The hedge fund industry is midway through an important transition
in its source of capital. Five years ago, hedge funds derived
virtually all of their assets from wealthy individuals. Institutional
interest was limited to a small number of endowments and foundations.
Over the next five years, institutions (including pension
funds) are likely to provide an additional $250 billion of
hedge fund capital, accounting for 35 percent of net new flows
in this period. Coupled with the increasing influence of the
fund of hedge fund industry, new hedge funds will be dependent
on "professional" sources of capital for 70 percent
of their capital
The thesis of our report is that this transition is having
a dramatic impact on the hedge fund industry. Relative to
individual investors, institutions have significantly different
product demand and return expectations. They also require
hedge funds to have business models that are more robust and
resource-intensive than has been heretofore acceptable. The
result will be an industry much more mature than it is today.
This is, therefore, an auspicious time to be studying hedge
funds. Yes, there will be a surge in institutional capital.
Capturing that opportunity, however, will be challenging.
Though many hedge funds are making the appropriate adjustments,
the great majority of hedge fund managers are unlikely to
meet the new stringent requirements.
Organizing Our Thoughts
Our objective in this report is to be both descriptive of
and prescriptive to the hedge fund industry.
Chapter 1 presents the current state of institutional demand
for hedge funds. We describe, among other topics: the size
of demand by segment; return expectations; use of fund of
hedge funds versus direct investing; and barriers to hedge
Chapter 2 anticipates the impact of increasing demand on
hedge funds. Over the next few years, how much capital is
likely to flow from institutions? How can the hedge fund industry
absorb more money? What will be the impact on traditional
Chapter 3 summarizes what we believe to be the keys to attracting
institutional capital. We present a list of seven attributes
against which hedge fund firms can benchmark whether they
meet the emerging industry standards for a leading hedge fund
firm. (We encourage institutional investors to employ this
Over 50 senior professionals from leading institutions,
hedge funds, and other hedge fund related organizations provided
their thoughts in individual interviews in the Spring of 2004.
We gratefully acknowledge their willingness to share their
time and unique perspectives.
Individual Interviewees Include1:
| Firm Name
|AFK & Partners
Angelo, Gordon & Co.
Angelo, Gordon & Co.
Barclays Global investors
John M. Angelo
Michael L. Gordon
Peter V. Landin
Chief Executive Officer
Chief Investment Officer
Chief Executive Officer,
U.S. Institutional Business
|Gartmore Investment Management PLC
General Motors Asset Management
|Glyn P. Jones
B. Jack Miller
|Chief Executive Office
Chief Investemnt Officer,
|GLG Global Investment Management
lowa Public Employees
Ivy Asset Management Corporation
Maine State Retirement System
Rocaton Investment Advisors, LLC
The Rohatyn Group
Seattle City Employees
State of Akansas Retirement System
Strategic Investment Group
Symphony Asset Management
Symphony Asset Management
Thunderbay Capital Management
Kathy S. Comito
Lawrence J. Simon
Robin S. Pellish
Brian C. Lippey
Gail H. Stone
Deborah D. Boedicker
Jeffrey L. Skelton
Chief Investment Officer
Chief Executive Officer
Chief Investment Officer
Chief Executive Officer
President and Chief Operating
Chief Investment Officer
Chief Operating Officer
President and Chief Executive
Chief Executive Officer and
|United Mine Workers
University of North Carolina
Management Company, Inc.
University of Rochester
University of Southern California
Verizon Investment Management Corp.
|John C. Mogg
Mel A. Williams
A. Duff Lewis Jr.
Jeffrey A. Fischer
Kevin E. Lynch
Director of Private Investments
Director of Research
We also thank Institutional Investor for allowing us to conduct
a poll of the attendees at their June 2004 Spring Hedge Fund
Investment Roundtable. Over 80 institutions were represented.
Given the current dynamic industry environment, we felt it
essential to talk firsthand with over 50 leading institutional
investors, hedge fund managers, and experts about this so-called
"institutionalization" of hedge fund investing.
