new rules of engagement - state street corporation · 2020. 7. 18. · 2 • new rules of...

New Rules of Engagement

Adapting for Growth in Alternatives

2 • NEW RULES OF ENGAGEMENT: ADAPTING FOR GROWTH IN ALTERNATIVES

ADAPT TO THRIVE

ALTERNATIVES

As the investment industry environment

transforms faster than ever before, alternative

asset managers’ ability to adapt their business

models is being tested in the extreme.

Institutional investors now outweigh high-net-worth individuals as a source of hedge fund capital, and they continue to grow their allocations in other unlisted assets.1 This influx of institutional money puts new demands on alternative managers.

These sophisticated clients are intensely focused on how fees are assessed, how investments are run and how risk-adjusted performance is reported.

Further, as the alternatives sector expands, the days of light-touch regulation are over. Regulators have the alternatives sector firmly in their sights, driving managers to restructure funds and rethink how they communicate and report to clients. As regulatory pressures grow, fast-evolving technologies present both opportunity and risk. Robotic automation and artificial intelligence (AI) can drive operational efficiency and enhanced investment insight — but they will challenge late adopters.

1 Preqin, Hedge Fund Manager Outlook, H2 2017

3

3

New research from State Street finds that more than half (52 percent) of alternative asset managers surveyed fear they will need to overcome significant operational inefficiencies to sustain growth for their firms.2 And 69 percent recognize that if

they don’t improve operational agility, their competitors will be better placed to capture growth opportunities. The environment is changing fast and only those that adapt at pace will thrive in it.

Keys to Growth for Alternative Asset Managers

Evolve to compete

Institutional investors’ appetite for alternative strategies is growing, but managers must prove they can deliver tailored outcomes, transparent reporting and a differentiated offering to win these new mandates.

Reboot performance

As investment returns prove harder to come by, hedge funds are looking to expand into emerging markets and new asset classes. In addition, many will implement more flexible pricing to link fees more closely with performance.

Elevate operations

Investor flows into PERE (private equity and real estate) funds continue to gain momentum, accelerating growth for many managers. But it will be impossible for most to meet the accompanying operational challenges as quickly as they arise. External partnerships will be critical if these businesses are to meet investor demands.

2 State Street 2017 Growth Readiness Study. State Street commissioned Longitude Research to conduct a global survey of more than 500 investment industry executives, including 93 respondents from the alternative asset management sector, during March and April of 2017. Study participants spanned investment, operations, sales and distribution roles. Alternative asset manager respondents included hedge funds, fund of hedge funds, private equity and real estate funds. For more details, see page 24. All figures in this report originate from this research unless otherwise noted.

ALTERNATIVES


Driven by the need for better long-term returns

and portfolio diversification, institutions have

increased their allocations to alternative

assets over the last two decades.

Since 1997, average allocations to real estate and other alternatives by pension funds in seven of the world’s largest pension markets has risen from 4 percent to 24 percent.3 And the total assets managed by the world’s 100 biggest alternative managers surpassed $4 trillion in 2016. Among these managers, real estate, hedge funds and private equity make up the bulk of the allocations.4

Against the backdrop of this impressive trajectory, 58 percent of alternative managers are confident that they will achieve their growth objectives over the

next year, and optimism jumps to 78 percent over the next five years. Future growth is far from guaranteed, however.

The global hedge fund industry saw net outflows of $102 billion in 2016 as performance and fee concerns drove some institutional investors to pull their capital.5 The dominance of institutional money in the alternatives market means that managers will need to work harder to find opportunities as global competition for high-quality assets intensifies. And the complexity of the regulatory environment is increasing the challenge of meeting investor needs.

NO ROOM FOR COMPLACENCY

3 Willis Towers Watson, Global Pension Assets Study 20174 Willis Towers Watson, Global Alternatives Survey 20175 Preqin, 2017 Global Hedge Fund Report

5

For the alternative asset managers in our study, regulation governing liquidity risk and regulatory focus on investment fees are the two biggest perceived macro-environmental threats to their growth prospects over the next five years (Figure 1).

Though institutional investors’ appetite for alternatives is increasing overall, there are distinct hurdles to greater illiquid holdings for some investors. In the pensions market, for example, illiquid holdings may limit pension funds’ ability to undertake buy-in and buy-out transactions, while rule changes in markets such as the UK are increasing demands from scheme members for lump-sum payouts. Alternative managers will need a detailed understanding of individual client pressures to allay such concerns.

Meanwhile, regulations such as AIFMD, MiFID II and Dodd-Frank continue to increase the cost of compliance for hedge funds and PERE firms as they require more detailed reporting both to regulators and investors.

