By Don Steinbrugge, Founder and CEO, Agecroft Partners
Below are Agecroft Partners’ 13th annual predictions for the biggest trends in the hedge fund industry for 2022. These predictions are based on insights from more than 2,000 institutional investors globally and hundreds of hedge fund organizations. The hedge fund industry is dynamic and we believe 2022 will be the most transformative in its history. Managers and investors can benefit from anticipating and preparing for the changes that are likely to occur. Those who effectively evolve with the industry improve their chances of success, while firms who remain stagnant, do so at their own peril.
- The recent Covid 19 outbreak will impact managers differently this time. During the first Covid outbreak, all travel by hedge fund managers was put on hold. Now with most people in the industry vaccinated and initial reports that the Omicron variant causes comparatively milder symptoms, we expect a majority of managers with competitive funds to travel in early 2022. Managers understand that there is a much higher probability of getting a meeting with an investor if the investor has the option of choosing either an in-person or a virtual meeting, and that in-person meetings tend to be more effective. For example, we continue to see very strong registrations for our January Gaining the Edge – Cap Intro Florida event, with a vast majority of recent manager registrations choosing to participate in-person vs virtual only.
- Virtual work is here to stay and virtual meetings will be disproportionately embraced by investors. This gives industry professionals more flexibility on where they live and reduces unproductive commuting time. While we expect managers to significantly increase their travel, many investors will continue to do a majority of their meetings virtually. Traveling is expensive, time consuming, and tiring. Investors will continue to use virtual meetings to increase their efficiency by performing a majority of the meetings that do not take place in their office virtually, and only traveling to visit their short list of top managers. In addition, as virtual meetings are often recorded, they can be shared with other members of their investment team or reviewed at a later date. Investors have also observed that senior members of the hedge fund team have a higher probability of participating in virtual meetings versus in-person meetings at an investors’ office.
- Hedge fund flows to new managers will set a record in 2022. There are 3 primary factors that drive flows to new managers: asset size of the hedge fund industry, manager turnover rate, and net flows to the industry. All 3 of these factors are signaling record flows to new managers with the dominant catalyst being pent up demand by investors who had put a majority of search activity on hold due to Covid 19. We expect to see above average search activity as investors catch up with updating their portfolios. For more detailed information please see our paper: Greatest asset raising environment in the history of the hedge fund industry.
- This is the time to be forward looking and focus on valuations. Many investors make investment decisions by looking back in time at historical performance and over allocating to strategies that have recently outperformed. Historical performance can be enhanced for equities when price/earnings ratios expand to levels that result in over valuation, fixed income when interest rates and credit spreads decline to artificially low levels, and real estate when cap rates decline to unsustainably low long term rates.
With valuations across most asset classes well above historical averages, this is the time to put more focus on current valuations and the implications for future returns. As multiples expand, performance is enhanced and investor optimism grows. This stretches valuations further until the whole process eventually reverses and markets with the most extreme valuations are disproportionately negatively impacted. With rising inflation and interest rates, current valuations face strong headwinds. Despite most market valuations being stretched, there are some areas of the market that have been less affected. This presents opportunities for skilled investors and managers to take advantage of the differences in relative valuations.
- Strong demand for long/short equity especially managers who focus on small/mid-capitalization and global stocks.Over long periods of time, price/earnings multiples of equity indices should reflect the expected growth rate of the constituent companies’ earnings and the level of confidence of the earnings forecast. At times, the relative valuations of indices widen, but at some point there is a reversion to the mean. The past decade has created wide disparities in valuation multiples between the S&P 500 and most small/mid-cap indices and non-US indices. At some point, these disparities in valuation multiples will contract, allowing active managers to outperform the S&P 500 with less tail risk. Long/short equity managers should benefit from this environment, especially those with moderate asset bases who have the flexibility to take meaningful positions in small and mid-sized companies globally.