(A partial list of interviewees can be found in the Acknowledgements
on Page 2.) We focused our discussions on topics such as:
o What are institutions' objectives in hedge fund investing?
o Where do hedge funds fit within an institution's portfolio?
o What do institutions look for in a hedge fund firm?
o How is the role of fund of funds changing?
o How will increased institutional demand change the industry
We conducted additional primary research through a survey
of over 80 participants at Institutional Investor's June 2004
Spring Hedge Fund Investment Roundtable. Here, investors and
managers were asked an extensive series of closed-end questions,
the results of which are incorporated throughout this document.
Finally, using secondary sources, we created a bottom-up
view of hedge fund demand by building a database of about
400 U.S. institutions identified as currently making hedge
The term "hedge fund" is challenging to define.
We view hedge funds more by investment approach than by legal
vehicle. For us, hedge funds are a sub-set of alternative
investments that incorporate all investment strategies run
with an orientation to producing primarily absolute returns
using largely marketable securities. These strategies typically
include short-selling and often include leverage. As a result,
correlations with broader markets are expected to be modest
Our paper will focus on four primary U.S. institutional investor
segments: corporate defined benefit plans, public defined
benefit plans, endowments and foundations, and insurance companies.
We exclude banks and broker dealers (who are increasingly
putting proprietary capital to work in internal and external
hedge funds) and family offices. We focus on the U.S., but
believe our exposition to be generally applicable to all geographical
markets and client segments.
Chapter 1: Current State of Institutional
This chapter provides a snapshot of the current institutional
interest in hedge fund investments. We size the market and
describe each institutional segment's investing behavior,
including performance objectives, non-performance criteria,
and predilection to using fund of funds. We conclude with
a discussion of the reasons why many institutions have not
and will not invest in hedge funds.
Current Demand by Segment
We estimate that, at the end of 2003, U.S. institutions had
invested approximately $66 billion in capital with hedge fund
managers. This capital came primarily from about 400 institutions.
As indicated in Exhibit 1, endowments and foundations have
been at the vanguard of institutional hedge fund investing.
Generally speaking, trustee familiarity with finance, more
modest regulatory constraints on fiduciary responsibility,
and less public scrutiny have allowed endowments and foundations
to be early and rapid adopters of alternative investing. Currently,
they account for about half of all institutional capital.
Nearly 40 percent of all endowments and foundations with more
than $100mm in this segment have made some investment, with
average allocations of nearly 12 percent of their total portfolio
and some allocations nearing 50 percent. Many are close to
reaching their target allocations of between 15 and 20 percent
of the total portfolio. Despite representing nearly five times
as much in assets as endowments and foundations, defined benefit
plans currently account for just 40 percent of institutional
hedge fund capital, roughly evenly split between corporate
and public plans. Only about 15 percent of pension funds currently
invest in hedge funds and, among investors, allocations average
merely 3 percent of invested portfolio assets.
Defined benefit plans, however, are the fastest growing
source of institutional capital. Five years ago, pension interest
in hedge funds was minimal. The stock market bubble and the
ensuing dramatic bear market and resulting swing to under-funded
status has forced pension funds to reassess their investment
policies. As a result, many pensions began in the early part
of this decade a systematic study of hedge fund investing.
At first accused of more talk than action, a large number
of pensions have begun making investments into hedge funds
over the last 18 months. More importantly, these plans have
begun to adapt their investment policies and sought legislative
approval to systematically include hedge fund strategies-a
step that will ensure continued capital flows over the next
Insurance companies (for their general account) represent
the least developed institutional market for hedge funds-less
than 10 percent of all institutional hedge fund capital. Demand
is not systematic, coming from a relatively small number of
firms. Insurance firms face multiple impediments: the tax-inefficient
nature of many hedge fund strategies; the challenges of insurance
accounting rules; variations in state laws regarding hedge
fund investing; and regulatory capital requirements.
Portfolio Role for Hedge Funds
Most institutions that have hedge fund investments have done
so via a dedicated allocation, with investors split evenly
between those that include them as part of a broader "Alternative
Investment" mandate and those that have a specific "Absolute
Return" sleeve. Only a small minority identifies their
hedge funds as part of existing "traditional" policy
ranges (e.g., long-short equity as part of a domestic equity
sleeve). To circumvent hedge fund restrictions, a few institutions
have turned to more creative solutions, for example, using
portable alpha strategies or using hedge funds as a liquidity
pool for private equity investments.
