Alternative-asset managers increasingly are being asked to create specialty products for their largest investors. More than a quarter of new money that flowed into the $3.2 trillion hedge-fund industry last year went into customized strategies offered through a separately managed account (SMA), or fund-of-one, according to research from Jefferies. In 2016, only 14% of hedge-fund investors said they would be interested in a hedge fund offered in a SMA structure, according to a FIS report.
Over the last two years, Jefferies estimated that two out of every three hedge funds have been asked by an investor to make a bespoke product and that it is now more likely for a hedge-fund manager to have a specialty one-off product for a single, big investor than not.
With thousands of hedge funds to choose from, investors are having funds tailor-made for them to fit their portfolio, liquidity, and risk-preference needs, Jefferies’ annual state-of-the-union report on hedge funds said.
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In these structures, a large investor is often the only investor in a fund. This gives these investors more leverage when negotiating fees and strategy requirements.
It’s another byproduct of the hedge-fund industry’s biggest investors — institutional capital providers such as pensions, endowments, and foundations — warping the industry to fit their wants and needs, instead of kowtowing to hedge-fund managers, who historically have demanded high fees and little supervision.
“Allocators increasingly go to hedge funds/alternatives managers first to solve specific portfolio needs, despite the fact there are more than 9,000 funds already in existence. We’ve entered an era of ‘ultra customization,'” said Shannon Murphy, head of strategic content in Jefferies’ prime services business.
It is hard to say no to an investor offering to give you tens or hundreds of millions of dollars, no matter how successful your hedge fund has been.
But there are clear drawbacks and cautionary tales of tying up all or most of your asset base with one investor. For starters, as one manager put it, you’re no longer running your own business: You’re a de facto employee working for a pension fund or endowment.
And while a sudden infusion of capital can help a small fund get established, redemptions can come just as quick.
For example, Quest Partners, a New York-based manager with $1.5 billion in assets in several strategies, received a $500 million investment from Man Group in 2002, a year after starting, said Scott Valentine, the firm’s head of investor relations.
Read more:Investors are asking hedge funds to move to a ‘o-and-30’ model, and it’s putting pressure on a big chunk of the industry
With a sufficient amount of capital, the firm focused on perfecting its models and running the money it had instead of seeking out more investors, Valentine said. But the financial crisis of 2008 forced Man Group to redeem several of its hedge-fund positions — leaving Quest with less than $50 million in assets in 2010 after the firm had been running more than $600 million before the crisis.
The founder, Nigol Koulajian, was funding the daily operations of the firm after Man Group pulled out, and, to keep the lights on, the fund turned back once again to a large investor — a large pension plan pumped money into its flagship strategy. The firm also rolled out an SMA in 2013 that has more short equity exposure for specific investors.
“When we were unable to raise money after 2008, I said let’s address the problem … we can be interested in what they are looking for,” said Koulajian.
The end of ‘supermarket’ managers
But raising capital and launching a fund has become tougher. Increased costs for technology and compliance, and more competition give the upper hand to investors with capital to burn during negotiations.
While Michael Gelband and Steve Cohen were able to raise billions of dollars for their new funds, liquidations outpaced launches last year for the first time since the fund tracker Preqin began watching hedge funds in 2003.
With investors holding the power, they’re able to fund strategies that will do exactly what their portfolio needs.
Michael Graves, a former quant manager in Point72’s Cubist unit, is shooting to launch his hedge fund with $600 million to $750 million this summer and is receiving backing from Paloma Partners, which helped seed D.E. Shaw and others. A former BlackRock alternative-credit manager, David Horowitz, is reportedly launching his systematic credit fund with a $300 million seed from an unknown US corporate pension plan, and the seed will mostly be managed through a separate account.
The future of the industry is no longer “multi-strategy” but “multi-product,” according to Jefferies. Large investors are moving away from dedicating part of their portfolios to hedge funds, instead slotting hedge-fund strategies into portfolio categories such as “absolute return” or “all weather.”
“The era of supermarket firms that try to be everything to everyone seems to have waned, as allocators seek a more precise match for their portfolios,” the firm said.
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