Transformation future alternative_investments

I N V E ST M E NT M A N AG E M E NT

Transformation
The Future of Alternative Investments

F I N A N C I A L S E RV I C E S

Acknowledgements
This report, produced by KPMG International in cooperation with International
Fund Investment, examines in detail the transformational change of the alternative
investment industry as it enters a period of significant growth, set against scrutiny
from regulators and institutional investors. It investigates how, in light of significant
market volatility and regulatory uncertainty, alternative investment managers,
institutional investors and administrators are adapting their business models to
maximize chances of success.
Our foremost thanks go to 200 organizations from 26 countries who participated in
this research.
We would also like to offer our special thanks to those 85 CEOs, CIOs and Board level
Directors who participated in our structured interviews. Their insights and foresights
have helped produce a comprehensive vision of the future of alternative investments.
We would also like to thank the members of the project team, editorial board, and
other colleagues around the world who have helped us in carrying out this research, in
particular: Marie Parker from KPMG in the Cayman Islands, Mireille Voysest and Una
Clarke from KPMG in the UK, Cara Scarpino from KPMG in the US, and Simon Osborn
and Rebecca Gooch from International Fund Investment.

Anthony Cowell Andrew Stepaniuk
Partner Partner
KPMG’s Investment KPMG’s Investment
Management Practice Management Practice

Project Team
Chaired by Anthony Cowell, KPMG in the Cayman Islands
Giles Drury, KPMG in the UK
Mikael Johnson, KPMG in the US
Jon Mills, KPMG in the UK
Andrew Stepaniuk, KPMG in the Cayman Islands
Simon Whicker, KPMG in the Cayman Islands

KPMG Editorial Board*
Chaired by Wanda Mellaneo
Kris Beighton Grant Green
Keith Blake Mark Harris
Tully Cornick Tanis McDonald**
Gordon Rajamohan
*KPMG in the Cayman Islands
**KPMG in the BVI

Additional Contributions
Leah Dering-Ridley, KPMG in the UK
Tim Fundell, KPMG in the UK
Nicholas Griffin, KPMG in the UK
David Yim, KPMG in the UK

© 2010 KPMG International Cooperative (“KPMG International”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International.
KPMG International provides no client services. All rights reserved.

Contents
About this research 1
Headline messages 2
Executive summary 4
Alternative Investment managers 16
Administrators 26
Institutional investors 36


About this
research
Transformation: The Future of Alternative Investments
explores the ways in which the alternative investment
industry is adapting and evolving.

Up until late 2007 the industry had largely enjoyed uninterrupted growth. From
,
2007 to 2009 a series of dramatic market events coupled with poor performance, Location of participants:
exacerbated in a number of cases by operational shortcomings, resulted in an overall Australia
loss of confidence in the sector. Since early 2009, the industry’s fortunes have Austria
improved considerably. The credit crisis is receding into the background. Managers are Bahamas
refining business models and focus; institutional investors are reviewing allocations Belgium
Bermuda
and operational requirements; administrators are eyeing technology and the labor
Brazil
pool; and the industry as a whole is preparing for the anticipated impact of increased
British Virgin Islands
regulation. What is clear is that the structure of the industry ahead will be vastly
Canada
different than it is today. Cayman Islands
Written in cooperation with International Fund Investment, this report is based on China
surveys and structured interviews conducted globally between February and June Curacao
Denmark
2010. The study has benefited from the participation of 200 respondents across
France
26 countries, and includes: alternative investment managers with US$515 billion
Guernsey
under management; administrators with US$4.2 trillion under administration; and,
Ireland
institutional investors with US$884 billion under management. In addition to the Jersey
above groups, interviews were also conducted with lawyers and independent Korea
directors. Luxembourg
Malta
References within the report to alternative investment managers are based on a
Netherlands
sample of respondents that invest in either (or a combination of) hedge funds, private
South Africa
equity, real estate, infrastructure and structured products, although the main focus
Sweden
has been on the hedge fund sector. Switzerland
United Kingdom
United Arab Emirates
United States

The information reflected in the graphs and charts was obtained by KPMG International Cooperative and
International Fund Investment during both the structured interview stage and questionnaire stage. The
anonymous interview quotes throughout this document were obtained during the interview stage of the
research project. Please note that with the graphs illustrated, not all answers add up to 100 percent because
of rounding or because respondents were able to provide multiple answers to some questions.