Where has the capital now dedicated to hedge fund allocations
come from? For endowments and foundations, the rise in hedge
fund investing has occurred in parallel with a systematic
reduction in both long-only equity and fixed income investments,
but particularly the latter. In effect, many endowments and
foundations have been using a diversified pool of hedge funds
as a substitute for fixed income, though this has been an
implicit rather than explicit policy. For pensions, the capital
commitments have been small enough to be funded through ongoing
portfolio rebalancing. For most pensions, hedge fund capital
has come from a decline in fixed income allocations, though
this has been a tactical, not strategic decision, given current
low but expected increases in interest rates.
Institutions have an average net-of-fee return expectation
from hedge funds of about 8 percent. As Exhibit 2 indicates,
nearly three quarters have expectations between 6.5 and 9.5
percent. This result was interesting to us, given that similar
research done three years ago indicated that expectations
were about 400 basis points higher. (Whether weaker returns
to date in 2004 will further dampen expectations, remains
to be seen.)
What accounts for this resetting of expectations? First,
many of the newer entrants to hedge fund investing (especially
defined benefit plans) prefer to do so through a lower volatility
aggregate hedge fund portfolio than was typical among earlier
adopters. Second, many institutions are setting target returns
on a risk-free-rate-plus basis, rather than as a static absolute
number; therefore, expectations have come down with rates.
Third, most institutions are placing a higher premium on hedge
fund strategies' ability to diversify their portfolio-outsized
returns are no longer the primary justification for making
a hedge fund allocation. Finally, many institutions are anticipating
a decline in returns as more capital pours into hedge fund
strategies (discussed in greater detail in the next chapter).
Fund of Funds Versus Direct Investing
Currently about one-half of all institutional investing is
done through a fund of funds structure. (In "fund of
funds" we include both literal fund structures and customized
separate accounts structured and maintained by third parties.)
Defined benefit plans have been more likely to use a fund
of funds format; as newer entrants, they require greater support
in gaining access, diversification, and education. Endowments
and foundations with longer experience in hedge funds have
had a greater propensity to make direct investments.
Institutional investing is not, however, proving to be as
black and white as described above. As indicated in Exhibit
3, about 25 percent of institutions are employing a dual investment
model in which both direct investing and fund of funds are
employed. Most typically, a dual investor adds individual
direct investments to an initial allocation to one or more
fund of funds. This is done both to achieve a total hedge
fund portfolio with the specific risk attributes the investor
desires and to avoid additional double layers of fees. As
they move into their "second stage" of investing,
current dual investor have on average greater capital allocated
to hedge funds than investors following the direct only or
fund of funds only models.
However, we find little evidence of institutions abandoning
their fund of funds relationships as they develop experience
with hedge funds. Most institutions are recognizing that the
depth of resources required to effectively source, select,
and monitor hedge fund investments are significant and expensive.
At most, institutions are taking it upon themselves to begin
to select managers in certain investment strategies, presumably
where they believe they have some expertise (such as long-short
equity or distressed debt). Even with these direct investments,
however, institutions are reliant on their fund of funds partners
to be a sounding board.
In this context, we find it interesting that, for many institutions,
fund of funds are becoming the de facto investment consultant
for hedge fund allocations. They are counted on as trusted
overall advisors, providing manager search, strategic and
tactical asset allocation guidance, as well as risk monitoring.
In our survey, traditional institutional investment consultants
were rarely mentioned as being influential in selecting individual
hedge funds for their clients; most have been relegated to
selecting fund of funds.
Barriers to Hedge Fund Investing
No summary of current institutional interest in hedge funds
would be complete without a fair representation of a contrary
view. After all, most institutions still do not allocate to
hedge fund strategies. Why?
As Exhibit 4 supports, the primary reason for not investing
remains Headline Risk. Headline Risk is the (not irrational)
view that poor performance (let alone malfeasance) among hedge
fund investments will bring outsized criticism relative to
the same performance from more traditional managers. For public
and corporate officials, whose careers are in the balance,
this asymmetric risk is often perceived as simply not worth
taking. One of the reasons endowments and foundations have
been earlier hedge fund adopters is that their trustees generally
face less retribution.
