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Industry matures as capital sourcing is transformed from high net worth individuals to institutions Back  
U.S. institutional investor capital in hedge funds is forecast to increase from $60 billion to $300 billion within five years, a new report commissioned by the Bank of New York reveals. Institutional capital is driving this growth, and will soon account for more than 50% of annual net new flows into the hedge fund industry.
The hedge fund industry is midway through an important transition in its source of capital. Five years ago, hedge funds derived virtually all of their assets from wealthy individuals. Institutional interest was limited to a small number of endowments and foundations. Over the next five years, institutions (including pension funds) are likely to provide an additional $250 billion of hedge fund capital, accounting for 35 percent of net new flows in this period. Coupled with the increasing influence of the fund of hedge fund industry, new hedge funds will be dependent on ‘professional’ sources of capital for 70 percent of their capital.
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Table 1: Summary, p8, finance october 2004

A report by The Bank of New York and Casey, Quirk & Acito, entitled, ‘Institutional Demand for Hedge Funds: New Opportunities and New Standards’, shows that this transition is having a dramatic impact on the hedge fund industry. Their survey was conducted amongst 50 senior professionals from leading institutions, hedge funds, and other hedge fund related organisations. Additional primary research was conducted through a survey of over 80 participants at Institutional Investor’s June 2004 Spring Hedge Fund Investment Roundtable.

Current state of institutional demand
According to the report, at the end of 2003, U.S. institutions had invested approximately $66 billion in capital with hedge fund managers. This capital came primarily from about 400 institutions.
Endowments and foundations have been at the vanguard of institutional hedge fund investing.
Generally speaking, trustee familiarity with finance, more modest regulatory constraints on fiduciary responsibility, and less public scrutiny have allowed endowments and foundations to be early and rapid adopters of alternative investing. Currently, they account for about half of all institutional capital.
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Table 2: Primary impediments to hedge fund Investing

Despite representing nearly five times as much in assets as endowments and foundations, defined benefit plans currently account for just 40 percent of institutional hedge fund capital, roughly evenly split between corporate and public plans.

Only about 15 percent of pension funds currently invest in hedge funds and, among investors, allocations average merely 3 percent of invested portfolio assets.

Defined benefit plans, however, are the fastest growing source of institutional capital.
Insurance companies (for their general account) represent the least developed institutional market for hedge fundsless than 10 percent of all institutional hedge fund capital. Demand is not systematic, coming from a relatively small number of firms.

Return expectations
Institutions have an average net-of-fee return expectation from hedge funds of about 8 percent. Nearly three quarters have expectations between 6.5 and 9.5 percent. Similar research done three years ago indicated that expectations were about 400 basis points higher.
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Table 3: Requirements for institutional success

Fund of funds versus direct investing
Currently about one-half of all institutional investing is done through a fund of funds structure. However, we find little evidence of institutions abandoning their fund of funds relationships as they develop experience with hedge funds. Most institutions are recognising that the depth of resources required to effectively source, select, and monitor hedge fund investments are significant and expensive. At most, institutions are taking it upon themselves to begin to select managers in certain investment strategies, presumably where they believe they have some expertise (such as long-short equity or distressed debt).

Even with these direct investments, however, institutions are reliant on their fund of funds partners to be a sounding board. In this context, we find it interesting that, for many institutions, fund of funds are becoming the de facto investment consultant for hedge fund allocations. They are counted on as trusted overall advisors, providing manager search, strategic and tactical asset allocation guidance, as well as risk monitoring. In our survey, traditional institutional investment consultants were rarely mentioned as being influential in selecting individual hedge funds for their clients; most have been relegated to selecting fund of funds.

Barriers to hedge fund investing
As Table 2 shows, the primary reason for not investing remains headline risk. Headline risk is the (not irrational) view that poor performance (let alone malfeasance) among hedge fund investments will bring outsized criticism relative to the same performance from more traditional managers. For public and corporate officials, whose careers are in the balance, this asymmetric risk is often perceived as simply not worth taking. One of the reasons endowments and foundations have been earlier hedge fund adopters is that their trustees generally face less retribution.
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What is a hedge fund?

Future capital flows
The report predicts that by 2008, U.S. institutions will have over $300 billion in capital invested in hedge funds. Assuming a market return of 7 percent per annum, this implies a net growth rate of over 35 percent per year. This increased capital flow will be driven disproportionately by defined benefit plans, as endowments and foundations have already made larger percentage allocations.
Fund of funds are expected to maintain roughly a 50 percent share of the capital allocated from institutions.

Perhaps more interesting and important than the absolute level of institutional hedge fund investing, will be the changes in net new flows. U.S. institutions will likely increase to a 50 percent of net new capital flowing to hedge funds globally. Add European and Asian institutions, and the percentage likely rises even higher. This transition is dramaticinstitutional share was less than 10 percent through 2001.

Attracting institutional capital
Which hedge fund firms will be successful in attracting institutional capital? Below are the seven attributes that will characterise successful firms.

1 . Business management
The growing ‘institutionalisation’ of hedge fund demand will require greater resources and higher professional standards than heretofore required for success. Organising these resources and instilling professionalism require strong tactical business management skills.

2. Culture of integrity
Leading institutional investors rightfully require very high standards for professional conduct throughout an entire investment management firm. They want to be assured that their advisors are acting in the best interests of their clients at all times.

3. Operational excellence
Institutions are placing greater emphasis on hedge fund firms’ business infrastructure.

4. Disciplined investment process
Institutional investors realize that great investment management is a blend of art and Science. That said, to appeal to institutions, hedge funds must demonstrate how they make clear investment decisions. Hedge funds must have investment processes that are understandable (even if complex), consistent, risk-aware, and perceived to be repeatable. A clearly-defined investment process establishes credibility among buyers and intermediaries. It establishes confidence in the consistent delivery of performance, within the agreed-upon risk parameters.

5. Investment strategy innovation
Many institutions recognize that hedge fund investment strategies face cycles and secular trends with regard to their effectiveness. As a result, they expect that hedge fund firms will dedicate resources to constantly evaluating the effectiveness of their investment process. Appropriately augmenting their investment capabilities will be a core competence of successful hedge fund firmswhether this is hiring a new trading desk or constantly developing new quantitative models.

6. Comprehensive risk oversight
Institutions have high expectations for their hedge fund managers with regard to risk controls. Most obviously, they expect a strong handle on all market risk factors to which a portfolio (not just an individual security) is exposed. Proprietary tools are encouraged, though thoughtful application of thirdparty packages is also satisfactory.

7. Sophisticated client interface
Historically, investment firms have been product-driven, focusing on clients only after the products have been created and are ready for sale. To be fully successful in the institutional market segments, hedge fund firms will require a broader set of distribution skills.

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