Good quality managers are at a premium, as are good quality opportunities. The investment market is much more competitive and challenging, and the search for returns is driving institutional investors towards heavier weighting in alternatives. As a primary consequence, more capital is coming into the alternative market. But at the same time, investors are becoming more demanding, and are looking to invest in brand name fund groups with a proven track record, strong visibility and global presence.
They are also increasingly demanding in terms of performance, results, fees and product range. Many are looking to participate in managed accounts and co-invest models, where they can access multiple investment options without commingling into a fund. Many more are looking for a one-stop shop with a range of high quality investment opportunities across all asset classes and appropriate expertise and global coverage. They are reluctant to continue to bear traditional fee structures.
Sovereign wealth funds are in some cases now more reluctant to invest through third parties, but are creating their own real estate businesses in their own names. Some funds are being cut off from this rich source of capital.
In response to these trends, the larger fund platforms are gaining in strength, partly as a result of greater brand name recognition and track record, but also because of economies of scale and their more efficient infrastructure, systems and processes. Importantly, they are trying to bring new offerings to their client base, driving them to expand into alternative asset classes outside their traditional expertise. All of this means that the alternative investment sector is consolidating at the same time as the major players are diversifying.
Groups such as Blackstone, Carlyle and many others have multiple offerings. A number of these developments have featured expansion into Asia Pacific real estate: Invesco took over AIG Global Real Estate’s Asia business; Blackstone recently bought the Bank of America Merrill Lynch Asian Property fund platform and has subsequently added the Valad Property Group, an Australian real estate firm, for about AUS207 million1; BRE has spent nearly USD1 billion2 buying real estate assets from The ING Group in the Netherlands, including the Asia management operations.
The alternative investment industry could split into two main segments: those large firms with truly global capability; and those niche players with specific skills, for example in a particular local territory. Many very small players might disappear. Some may be absorbed, but many may simply not recapitalize once existing funds are wound up. People could migrate to larger houses. That these trends carry major challenges is obvious. Expansion beyond a firm’s core historical business into different geographies or different asset classes can bring significant benefits; but it can also tarnish long standing investment results unless it is carefully considered. There are major implications for talent and expertise, for systems and processes and for the tax characteristics of new business models.
Horizontal expansion of funds or multiple strategy managed account platforms into other asset classes requires talent movement and then assimilation of those teams into the culture and decision making processes of different organizations. In some cases due diligence for specific asset classes and industries can be outsourced depending on the circumstances, but many could acquire the deal and diligence talent in house.
Diversification brings about a host of risks. The move from real estate into private equity or vice versa needs new skills from a risk management standpoint. Private equity managers may be experts in risk management in their own field. But understanding and managing risks in hedge products, for example, is very different and requires a different skill set. Such skilled managers are culturally very different from private equity dealmakers. Hedge funds themselves will find that global trading will require a different level of expertise.
There are significant issues in terms of systems and processes and in functions such as tax and risk management. Both territorial expansion and diversification into different alternative investment asset classes are likely to pose requirements for which existing systems are inadequate. There are other potential ancillary effects: the need for different types of systems, analytical tools and operating financial controls. These have to be compatible with existing reporting and information systems which fund investors are accustomed to from that fund group. Clearly, back office functions have to support the new accounting, reporting and tax demands. Existing IT systems may be wholly inappropriate to these challenges.
Taxation issues will vary by asset class. Certain opportunities will arise from structuring and modeling scenarios where the entire lifecycle of the asset is considered from acquisition, operating or holding through to properly structured exits. Even in global trading of financial instruments, different taxing jurisdictions have a wide range of sophistication in understanding and taxing financial instruments. This creates issues for organizations in capturing and reporting capital gains depending on trading strategies. This not only extends to risk management but impacts on financial reporting.
A number of cross-over type products are now emerging, such as distressed assets funds, which may blend investments in traditionally different asset classes. These too require very different levels of tax expertise. The tax implications of non-performing loans, for example, are very different from those of conventional private equity holdings. Another layer of complexity is added.
The changing structure of the alternative investment industry could drive firms either to size, global reach and multiplatform offerings; or to niche positions where they perceive a real advantage. Either way, firms will need to target quality and expertise, where fees can be supported. The winners will be those who achieve the difficult transitions most effectively. Large institutional investors should gain from increasing responsiveness and competitiveness in the sector. But retail investors may tend to suffer: their costs could stay relatively high while the range of non-correlated investment choices available to them may decline.
In five years’ time, the landscape could look very different.
1www.businessday.com.au (April 2011)
2www.worldnews.com (July 2011)