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How Shifting Investor Needs are Altering the Next Generation of Hedge Fund Managers

Ryan FitzGibbon  Follow

inst_investors As a result of the financial meltdown five years ago, institutional investors, particularly pension funds, are facing a funding conundrum–if they don't do something, they will run out of money in the foreseeable future. Therefore, they are turning to hedge funds to help close this gap. The result is a drastic change in hedge funds' investor base, from high-net-worth individuals and family offices pre-crisis to institutions predominately today.

The shift seems benign, but it has the potential to greatly change the industry. It is not because of the issue of fees, but instead the issue of liquidity, and how frequently investors can redeem their money.

To find opportunities that are less correlated to the markets, hedge fund managers need to be creative, look in different places, develop contrarian viewpoints, etc. This is how they extract differentiated value via risk-adjusted returns. However, it takes time to extract the proper value, which means money will be locked up for a period of time.

Illiquid investments traditionally make pensions extremely nervous. Due to fears of another crisis, they want to know if they can get their money out when they want to in order to safeguard themselves from further depleting their already finite assets.

Due to the type of opportunities hedge funds invest in across strategies, offering the type of liquidity pensions are seeking makes it difficult for funds to pursue many of the opportunities that have made them so profitable and why pensions are turning to them in the first place. Larger firms can demand longer lock-up periods due to their brand names and vast investor base. But for the new crop of managers–"emerging managers"–this presents a much bigger problem. To be able to compete with their larger competitors for investment opportunities, emerging managers need to be able to invest for the long-term. On the flipside, in order to amass assets they also need to offer more attractive investment terms than the larger players.

Therefore, they are left in a bit of a quandary.

Right now we are seeing emerging managers doing one of two things:

  • Accepting the situation and looking for investors with time horizons that correlate to theirs, meaning they will grow at a slower pace
  • Taking a risk by offering liquidity on a more frequent basis and hoping that no major economic events occur that will cause their investors to actually pull their money

So you have the planners and the risk takers, nothing really new, especially in this industry, but emerging managers' predicament is important to note because it has the potential to alter the makeup of the next generation of hedge funds.

Today, it is more difficult for emerging managers to raise capital and become overnight successes like their predecessors. Additionally, the fight over liquidity is frustrating managers as they are being stymied in their ability to invest, leading many to question why they are in the business. Simultaneously, the founding hedge fund generation is aging, looking to step back from the limelight and potentially close up shop in the next 10-15 years. All of this compounded together has the potential to leave a gap in the plethora of managers that investors can choose from that the next generation may not be able to fill.

Should we be concerned about our future investments?

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