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Special report

Surge of Asian assets into fund of funds not expected to be saving grace for industry

The tide of Asian capital that's beginning to wash into customized private markets or hedge fund-of-funds vehicles now should offer some respite for a segment of the global manager universe that's struggled in recent years, but it's not going to lift all boats, industry veterans warn.

Huge pools of capital in the region making their first forays into alternatives now via “funds of one” — including South Korea's 565 trillion won ($496 billion) National Pension Service and Japan's 207.8 trillion ($1.86 trillion) Japan Post Bank Co. Ltd. for hedge funds, and Japan's 144.8 trillion Government Pension Investment Fund for private markets — are demanding levels of client service and fee discounts that will squeeze managers and leave the industry facing further consolidation, some say.

At the same time, big asset owners' quest to gain the expertise they'll need to eventually invest directly in alternatives funds and private markets will force global managers to continue fine-tuning the mix of asset management and advisory services they offer.

For now, though, with rock-bottom sovereign bond yields pushing a growing number of large public and semi-public asset owners into the alternatives arena, most recently the 80.3 trillion Japan Post Insurance Co. Ltd., some market veterans anticipate a regional tailwind for the embattled fund-of-funds manager segment.

This “new wave of capital coming into the industry will allow some funds of funds to stick around against the backdrop of declining interest in the fund-of-funds model from legacy investors,” predicted Suvir Varma, a Singapore-based partner with Bain & Co.'s Southeast Asia practice and leader of the firm's Asia-Pacific private equity and sovereign wealth fund practice.

On the hedge fund side, Asian flows will help but probably not enough to offset continued outflows from U.S. clients who have accounted for the biggest chunk of global hedge fund-of-funds assets, said Paul Price, London-based global head of distribution for Morgan Stanley (MS) Investment Management Ltd.

Assets under management in hedge funds of funds and funds of one globally fell 10% in 2016 to $418.8 billion, according to hedge fund database Eurekahedge Pte. Ltd.

And if Asia looks set to offer new business opportunities, they're not likely to be of the low-hanging fruit variety, industry veterans warn.

Size doesn't always provide a leg up, but in this instance, the challenges of “servicing whale-class investors” could give large, deep-pocketed managers a distinct advantage in competing for their business, said Richard Tan, Hong Kong-based senior investment consultant and head of private markets, Asia, with Willis Towers Watson PLC.

“People are going to have to make investments in their franchises in Asia to be able to participate in this,” agreed John McCormick, New York-based senior managing director and head of global business strategy for Blackstone Alternative Asset Management.

“If you don't have an onshore presence in Japan, or the ability to speak Korean (or) the infrastructure to handle these big mandates,” fighting for that business will be an uphill battle, he said. Blackstone opened an office in Tokyo at the end of 2015, with six of its 20 professionals there now working on the firm's hedge fund business.

Sufian Omar, managing director, international sales, with EnTrustPermal in Singapore, said: “Only a few (managers) stand to benefit — those offering a differentiated proposition and true value-add, like education and knowledge transfers.” He said those kinds of “strategic partnerships” — accounting for $10.1 billion of EnTrustPermal's $25.2 billion in assets under management as of Dec. 31 — are the focus of the firm's business now.

Meanwhile, market veterans say there's little prospect that a pickup in demand from big Asian asset owners will halt the decline in fees hedge fund-of-funds firms have endured since their salad days 15 to 20 years before, when conversations with clients revolved around a 1% management fee and a 10% performance fee.

“There was a period when fund of funds were paid like true principal fund managers,” said Luke Ellis, the London-based CEO of Man Group PLC who previously led the FRM fund-of-funds business Man acquired in 2012. Now they're paid “like advisers, with a material change in fees from one to the other,” he said, adding “it is what it is.”

Asia-Pacific clients account for roughly 50% of FRM's global AUM, said Mr. Ellis. Still, he struck a note of caution regarding the business opportunities offered by the “mega-investors” in the region coming to the table now, saying extremely competitive fee negotiations will make the impact on the bottom line far less dramatic than the boost to the “funds under management you report.”

The head of institutional sales with one global fund-of-funds manager, who declined to be named, said management fees, currently in the 45 to 50 basis point range, could eventually bottom out somewhere between 20 and 30 basis points.

Market veterans, who likewise declined to be named, said management fees for the first round of customized mandates awarded last year by Korea's NPS and Japan Post Bank ranged from less than 10 basis points to 20 basis points. Spokesmen for both funds declined to comment.

In June, 2016, NPS announced that it had selected BlackRock (BLK) Inc. (BLK) and Grosvenor Capital Management LP for allocations of $500 million each.

Sources, who declined to be named, said Blackstone, Goldman Sachs Asset Management and UBS Asset Management garnered mandates last summer from Japan Post Bank. Spokesmen for the three firms declined to comment.

Willis Towers Watson's Mr. Tan said the growing number of sizable asset owners making material allocations to hedge funds and private markets could lead to a revival in demand for the services of customized fund-of-funds providers. Asset owners will continue to pursue direct investments but when allocations approach a scale that makes managing an ever larger number of relationships with private equity or hedge fund managers increasingly challenging, there will be “a realization that fund-of-funds managers could play a role,” he said.

A Hong Kong-based head of Asian institutional sales for a manager with global private equity fund-of-funds offerings, who declined to be named, said he's already seeing that trend gather steam. “The model is shifting,” and a growing number of clients with core portfolios in place are coming and saying “can you and your people help us with specific areas that we're not getting to on our own,” such as secondaries, private credit or small market buyouts, he said.

Even so, said Mr. Tan, “I think we're far too advanced into the industry consolidation cycle for any upsurge in investor appetite to help some industry players.” The bigger competitors should have a leg up in hiring the proven investment talent and client service professionals to pursue the mandates coming to market now, he said.

Client opportunities will range from “pure advisory” relationships to partnerships that provide “systematic portfolios” to address the specific risks a client is facing in areas such as inflation, currency and bond duration, said MSIM's Mr. Price.

Richard Johnston, a Hong Kong-based partner and regional head of Asia with alternatives investment consultant Albourne Partners Ltd., said it may still be easier for “solutions providers” to find takers for their discretionary offerings in the Asia-Pacific market, with its “delegation culture,” than in the U.S. or Europe, but as asset owners here grow more sophisticated, demand should grow for Albourne's fixed fee, pure advisory “self-drive with assistance” approach.

If talk about the very low fees big fund-of-funds firms have accepted for the mandates issued last year by the largest Asian asset owners is true, that would be a sign of “how blurred the lines are getting” between those solutions providers and advisory firms like Albourne, he said.

Still, fees aren't always the biggest aspect of the value proposition.

The fees clients pay their strategic partners should be judged in tandem with the fees those partners are able to negotiate with the underlying hedge fund managers on their platforms, said EnTrustPermal's Mr. Sufian. EnTrustPermal is generally able to negotiate “lower fees and better terms” with those underlying managers, he said. He declined to provide specific numbers.

The head of a top-10 hedge fund-of-funds firm, who declined to be named, agreed, saying the fee cuts fund-of-funds heavyweights are able to negotiate with underlying hedge funds can more than offset the fees clients pay to the fund-of-funds provider.