Do institutional investors benefit from alternative assets?

It's no mystery as to why so many of us are shooting for those much vaunted exit ops into private equity and hedge funds. There's money and prestige, to say nothing of the models and bottles and perhaps the chance to do interesting work.

But how much of the wealth that we see PE/HF ballers throw around is generated by making consistently good investments, and how much of is it generated from management fees?

At least one institutional asset manager is remarkably skeptical of the whole endeavor, and he gives us at least three reasons why institutions should stay away from hedge funds and private equity. Given how much money flows from the big institutions into PE and HFs, this can have serious impacts on the alternative investing world…

First, he argues that alternatives are far too illiquid for the typical institution:

Our institution was invested in a hedge fund that decided to return capital to investors.  They gave us the choice of taking a huge write-down up front or getting the money back as the investments were sold off.  We decided to wait and it ended up taking four years to get the entire investment back.   And each time they sent chunks of money back the remaining funds got marked down even further.  This is a huge opportunity cost.

To reduce the risk of a blow-up like this, institutions diversify among multiple hedge funds and strategies, which only increases the likelihood of picking below average funds.

Funds normally have at least a 1 year lock-up with your initial investment but it’s possible that the lock-up can be 3-5 years in some cases before you can pull your money out.  I also witnessed multiple funds side pocket hard to value positions or lock up all investments during the financial crisis.  You tell me whether it’s worth it to pay 2 & 20 or even more for this deal.

Next, we hear that the management fees are just too damn high, and come with great opportunity costs that don't justify the benefits:

I've done due diligence on some hedge funds with fees consisting of expenses & 30.  Those expenses can run in upwards of 6-8% in good years.  So, it could be an 8% management fee & 30% of profits.

Private equity also comes with huge opportunity costs.  You don’t simply hand over the amount you commit to the fund on day one and start investing.  With extensions, the investment period could last up to 10 years.

Finally, he argues that investing in alternatives is just far too complex for most institutions to do effectively:

The investors that run these portfolios are highly educated individuals who are very intelligent.  It’s hard for them to admit that the simple solution makes the most sense.  Being able to understand complex strategies makes them think they are superior to index funds and ETFs. There is false sense of security when you spend your time talking with brilliant, wealthy alternative managers. I’ve been in a number of meetings with active managers or consultants who have said the only clients they have lost left to invest with index funds.  They wear this fact like a badge of honor.  Everyone shares a laugh at the poor investors earning low-cost, market returns.  They fail to acknowledge study after study that proves index fund superiority.

The assumption that complex financial markets require complex solutions is the first response for institutional investors.  But new and exciting is not the same thing as useful.  Value at Risk (VAR) and PhD’s running risk management models all work until they don’t. This is especially true with complex strategies that are impossible to track correctly because of their lack of transparency.

Do you think that the large institutions are growing increasingly wary of alternatives? Is the famous Yale model past its prime? I'm sure there are some monkeys out there with experience in capital raising or in institutional investment management who can offer their opinions: what do you think? Are his concerns overblown, or will we likely see institutions shifting away from alternatives? Or is it more likely that general partners will re-write contracts to lower costs and provide more liquidity to investors?

 

An issue to take a look at is that many institutions rely on multiple investment consultants for alternative assets. Most of these consultants have already "pre-screened" GP's and fund managers that they have had long relationships with. Due to this nature of the business, many institutions only have a certain percentage of the entire fundraising universe available to them (aka who consultants feel comfortable recommending/pitching or allocating an institution's capital to.) Most of these pre-screened managers are the bigest names with the highest fees. Thus many of these institutions who are not empowered internally to find manager's outside of their consultant's realm may not perform as well as those with an in-house alternatives program. For example, a client of mine is a very sophisticated LP who has no outside consultant help and 10 individuals on their investment team (the whole organization is less than 80 staff members.) They have strong interests in learning as much as possible about realtively small Chinese, African, Brazilian, etc. GP's that many of their peers may have never heard of due to their full reliance on consultant recommendations, stemming many times from their prior relationships. Though it is certainly expensive to run your own insitutional HF program per say(probably 1 million a year in costs) many insititutional investors have certainly become more proactive in atleast hiring more analysts or employing more data to form a stronger in-house system for alternatives. As more and more institutions begin empower themselves and gain more awareness and new perspective of different alternative asset classes and managers (with LOWER FEES), I am confident we will see a rise in returns for institutions globally in this portion of their portfolios.

