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?