How to attract institutional investors: get an edge, manage risk, and emphasize pedigree

It seems like just yesterday when most hedge funds were already closed to new investment before they even got off the ground, leaving pensions and other institutional investors clamoring to get in to the party, seemingly at any cost.

According to a recent white paper published by Merrill Lynch – Bank of America entitled “The New Hedge Fund Environment: Attracting Institutional Capital in a Post-Crisis World,” (the report is not available online, though readers can click here to send an email request for a copy, or call 1-646-855-0233) those days are long over.

It is now hedge funds that have to prove they’re worthy enough to get past the velvet rope, with a much more stringent selection process.

Indeed, the report, which was compiled from surveys of 111 institutional investors representing some $1 trillion in assets, found that the negatives of 2008 – poor performance, suspended redemptions/gates, liquidations, and, in some cases, scandal – have pushed the pendulum away from managers dictating terms to investors, who are refusing to even consider cutting a check unless there is an “alignment of interests.”

What exactly are these “alignment of interests”? According to the survey results, better fee structures, better liquidity terms, better delivery of alpha, better capital preservation techniques, better portfolio and operational transparency and better communications. The graph below illustrates what investors deem important when it comes to investing in hedge funds.

While institutions remain willing to pay for performance, they are also not afraid of demanding fair fees and terms. Those with longer-term investment horizons want fee and compensation structures that are longer-term in nature. Similarly, these investors want the liquidity terms of a fund to match the liquidity of the instruments being traded.

They are also still understanding of gates and lock-ups – so long as they are imposed for a valid reason. When asked whether they would invest with a manager that had suspended redemptions or imposed a gate on fund assets, a majority of investors (61%) said they would consider the circumstances under which a manager suspended redemptions or gated and evaluate them on a case-by-case basis, compared to less than a third (29%) who said they wouldn’t even consider investing with such a manager (see chart below).

As for managed account structures, nearly two-thirds of investors indicated they have no plans to implement managed accounts for their hedge fund investments, for the simple reason that administrative costs offset the benefits of transparency and security of assets.

To be sure, the original premise of why institutions even want to invest in hedge funds in the first place still holds: diversification, absolute uncorrelated returns, capital preservation, higher Sharpe ratios and, of course, return enhancement. But the lengths institutions will go before actually deciding to allocate are much more stringent than ever.

But the party has definitely moved across the street, with managers clearly no longer in the driver’s seat when it comes to deciding who gets in.

We have written before about the need for managers to clean up their rooms, so to speak, or risk getting passed over for another manager that is willing to accommodate what institutions want and expect. It is a trend we suspect will remain in place for some time to come.

(Editor’s Note: Due to the Good Friday Holiday, we’re taking a day off tomorrow.  We’ll be back Monday.)

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