"I'm a historian, and that freaks me out."- Mike Tyson
 
Best Response

I would have to agree with his concerns and would even add that I don't think the private equity (can't comment as much on hedge funds) asset class makes sense for a lot of investors. Private equity is even worse in terms of liquidity (10 year lock-up and many times it can take that long to realize investments) and the returns are based mostly on luck and the year you happen to raise a fund. To top it all off, a lot of institutions are invested in multiple, similar, funds, and these funds end up bidding against each other in auction processes and selling assets to each other. I remember we sold one flailing company to another PE firm who had many of the same investors as we did. I've always wondered what the LPs did when they got one quarterly letter from us saying "great news, we finally got rid of that awful XYZ Co.," and then another quarterly letter from the other fund saying "great news, we make a new investment in XYZ Co. and are excited by its prospects."

It's largely a shell game aimed at moving large sums of money around and clipping fees as the money passes by. Some of the institutions are starting to push back (we had to produce a lot more reporting docs for our last fund than was previously the case) but as long as there are easy money waves that produce returns every so often I think they'll keep funneling money into the asset class.

 

Well #1 holds no weight, as an INSTITUTION should have a time horizon beyond lives. What's a lock-up period of 3-5 years? As long as it isn't heavily weighted, the rest of the portfolio should easy carry an organization through the ups and downs. Alt Inv is really to reduce correlation to that volatility and allow for superior returns over a much longer horizon.

2 Management fees were higher, but that was at a time when it was a frontier and experienced rapid growth. People fought over getting a part of an LP pie, now that the music stopped, I'd love to see how many are still commanding 2 & 20.

3 If you can't understand alt inv, don't invest directly or cure the symptom and get some damn education. That's what Canada (OMFG DID AN AMERICAN JUST BIG UP CANADA?!?!) did and now the huge institutions run their own damn fund b/c they can have carried interest AND learned proper due diligence AKA you can't understand what they're saying ask some freakin questions.

If the glove don't fit, you must acquit!
 

The problem with alternative investments such as private equity is that it does not provide diversification as most portfolio managers thought it would. Private equity should not be considered an alternative asset class because you are taking on the same equity risk as you would be if you are investing in the public markets. I believe that alternative assets will still play a huge role in portfolio diversification but it will involve less private equity, venture capital, equity investments and more about finding asset classes with zero correlation to the equity markets such as currencies.

 

I would completely disagree. Lots of alternative investments are negatively correlated or have zero correlation with the stock and bond markets. They even move the efficient frontier up and to the left. And fees have started to drop tremendously. The liquidity part makes me think he does not understand alternative investments. Real estate and PE are going to have huge liquidity issues, its the returns over the long run that help. Hedge funds have started to do shorter lock ups, it really depends on the strategy.

I really think the guy who wrote the article just does not understand alternative investments. They are for the institutional investors, not for everyone. Sounds like he should just hire someone with the CAIA.

 

^Someone that actually knows what's going on. I've never heard of any stable 'institution' complain about lockups. The fact they are an 'institution' would imply some sense of perpetuity. Mismanagement of any asset can be bad, doesn't make the asset itself bad...look to the management.

SquaredFractals:

I would completely disagree. Lots of alternative investments are negatively correlated or have zero correlation with the stock and bond markets. They even move the efficient frontier up and to the left. And fees have started to drop tremendously. The liquidity part makes me think he does not understand alternative investments. Real estate and PE are going to have huge liquidity issues, its the returns over the long run that help. Hedge funds have started to do shorter lock ups, it really depends on the strategy.

I really think the guy who wrote the article just does not understand alternative investments. They are for the institutional investors, not for everyone. Sounds like he should just hire someone with the CAIA.

If the glove don't fit, you must acquit!
 

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