Convergence to be more common in alternative investments

NEW YORK — Convergence in the alternative investment arena is likely to increase in the next 18 to 36 months, predict investment bankers at Freeman & Co. LLC, New York, in a new report.

As part of the tendency toward blending the lines among alternative investments, Freeman analysts think alternatives firms will expand into other areas — hedge funds adding private equity funds, private equity firms adding real estate funds and mezzanine funds starting collateralized debt strategies, for example. Firms will likely add capabilities through mergers, joint ventures, product expansion and team liftouts.

The best example of a crossover firm, according to the report, is The Blackstone Group, New York, which offers an array of alternatives from hedge funds of funds (with $9 billion under management) to private equity ($14 billion), senior debt (more than $2 billion in collateralized debt obligations), mezzanine financing vehicles ($1.1 billion) and real estate ($6 billion). While Blackstone has few competitors on its scale in alternatives, Freeman analysts singled out Mesirow Financial, Chicago, as a potential contender, with $6 billion under management in hedge funds of funds and about $1 billion in private equity.

Freeman researchers also think managers in every alternative asset class will begin to invest in securities outside their "normal" sphere of investment, with the most notable example the push by hedge funds into private equity. From the other side of the convergence equation — private equity managers moving into hedge funds — the analysts identified Auda Associates LLC, New York, which added a $1 billion hedge fund of funds to its existing private equity funds of funds, as a prime example. Private equity manager Hamilton Lane Advisors' acquisition of New York-based hedge funds-of-funds manager The Richcourt Group also was cited in the report as an example of the deepening trend. Hamilton Lane is located in Bala Cynwyd, Pa.

There's also been more straightforward merger and acquisition activity. The Freeman report said the third-quarter acquisition by JPMorgan Chase & Co., New York, of 85% of hedge fund manager Highbridge Capital Management LLC, New York, was most noteworthy. And while most deals of late have been large companies acquiring smaller hedge fund operations, Freeman researchers predict the dynamic will shift fairly soon with a number of alternatives shops combining their activities within a single firm to better leverage resources and geographic coverage under a single brand name.

The report's findings are based on a study by Freeman analysts of overall and institutional investor investment in alternatives, using data from Pensions & Investments' annual directory of the 200 largest U.S. pension funds, as well as other sources.

Freeman researchers projected about $3 trillion will be invested in the more traditional of alternative asset classes — hedge funds, real estate and private equity — worldwide as of the end of this year. Within the United States, among all investors, alternatives should attract about 8% or $1.9 trillion of total investments by Dec. 31, led by private equity with 3.9% of allocations ($876 billion), followed by hedge funds with 2.8% of total assets under management or about $649 billion.

With so much institutional investment going into alternatives and based on analysis of the past acceptance of "new" asset classes, such as exchange-traded and mutual funds, Freeman analysts predict that some alternative investments will soon be thought of as "traditional" investments. Hedge funds, real estate and private equity likely will become mainstream with the development of better sources of data, established and widely accepted benchmarks and advances in information technology and administrative systems. Other less well-used asset classes — natural resources and financial derivatives, for example — will remain outside the mainstream for some time to come.

In terms of current demand for alternatives by U.S. institutional and high-net-worth-investors, Freeman researchers estimated that by year-end 2004, the investors will have about $22.6 trillion of total assets, of which 8.4% or $1.9 trillion will be invested in alternatives. High-net-worth investors will lead the pack, with an estimated $833 billion, followed by public pension plans with $452 billion; corporate pension plans, $311 billion; life insurance companies, $119 billion; foundations, $65 billion; endowments, $56 billion; other insurers, $28 billion; and Taft-Hartley plans, $20 billion.

By 2010, demand for alternatives by U.S. institutional investors is expected to grow to 10.8% or $3.3 trillion out of total assets of $30.3 trillion, according to the report. High-net-worth investors will remain the largest consumers of alternative investment strategies with $1.3 trillion of investment. Public pension plans still will hold second place with $757 billion of alternative investments, but according to Freeman estimates, corporate pension plans will have caught up sharply in terms of alternative allocations, with an estimated collective allocation of $713 billion. Life insurers will follow, distantly, with $212 billion of projected investments in alternatives, followed by foundations ($116 billion), endowments ($98 billion), other insurers ($53 billion) and Taft-Hartley plans ($39 billion).