Below we have summarized the top 16 trends we are actively discussing amongst our team, managers and investors to adapt to the opportunities in our industry. We believe Stonehaven's 2015 trends piece was relatively accurate in hindsight, and this year we expect the evolution of several longer-term trends along with some significant new trends.
1. The ability of managers to predict and react to China's impact on the global economy will be the biggest factor determining the winners and losers of 2016.
Last year we predicted that energy would be the most important investment theme of 2015, impacting pretty much every asset class. Energy will continue to be among the biggest trends of 2016, but we think the most important theme this year will be predicting the glide path of China.
China's economic growth will primarily be determined based on the government's ability to slowly guide down the yuan, address large inefficient state-owned companies sitting on mountains of debt that are increasingly difficult to service, prevent the unraveling of the property market by absorbing huge vacancies, and maintain a level of confidence in their equity and credit markets so their corporate sector has access to critical financing. These are all monumental tasks with large potential for error.
Recessions in the post-World-War-Two environment have primarily started in the United States and then spread globally. We are likely entering an era where future recessions have a higher probability of emanating out of China. Given the unreliability of data coming out of China and the challenge of anticipating potential responses by the Communist Party, predicting recessions has become more difficult.
Given China has accounted for approximately one-third of global GDP growth according to Eurasia Group, China's economy impacts all asset classes globally. In 2016 the best performing managers will make the right predictions relating to how soft or hard China's landing will be and how governments globally will react.
The most important questions to answer are:
- How sharply will China's yuan devalue, and will devaluations force other emerging markets to react with their own devaluations?
- What is the longer-term impact of China switching from being a significant buyer to a significant seller of Treasuries?
- How will China's declining appetite for commodities impact pricing, and how will that pricing impact commodity-exporting countries?
- How far will the government intervene in the economy and markets, and what are the potential negative implications both in China and globally?
2. Macro strategies, lower-net-exposure funds and credit substitutes will receive the largest incremental increase in fund flows in 2016.
Currently there is very high anxiety among allocators about a potential broader market downdraft. As a result, preserving capital is more important to allocators right now than reaching for returns, and lower correlation is a higher priority.
While many macro funds have underperformed, the subset that have outperformed are in very high demand, particularly managers that have made money from recent market disruptions (commodities, emerging markets, China, widening spreads, etc.). In a perplexing market environment, allocators increasingly seek out macro managers with an articulated world view that resonates with them.
From 2009-2014, managers with significant beta and mediocre alpha often outperformed managers with low beta and more significant alpha. Lower beta funds naturally underperformed higher beta funds given the strong tailwinds. Allocators are becoming less comfortable with the macro environment, so they increasingly prefer to reduce the overall net exposures of their alternative portfolios. This is happening at the same time that managers with low beta and more significant alpha are starting to shine relative to higher beta and mediocre alpha after a sustained difficult market environment.
Demand for credit substitutes such as private credit managers will likely continue to increase in 2016. Private credit has emerged as its own distinct category in alternative investments, driven by a combination of (a) the opportunity to fill the vacuum created by shrinking bank lending activity caused by Dodd-Frank and Basel III, and (b) a desire by allocators to increase returns on their fixed income holdings in a low-rate environment. The proliferation of lending platforms driven by technology has helped create new sourcing and underwriting capabilities, especially among borrowers that previously had less access to credit. While credit is widely available for larger companies and certain forms of real estate, credit remains tight in many other sub-sectors of the economy. Private credit is a very wide category spanning loans for private-equity-sponsored companies, non-sponsored companies, consumer, real estate, other asset-backed collateral and a wide range of niche areas. Allocators are increasingly willing to lock up a portion of their fixed income capital for 3+ years to pursue higher expected returns than more traditional liquid fixed income.
3. While industrywide AUM will continue to consolidate amongst the largest players, we are in the middle of a significant shake-up of the top players.
The economies of scale continue to grow in the asset management space, and many allocators remain most comfortable with larger managers. As a result, the large will continue to grow larger.