The growth shortfall

As the industry environment presents these considerable challenges, alternative managers will need to reconfigure their operating models and develop new competencies if they hope to capture the growth opportunities on the horizon.

Our Growth Gap Matrix (Figure 2) identifies the areas that alternative asset managers must prioritize to achieve their growth ambitions over the next five years. It does this by analyzing the competencies that these respondents rate as most important for enabling long-term growth versus their relative strengths and weaknesses today.

The results are telling. Across the alternatives sector, there are three areas that respondents deem to be of critical importance for their long-term growth, but also recognize are relative weaknesses today:

• Strong organization culture that is connected to mission and values

• Adequacy of talent to keep pace with evolving business needs

• Geographic scope of distribution network

Talent and culture will be top priorities for alternative asset managers seeking to accelerate their growth. And as their environment becomes more tightly regulated — and institutional investors seek closer control over the management of their assets — alternative managers recognize that stronger governance will be necessary. This means putting robust processes and controls in place at both the fund and firm levels, and ensuring clear separation of responsibilities between front-, middle- and back-office personnel.

Figure 1: Threats to growth

Which of the following factors present the greatest threat to your organization’s ability to achieve its growth targets over the next five years?

Source: State Street 2017 Growth Readiness Study

Alternative managers (All) Hedge fund managers PERE fund managers

Regulation governing liquidity risk

49%

48%

48%

Regulatory attention to investment fees

45%

44%

43%

Equity outlook in our key market(s)

42%

37%

30%

Monetary policy in our key market(s)

40%

35%

30%

Regulation governing investment behavior

30%

33%

38%

Political outlook in our key market(s)

23%

28%

35%

Economic growth outlook in our key market(s)

34%

27%

18%

Emerging technologies

13%

14%

15%

Fixed income outlook in our key market(s)

9%

12%

15%

50% 50%

ALTERNATIVES


Figure 2: Mind the gap

How important do you think these internal capabilities will be in enabling your organization to meet itsgrowth targets over the next five years? And how would you rate your organization’s capabilities today?

Performance (% rating “highly effective”)

Impo

rtan

ce (%

rat

ing

“hig

hly

impo

rtan

t”)

KEY AREAS FOR IMPROVEMENT KEY AREAS OF COMPETENCE

LOWER PRIORITY AREAS OF IMPROVEMENT LOWER PRIORITY AREAS OF COMPETENCE

Importance/Performance Average

35 40 45 50

50

55

60

45

40

35

30

Strong organizational culture that is connected to our

mission and values

Proficiency in digital distributionof our products and services

Adequacy of our talent to keep pace with evolving business needs

Ability to adapt toindustry regulation

Ability of our technology tokeep pace with evolving

business needs

Geographic scope ofour distribution network

Strong governance framework

Ability to manage technology risks

Ability to extractmeaningful insightsfrom data

Investment expertise innew asset classes

Efficiency of ourinvestment operations

Ability to manageinvestment risks

Ability to manageoperational risks

55


7

ALTERNATIVES


The needs of institutional investors are

evolving as their own growth models are

subjected to profound pressures.

For alternative managers to capitalize on this and win investor trust, they will need to anticipate these shifting needs and embed the resources to service them.

Our research shows, however, that there are some important misalignments between the areas that alternative managers believe they need to prioritize to attract investors, and the areas that investors would most like them to address.

The biggest difference is cost transparency, where 39 percent of asset owners say that managers should be making changes, yet only 12 percent of alternative managers say the same (Figure 3). While alternative managers do agree they will need to bring fees down, the investor response suggests that clearer fee structures will be more important in the long term.

EVOLVE TO COMPETE

9

Another important divergence is in alternative managers’ ability to deliver bespoke solutions to investors, and to align their interests more closely with the investors they serve. Again, these changes are farther up the agenda for investors than for alternative managers.

According to our research, 44 percent of asset owners and insurers are planning to consolidate their use of external asset managers over the next five years, placing larger mandates with fewer providers. Managers that can deliver tailored solutions to meet

investor objectives — whether portfolio growth, liability matching or downside protection — will be best positioned to compete for new business.

To deliver on this, alternative managers identify a clear need to improve their access to emerging market investment opportunities and to strengthen their front-office teams. These measures will help them better understand the specific investment needs of individual clients and match them with the right investment opportunities (Figure 4).

Figure 3: Realigning expectations

What are the most important changes that managers will need to make over the nextfive years to remain attractive to investors?