Headline
messages
The following headlines represent the views expressed
from each of the three main groups of participants
involved in our research: alternative investment managers,
administrators and institutional investors. Their insights are
developed as 10 key themes in the rest of this executive
summary, and further in sections 2, 3 and 4. Together, they
provide a detailed analysis of the future of the alternative
investment industry as it faces unprecedented change.

• The majority of institutional investors intend to increase their allocations to
alternative investments in the next 3 years. As a result, they will have a far
greater influence over the shape of the industry in the future.

• Anticipated regulation, driven by external forces that continue to blame alternative
investments for the meltdown of the global financial system, is not wanted by the
majority of investors, managers or service providers. The widely held view is that
the industry did not cause or contribute to the credit crisis. Furthermore, investors
believe more regulation will not produce any tangible benefits.

• Managers and administrators believe that regulation and governance are the
most important challenges facing the alternative investment industry over the
next 3 years.

• There will be four different manager business models that will come to
dominate the industry in future. In addition to ‘niche’ boutique managers and
the ‘super-boutiques’ (independent managers moving on to become multi-billion
dollar players) there will be further and significant development of managed
account platforms as well as the emergence of what might be termed the
‘entrepreneurial-institutional’ manager.

• Investors forecast that managed account structures will experience substantial
growth. Whilst their benefits include improved transparency, liquidity, control
and customized fee arrangements, managers believe that cost and operational
complexity are some of their key shortcomings.

• Investors want a better alignment of interests with managers. The main
changes will likely feature longer term performance fee arrangements,
increased capital investment from managers, and a move towards enhanced
liquidity and transparency.


• The overwhelming majority of existing alternative investors are happy to
continue to allocate to funds that are located in offshore jurisdictions.

• There will be a further move towards independent administration, particularly in
the US where many alternative investment managers administered their funds
in-house. This will exacerbate the capacity mismatch that is developing in the
industry. Administrators report that they are operating at near to full capacity whilst
less than half of managers interviewed stated that they are in a similar position.

• The ‘bifurcation’ of the alternative investment industry is continuing. Newer
institutional investors into alternatives are more likely to be attracted to
managers promoting funds with greater liquidity and transparency than
experienced, longer term institutional allocators.

• Levels of investor satisfaction with alternative allocations are correlated to the
length of time that they have been active in allocating to alternatives because of
their detailed understanding of the industry. Investors with the most experience
of this activity tend to be the most satisfied with their allocations.

• There is little to no consensus amongst investors on the route to take to allocate
to hedge funds. The popularity of fund of funds is in decline but there is no
obvious replacement for most investors. As a result the well known billion dollar
fund of funds will prosper but there is also likely to be significant consolidation
amongst the smaller players.

• Manager fee structures are expected to be less uniform in the future, as
institutional investors negotiate more local agreements.

• Barriers to entry from regulation and institutionalization will impact the rate of
new start-ups. Moreover, managers with assets of less than US$100m will find
it increasingly challenging to run a long term business as a result of increased
costs from regulation.

• Fund servicing related issues are growing in importance. Investors now take
fund servicing very seriously and a number of managers report that events over
the last 18 months have had a dramatic effect upon the type of firms that they
would want to hire as service providers.

• The fallout from the credit crisis and events such as Madoff have led to
substantially increased levels of due diligence across investment management,
particularly from institutional investors.


Executive
Summary
“Twas the best of times, ‘twas the worst of times.
‘Twas the age of wisdom, ‘twas the age of foolishness”
Charles Dickens

The era of transformation
One of the constants in the alternative investment industry is the presence of
“For a brief moment, the industry
change. From its origins to expansion in the 1990s and through the explosive growth
had a heart attack. It’s now being
of the 2000s, the one thing that the industry could count on was continued change.
resuscitated”
However, in reality, the basic structures of the alternative investment business were
not very different in 2007 than they were in 1997 The industry was a great deal
.
larger but practices and structures remained largely unaltered. Investors considering
alternatives, including the world’s largest institutions, had to do so on the manager’s
terms, not their own.

Those days are now over. The industry is going through a period of transformational
adjustment to a very different and more regulated operating environment. The
majority of institutional investors included in the survey intend to increase their
allocations to alternative investments in the next 3 years, with some intending to
allocate over 10% of their total assets. As a result, these investors will have a far
greater influence over the shape and culture of the industry in the future - they will
demand institutional grade controls, increased transparency and flexible product
strategies in order to invest their capital. In addition to the credit crisis, events such
“Headline risk scares us out of as Madoff, whilst not a hedge fund, highlighted the need for a robust due diligence
our minds” process. The influx of more institutional capital into alternatives will result in further
substantial growth of the well known, billion-dollar managers.

