Push for alternatives forcing managers to change stripes or die

The inexorable move into alternative investments by institutional investors is reshaping the money management business.

Facing uncertain long-term returns for equities and fixed income and declining funding ratios, institutions have poured tens of billions of dollars into alternative investment strategies — real estate, private equity, hedge funds, venture capital, real assets and credit — at the expense of long-only money managers, sources said.

With close to $1 trillion invested in alternative strategies by the 200 largest U.S. defined benefit plans as of Sept. 30, up from $680 billion as of Sept. 30, 2008, and $232 billion and $148 billion, respectively as of the same date in 2003 and 1998, money hemorrhaging from old-fashioned managers over the past 15 years has been substantial, according to Pensions & Investments' data.

“Alternative investment firms have been the disruptive force in the money management industry,” said Kevin P. Quirk, co-founder and partner at Darien, Conn.-based Casey, Quirk & Associates LLC, a management consultant to investment companies.

“Alpha and beta separation is the new investment foundation, and traditional managers have been at the losing end. They have had a hard time holding on to assets,” Mr. Quirk said.

A number of large, institutionally oriented private equity and hedge fund managers wasted little time in expanding their businesses from a single focus to converge a broader spectrum of alternatives investment approaches, including:

• The Blackstone Group LP, which managed $271.7 billion in private equity, real estate, credit, hedge funds of funds, credit and mutual fund strategies;


• The Carlyle Group LP, which managed $198.9 billion in private equity, real estate, and hedge funds- and real estate funds of funds;


• Apollo Global Management LLC, which managed a total of $159 billion in private equity, real estate and credit strategies;


• KKR & Co. LP, which managed $102.3 billion in private equity, real estate, energy and hedge funds-of-funds approaches;


• Fortress Investment Group, which managed $62.5 billion in private equity, credit, global macro hedge funds and long-only strategies; and


• Och-Ziff Capital Management Group LLC, which managed $42.6 billion in hedge fund, real estate and credit strategies.

(All asset figures are as of March 31.)

“There has been significant interest recently in convergence because there's so much efficiency in the public markets that it's tricky to generate alpha, there's more competition from intelligent money chasing it,” said veteran hedge fund attorney Steven B. Nadel, partner, Seward & Kissel LLP, New York.

Mr. Nadel said “everyone is dipping their toes into other people's water,” led by “hedge fund managers who are going after every bucket,” typically moving away from their more liquid flagship strategies that have monthly or quarterly liquidity toward lockup periods of between three and five years.

Crestline Investors Inc., Fort Worth, for example, has maintained its hedge funds-of-funds commingled and separate account strategies, but led by high-returning opportunities, moved into credit- and distressed-recovery funds with much longer lockups, suitable for Crestline's largely institutional client base, said Douglas K. Bratton, president and CEO.

As early as 2004, Mr. Bratton said the firm's investment team found that the “liquidity premium is highest in the one- to three-year lockup range” and going forward, continued to find that credit opportunities were much better suited to a fund vehicle with less liquid redemption terms.

“From the business of money management perspective, we have had the confidence to staff up and bring in private equity and special situations experts to help us build these vehicles right. We reinvested in the business and it has paid off,” Mr. Bratton said.

As of March 31, Crestline's opportunistic and private credit strategies accounted for 36% of total assets of $7.6 billion, growth of $2.7 billion since their introduction in 2004, Mr. Bratton said. Assets managed in hedge funds-of-funds business totaled $2.7 as of the same date, while $2.2 billion was managed in hedged beta strategies.

Specialist alternative managers are being encouraged to broaden their investment capabilities by two main factors — investor demand for solutions-based approaches and a need to diversify beyond their original forte — said Davis Walmsley, vice president and consultant at industry researcher Greenwich Associates Inc., Stamford, Conn.

“Institutional investors below the tier of the largest, most sophisticated funds want more global alternative investment strategies. They want broad coverage of the alternatives spectrum and they want to get it from a single manager,” Mr. Walmsley said.

Private equity managers, especially midsized firms that are most likely to be in the “crosshairs of their competition when it comes to fundraising” are more readily facing the fact that “their ability to raise money is highly dependent on the performance of their last fund,” Mr. Walmsley said.

