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Meeting in the middle: the new alternatives battle ground

By Denise Davidson, Associate Partner, EY – Investor demand for long-term, non-correlated returns is driving convergence and competition, pitting traditionally distinct players against one another in a new alternatives middle ground.

Ten years ago, it would have been unusual to find a hedge fund and a private equity house crossing paths in the entrance to a beauty parade, not least because of their differing traits. 

Traditionally, the people-driven, synergy-seeking psyche of private equity has seemed far removed from the quant-driven disposition of the hedge fund industry, but market convergence is blurring these lines.

Investor demand for customised products and outcome-oriented solutions is drawing previously siloed market players against one another in a fierce new battle for assets. 

A decade of low-yields, low vol and a tide of monetary stimulus has pushed up investors’ tolerance of illiquids and alternatives now comprise a much more meaningful portion of portfolios. New product development in illiquid credit, real estate and real assets is now in play for both private equity and hedge fund managers, with competition even extending into primary offerings. 

According to EY research, nearly one third (30 per cent) of hedge fund managers now have a private equity offering, while one fifth (20 per cent) of private equity managers provide hedge products, evidence of the wider convergence currently in train.

Private credit is a rapidly growing component of investors’ alternatives allocations and is at the heart of the struggle for the middle ground. Investors seeking to capture the illiquidity premium and higher returns to be found higher up the capital structure, attracting huge interest and flows incoming from nearly every major asset class. 

Traditionally an intersection between hedge funds and private equity managers, private credit is now a major thoroughfare for market players tapping into investor appetite for illiquid credit products. 

Alongside the shift into more complex, illiquid products, investors are seeking to become more active partners alongside their managers and a voice on investment and operational decisions. More than one-third of investors plan to increase this behaviour as “active LPs” and 32% say they will increasingly build out investment capabilities to replicate the strategy internally without the assistance of a third-party external manager.

Investors seeking a more active partnership want a seat at the table in designing portfolios, either to target specific outcomes or to better align fee structures. In many cases, the move into active partnerships goes hand in hand with requirements for enhanced customisation and control in more tailored product solutions, which presents additional operational challenges in execution.   

So far, hedge funds are leading the pack in customisation by increasing the number of separately managed accounts (SMAs) and funds of one on offer. Yet, while these vehicles meet investors’ demand for improved transparency, tailored fees and liquidity, they create operational headaches, with processes and technology often requiring investment to support new products. 

Some managers have been reluctant to develop SMA offerings due to the potential for conflicts of interest with other commingled vehicles. Robust trade and expense allocation policies can mitigate these risks, but for many firms, the task of running multiple vehicles risks product cannibalisation. 

Risks aside, innovation remains a crucial component of managers’ continued asset growth, requiring investment in both talent and technology – which continue to be hard-fought frontiers for both private equity and hedge funds. 

The use of artificial intelligence, automation and big data, a frontier once dominated by quantitative managers, is now open to all. Data scientists, programmers and technology, underpinning innovation in front and back office roles, are transforming the execution of strategies and redefining competitive advantage as the industry recognizes the power of technology in a digital era.  

Of course, talent remains critical driver of innovation and, behind asset growth, sourcing key skills remains the top strategic priority behind asset growth for both hedge funds and private equity managers.  In many cases, firms are seeking increased gender and cultural diversity to bring fresh perspectives and leadership and the target talent profile continues to evolve rapidly. 

The successful combination of technology to drive investment returns in the front office, while embracing new technologies and outsourcing capabilities in the back office, provides the most competitive platform for alternative managers operating in today’s fast-evolving market. Managers who continue to operate in well-trodden silos may find themselves on the side lines of a battle ground moving away from them. 

 

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