The desire for more transparency and liquidity is the main driver behind the recent
growth in new product structures in hedge funds, including managed accounts and
managed account platforms as well as onshore regulated products. Managers are
being forced to make adjustments to the new environment, whether they like it or
“Transparency, liquidity and
not (and some emphatically do not). For many of them, the frustration of having to
understanding risk are paramount;
everything else is a bonus” review internal procedures and systems, consider different domiciliation options,
gear up for more regulation and so forth has a pay off. They believe that this painful
and expensive process will enable them to attract many more and different types of
investors to their funds.


What do you believe are the major challenges facing the alternative investment
industry over the next 3 years?

75% “We always want to see alignment
Regulation and governance 67% of interests. If the manager isn’t
97% prepared to lose his shirt then we’re
63% not in the business of investing”
Investment performance 44%
56%

55%
Transparency 78%
56%

55%
Liquidity risk 33%
13%

43%
Downward fee pressure 33%
34%

35%
Operational risks 44%
28%

25%
Taxation
31%

20% Managers
Systemic risk Insitutional Investors
6%
Administrators
13%
Shortage of talent
13% “Growth will be phenomenal, unless
regulation stifles it”
0 20 40 60 80 100
% of respondents

The paradox of regulation
The results of this survey show that the anticipated increase in regulation is not
wanted by the majority of investors, managers or service providers. Despite
regulation being widely promoted as a way to protect the investor, it is these investors
who are most strongly against it. Few investors believe it will produce any tangible
benefits. Some see it as being protectionist to certain jurisdictions and therefore
detrimental to the development of the global alternative investment industry whilst
others fear that it will inhibit the competitive positioning of investment managers
“The halcyon days are back – we want
by adding to costs. As a result, many investors in Europe believe it will reduce the
star performance and star treatment!”
number of new start-ups, thereby stalling the industry’s engine of creativity – the
production line of boutiques that provide vitality and talent in the future.


What do you think will be the impact of forthcoming regulations in the below
regions on worldwide growth of alternative investments?

“Fear and greed motivate managers -
both in equal proportions”
Managers 13% 51% 36%

Asia Administrators 10% 61% 29%

I. Investors 11% 78% 11%


North 32% 35% 33%
Administrators
America



Europe Administrators 72% 6% 22%


0 20 40 60 80 100

Positive Impact Neutral Negative Impact
% of respondents

Nevertheless, the universal view is that further regulation is on the way. Investors,
“Independent directors are the
managers and service providers take a fatalistic approach to this subject. It is viewed
panacea for the industry. Too much
as an inevitable consequence of the recent well publicized scandals affecting the
self interest is a bad thing”
industry, combined with the dramatic market volatility in recent months. Furthermore,
numerous respondents made the point that alternative investments were in no
way responsible for the market crisis. Indeed they were often victims themselves.
Nonetheless, managers recognise that they cannot escape from the increase in
“All the talk of extra regulation is financial regulatory supervision occurring around the world.
creating insecurity amongst investors” Regulation is coming to the alternative asset management industry on both sides of
the Atlantic. The impact of various US regulatory and legislature initiatives, including
the so called ‘Volcker’ rule, which proposes a ban on proprietary trading by banks,
will likely be considerable for the alternative investment industry, as talent migrates
towards boutiques. In Europe, the Alternative Investment Fund Managers Directive
“Making money is obvious; telling
(the “AIFM Directive”) is closer to finalization. The European Parliament’s Committee
everyone how you’re going to do it is
the challenge” for Monetary and Economic Affairs recently voted for the draft directive and the EU
council’s group of finance ministers followed suit on its version of the text.

KPMG International provides no client services. All rights reser ved.

A new breed of manager and what it means for the industry
As the alternative investment industry expands and matures so it continues to add
“This is going to be a really critical
variety to its manager models. The business started as a fragmented collection
year for a lot of managers... 2010 is
of niche boutiques. As the industry developed, a number of these managers then
the right time for them to prove
became ‘super-boutiques’ - investing institutions in their own right. For many years,
their worth”
the industry was characterized as being divided between these multi-billion dollar
‘super-boutiques’ and numerous smaller ‘niche’ boutiques.

