5 Predictions For The Alternative Investment Industry For 2017

by: BaseVenture
Summary

Last year was an exciting one in the Alternative Investment industry. Here are 5 predictions that will dominate the industry this year:

Private Equity funds will continue to grow.

Regulatory & compliance pressures will continue to increase (even with the new administration of President Trump).

Fund Administrators will continue to consolidate, and will become bigger forces in Private Equity & Real Estate, as well as with Family Offices.

Technological capabilities will become as important as accounting capabilities for Fund Administrators.

Last year was an exciting one in the Alternative Investment industry, and all indications point to another great year in 2017. Here are 5 predictions that will dominate the industry in 2017:

  1. Capital invested in Private Equity funds will continue to increase amidst a further decline in Hedge funds
  2. Regulatory & compliance pressures will continue to increase (even with the new administration of President Trump)
  3. Technological capabilities will become as important as accounting capabilities for fund administrators
  4. Consolidation will continue to increase in the fund administration business
  5. Fund administrators will become a bigger force in Private Equity & Real Estate funds, as well as with Family Offices

Let's look further into each prediction:

1. Capital invested in Private Equity funds will continue to increase amidst a further decline in Hedge funds

Growth in alternative investments will continue to be explosive in 2017. According to a report from Cerulli & Associates, the mean allocation of alternative investments is still less than 5% of overall assets. Depending on the industry source, the general guidance is that the ideal allocation should be in the 15% to 25% range, signifying plenty more upside.

Nowhere has that growth been more evident than in Private Equity funds, which have increased dramatically over the past few years. Assets have risen from $30 billion in 1995 to around $4 trillion in 2015. This growth will continue, as 64% of limited partners plan to increase their allocation to Private Equity funds, which is up from 26% just 5 years ago.

The median private equity benchmark outperformed public markets on a 3-year, 5-year, and 10-year basis. Over a 10-year horizon through 2015, the median private equity benchmark achieved close to a 12% annualized return, which nearly doubles that of the S&P 500 during the same time frame.

Hedge funds, on the other hand, have struggled. The average Hedge fund returned a little more than 4% through Q3 2016, which is about half of what the S&P 500 Index returned over that same period. This performance, compounded by high fees, resulted in large outflows in 2016. Investors in Hedge funds pulled out close to 1% of the industry capital in Q3 2016, with outflows totaling $28 billion. This raised the total outflows for 2016 through Q3 to over $51 billion.

2. Regulatory & compliance pressures will continue to increase (even with the new administration of President Trump)

Regulatory and compliance have been dominant factors in the Alternative Investment industry (and especially among Hedge funds) for several years now. Despite some industry leaders having an optimistic outlook of a potential loosening of regulations driven by the new Trump administration, the trend toward more transparency will continue to grow.

Study after study shows the impact of mounting regulatory and compliance pressures. Here are two reports that paint a clear picture:

· A Longitude Research study last year showed that more than 50% of fund administrators predicted that the need to keep up with regulation would have the greatest impact on their activities over the following 3 years. In fact, close to 90% of fund administrators said that they planned to make investments in new systems to keep pace with regulation and due diligence demands

· A report from Linedata showed regulatory & compliance being the chief concern facing fund administrators and fund managers alike

3. Technological capabilities will become as important as accounting capabilities for fund administrators

Fund administrators are traditionally thought of as providers of accounting services. In the past, the role that technology played in enabling the fund administrator to perform these accounting services was downplayed. Technology was mostly thought of as internal "plumbing", and the decisions made about the use of technology were often left in the hands of an IT department, with little senior-level involvement.

Well, it's safe to say that those days are over. 2017 will see the further emergence of technology as an integral capability for any fund administrator - on par with the importance of their accounting capabilities.

Investors of all types are placing greater emphasis on transparency, and the due diligence done on general partners and the funds that they manage is more thorough and is starting earlier than ever before.

Fund administrators can only turn to technology to give them the data, reporting, and understanding that are needed to satisfy the evolving needs of their clients and investors. Subjects like the Middle-and-back-office are now commonplace in C-level meetings. In fact, 9 out of 10 fund administrators plan to invest in technology in the next 3 years.