Asset owners Alternative asset managers

Improving transparency on cost

12%

39%

Expanding distribution network

36%

30%

24%

30%Shifting from being product- to solutions-focused

24%

31%Enhancing environmental, social and governance (ESG) investment capabilities

Better alignment with investors’ priorities

24%

33%

Expanding product offering

36%

32%

36%

28%

Incentivizing investor loyalty

32%

30%

Reducing fees

50%

ALTERNATIVES


Figure 4: Positioning for the future

How important do you think the following areas are for the future growth of your firm? And how effective do you think your firm is in each of these areas today?


Having wide-ranging access toemerging markets

Investment conversations focused onoutcomes, rather than “product-first”

Researching individual clientneeds and behaviors

Delivering low-cost pricing

Delivering transparency on costs and fees

Strong presence on social media

Producing proprietary content to shareinsights with investors

Flexible approach to portfolio construction

50% 35%

42% 38%

42% 31%

38% 31%

35% 27%

35% 23%

31% 50%

27% 42%

Rating important Citing strong performance today

11


ALTERNATIVES

6 Preqin, 2017 Global Hedge Fund Report7 Ibid.

The hedge fund story has been one of

meteoric rise over the last two decades.

Since the mid-1990s, the industry has

grown its AUM by more than $2 trillion.6

However, returns have proved more challenging in the aftermath of the financial crisis, and some investors are beginning to question the benefit-cost ratio of their alternative allocation. Investors withdrew a net $102 billion from hedge funds in 2016 and 981 funds were forced to close.7 As they seek to win back investor trust, hedge funds will need to reignite investment performance and adapt existing fee structures.

Among the alternative asset managers in our study, the most likely fee-related change over the next 12 months is the introduction of new funds with more aggressive performance-related management fees, with 69 percent expecting to launch these types of funds. Only 38 percent anticipate a direct reduction of fees within the next year, however (Figure 5).

REBOOT PERFORMANCE

Figure 5: Restructuring fees

How likely do you think it is that your firm will implement the following fee-related changes over the next 12 months?

Launch new funds withmore aggressive

performance-relatedmanagement fees

Offer more loyalty-basedpricing incentives

to investors

Provide more detailedinformation to clients

about fee structure

Reduce investmentfees

65%69% 54% 38%


13

This shift toward more performance-related fee structures, combined with rising investor skepticism about hedge funds’ ability to generate alpha, is putting intense pressure on investment strategies.

While hedge funds have been instrumental in helping to open new markets such as credit derivatives and emerging markets,

they should continue to broaden their investment horizons to enhance returns. The hedge funds in our study that managed to achieve their targets over the last year say that increasing their investments in new asset classes and improving the sophistication of their investment risk management were the most important factors in their success (Figure 6).

Figure 6: Strategies driving performance

Which, if any, of the following actions were most important in enabling your institution to achieveits growth targets over the last year?


Increased investments in new asset classes

Improved sophistication of investment risk management

Upgraded front-office technology

Expanded our sales and distribution network

Improved expense management

Upgraded our middle- and/or back-office technology

36%

33%

31%

29%

26%

24%

Strengthened in-house investment expertise

Expanded the products and services we offer

Entered new country markets

21%

19%

14%

50%

ALTERNATIVES


15

To drive better returns, it will be important for hedge funds to recruit new investment expertise, and combine this with data analytics specialists and advanced software.

Technology spending will focus primarily on upgrading performance analytics, a priority cited by 40 percent of hedge fund respondents. Risk and

liquidity analytics are also major areas targeted for development (Figure 7).

Both the hedge funds and the investors we surveyed identify expertise in emerging markets and in newer alternative asset classes as key investment capabilities that fund managers must focus on strengthening (Figure 8).

“A grain in the balance will determine which individual shall live and which shall die — which variety or species shall increase in number, and which shall decrease, or finally become extinct.” CHARLES DARWIN

On the Origin of Species, 1859

Figure 7: Focusing on data tools

What are your institution’s top technology priorities for the next year?

AI/machine learningsolutions

Advanced investmentperformance analytics tools

Advanced risk and liquidityanalytics tools

Automated advisoryplatforms

RegTech solutions

Distributed ledger solutions


38%

40%

30%

26%

23%

19%

ALTERNATIVES


Figure 8: Strengthening investment capability

To what extent do you think that fund managers need to improve the following investment-related capabilities, to better serve institutional investors’ needs? (Percent citing strong need for improvement)


Hedge fund managers

Customization of portfolios/solutions

57%

47%

Expertise in emerging and frontier markets

70%

71%

60%

71%Advanced portfolio analytics

57%

59%

Expertise in environmental, social and governance (ESG) investment strategies

68%

59%

Expertise in newer alternative asset classes

64%

59%

Strategic investment decision support

Asset owners

17

ALTERNATIVES


PERE funds have experienced sustained

growth in allocations in recent years as

institutional investors search for better

returns and diversification of the inherent

risk exposures of listed strategies.