Forces pushing and pulling the Alternative Investment industry between boutique and institutional

Timeline

1990 2010
Super Entrepreneurial- Pure
Boutique Boutique institutional institutional

• Owner/Manager led • Partners/shareholders
• Performance and innovation • Asset gathering
• Creativity • Standardization
• Flexibility The • Processes and rules
• Lifestyle Alternative • Diversification
• Infrastructural • Strong governance/
constraints Investment control
• Low staff numbers and/or Industry • Regulation e.g.
staff retention EU AIFM Directive
• Regulation • Transparency
e.g. ‘Volcker’ rule • Liquidity
• Small service providers • Brand name
service providers

Two other types of structures have come into the business to challenge the boutique
model. In addition to the next generation of niche boutique managers and the ‘super-
boutiques’, there will be further and significant development of managed account
platforms as well as the emergence of what might be termed the ‘entrepreneurial-
institutional’ manager.

‘Entrepreneurial-institutional’ managers started out as smaller alternative
“Administrators had to step up their investment managers but have since diversified their businesses into mainstream
game, and they have done”
fund management, as well as other complementary investment activities such as
financing, private placements, proprietary trading, restructuring, and structured
products. This development will have consequences for the entire financial world, not
just alternative asset management. ‘Entrepreneurial-institutional’ managers will be
able to outflank competitors by offering allocators a range of investment opportunities
covering other alternative, and perhaps even mainstream, asset classes. Their controls
“Blow ups happen because no-one and processes are likely to be institutional grade, yet they retain their creativity and
understands the strategy” focus on alpha, rather than asset gathering.


The rise of the ‘entrepreneurial institutional’ manager does not, however, signal an
end to the boutique – far from it. As the industry institutionalizes, through increased
bureaucracy, formalization and rigidity, the allure of reward, creativity and freedom
“Three years ago, investors were will continue to attract talent to the niche end of the industry. Hence, the number
looking for a hot manager; now of boutiques will thrive. Furthermore, their numbers may be impacted considerably
the focus is on more established by the proposed ‘Volcker’ rule in the US, as proprietary traders are forced out of
managers with proven track records” the mainstream to set up their own firms. Nonetheless, if they are successful in
their diversification strategy, whilst maintaining healthy performance in their core
funds, the coming breed of ‘entrepreneurial-institutional’ managers will likely attract
a large proportion of institutional capital – the boutiques may be able to compete on
numbers, but not on asset size.

The Matrix: Growth and Transformation

US$5 billion + US$5-20 billion + US$20 billion +
• Global investment management capability • Strong risk-governance arrangements
(US, Asia, EU) (comprising 3 lines of defence, multiple
governance committees with integrated risk/
control framework and non-exec directors)
Global

• Formalized risk/control arrangements (high
degree of discipline and formalized control
evidence); and strong compliance culture
• High focus on assurance agenda – SAS70/AAF/
GIPS/HFSB
• High degree of transparency
• Regulator “relationship-managed”
Super Boutique
US$1 billion + US$3 billion + US$10 billion +
• International sales reps (US, Asia, EU…) • More formalized risk-governance arrangements
(Board/Executive Committees)
• Moderate adoption of investor assurance
Global Reach
International

agenda e.g. SAS70 or GIPS
• Greater degree of process/control discipline
• Moderate interaction with regulatory bodies

Entrepreneurial
Institutional
Manager
US$100 million + US$1 billion + US$5 billion +
• Entrepreneurial, craft orientated • Multiple funds / managed accounts • Multiple product ranges (Hedge funds, absolute
• One main fund • Multiple strategies return strategies, long only)
• Low degree of transparency • Multiple distribution channels – fund of funds,
Single Office

• Informal risk-governance/control arrangements managed accounts, retail, direct
• High degree of reliance on legal vs compliance • Performance focused, no mediocrity
culture
• Low relationship with regulator
(deemed “low risk”)

Boutique

Single Product Multiple structure / product Multi Channel

Product Breadth


Managed accounts: great in theory, more difficult in practice
Separately managed accounts have always been a mainstay of the investment
“There is no shortage of talent. management industry. Managed account platforms, however, are a relatively new
Money supply is the biggest
phenomenon.
challenge”
Using managed account structures as a method of investing in alternative
investments, has become considerably more attractive than fund of funds with
institutional allocators. Investors surveyed forecast that managed account structures
will experience substantial growth. (After direct investment into single manager
funds, managed accounts are predicted to see the largest increase in asset
allocations over the next 3 years.)