However, large marquee managers who have underperformed are becoming more and more vulnerable as increasingly sophisticated institutional allocators grow impatient. Now that beta tailwinds have reversed, managers that were flat or down in both 2014 and 2015 should expect significant redemption pressure especially if the rest of 2016 looks anything like the first week of this year. A small stream of redemptions can easily turn into a big wave of redemptions if allocators feel they may be in a sinking ship. Giants presumed to be stable will unexpectedly fall in 2016.
Allocators exiting falling giants will seek out the next wave of capable small/medium-sized managers that provide a more compelling value proposition. Despite overall industry underperformance, allocators will continue to search out alternative investments that can provide stable returns with low correlations - especially after broad indices for equities, fixed income, and commodities were all down in 2015.
4. Historically successful managers will convert to family offices at an increasing rate.
There is a good recipe to convert historically successful managers into family offices. First, start with managers with many years of strong historical performance who have created substantial wealth for themselves and their partners. Add the following ingredients:
- Rising cost structure, built for ever-increasing AUM with costly and fickle talent
- Challenging regulatory environment
- Volatile market environment
- Increasing competition among active managers
- Difficulty producing compelling returns with a substantially larger asset base
- Decreasing fees
- Dissatisfied LPs with increasing demands
Put these ingredients into a pressure cooker, wait 1-3 years, and voila! You have now turned a manager into a family office. This is not an entirely new trend with George Soros, Steve Cohen and Stanley Druckenmiller as high-profile examples of managers that made the transition in years past, but the recent environment has created an increasing number of example of managers that have made the transition:
- Scott Bommer of SAB Capital
- Doug Hirsch of Seneca Capital
- Michael Platt of BlueCrest
- John Thaler of JAT
- Martin Taylor and Nick Barnes of Nevsky Capital
With these ingredients present in quite a few organizations, we expect more family-office conversions in 2016.
One mitigating factor to this recipe is the motivation of managers to sustain through these periods in order to achieve operating company monetization events and hand the reins over to their lieutenants over time. An increase in private equity capital investing into the operating companies of alternative managers helps propel this trend for the larger funds which are able to persevere.
5. Redemptions will increase from sovereign wealth funds of commodity exporting countries in order to meet domestic funding needs.
Several significant sovereign wealth funds started contracting in 2015. As this continues in 2016, their need for liquidity will increasingly create redemption pressure on some of the largest managers that were able to win allocations from these behemoths. Additionally, some fund of funds will be impacted, forcing them to decrease allocations to other managers down the food chain. While many pools of Middle Eastern capital are not impacted by this trend, overall this dynamic makes the region less attractive from a capital-raising perspective.
6. Increasing redemptions, decreasing overall market liquidity, and increasing asset-liability mismatches will create a new wave of illiquid side pockets.
In 2015 we witnessed an increasing rate of managers shutting down: Fortress' macro fund, Bain's Absolute Return Fund, Trafigura, Black River, Galena, Stone Lion, Third Avenue, Lucidus and many others. This trend will continue. The decrease in market liquidity has been broadly documented as banks have dramatically decreased the portion of their balance sheets dedicated to making markets in reaction to Dodd-Frank, Basel III, and other pressures.
The Great Recession created a significant supply of illiquid side pockets due to mismatches between the liquidity of assets on managers' balance sheets and the liquidity provided in fund structures. Following the crisis, managers were religious about avoiding asset-liability mismatches. However, eight years into the recovery, managers have become much more complacent, increasingly investing into less liquid level-2 assets (particularly in credit) as well as level-3 assets (whole loans, real estate, private equity, pre-IPO unicorns, etc.) to chase returns in a difficult environment.
It is still early to know how many fund closures will result in significant side pockets, but more are on their way. It's also hard to know how many of the holders of these side pockets will want to sell, but the supply of illiquid side-pocket sellers will overwhelm the approximate $1-3 billion of current capital dedicated to purchasing illiquid side pockets. This will create a very compelling opportunity to buy assets from distressed sellers at material discounts.
7. Industry leverage levels will decrease due to increased interest costs, decreased credit availability and reduced risk levels.
