A New Era Anthony Cowell, Partner, and Mikael Johnson, Partner
As many institutional investors, seemingly disillusioned with traditional equity markets, turn to the alternative investment industry in search of better performance and risk diversification, their demands for institutional grade controls, increased transparency, more liquidity and flexible product strategies are helping to drive fundamental changes.
One of the main underlying transformations is in the approach to the manager-investor relationship. In the past, managers focused mainly on performance, giving relatively low priority to communicating with investors or developing close client relationships. Now, many managers recognise that the new breed of investor expects a closer relationship – in our recent research, 70% of managers say that after performance, client service is their top priority. These managers are keen to adopt what we have called 'Attentive Anticipation': building an organisational culture that anticipates clients' needs and expectations and ignites innovation.
For their part, institutional investors are demanding closer alignment between their interests and those of the managers. This means managers putting more of their own seed capital into their funds, listening to clients rather than just pushing products on to them, and offering more transparency and liquidity, for example, through different fund structures such as managed accounts and, in Europe, UCITS wrappers.
Alignment is also being sought through fee structures. Institutional investors do not regard the old '2 and 20' formula, by which the manager charged an annual fee equivalent to 2% of the fund's net asset value and 20% of the profit, as sustainable. Instead, institutional investors are seeking individually negotiated 'local' agreements – and managers are accepting their arguments.
The Rise of the 'Entrepreneurial-Institutional' Manager
Having started as a fragmented collection of niche boutiques, the alternative investment industry later developed multi-billion dollar 'superboutiques' as investing institutions in their own right. Now, the industry is evolving further as managers respond to regulatory reform and upgrade their infrastructure, governance and controls to build business operations that are acceptable to institutional investors.
In particular, they are seeking to improve their investment and operating capabilities to accommodate significant scale so they can attract capital from institutional investors and generate investment ideas to drive alpha. As a result, a new breed of investment manager is emerging – the 'entrepreneurial-institutional' manager. They can be characterised by three key features. First, these managers offer clients multiple products, including alternative investment products and mainstream funds, as well as complementary services like financing, private placements, proprietary trading, restructuring and structured products.
Second, their mission is focused on performance and the needs of their investors, rather than the further acquisition of investment capital. Third, their controls are institutional-grade, yet they maintain creative environments that enable the birth and growth of new ideas and 'superstar' individual managers. Because the 'entrepreneurial-institutional' managers offer product diversity and focus on performance and investor needs, as well as institutional grade controls, they are likely to attract a large proportion of institutional capital.
Administrators: Meeting the Infrastructure Challenge
Administrators are increasingly playing a central role in the alternative investment industry by acting as the glue that holds investors and managers together. Administrators provide not only the day-to-day information and transaction processing managers need, they can also provide the additional services, such as financial reporting, net asset valuation and risk management support that enable the institutional investor to satisfy their due diligence requirements.
With the increasing involvement of institutional investors, the information needs of investors, managers and regulators are set to grow exponentially; but based on our research, many administrators say they are currently operating at or near full capacity. In addition, a lack of investment in technology and other infrastructure in recent years – together with downsizing of personnel – means that the operations of many administrators are not readily scalable because their information systems and processes are dependent upon manual intervention or outdated systems.
Many administrators may find it difficult to accommodate the growth that is expected in demand for their services unless they invest in robust and flexible technology platforms that are capable of high-volume transaction processing and customised 'real-time' reporting. Many administrators may also have to re-hire, looking particularly for skills in front and middle-office services, as well as risk management, to accommodate the diversification of service demands placed on them by investment managers. Given the need for significant capital investment in new technology platforms, increasing consolidation through mergers and acquisitions should be expected, as the larger administration businesses seek economies of scale to match their growth aspirations.
Increasing Regulation is Unwanted, but Inevitable
These fundamental changes are happening against a backdrop of proposed government regulation of the alternative investment industry. The paradox is that according to our research, the majority of investors do not want more regulation. Despite regulation being widely promoted by governments as a way to protect investors, many investors themselves oppose new regulation because they fear it will add costs, inhibit creativity and hinder competitive development globally. Institutional investors, who already have strong control frameworks, want transparency and liquidity so they can optimise the return on their investments. They are not convinced the proposed new regulations will add to investor protection.
Nevertheless, new regulation is coming and it will be part of a sea change in the alternative investment industry, as the rise of the institutional investor drives the transition from a product-centric to a client-centric culture. Many managers predict a buoyant future for the industry: but it comes with new challenges – enhanced governance, more transparency, more liquidity and, ultimately, more costs.
This article first appeared in AIMA Journal (Q4 2010, Page 25). For more details, please visit www.aima.org