The control that managed accounts offer investors was mentioned by all those that
use, or intend to use, these structures. After control, liquidity (in particular avoiding
gates, lock-ups etc) and transparency were the next most popular reasons for
turning to managed accounts. As a result, managed accounts are being used almost
“Stars are the life source of the systematically by large institutions when they wish to make a large allocation to a
industry; they know what they want manager.
and they know how to get it”
However, managed accounts have drawbacks. Their biggest drawback is that
they do not provide access to all managers or strategies. They are also difficult to
implement for illiquid strategies, like distressed funds, due to increased reporting
and administration demands. In addition, investors are conscious of the added costs,
resources and responsibilities that are imposed upon them. Only large institutions
have the means to employ the staff to implement and monitor a successful managed
accounts program. Other concerns included performance diminution and the fact that
they place more operational risk on the investor (and less on the manager). In addition
to complexities with implementation, capacity constraints are already emerging in
the managed account sector and investors are likely to have some difficulty finding
the managers they want via these structures. Managers interviewed complain that
“We want respected names, known managed accounts are taking up too much of their time and resources. They are
to investors, on the prospectus” concerned that their own fund investors must come first. Some managers have
declined to take on managed accounts and others are imposing limits.

Imposing limits on managed accounts could become a badge of honour with
successful, well known managers in the future. Pre market crisis, finding capacity
with such well regarded managers, those that were often technically closed, was
a concern for large investors. Post crisis, a variation of this problem could reappear
within the managed account universe. Hence, direct investment into alternative
investments is forecast by investors to increase more quickly than investment via
managed accounts over the next three years.


Twin track alternative fund domiciliation
The alternative investment industry has always been drawn to offshore jurisdictions.
They have grown up together. These domiciles are ideal locations both for their
original core investors – the high net worth crowd – and managers. Locations
offering regulation where it is quick, flexible and inexpensive to launch funds are
what alternative managers want. However, a combination of increased investor
nervousness, and the evolving regulatory environment have led managers to
question whether they should continue to domicile their funds offshore or re-
domicile onshore. Some managers have taken the step of re-domiciling onshore. “The credit crunch was a symptom,
Others have launched funds in onshore locations, such as Dublin, whilst keeping not a disease”
their offshore funds in operation.

Results indicate that the overwhelming majority of investors are happy to continue
to allocate to alternative funds that are located in offshore jurisdictions. There is no
evidence that the domiciliation structure of the alternative investment industry is
of concern to those that currently allocate to these products. These respondents
represent the bedrock of the industry’s investor base. Investors in this category often
view with disdain more regulated alternative fund domiciliation, which has become
something of a craze in Europe.

In addition, investors with longer tenures of investing in alternative investments tend “Politics and regulation are killing
to be the least concerned with operational issues and fund domiciliation, whilst being our business. We can work on our
the most sceptical that more regulation is in any way beneficial. Managers would performance, but its difficult to work
therefore be wise to maintain their offshore fund range for their bedrock investors. For on politics!”
the next wave of investors, a different strategy looks likely to be beneficial to secure
such investors’ capital (at least for European allocators). They are more likely to want
onshore funds in addition to their offshore structures.

Alternative investment domiciliation is diverging. The traditional homes of the hedge
fund and private equity industries are not under significant threat. They will continue
to be the logical place to go for funds aimed at the traditional alternative investor.
However, EU domiciles are developing complementary structures to compete for
this business and appeal to the new generation of investors. How these funds fare
remains to be seen.

The growing role of the administrator
Third party, independent fund administrators find themselves in a pivotal position
as the alternative investment industry is transformed in this new era of increased
regulation, investor scrutiny and institutionalization.

10 The Future of Alternative Investments

What do you think are the key challenges facing the administration industry over
the next 3 years?

66%
Continuous IT development
and investment 43%

66%
Regulatory compliance
63%

59%
“Institutional investors are like royalty
Independent valuation
of complex securities 65% - they attract a lot of interest in your
fund but they come at a price”
50%
Maintaining margins as
assets under management fall 28%

19%
Developing a
sustainable client base 33%
Administrators
Managers
16%
Shortage of skilled staff
40%

0 10 20 30 40 50 60 70
% of respondents

Administrators are at the center of structural changes occurring throughout the
industry. Increased standardization of administration will be the main change,
particularly with regards to reporting transparency and liquidity requirements for
investors. The anticipated increase in regulation is also forecast to have consequences “Investors did not like being told they
for all industry practices, including administration. One respondent referred to the couldn’t have their money back”
speed at which internal control reports (e.g. SAS70) have become standard in the
industry as an example of how quickly practices can change.

