Agecroft Survey Identifies 2010 Hedge Fund Trends
Thursday, January 07, 2010

Agecroft Partners has observed several dominant and emerging trends regarding capital flows into the hedge fund arena as a result of a survey conducted through conversations with more than 200 hedge fund organizations and 1,000 institutional investors during 2009.

According to Agecroft, the trends included:

• Continued improvement of capital flows;
• Increased competition;
• Increased importance of marketing;
• Extension of the due diligence process; and
• Segmentation of the hedge fund marketplace by investor type.

In the past 16 months Agecroft witnessed unprecedented changes in the hedge fund industry, with assets off 40% from their peak levels and industry revenues down approximately 70%.

The environment was worse for fund-raising, where Agecroft estimated new flows to be likely down 95% from peak levels for the 4Q-08 and 1Q-09.

The asset raising environment slowly improved during the 2nd and 3rd quarter, with a significant increase in the 4th quarter. However, it was still down an estimated 60% to 70% from the peak, according to Agecroft.

During each successive quarter in 2010, Agecroft expects hedge fund capital inflows to continue to improve. Agecroft anticipates that a major driver of this renewed growth will be a gradual yet substantial increase in allocations made by pension funds.

While asset flows were a fraction of their previous highs, Agecroft saw a significant increase in competition in 2009 as many hedge funds, previously closed to new investors, began to market their funds. Agecroft announced that it expects the trend to continue throughout 2010 as many leading hedge funds strived to return to their previous asset peak.

The asset raising environment in 2009 was also affected by the development of a large secondary market for hedge funds, where investors could buy into many hedge funds at a large discount to NAV, as well as receive the benefit of investing below the high-water mark. Secondary funds should not be as big a factor in 2010 as discounts to NAV narrow, according to Agecroft.

While there was a ‘flight to safety’ by institutional investors to larger hedge funds with strong brands in 2009, Agecroft expects the trend to reverse itself in future as investors sought out smaller and more nimble alpha generators.

Focussing on investor demographics in the wake of 2008, Agecroft announced that institutional investors have featured as the hedge funds' preferred client, controlling a greater market share of hedge fund allocations.

The due diligence process of hedge fund investors was longer, more focused and deeper than ever before, according to Agecroft. Institutional investors typically required three to five meetings before making an investment decision. This process, according to Agecroft, focused on multiple evaluation factors including:

• Organizational quality;
• Investment team;
• Investment process;
• Risk controls;
• Operational infrastructure;
• Terms; and
• Historical performance.

Agecroft explained that the weighting of the various attributes varied among investors, but the trend, particularly in the wake of the Madoff scandal, was toward longer due diligence and increased focus on areas of operational due diligence and risk management policies.

2009 saw significant contraction in hedge funds of funds' assets. Agecroft thought that the crisis of 2008 did not treat all funds of hedge funds equally. Some funds of funds experienced significantly fewer redemptions relative to peers due, in Agecroft's view, to a variety of factors including:

• Higher concentrations of institutional clients;
• Avoiding extreme leverage;
• Low Madoff exposure;
• Outperforming peers; and
• Proactively educating clients on appropriate comparative benchmarks.

The hedge fund of funds industry also consolidated throughout 2009—a trend Agecroft expected to continue.

Generally according to Agecroft, high net-worth investors fell into two categories: institutional and non-institutional. The first group, categorized by high sophistication, portfolio stability and endowment style approach to investing, constituted a desirable investor. Many among this group operated from a family-office structure or spent a majority of their time independently evaluating hedge fund managers.

The second category, characterized by less sophistication and fewer resources, tended to chase performance, and utilized a 'follow the herd mentality' to investing. Agecroft believed that this group bore primary responsibility for redemptions from both hedge funds and hedge fund of funds in the recent crisis, and suggested that the return of this capital would likely involve the engagement of advisors and consultants.

Agecroft Partners concluded by predicting that the hedge fund industry is moving toward a period of sustained growth driven by institutional investors and a more institutionalized process for evaluating hedge fund managers would evolve.

It suggested that the winners were likely to be firms with strong distribution, clear comprehension of nuances among investor segments, a strong brand, and consistent high-quality marketing messages.