Among non-investors, the next most important concern is that
hedge funds will fail to deliver the promised goods. In particular,
these institutions expect that especially with greater flows
of capital to hedge funds, returns will be reduced and/or
that correlations will increase. Any remaining perceived benefits
do not outweigh the additional headaches associated with hedge
For a few particularly large institutions (say, over $30
billion in assets), one additional reason for not investing
was their inability to effectively put enough capital to work
in hedge funds to receive the full benefits of diversification.
While this is a small number of institutions, they represent
a large pool of potential capital.
Finally, our survey work indicates that lack of sophistication
is not necessarily an important factor among most non-investors.
Many have begun or continue to study alternatives in general
and hedge funds specifically. Exhibit 4 also indicates that
most do not overly weight lack of transparency or high fees
Chapter 2: Impact of Increasing Demand
Whereas the previous chapter discussed the current state
of institutional investment in hedge funds, this chapter attempts
to discuss the future potential. We believe that as total
hedge fund capital grows beyond the $1 trillion mark, the
nature of the industry will change as well. These changes
can be expected to range from the institutionalization of
capital flows, to the lowering of expected future returns,
to the waning of traditional long-only management
Future Capital Flows
We expect that by 2008 U.S. institutions will have over $300
billion in capital invested in hedge funds. Assuming a market
return of 7 percent per annum, this implies a net growth rate
of over 35 percent per year. Exhibit 5 illustrates our projection.
This increased capital flow will be driven disproportionately
by defined benefit plans, as endowments and foundations have
already made larger percentage allocations. We expect pensions'
proportion of institutional capital to move from 40 percent
to over 65 percent by 2008. Defined benefit plan capital contributions
will come from both first time investors as well as current
investors fulfilling their investment policy objectives.
We anticipate that fund of funds will maintain roughly a
50 percent share of the capital allocated from institutions.
While direct investing will continue to grow, the dual investment
model (described in Chapter 1) will preserve a base for fund
of funds that will also grow with new investors (who will
more likely choose the fund of funds vehicle over direct investing).
Perhaps more interesting and important than the absolute
level of institutional hedge fund investing, will be the changes
in net new flows. As illustrated in Exhibit 6, U.S. institutions
will likely increase to a 50 percent of net new capital flowing
to hedge funds globally. Add European and Asian institutions,
and the percentage likely rises even higher. This transition
is dramatic-institutional share was less than 10 percent through
Why won't individual investment keep pace with institutions?
First, the high net worth individual market is already very
large at about $800 billion. At this size, it is unlikely
to sustain as high a percentage growth rate. Second, we believe
it not unlikely that a reduction in average hedge fund returns
will temper individuals' enthusiasm for hedge funds, as individual
investors will continue to have higher return expectations
Where Will the Capacity Come From?
Can the hedge fund industry sustain its rapid growth? As
illustrated in Exhibit 7, net new flows will begin to exceed
$100 billion per year-a figure larger than the entire industry
To put this into perspective, $100 billion of capital can
provide $2 billion in new capital to 30 firms while seeding
400 new funds with $100 million each. Does the math work?
Is there really enough talent? Are there enough strategies?
Lower Returns. One mechanism for avoiding future disappointment
is for investors to lower their expectations. In Chapter 1,
we established evidence that institutions have already dropped
their return expectations relative to three years ago. Exhibit
8 presents evidence that continued reductions in expectations
are likely. Thirty-seven percent of surveyed investors believe
that increased capital flows will "significantly"
reduce average returns in the future; another 29 percent believe
that they will fall "slightly."
New Strategies. A second moderating factor is the
ability to create more investment capacity. We are likely
at a current point in time where rapid increases in demand
for quality hedge fund capacity is temporarily outpacing the
market's supply. Yes, some hedge fund strategies will continue
to be plagued by a surfeit of capital. However, fertile minds
will advance ever more esoteric strategies into existence.
(Several interviewers made remarks akin to: "Any activity
within an investment bank with an IRR of 15 percent is ripe
to become a hedge fund.")