Administrators included in our survey also believe there will be significant
developments in the use of technology, in order to keep pace with increased
demands placed upon their businesses by the alternative investment industry. There
will be a requirement to accommodate an exponential increase in data demanded
from fund managers, investors and regulators. As a result, administrators will need “Managers need administrators more
robust and flexible technology platforms that are capable of high volume transaction than ever”
processing and customized ‘real-time’ reporting. Furthermore, for several years,
administrators have been diversifying into services that are complementary to
their core activities, such as performance attribution analysis and risk reporting
services. The new environment is likely to see an acceleration of complementary
services offered, including functions that support managers’ front and middle
office activities. In Europe, administrators have been particularly successful in
diversifying their product range to capture reporting requirements for UCITS funds. “Administrators have distanced
Globally, it is significant that when asked the question, ‘Which services do you themselves from their responsibilities;
provide currently and which do you expect to grow significantly in the next 3 years?’ the crisis has driven them to seek
Administrators said that they expect there will be a big jump in front and middle legal protection”
office services and risk management.

The Future of Alternative Investments 11

However, with demand comes challenge. Despite a significant investment in
technology, the administration industry remains very labor intensive and lacks
operational leverage. There is an increasing capacity mismatch, with nearly 3 in 4
“No matter what any manager will tell administrators operating at between 71-100% capacity. MA activity is therefore
you, if the world falls apart again and inevitable. A number of administrators have already expanded into other areas and
everyone runs for the doors, you’re
we are beginning to see convergence (hedge fund administrators buying into private
not going to get your money back!”
equity for example). New firms and new product offerings are also likely to emerge to
service the operational demands of clients. If alternative inflows develop as forecast,
or anywhere near to it, administrators will face serious infrastructural challenges. This
is an issue that few have yet to address.

The bifurcation business
Bifurcation of the alternative investment industry is occurring in a number of ways. It
“Leverage is an unpopular word can be seen in the growing gulf between the boutiques, those managers that have
these days; its making it hard to raise stayed focused upon implementing their particular specialist investment strategy, and
capital” a number of the multi-billion dollar managers that diversified into other areas of the
market and/or whose business models have moved beyond fund management.


There is now evidence that bifurcation is also occurring between institutional
“You don’t send a football team onto
investors. The offshore fund industry will continue to serve the majority of those
the field without some reserves.
currently investing in alternatives, largely sophisticated and experienced investors
Why would we do the same here.
who remain satisfied with its structure. However, new investors into alternatives
We’re always looking for star
are more likely than seasoned allocators to be attracted to managers promoting managers and have reserves to
funds with greater liquidity and transparency than is typical in traditional alternative allocate when we find them”
structures. This has been an important part of the reason for the growth in UCITS,
or ‘Newcits’, funds in Europe. Meanwhile, much of the wealth management sector,
as well as the longest serving and most sophisticated institutional investors, remain
prepared to allocate to funds in offshore jurisdictions that are less transparent and
considerably more illiquid than alternative UCITS products. These investors are also
more understanding of industry practices such as gates, lock-ups and side-pockets,
that evolved and were subject to so much criticism during the credit crisis.

The continued establishment of onshore regulated products will fundamentally “We won’t accept lock ins anymore;
change the dynamics of the alternative investment industry. It is likely to lead to a we’ll barely tolerate gates”
considerable increase in fund launches as parallel, or ‘mirror’ funds, are launched
in onshore locations that mimic established offshore funds. Established offshore
jurisdictions will continue to thrive and prosper in the new environment. There
will also be a lot of activity in locations such as Ireland, Luxembourg and Malta as
alternative UCITS become established in Europe.

The changing structures available to allocators
The way in which institutional investors currently access alternative investments Do you believe the alternative
will change in the next 3 years. At present, investors generally allocate capital to investment industry will become...
alternative investments through fund of funds, managed accounts, indexed products
or direct investment. Institutional investors with the requisite resources are now

5%6% 6%
moving to a hybrid allocation model. A clear trend in favor of single manager funds
and managed accounts is emerging as allocations to fund of funds diminish.
13%
Fund of funds did not have a good market crisis, say their investors. Their raison d’être
to reduce market risk through enhanced diversification failed to materialize when 14%
it mattered most. Whilst large institutional investors favor a hybrid model of single
manager funds and managed accounts, smaller institutional investors have more
49%
limited allocation options and fund of funds will remain their gateway to the industry.
33%
A number of these investors note that larger fund of funds are proving to be adaptable 74%
and innovative; some have enhanced their communication with investors and provide
a far more customer centric experience.

