New year, new reality for alternatives

Selective survivors are more ready to accept new clients and more flexible on fees than they were two short years ago.

“In case you missed it, 2008 was a little bit of an interesting year,” Black wryly notes. “All of us learned a lot of lessons.”

Chief among those lessons is that assets under management, like real estate values, don’t always go up.

“For 15 years, the hedge fund industry did nothing but go up,” he observes. “Then, in 2008 and 2009, 2,000 funds closed as the industry recorded net losses. Investors pulled $290 billion. While hedge funds still have $1.5 trillion in assets, that’s down 18% from 2007. Formerly $1 billion funds are now managing $300 million, and wondering whether it’s worth the effort. Instead, they’re thinking of joining larger, $1-billion shops.”

That, explains Black, is leading to an “institutionalization” of the hedge fund marketplace. Family offices and high-net-worth investors have pulled out, leaving 90% of the assets to 25% of the funds, which are now seeking “sticky” money from pension funds, endowments and foundations.

“It’s not a seller’s market; it’s a buyer’s market,” he says. While hedge fund assets are down, even more dramatic is the decline in leverage. Hedge funds have reduced leverage from 3x to 2x, and so the assets they control has dropped in half, to $2.9 trillion. But proprietary trading desks at investment banks have seen an even more massive reduction: leverage of 8x has been taken down to 4x, and assets levels are now one-tenth what they were in 2008.

“What does it mean when 2,000 hedge funds have closed? What does it mean when the proprietary trading desks are out of business?” he asks. It could mean a new trading opportunities, and so “now might be a good time to allocate to hedge funds.” It’s no longer the crowded space it used to be.

Terms are more favourable for investors now and fees are on the decline. The traditional 2% management fee, with a 20% incentive fee — or “2 and 20” — had bloated up to 3-and-30, or in some instances 5-and-50. That has now collapsed to a 1% management fee and a 20% performance fee, with some fund of fund managers forgoing the incentive fee altogether.

But at least hedge fund managers have seen an uptick in hedge fund allocations in recent months. That’s not the case in other alternative sectors, such as private equity and real estate.

“What happened in 2008 was the equity markets came down pretty quick,” Black notes. This led to the “denominator effect.” Declining equity markets contorted strategic asset allocations, leaving many institutional investors overweight in alternatives and underweight in equities. “What was 10% in the third quarter of 2008 is now 15% in the fourth quarter of 2009.”

As a result, money is not flowing into the business, and leverage has dropped sharply.

Limited partners in private equity funds previously funded new capital calls from distributions made by funds of older vintage that were being wound up, typically after five years. Unable to meet new capital calls, limited partners are selling their stakes on the secondary market at 80% to 90% of net asset value.

Perversely, this could be a buying opportunity, though Black admits “it is very difficult to tell people now is the time to invest.” The 2003 vintage year would have funded the 2008 vintage year, which was a cyclical low. But, given the risk of capital calls without funding, some investors are paying secondary buyers to take limited partnerships off their hands.

Black suggests the smaller partnerships are going to be the opportunities. Moreover, a fund of funds might be able to offer diversification across vintage years as well as sectors. Still, on the downside, deal flow has slowed, it’s harder to find an exit — there were eleven IPOs last year — and investors will have to submit to longer lockup periods.

In addition, new accounting standards will remove some of the diversification advantage enjoyed by private equity. Instead of appraisal-based valuations, companies will be marked to market.

“You’re going to see more volatility like the equity markets,” Black says.

Real estate is similarly beaten up in what could be the worst year of the decade, which witnessed a substantial downturn in commercial real estate. As troubled banks have curtailed lending, “most of the deals are being done in cash — cash is what is moving this market.”

Again, perversely, “the investment environment could be very positive,” but only for those who have “the cash to take down those deals.” In this environment, real estate investment trusts are doing well because they do have access cash.

Of the three main sectors in real estate, core properties are holding up best, because they have stable tenants. But that’s only relative; they’re still down 30%. Value-added properties, which involve fixing up buildings to increase rents or occupancy, and opportunistic plays, which involve buying in emerging markets, are both down 40% to 70%.

Gates and redemption suspensions also characterize private funds. “What you thought was monthly and daily liquidity could be three-year liquidity,” Black observes.

Liquidity and performance remain concerns across alternative asset classes. Some investors, for example, will only talk to funds that didn’t suspend redemptions in 2008. And, there is a closer scrutiny of managers after the Madoff affair. For his part, Black says, “I don’t even look at returns till I’ve met the manager.”

Managed accounts, which secure assets from the hedge fund acting as a trading advisor, are growing in popularity, along with third-party service providers who can check a manager’s valuations.

“What we’re seeing now is a dramatic change in the terms between the limited partners and the general partners” — the people running the various funds, Black says. The managers are “having to give back on the transparency side and on the liquidity side,” and in some instances, deferring their incentive fees.

More on managed accounts.

(01/26/10)