Unfortunately, traditional arbitrage and new exotic strategies
may not be able to effectively absorb the majority of new
capital. Therefore, we expect the continued expansion of high
capacity strategies such as some Macro and CTA strategies
and, especially, public equity-based strategies. In particular,
a majority of our survey participants indicated a growing
demand for non-traditional, generally long-only portfolios
(e.g., those with an absolute return orientation, the potential
for modest shorting, and commanding high fees, usually including
a carried interest). We refer to these strategies as hybrid
strategies, neither traditional long-only nor the usual long-short
equity or fixed income strategy.
Challenges to Traditional Active Management
The significant movement of institutional capital to hedge
fund strategies will create business challenges for traditional
active money management firms, both in equity and fixed income
management. First, there is the direct effect of capital redeployed
from traditional2 long-only active managers to fund hedge
fund allocations. Second, a more important indirect effect
is that the hedge fund phenomenon reflects a growing desire
to separate alpha from beta, taking market exposure through
low cost vehicles such as index funds, exchange traded funds,
or derivatives while directing advisory fees to those managers
who deliver high alpha for their level of risk.
Exhibit 9: The Alpha Beta Squeeze on Traditional
Source: Casey, Quirk & Acito and The
Bank of New York analysis.
Thus, traditional active managers are currently caught in
an alpha-beta squeeze. As illustrated in Exhibit 9, "a
pressure" represents institutions' willingness to search
and pay for pure alpha; "ß pressure" represents
institutions' unwillingness to pay much for broad market exposure.
The pressure from both sides is squeezing asset allocation
out of traditional active management and into index-like and
alternative investing strategies. Over the next several years,
we are likely to witness a diminution of active management
for institutional investors-both as a percentage of the overall
portfolio and, barring high market returns, on an absolute
basis as well.
Exhibit 10 reflects how the alpha-beta squeeze is affecting
institutions' behavior towards long-only active management.
Over one-third of respondents indicated that they expect (or
already have) significantly reduced long-only allocations
in favor of beta (index-like) products and alpha products
(hedge funds and other alternative strategies). Additionally,
another one-third of respondents indicated that they expect
their long-only managers to become more absolute return oriented.
Current long-only managers will need to turn their attention
to the hybrid product area previously discussed to tap into
this growing market. Unfortunately for them, these hybrid
approaches have not gone unnoticed by hedge fund firms. Many
are having discussions with clients to run long-only like
strategies. Hedge fund firms may have an advantage here-institutions
seem more confident in their ability to focus on absolute
returns than with managers who have historically been rewarded
for being down 25 percent when the market is down 30 percent.
Chapter 3: Attracting Institutional Capital
Which hedge fund firms will be successful in attracting institutional
capital? This chapter introduces the seven attributes that
we believe will characterize successful firms. These factors
were the most often mentioned during our extensive interviews.
This checklist can serve as a benchmark for evaluating a firm's
current and future competitive position.
Taken in their entirety, these attributes define a much more
mature business model than has heretofore been required in
the hedge fund industry. It is more resource-intensive and
will require overall higher professional standards. And, while
institutions believe large and small hedge fund firms alike
will be viable in the future, meeting these institutional
standards will require greater scale than before.
We begin with the assumption that the primary driver of hedge
fund success will be the investment professionals' perceived
ability to deliver returns in line with clients' expectations.
Given managers of equal skills and the proper alignment of
financial interests, which are the hedge fund firm attributes
that will most appeal to institutional investors? Based on
our interviews, we have settled on seven primary requirements
for institutions' success, listed in Exhibit 11,and described
throughout this chapter.
1. Business Management
As this paper argues, the growing "institutionalization"
of hedge fund demand will require greater resources and higher
professional standards than heretofore required for success.
Organizing these resources and instilling professionalism
require strong tactical business management skills. Just as
venture investors pair business leaders with inventors, institutional
investors are expecting CFO's and COO's to complement investment
professionals. The larger and more complex the hedge fund
firm, the higher the premium put on business acumen.
The attention to business management is rational. Institutions
want to be assured that their hedge fund advisor is a viable
long-term business and that investment professionals are not
distracted from making good decisions about their portfolios.
They want to minimize potential disruption due to over-dependence
on any one individual for the effective operation of the firm.
