And – once an investor decides on asset allocation – is performance all that matters? Almost inevitably, the answer to the last question is a firm ‘no’, especially when investors and investment providers are dealing with a wider spectrum of sophisticated investment products in an increasingly litigious environment. Risk management, controls and transparency are fast becoming buzz words and perhaps more will be more so, in time to come.

Our recent global alternative investments survey1 conducted by PricewaterhouseCoopers2 and the Economist Intelligence Unit (EIU), revealed a strong and growing appetite for alternative investments, especially in Asia. Researched between December 2007 and January 2008, this global survey of 226 institutional investors and alternative investment providers also revealed a strong desire among investors for better risk management, controls and transparency.

Robust Growth Expected in Asia

In Asia, investors expect to increase their asset allocation to alternative investments, particularly in private equity and real estate funds.

Private equity and real estate funds continue, and will continue, to attract investors seeking diverse cash flows and returns with minimal correlation with equity and fixed income markets. The survey also highlighted significantly greater satisfaction with the performance of private equity and real estate/infrastructure funds than with their more mature hedge fund counterparts. This supports the shift in allocation into private equity and real estate/infrastructure products expected in the next three years.

The Growing Importance of Risk Management, Controls and Transparency

Alternative investment providers, besides understanding and responding to the evolving trends in terms of asset allocation, need to look beyond generating competitive returns to ensure their continued success in today’s competitive environment – namely, in the areas of risk management, controls and transparency.

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With the increased sophistication, knowledge and experience of allocating assets into alternative investments over the past decade, investors’ expectations have developed beyond looking at returns with little regard to risk. Investors’ concentration on risk management, controls and greater transparency from their service providers is expected to intensify, not only in more mature economies such as Europe and North America, but also in Asia. Larger alternative investment providers have developed robust middle- and back-office infrastructures to cope with investors’ increasing demands, in particular, providing comfort over risk management monitoring, controls and reporting. Now, small- and medium-sized boutique alternative investment providers are beginning to experience similar demands from their clients.

In Asia, professional risk managers are beginning to see demand for outsourced risk management services. Some boutique alternative investment providers either cannot afford, or do not have a sufficiently large scale of operations, to possess and operate robust middle or back offices. Services offered by these risk managers range from valuation of over-the-counter (OTC) instruments to third-eye reconciliations, stress testing of portfolios, value-at-risk (VAR) analysis and reporting.

According to the survey, the rapid growth in hedge funds, private equity, real estate and infrastructure funds has shown that investor expectations are changing with regard to how they allocate assets, who they select, why they deselect them and what they expect beyond performance. Alternative investments are fast losing their ‘satellite’ status as destinations for small portions of investment portfolios. Murmurs of alternative investments becoming ‘mainstream’ are more common. While performance remains investors’ top priority, transparency and risk management are fast becoming hot topics, as shown by the survey results.

So what do investors expect from alternative investments and their managers besides superior returns?

Adequate transparency of fee structure, qualified personnel, no conflicts of interests, risk management policies and monitoring, use of third parties and quality/timeliness of reporting are among the selection.

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Click on the image for an enlarged preview

Selection and Deselection of Investment Managers

Interestingly, Asian alternative managers believe there is a lack of focus on risk management when times are good, yet when markets plunge the spotlight is switched on. The survey revealed that the majority of the survey respondents globally, including Asia, still considered performance as their top selection criterion for alternative managers. Significantly, respondents from Asia placed greater emphasis on the quality of compliance and risk management than their peers elsewhere. Fewer than 60% of the respondents from Asia viewed quality of compliance and risk management as key criteria when considering third party alternative investment providers vis-à-vis their North American (47%) and Western European (50%) counterparts.

When deselecting an investment manager, risk management, controls and transparency assume far greater importance across the globe.

It is also interesting to note that size matters to Asian investors when deciding if an alternative manager should be deselected. About 31% of respondents from Asia, compared to 18% from North America and 25% from Western Europe, considered size as a key deselection criterion. This predominantly comes from the fact that Asian alternative funds are generally smaller in size than their Western counterparts. Therefore, the risk of becoming a substantial investor in a shrinking alternative fund is greater in Asia than elsewhere in the world.

Quality of Reporting

At present, the breadth and depth of reporting leaves much to be desired. Best practice from developed markets is starting to find its way into emerging markets, but Asian alternative managers must do much more to rise to the challenge and to gain deeper investor trust and acceptance. Managers also need to enhance their operational infrastructure and risk management processes to stay in the game, especially as investor due diligence starts to bring this into focus.

One of the key survey findings suggested that while information provided on investment strategy and performance is satisfactory, there is a lack of confidence in reporting. This is the case in the areas of: back-office operations, reporting potential conflicts of interest, management fee structure, valuation techniques and the use of third-party administrators, and monitoring thereof.

Only a minority of the respondents in Asia (less than 20%) consider the quality of reporting in the above areas as excellent or good. Investors are taking a keen interest in the quality of policies and procedures for back-office operations, valuation techniques and the capabilities of third-party administrators. Investors also seem to expect a higher level of disclosure of conflicts of interest and fee structures.

The survey also revealed that only a minority of Asian respondents believe their investment providers are good at operational risk management. Overall, less than 40% of respondents believe that their hedge fund and private equity managers have good risk management policies and practices. In particular, investors appear least confident in the areas of IT security (only 5% and 19% of hedge funds investors and private equity investors, respectively, gave a positive response), and segregation of roles and responsibilities (21% and 23%). The results may be attributable to the fact that Asian alternative managers, with the exception of real estate/infrastructure fund managers, are generally small- to medium-size enterprises (SME) with limited resources dedicated to back-office infrastructure. Clearly, while this may have been acceptable practice as the industry sought to establish itself in the early days, there needs to be a significant change in behaviour and focus going forward.

Similarly, the survey findings showed only a minority of the respondents from Asia Pacific believe that their alternative investment providers are good at financial risk management, with the main areas of weaknesses around valuation and stress testing of portfolios. Only between 5% and 27% of respondents believed that their alternative investment providers were strong in valuation, the use of VAR and stress testing. Respondents tended to have less confidence in their hedge fund investment providers’ financial risk management capabilities than in private equity managers’ capabilities (excepting the use of VAR).

Are Investors Themselves Prepared for This Shift?

Despite the growing calls for increased transparency and risk management, it is surprising that investors themselves have not done much internally to monitor the risks in alternative investments. In Asia, 56% of investors in alternative assets had not made any changes to their internal risk management frameworks as a result of increased exposures to alternatives. This is a concern, as the recent crisis in financial markets has shown that where risk management is lacking, great dangers lurk with painful lessons waiting to be learnt.

To this end, investors’ knowledge of risk management needs to be enhanced – only then can they demand better reporting from their alternative investment providers and push the industry to the next level.

Where to Next?

Risk management, controls and transparency are clearly areas for improvement for Asian alternative investment providers. The sooner they realise that investors are now focusing on such areas when considering deselection of their investment providers, the better. Alternative investment managers must move with the times to ensure their continued relevance in an increasingly transparent world; if not, they risk being marginalised as investor demand for governance means only the serious organisations will remain in business.

This article first appeared in PricewaterhouseCoopers Asia Pacific Investment Management and Real Estate News July 2008.


1Transparency versus returns: the institutional investor view of alternative assets

2PricewaterhouseCoopers refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.