In 2016, closed-ended real estate fund managers had $239 billion to deploy, up from $210 billion in 2015.8 As the risk-return profile of private equity and real estate continues to perform favorably compared to public markets, and many institutional investors remain below their target allocations to these asset types, there is good reason to believe the growth in flows will continue.

The PERE firms in our study are clearly seeking to capitalize on this global demand. The top priorities for their businesses over the next five years will be to expand their international footprint and to broaden their distribution networks (Figure 9).

The upshot for the sector is that many once-small firms are launching larger, global funds as they achieve multi-billion dollar fundraising in some cases. But as they bring more capital under management, and construct global and diverse funds, PERE firms are facing significant operational pressures.

Multi-regional funds generate onerous compliance and reporting requirements. As they scale up, process efficiency gains greater importance. PERE firms that can achieve the greatest level of automation can keep costs down, while others may see their margins increasingly squeezed.

8 EY, 2017 Global Market Outlook: Trends in real estate private equity

ELEVATING OPERATIONS

Figure 9: On the expansion charge

Which of the following strategies will your firm prioritize over the next five years to achieve its growth objectives?


Entering new country markets48%

Expanding sales/distribution network28%

Strengthening in-house investment expertise20%

Upgrading back- and/or middle-office technology20%

Improving expense management18%

Increasing investments in new asset classes15%

Expanding the products and services we offer15%

Upgrading front-office technology13%

Improving the sophistication of our investment risk management5%

50%

19

ALTERNATIVES


Cognizant of these challenges, the PERE respondents we surveyed cite their ability to manage operational risks and to improve the efficiency of their investment operations as the most important internal capabilities to support their long-term growth plans.

Many PERE firms are recognizing that it no longer makes economic or business sense to manage everything using in-house teams. As a result, they’re turning to third-party service providers that can help them scale their operations at the necessary pace, and perform functions more efficiently.

Over the last five years, the alternative asset managers in our study have put significant focus on outsourcing trade execution and investment operations. And in the year ahead, these firms will be looking for partners that can manage their fund accounting and offer an integrated array of services, including distribution support (Figures 10 and 11).

Figure 10: Outsourcing drivers

What were the most important factors in your institution’s decision to outsource certain functions?

We need tofocus our in-

house resourceson value-adding

activities

We needed astrategic partner

capable ofsupporting our

long-term growth

We couldn’t scalethis function

quickly enoughin-house

To access talent/expertise we

don’t have

Our externalprovider(s) will

perform thisfunction better

than we can

44%44% 33% 28% 19%

We lack thecapital requiredto resource this

function in-house

14%


Has your institution outsourced any of the following functions to an external provider within the last five years?

Will your institution seek to outsource any of the following functions over the next year?

Figure 11: Strategic outsourcing

Tradeexecution

45%

24%

Investmentoperations

36%

33%

Globalcustody

33%

40%

Distributionsupport

31%

38%

Fundaccounting

31%

48%


21

ALTERNATIVES


23

As a whole, the alternative asset management sector has enjoyed a healthy growth trajectory over recent years.

But with more capital coming into the sector, the ability of hedge funds and PERE firms to achieve a performance edge and adapt their operating models has never been so profoundly tested.

Our research finds a sector that is bullish about its growth prospects, but also aware of the significant

challenges that lie ahead. We’ve found that leading managers are rewriting the rules for engaging investors. They’re working toward more customized solutions, performance-linked fees and transparent dialogues. They’re onboarding new investment expertise and tools that reassert their reputation for performance. And they’re forging integral partnerships that can help them fulfill their growth ambitions.

PLAYING BY THE NEW RULES

©2017 State Street Corporation - All Rights Reserved17-31352-0817 CORP-3233Expiration date: 10/31/2018

About the Research State Street commissioned Longitude Research to conduct a global survey of more than 500 executive respondents representing institutional asset owners, asset managers and insurance companies during March and April of 2017.

The respondents span investment, operations and distribution roles and collectively represent 19 countries. Approximately 36 percent of respondents were located in the Americas, 40 percent in Europe and 24 percent in Asia Pacific.

In addition to the survey, we conducted a range of in-depth interviews with select leaders across the industry about their priorities and strategies for growth.

For more information, please visit growth.statestreet.com

For more industry insights, please visit listen.statestreet.com

The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street’s express written consent.

State Street CorporationState Street Financial CenterOne Lincoln StreetBoston, Massachusetts 02111-2900+1 617 786 3000

For more information about our solutions for alternative asset managers, please contact: Maria Cantillon +44 203 395 7502 [email protected]

mailto:[email protected]

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new rules of engagement - state street corporation · 2020. 7. 18. · 2 • new rules of...

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