- Lower expected returns from private equity. Returns for private equity have been exceptionally strong over the past decade causing record flows to the industry. This has stretched valuations of many new deals. Some industry experts estimate that there is close to $1 trillion of undeployed capital by private equity funds, which should expand valuations even further as this money is invested in new deals. Many private equity funds are illiquid leveraged equity plays that have a lot more risk than most investors perceive. With all of this cash competing for deals, we believe return expectations for private equity should be lowered while increasing expected tail risk. With that said, this market is highly inefficient and there still are some niche areas of the market that offer above average returns.
- Increased institutional demand for fixed income substitutes. With interest rates and credit spreads expected to rise, investors will look to hedge funds to enhance returns in two ways:
- Moving assets away from the fixed income allocation of their portfolio into a diversified portfolio of uncorrelated hedge fund strategies, such as market neutral equity, relative value fixed income, merger arbitrage, convertible bond arbitrage, CTAs, global macro, and reinsurance among others.
- Including hedge funds in their fixed income allocation by re-categorizing them as a “best in breed” manager, and investing in strategies such as distressed debt, specialty financing, structured credit, relative value fixed income among other strategies.
With the yield on the aggregate bond index approximately 2%, the bar is low for hedge funds to add value on a risk adjusted return basis as a fixed income substitute.
- Cryptocurrency market is too big to ignore. The crypto market surpassed $3 trillion in market capitalization during the 4th quarter of 2021 and will impact the hedge fund industry in many ways in the future. The 4 biggest long term trends we see include:
- Significant increase in flows to funds focused specifically on cryptocurrencies
- More hedge fund strategies including cryptocurrencies in their portfolios (for example CTAs, global macro and multi-strategy funds)
- Funds offering a Bitcoin share class. Many funds offer shares in multiple currencies and at some point they will also offer a Bitcoin share class.
- Funds converting to cryptocurrencies. This is a way to create liquidity for an illiquid fund structure.
- Capital Introduction Events will see increased demand. We expect this month’s independent cap intro events in Florida to shatter historical registration records for both investors and managers as we head into a year with expected record asset flows to new managers. Investors view these events as enhancing the efficiency of their research process of managers, where they can screen a large number of managers and quickly meet with a short list of those that look the most attractive.
Most managers based in North America and Europe will participate in person in these events, while most managers based in Asia will choose to participate virtually. We expect a higher percentage of investors to participate virtually compared to managers as investors do more preliminary meetings virtually. In addition, many large institutional investors will have more conservative travel policies relative to Covid than managers.
- Evolution in alternative investment fund structures as the line between hedge funds and private equity continues to blur.
Allocators to alternative investment managers historically divided research responsibilities of managers to members of their team based on a manager’s evergreen or drawdown fund structure. Today, many research teams have evolved, increasingly organizing their research by strategy or asset class, rather than fund structure. It has become broadly understood that hedge funds are not an asset class. They include a broad array of asset classes and investment strategies and drawdown funds are not limited to just private equity, but can include any type of illiquid asset.
Over the past decade, private equity firms and hedge funds have increasingly offered similar strategies with different fund structures. A drawdown structure for private equity and an evergreen structure for hedge funds. Among others, examples of this include distressed debt, specialty finance and reinsurance.
More recently, hedge fund managers are offering both drawdown and evergreen funds. At the insistence of investors, managers are appropriately focused on aligning fund structures with the underlying liquidity of the securities in which they invest.
The line between the two fund structures is becoming increasingly blurred. Some evergreen structures with less liquid securities have reduced the liquidity of their funds by extending their notice of redemption period, including gates that limit the amount of allowed redemptions over a period of time and adding slow pay redemptions. Slow pay provides redemption payouts as securities are liquidated. A pro rata share of securities that are liquidated are paid out to meet redemptions, while the remainder are reinvested within the fund. Funds also have the right to suspend redemptions if they believe it is in the best interest of the LPs.
Fund managers are also evolving their fee structures by charging lower management and performance fees. In addition, we are seeing an increase in performance hurdles for evergreen funds, which historically were much more common with a drawdown structure. Finally, some large institutional investors have negotiated longer crystallization periods for performance fees.
This convergence of hedge funds and private equity will impact all aspects of the industry. Capital introduction events, for example, already often include private equity, private credit, and real estate firms. This convergence will also be seen in industry journals and trade organizations, databases, and service providers.