Rising rates reduces the attractiveness of carry trades and leveraged-up relative value situations. Meanwhile, banks are reducing their balance sheets dedicated to prime brokerage and focusing what's left on their best clients. This is leaving many managers with reduced lending availability. We have heard reports of managers having difficulty finding leverage for instruments as liquid as convertibles. Lastly, increasing volatility will force managers utilizing Value-at-Risk constraints and/or stop-losses to reduce the size of their balance sheets.
8. Women fund managers will earn a higher share of allocations.
100 Women in Hedge Funds is now a global association of more than 13,000 professional women, demonstrating the scale of women in the industry. Despite the abundance of investment talent, female managers are dramatically underrepresented in the industry. This dynamic is gradually changing. Women worldwide are rising up through the ranks of organizations and building their own firms.
Leda Braga's success growing Systematica into an $8.5B firm after spinning out of BlueCrest has helped break a glass ceiling. This will help provide confidence to the next generation of female managers.
Female portfolio managers are highly differentiated from a marketing standpoint and will earn a greater spotlight in the media. Allocators will recognize the untapped potential, and capital flows will increase.
9. There will be continued convergence between alternative and traditional asset managers.
More alternative managers will launch liquid alts or long-only products, and traditional managers will launch more alternative products. Long/short equity managers are now competing head-to-head with long-only managers for the equity bucket of institutional investors, and the same is true for every other asset class. While there are definitely unique proficiencies to shorting, skills in security selection and portfolio construction are applicable to both alternative and traditional asset management. This trend places an increased importance on the business management skills of top executives in these organizations overseeing increasingly diverse product lines with more operational complexity.
10. Outsourced-service-provider models will continue to flourish as a way for emerging and mid-sized managers to scale and gain credibility, helping them achieve the institutional standards demanded by allocators at a much lower price point.
We will see continued growth among outsourced service providers (compliance, risk, back/middle office, trading, technology systems, etc.). While barriers to entry in the hedge fund space continue to increase, this trend helps facilitate a shift to more inflows to small and medium-sized managers. We expect more regulatory scrutiny into the outsourced-service-provider model. However, this scrutiny will ultimately help validate the viability amongst many institutional class providers.
11. Structural inefficiencies in certain retail-oriented structures are creating increased trading opportunities for specialized hedge funds and potential threats to the market structure.
A sub-set of retail-oriented investment structures has been poorly designed or has structural inefficiencies. Some structures that worked well in a bull market with strong liquidity have serious flaws in a bear market with reduced liquidity. Closed-end funds and BDCs can deviate significantly from NAV, magnifying losses in downturns and creating opportunities when discounts shrink. Leveraged ETFs are forced by their design to buy on days when the market goes up and sell on days when the market goes down to maintain leverage ratios, causing their NAV to decay over time. Some ETFs are set up to provide instant liquidity on less liquid instruments, creating potential asset-liability issues that can trigger during market disruptions. Hedge funds will focus increased attention on these structures to identify opportunities and threats.
12. Overall pressure will continue to be exerted on fees with legitimate reasons for some managers to provide discounts while others maintain pricing power.
Like anything else in a market-based economy, fees are a function of supply and demand. Negotiating fees used to be viewed as a sign of weakness, but now it is viewed as a smart business decision under the right circumstances. Founders' share classes are increasingly mainstream for emerging managers with cut-offs based on the duration since launch and/or AUM levels. Managers realize that AUM growth is a self-perpetuating cycle where it makes sense to make concessions to grow at an early stage for the right investors. Larger managers are also selectively providing fee concessions for substantial allocations and/or longer lock-ups.
Despite the overall push for lower fees, managers with consistently strong alpha production, institutional infrastructure and finite capacity will consistently maintain pricing power. Investors that pass on outstanding managers solely based on fees may be missing compelling opportunities.
13. The increasingly complex and challenging patchwork of global private placement regulations (i.e. AIFMD in Europe) will cause most U.S. managers to focus the majority of their marketing efforts domestically.