A quote from the Longitude Research study says it best:

"Those administrators that do not invest in innovative technology could fail to provide the new and improved tools that asset managers are looking for - and risk being left behind."

4. Consolidation will continue to increase in the fund administration business

Competition in the fund administration industry is intense. This is being driven by the explosion in capital being invested, the increasing demands for regulatory transparency, as well as the economies of scale needed to effectively compete in a low-margin business. No metric shows this better than the one reported by Preqin that 28% of fund administrators have been fired by their clients in the past 12 months.

The trend toward consolidation has escalated significantly in the past 2 years, with SS&C acquiring the fund administration businesses of Wells Fargo, Citibank & Conifer, Maitland buying Phoenix Fund Services, and Apex buying Pinnacle, just to name a few. In fact, from 2015 through Q3 of 2016 there were over 9 acquisitions in this space.

While consolidation can be good news for the largest of funds that can afford the services of the largest of fund administrators, this consolidation is likely bad news for both mid-market fund managers as well as mid-market fund administrators.

Mid-market fund managers can expect the costs that they pay to their fund administrators to increase, and they can also expect that the quality of service they are accustomed to receiving could decrease as they become more of a "small fish in a big pond."

Mid-market fund administrators can expect that their already low margins will be squeezed even further, as their ability to compete with larger fund administrators will require more investment in technology in order to keep pace.

5. Fund administrators will become a bigger force in Private Equity & Real Estate funds, as well as with Family Offices

The use of fund administrators is pretty much a requirement for Hedge funds, as evidenced by the outsourcing to fund administrators increasing from 50% in 2006 to 81% in 2013. This dynamic really started taking shape in the wake of the Bernie Madoff scandal, which showed the perils of a lack of validation & supervision within the industry.

In comparison, fund administrators are under-penetrated in Private Equity & Real Estate funds, with estimates showing fund administrator penetration at around 30% of AUM today. However, this is expected to increase 45% by 2018.

As detailed in a prior article that I wrote in Seeking Alpha, the same conditions that drove the shift to fund administrators in the Hedge fund space affect Private Equity & Real Estate funds as well. Just as happened with investors in Hedge funds, investors in Private Equity & Real Estate funds are demanding third party validation of assets and performance. Regulatory pressures are already having an impact on general partners of Private Equity & Real Estate funds, as 80% of general partners stated that compliance costs are climbing faster than other operating expenses.

Although occurring more slowly, the need to turn to fund administrators is also happening in the single & multi-family office space. Thanks to an increasing rate of wealth, not only are more family offices being created, but large single & multi-family offices are investing in ever more complicated asset types. Portfolios of large single & multi-family offices often include equities, real estate, fixed income, private equity, hedge, and more. Because many family offices have grown to become legitimate financial firms, regulatory oversight will also become an increasing reality. Small in-house administrative teams will quickly find themselves out-matched, as the combination of complex transactions and regulatory pressures will prove difficult to handle.

Additionally, families can sometimes be fickle, and emotions tend to grow more intense as more money is at stake. Family members change through marriages, children, divorces and deaths. A strong and independent voice is critical not only to provide validation and transparency, but also to provide objective guidance that can be taken at face value by family members.

Sources:

American Investment Council "Private Equity Returns Far Exceed Declining Market Returns on Multiple Time Horizons" 4/12/2016

Investopedia "Investing in Hedge Funds vs Private Equity in 2016" 2/25/2016

Fortune "Here's How Much Investors Have Pulled from Hedge Funds in 2016" 10/20/2016

Longitude Research "From Coal to Diamonds: 2020 Vision - The Future for Fund Administrators" 2016

Linedata "2016 Global Asset Management & Administration Survey" October 2016

SEI "The Future of Private Equity", October 2016

Cerulli & Associates "U.S. Alternative Products & Strategies 2016: The Multiple Roles of Alternative Investments"

Phoenix American Financial Services "Why Strong Administration Infrastructure is a must for the Family Office" 10/17/2016

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.