Fund of fund managers with assets in excess of US$5 billion have the resources to More
Bifurcated between
expand into managed accounts and to diversify their offerings in other ways. In 2010 large asset providers institutional
and small boutiques
and beyond, the best of these large, multi purpose operations are likely to continue
to expand into new areas (offering investors different structures and strategies). More boutique Remain
focused the same
Convergence and divergence across strategies and structures will drive consolidation.
Recent mergers in the hedge fund industry, including that of two well known firms
% of respondents
in the business, both with assets in excess of US$5 billion, are an example of this.
This is widely expected to lead to a further wave of MA activity. There is always
a possibility that something similar to the ‘merger mania’ that gripped the custody
industry in the 1990s could be replicated amongst today’s independent alternative
asset managers.


The future is much bleaker for smaller fund of fund managers. For far too many, the
market crisis exposed shortcomings in their core business proposition. Unlike their
larger competitors they do not have the resources to fight back. The largest fund of
funds are diversifying and/or using their brand name to attract institutional and high
net worth investors in order to grow in different directions. But the smaller players
are unable to compete in these areas. They are struggling.

Challenge to the 2 and 20
The majority of investors interviewed do not believe that the industry’s 2 and 20 fee
“We’ll pay performance fees for
structure is sustainable. Whilst not top of their list of priorities for industry reform,
performance but we don’t like
fee reduction is still something that they want and anticipate will happen. Equally,
a manager making money from
manager fee structures are expected to be less uniform in future.
management fees”
Manager fee structures are under pressure because investors have much greater
negotiating power as a result of the market crisis. Added to which the industry
is being driven forward by super-sized allocators. They have always been able to
negotiate lower fees, including with many of the most sought after managers. This
was common practice even at the height of the boom. It is these institutions, with
their significant fee negotiating power, that are chiefly responsible for the recent
strength of inflows into alternative investments.

In addition, a number of the largest institutions want to see more alignment of their
interests with managers. They believe managers should make a greater effort to build
a long-term business compensation culture. For certain strategies, this may simply
require a performance hurdle feature. One institution made the point that they are
long term investors and they want to work with managers who think, and act, like
them. There is evidence that a number of the more recent start-ups have recognized
this issue by redesigning their business models to incorporate longer term fee
structures and hurdle features.

It is believed that differences in fees will only grow in the future. The uniformity is
gone. In its place will be many more ‘local’ agreements. Some managers will be able
to charge more than 2 and 20, as has always been the case. But results from this
research suggest that with the largest institutional investors in the driving seat, most
fee negotiations will be going in the opposite direction.

Professional fund servicing is now key to investor contentment
Fund servicing related issues are becoming ever more important for investors.
“Fund servicing issues are the most The growing institutionalization of the industry have made topics surrounding fund
important business decisions that you servicing central to the well being of the industry. Fund servicing issues such as
can make. 60% of the success of the investor demands for due diligence procedures had been growing in importance well
fund depends upon it” before Madoff, a fraud that has added impetus to this trend. That such a relatively
simple fraud could have taken place on such a large scale in a highly regulated
environment, indirectly affecting numerous investors, has profoundly shocked many
constituents across financial services.

All investors now take fund servicing very seriously. A number of managers noted
that events over the last 18 months have had an effect upon the type of firms that
“We’re asking so many questions, they would want to hire as service providers. Recognized names that prospective
we don’t have space to write the investors are familiar with have become more important than was the case pre crisis.
answers” It has become essential to have organizations listed on the fund’s prospectus that
reassure investors. Service provider name recognition is becoming paramount.


What impact, if any, has the market crisis and/ or the news of recent financial
scandals had on your operational due diligence process?

43%

Managers 49%

8%

High Impact
41% “Hedge funds were not out of control;
Low Impact they did not cause the crisis”
Administrators 53%
No Impact
6%

67%

I. Investors 22%

11%

0 10 20 30 40 50 60 70 80
“Our checklists have doubled”
% of respondents

As the industry grows its institutional investor base, managers expect that scrutiny
of their operational procedures by investors will only increase further in future.
This includes their third party service providers. Due diligence on administrators, in
particular, has become a lot more intrusive and regular. In 2009 alone, administrators
say that there was a substantial increase in investor requests for due diligence “Robust due diligence is critical –
meetings as well as detailed and regular due diligence reports. One administrator has we won’t even open the door to a
noted that this type of activity has increased by 30% alone in 2009. manager without this”

The point is that the institutional investor now has far more power to shape
operational aspects of the industry, as a result of the sheer weight of its capital.
Managers surveyed say that both their existing and prospective investors and
regulators want clear and transparent operational oversight. This is now occurring.