And big private equity money management firms are being goaded into adding new investment strategies because “the days of raising the next ever larger buyout fund are not certain anymore,” Mr. Walmsley added.

Sources were divided on whether building, recruiting or buying the needed investment capability is the best option for alternative and traditional money managers.

“Traditional managers have not been very successful in getting into alternative investments either by building organically or by acquisition,” Mr. Quirk said. “It's very hard to even make conversation with the best alternative investment firms because the best of them don't need to partner with larger firms.”

While there are plenty of hedge fund startups that are good, but struggling to raise assets, for acquirers to choose from, “there's a lot of talk about bolting on new investment teams, it's a lot of work to incorporate new teams into your culture and there are few examples that have been really successful,” Mr. Walmsley said.

Grosvenor Capital Management LP, Chicago, is one of the few firms to have “nailed it” regarding a strategic acquisition, said a source who asked not to be identified. Other sources agreed, also requesting anonymity.

A hedge funds-of-funds manager by legacy, Grosvenor managed $25 billion for an institutional client base that increasingly used Grosvenor to create customized hedge fund separate accounts or for advice on investing directly in hedge funds.

In January, the firm completed its acquisition of the Customized Fund Investment Group from Credit Suisse Group AG. The Swiss bank was forced by the Volcker rule, sources said, to sell some of its riskier assets. The customized unit managed $20 billion in private equity, real estate and infrastructure funds of funds.

Grosvenor is a firm with “capability across the full spectrum of alternative investments. Our ability to offer a full suite of alternatives and to tailor investments and portfolios enables us to deliver more value to our clients,” said Michael J. Sacks, the firm's CEO.

He added that with regard to the Customized Fund Group acquisition, “integration is critical. From the outset, we stressed that we are one firm with one culture. We've centralized all of the operational functions — marketing, compliance, legal, information technology, etc. While the investment teams still manage their own strategies, more communication with them means that each portfolio manager is now better informed about a broader range of strategies and better able to find opportunities.” For plain vanilla institutional money managers, it is “still very early days when it comes to bringing alternatives into traditional firms. Given the favorable economics of alternative strategies, not as much has happened as we thought it would by now,” CQA's Mr. Quirk said.

For example, just five of the 20 largest managers of U.S. institutional tax-exempt assets in P&I's annual survey of money managers (May 26) had more than 5% of their assets invested in some combination of the seven alternative investment strategies being tracked.

INVESCO, for example, managed $23 billion, or 17.8%, of total assets in alternatives; J.P. Morgan Asset Management had 16.8% in alternatives; Prudential Financial, 11.7%; TIAA-CREF, 9.9%; and The Capital Group Cos. Inc., 7%.

One part of the investment management industry that CQA's Mr. Quirk said is primed for growth is large mutual fund firms with broad distribution networks that have been hiring or acquiring hedge funds-of-funds managers to run daily-valued mutual funds using hedge fund-like strategies.

Some examples include Fidelity Investments' hiring of Arden Asset Management LLC and Blackstone Alternative Asset Management as subadvisers for funds on its wealth management platform; Legg Mason Inc.'s acquisition of Permal Group and Fauchier Partners LLP; and Wells Fargo Asset Management's purchase of a 65% stake in Rock Creek Group LP.

Eventually, daily-valued hedge fund-like mutual funds will likely make their way into defined contribution plans or at least as a component in their target-date funds, Mr. Quirk said. But for the moment, most of the demand for alternatives mutual funds is from retail investors, Mr. Quirk said.

One way to make the industry's growth into alternatives clearer is to look at a spectrum on which the most liquid investments, exchange-traded funds for example, are on the left side; mutual funds, liquid alternatives and hedge funds are in the center; and the least liquid investments, namely real estate and private equity, are on the right, said Jeffrey J. Kollin, partner in charge of the financial service advisory business, based in the New York office of fund administrator Rothstein Kass.

Mr. Kollin said it's easier to see that both institutional and retail investors are really looking for ways to “dial up to the most liquid investments or down for the least liquidity.”

He predicted that most of the growth over the next three to five years will be in the middle of the liquidity spectrum as retail investors seek better returns, but noted that less liquid strategies also will grow, just more slowly.