Putting into place the appropriate business management talent
will be a challenge for the hedge fund industry. First, the
current supply of experienced talent is limited. Second, the
investment professionals who dominate most hedge fund firms
are often still reluctant to recognize the importance of such
skills. Quite possibly, the institutionalization of hedge
fund demand may require consolidation around the short commodity
of business leadership.
2. Culture Of Integrity
Leading institutional investors rightfully require very high
standards for professional conduct throughout an entire investment
management firm. They want to be assured that their advisors
are acting in the best interests of their clients at all times.
Hedge fund managers must instill in their firms unimpeachable
ethical standards with little to no tolerance for infractions.
Adequate resources must be dedicated to compliance.
Best practices will include a series of independent checks
and balances that reinforce the culture of integrity, especially
with regard to valuation, risk management, trade settlement,
cash movements, and custody. These duties should be segregated,
and potentially performed by third-parties (especially with
regard to valuation). A culture of integrity must be reinforced
by policies in the spirit of "trust but verify."
3. Operational Excellence
Institutions are placing greater emphasis on hedge fund firms'
business infrastructure. As indicated in Exhibit 12, "operational
and infrastructure excellence" and "outstanding
risk management" are clearly the most important non-investment
characteristics to institutional investors. (At this point
in time, investors are placing much greater emphasis on these
attributes than on client service and investment process or
During our interviews, institutions most often specifically
mentioned the following operational concerns:
o Third-party verification of pricing.
o Documented policies and procedures. Institutions require
documentation; leading firms
have and make available written details of all key operations.
o Well-designed trading infrastructure that links trade-order
accounting, and risk management.
o Robust disaster recovery.
o Senior professional operational leadership independent
of the investment team.
Meeting the increased standards for operational excellence
will be a significant challenge for many firms. As a result,
we are likely to see the continued growth of outsourcing options
for hedge fund firms.
In addition, we believe that institutions will also expect
hedge fund managers to systematically address Embedded Alpha
or the less apparent "frictional" costs of managing
an investment portfolio. These costs include portfolio financing;
the opportunity cost of failing to execute trades efficiently;
ineffective cash and collateral management; and the negative
market impact of trading. Embedded Alpha costs have been estimated
to be 100 to 200 basis points or more per annum. To date,
most hedge fund managers have not explicitly managed Embedded
Alpha. However, with lower expected returns, these embedded
alpha costs become even more relevant.
4. Disciplined Investment Process
Institutional investors realize that great investment management
is a blend of art and science. That said, to appeal to institutions,
hedge funds must demonstrate how they make clear investment
decisions. Hedge funds must have investment processes that
are understandable (even if complex), consistent, risk-aware,
and perceived to be repeatable. A clearly-defined investment
process establishes credibility among buyers and intermediaries.
It establishes confidence in the consistent delivery of performance,
within the agreed-upon risk parameters.
To appeal to institutions, hedge funds must also be able
to articulate in a clear and concise manner the true competitive
advantage that they possess-i.e., how they will deliver alpha
in a manner that is unique and compelling.
Sophisticated evaluators are also assessing whether hedge
funds have the appropriate quantity and quality of investment
professionals to credibly implement their investment process.
This is particularly true of fund of hedge fund firms, where
the staffing requirements have increased substantially over
the past few years.
Quantitative research skills and tools have taken on a significant
role in the investment industry, and hedge funds should be
able to master and leverage these tools, even if their core
processes are fundamental in nature. They are not a panacea
but can provide support for the research and decision-making
processes. They can also provide significant leverage to an
investment team. Leading hedge fund managers are integrating
quantitative tools into several parts of the investment process
such as: screening and idea generation, portfolio construction,
attribution analysis, and performance monitoring.
5. Investment Strategy Innovation
Many institutions recognize that hedge fund investment strategies
face cycles and secular trends with regard to their effectiveness.
As a result, they expect that hedge fund firms will dedicate
resources to constantly evaluating the effectiveness of their
investment process. Appropriately augmenting their investment
capabilities will be a core competence of successful hedge
fund firms-whether this is hiring a new trading desk or constantly
developing new quantitative models.