“High Net Worth investors have been
hibernating for over a year now; surely
its time they woke up”


“Only when the tide goes out do you
discover who’s been swimming naked”
Warren Buffet

Managers
This section presents the results from the survey and
structured interviews involving alternative investment
managers. Case studies with industry participants are
presented at the end of the section.

Core capacity
“In a downturn, transparency is
trendy, but when the industry moves The supply side of the alternative Approximately, how much of your
investment industry has changed company’s core capacity is currently
on, trends change. The return to the
being used?
status quo is inevitable” considerably in recent years. Prior to
the credit crisis, questions were raised
regarding the availability of talented
6%
1%
managers who could generate alpha at 6%
a rate demanded by investors. Currently, 21%
there is significant amount of capacity
available to manage funds, with only 44% 14%
two in five managers operating at or
near full capacity. 13%
“Sometimes the red flags are so
Our interviews revealed evidence of
a next generation of talent migrating
74%
huge, you have to close your eyes
from brand name investment houses 21%
to miss them. Even then, your other
to set up new businesses. Whilst the
senses tell you its not quite right”
industry continues to institutionalize, the
allure of reward, creativity and freedom
10% 10-30% 31-50%
on offer from the boutique sector will
always attract alpha generators. Hence,
the number of boutiques will continue
to thrive, although in capital terms, they 51-70% 71-100%
will represent a far smaller proportion of % of respondents

the industry. The pace of change may
be impacted further by the proposed
‘Volcker’ rule in the US, as proprietary
traders are forced out of the mainstream.

The future choice for investors looks
bright - the difficulty will be finding the
star in all the mediocrity.


Products and performance

Which alternative investment products do you expect your clients will be attracted
to in the next 3 years?

Single strategy hedge funds 59%

Private Equity 39%

Multi strategy hedge funds 33%

Fund of hedge Funds 28%

Structured products 26%

Real Estate 26%

Infrastructure 22%

Reinsurance products 4%

Other 13%

0 10 20 30 40 50 60
% of respondents

“Our investors want us to do well, but
there are plenty waiting to write about What returns do they expect?
us if we fail”

Private Equity 19% 50% 19% 12%

Multi strategy
42% 58%
hedge funds

“I feel sorry for administrators - Infrastructure 43% 57%
they get a tough deal, but at last
they’re being recognized as being an
important part of the process” Structured products 50% 30% 20%

Single strategy
hedge funds 23% 73% 4%

Real Estate 62% 38%

Fund of
78% 22%
hedge Funds

0 20 40 60 80 100

“Investors got hurt, but time is a great
1-10 % 11-20 % 21-30 % 31-40 %
healer”
% of respondents


As investor appetite for absolute returns higher risk bonds and other investments
continues to grow, over 3 in 5 managers such as art funds.
expect that single strategy hedge funds
Hedge fund and private equity products
will be the main route to market, with
“When the markets are rising, who are preferred by managers – an indication,
the majority of them expecting returns of
cares about hedge funds when you perhaps, that investors have short
can have long only” between 11-20%. This data is confirmed
memories and are willing to try again,
by investors who are increasingly
albeit under new and improved terms.
searching for direct investment
into funds. From our interviews, it is clear that the
fund of fund industry is at a crossroads.
Expectations for returns favor private
Transparency, liquidity, alignment of
equity, single strategy hedge funds
interests and customer centricity are all
and structured products, although it is
changes which the industry is making.
unlikely that we will see a significant
Many managers commented that they
“Regulation is depressing; its costly increase in the latter before the next
lost sight of investors and with that the
and will not prevent a year. Whilst investors have short
trust between investor and manager
blow up” memories, they will likely not forget
was broken. The surviving fund of fund
the term CDO (“Collateralized Debt
brand names will continue to thrive
Obligation”) in a hurry. The events
as institutional investors have limited
in recent years, however, have not
opportunities with which to access
caused the structured product industry
talent. For the smaller fund of funds,
to close, and a number of larger
there needs to be a mindset change
managers have expressed a desire
towards the investor, and improvements
to ramp up their CLO (“Collateralized
“We didn’t lock down investors. in communication will be essential.
Now we’re getting the benefit of that Loan Obligation”) businesses when
Nonetheless, we are likely to see
confidence with new investments” the market fundamentals change. Our
stronger asset growth from managed
interviews suggest that investors are
account platforms in the next 3 years
regaining confidence in the sector and
as investors seek more control and
are beginning to search for innovative
transparency in their investments.
products, with a growing interest in


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Transformation future alternative_investments

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