Predominantly only larger managers are willing to make the investments needed to navigate the global patchwork of regulation, increasing barriers to access global investors. In fact, Bloomberg reported that the total net number of European hedge funds shrunk in 2015. This same trend is impacting capital-raising firms where only the largest groups are investing the resources to build global capabilities. The days of "parachuting" into foreign jurisdictions is coming to an end. However, contrary to this trend, the rising dollar is causing more offshore investors to seek dollar denominated investments.
14. Asset managers will increasingly embrace exposure through media channels to enhance brands.
"No media" used to be the media strategy of most alternative investment managers. The environment has changed with many managers actively leveraging media to help build their brand and in some circumstances increase the impact of activist campaigns. LinkedIn has become the social media platform of choice to connect across the industry. While Twitter is being used primarily by managers to consume content, some managers are starting to post content, particularly activists. Managers are also increasingly creating their own video content to help communicate with allocators in engaging formats. Citadel recently launched a YouTube page that now hosts 15 videos. Expect more of this activity in 2016. PR agencies, video production firms and technology firms analyzing social media data are likely to benefit alongside the managers utilizing media to enhance their brands.
While salespeople in our business are called "marketers," most marketers lack traditional marketing skills and have little experience interfacing with the media. The demand for capital raisers (both in-house and placement agents) with these skill sets will continue to increase. As a result, sales campaigns will also grow in sophistication with the integration of more true marketing tools to build brands.
Stonehaven has produced five videos that we will be rolling out in Q1 on a completely new website that has been optimized for video and mobile access. We believe it is important for us to gain experience creating video content to be in a leadership position to advise our clients on best practices.
15. The most successful capital-raising organizations of the future will embrace a combination of close personal relationships and highly integrated technology.
Many market participants believe the most successful business model for capital raising will be one of two diverging business models: (1) technology-driven platforms that connect GPs and LPs directly, or (2) traditional relationship-driven capital raising without much use of technology besides email and basic pipeline tracking. Neither of these approaches will be the most successful model of the future.
Allocators will always place a high value on relationships with managers and intelligent intermediaries, no matter how sophisticated technology becomes. Allocators rely on their network to source and perform due diligence as much as ever today.
At the same time, technology is radically changing the efficiency of the marketing process. The most successful marketers are increasingly embracing sophisticated technology systems. The most important elements are:
- Efficiently capturing all the data created by every interaction with the marketplace and through third-party sources into one integrated system in the cloud;
- Intelligently filtering the data to produce insightful information;
- Combining a large number of reports into highly useful dashboards with graphics that quickly point out actionable insights; and
- Running a capital-raising team with a culture built around technology systems that enable capital raisers to optimize the amount of quality time they are spending with the right prospects discussing the right opportunities.
Executed correctly, this approach adds value to both capital raisers and allocators.
16. The institutionalization of the hedge-fund business will increase demand for institutional capital-raising firms.
Raising capital has become increasingly difficult for emerging managers at the same time that break-even AUM levels for managers continue to increase. The decreasing percentage of capital managed by FOFs has also spread the sources of capital among a larger number of institutional investors. This means that the capital-raising process requires relationships with a larger number of institutions and the ability to address increasingly institutional demands.
Managers increasingly recognize that they need much more than just introductions to potential sources of capital. They want an end-to-end solution to the entire capital-raising process. Beyond the day-to-day sales efforts, the services most needed are strategic market positioning, sales strategy management, sophisticated pipeline tracking, analysis of fund structure options, compliant delivery of content, roadshow logistics organization, etc. Capital-raising firms that have experience building many emerging managers into large institutions are able to act as a sounding board for managers to execute growth plans. Capital-raising firms that can combine deep relationships, product know-how, technology and project management to enhance their execution ability will outperform relationship-only providers and pure-play technology platforms attempting to match managers with investors. These institutional-class capital-raising organizations will play an increasing role in helping build momentum behind many of today's leading asset management firms.
Prepare for the worst, hope for the best, and count on surprises in 2016. We wish you a terrific year, and we invite you to please reach out with any feedback.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.