In some ways, institutions seem much more tolerant of such
investment process reinvigoration among hedge funds than among
traditional managers (where it is perceived as "style
drift"). Many institutionally accepted hedge fund firms
have migrated, for example, from merger arbitrage specialists
to broader event-driven managers, or from convertible bond
specialists to capital structure arbitrageurs.
6. Comprehensive Risk Oversight
Institutions have high expectations for their hedge fund
managers with regard to risk controls. Most obviously, they
expect a strong handle on all market risk factors to which
a portfolio (not just an individual security) is exposed.
Proprietary tools are encouraged, though thoughtful application
of third-party packages is also satisfactory.
However, institutional caliber firms will approach risk as
being broader than simply market movements. As Chapter 2 described,
institutions view "Headline Risk" as the most significant
impediment to hedge fund investing. They also believe that
operational breakdowns are the most prevalent source of hedge
fund failures. As a result, hedge fund managers should also
have a compelling approach to operational, regulatory, and
counterparty risks if they are to appeal to institutional
Institutions perceive risk oversight best practices to include
having senior risk professionals who are independent of the
7. Sophisticated Client Interface
Historically, investment firms have been product-driven,
focusing on clients only after the products have been created
and are ready for sale. To be fully successful in the institutional
market segments, hedge fund firms will require a broader set
of distribution skills, among them:
o Dedicated Client Service. Institutional clients
expect hedge fund managers to provide professional interaction.
Institutions do, however, respect the fact that senior investment
professionals should spend the majority of their time managing
capital. Leading hedge fund firms are beginning to employ
senior individuals to act as intermediaries between the manager
o Quality Communications. Institutions require that
information and insight, not just data, be provided to them
at regular intervals.
o Solutions Resources. Institutions often look to their
investment managers not only as a provider of product, but
also as a sounding board for their investment issues. Leveraging
proprietary intellectual capital as a means of influencing
the institutional market can therefore, provide an enormous
competitive advantage. A well-structured thought leadership
effort can play an important role in establishing such a market
reputation and can create a most effective "dialogue-generation
tool" to reach the firm's target audience.
o Willingness to Provide Transparency. Most institutions
do not (yet) want hedge funds to provide them with full transparency
on their holdings-most have little ability to process and
assess this information. However, institutions are interested
in the willingness to provide this information to their fund
of funds or third-party risk vendor (on a detailed level).
Institutions will increasingly negatively view complete intransigence
on this issue.
Sophisticated client interaction generates a more stable
capital base for existing products and will provide greater
opportunity to raise future funds.
As documented in our report, the hedge fund industry is midway
through an important transition with regard to the sources
of its capital. Five years ago, hedge funds derived nearly
all of their assets from wealthy individuals. Institutional
interest was limited to a small number of endowments and foundations.
Over the next five years, institutions (driven by defined
benefit plans) are likely to provide an additional $250 billion
of hedge fund capital, accounting for 35 percent of net new
flows in this period. Coupled with the increasing influence
of the fund of hedge fund industry, new hedge funds will be
dependent on "professional" sources of capital for
on average 70 percent of their capital.
The good news is that the next several years will provide
hedge funds with an opportunity to raise significant capital
from institutional investors, a desired client base for most
hedge fund managers.
However, capturing this opportunity will not be easy. Institutional
investors are much different than the traditional individual
investor base for hedge funds. Relative to individual investors,
institutions have significantly different product demands
and return expectations. They also require hedge funds to
have business models that are more robust and resource-intensive
than has been heretofore acceptable, including higher standards
for overall business management and operations and greater
demands for client service. Given that serving institutions
will be a business necessity for the average hedge fund, we
expect that this transition will have a dramatic impact on
the hedge fund industry, resulting in more mature business
models than are typical today. Though many hedge funds are
making the appropriate adjustments, the great majority of
today's hedge fund managers are unlikely to meet the new stringent
requirements. Likely, the next great generation of hedge fund
firms are only beginning to be built today.
1Most interviewees requested to remain anonymous.
Their names are not listed above.
2We define "traditional" investment management to
be fully-invested, non-leveraged, long-only portfolios of
liquid securities managed for a flat asset-based fee with
performance measured relative to a benchmark.