March 2017

Like a space-bound astronaut, the alternative investment industry is on a journey into the unknown. Those unknowns, including a post-Brexit world, potential liquidity droughts, advancements in the digital age, a busy regulatory agenda, mean major change for the industry as it lifts off into a new frontier.

Nowhere were the possibilities of change more visible than at the Cayman Islands Alternative Investment Summit (CAIS). The event provided a fitting launch pad for the industry to respond to the change in three ways: by adopting new ways of thinking about how to do business, embracing machine learning and disruptive technologies and by innovating in asset allocation and investment strategies.

New ways of doing things

Driven by change, the alternatives industry is looking at things through a different lens, and new ways of thinking and doing things are at the core of that.  Alternatives managers, including Arbiter and Lyxor, were invited by Deutsche Bank to participate in these topics. There was an interesting level of participation across all levels of alternatives, both hedge and private equity, with attendees spending 30% of the time on concepts of leadership, personal development and successes, noted Jason Sheller, Head of Sales, Alternative Fund Services, Deutsche Bank. 

Topics such as ‘The birth of stars – an explosion of philanthropy’, which explored making the difference and promoting better governance, to ‘Finding Alpha, Creating Trust’, which explored harnessing the power of digital tools in operations, and venturing into new asset classes with alignment of interest, all presented new ways of doing things.

Arnold Schwarzenegger shared his experiences as a leader, activist investor and philanthropist in a keynote address, while highly decorated NASA astronauts and twin brothers Mark and Scott Kelly shared insights on a big data study of the differences of physiological, neurobehavioral and molecular information on their DNA when one twin was sent to Mars and the other stayed behind. The study, which found correlations and patterns between the twins, and provided insights on how to keep astronauts safe on their journey to Mars, spurred new thinking on how businesses could approach data. 
The technology boom is also priming the industry to think about technology in a different way. The new Trump presidency and a post-Brexit world are already changing the way the industry does business. In an industry faced with heightened volatility and correlations, with politics more than economy driving markets, possible rate hikes in the US, the relentless rise of passive funds, ensuring the relevance of alternatives in this turbulent environment is also shaping thought patterns.

Innovation in asset allocation and investment approaches

These industry themes are already changing the way managers think. This was evident in a panel titled ‘Recalibrating active management in the new world’. Setting the scene, David Rhydderch, Head of Alternative Fund Services, Deutsche Bank, noted that 86% of active managers underperformed their benchmark in 2016. However, in looking at what will drive their success, one manger said that asset class returns have been much less helpful than in the past, and the debate is no longer about active vs. passive. Managers should instead focus on access, he said. “Unless we take advantage of the value to an investor like us in the form of partners that can do things that are well in excess of their economics to add value to an asset class there is no reason for us to exist. Active management really comes down into three things: skill-set, opportunity and conviction, rather than track record.”

The role of technology and data in investment is also important, with artificial intelligence and machine learning gaining traction. There have been a lot of changes in this area in the last few years in terms of technology and algorithms and that will be part of our fabric, said one asset manager. “We have to embrace them into our DNA and use them as efficient tools, for example, there are some good quant strategies that have done incredibly well using new technologies,” he said.

 But the tendency towards passive investment was evident, with more investment going into private equity. The reasons for this include performance and the technology, which presents a cost barrier for managers looking to get into active investing.  

Momentum may still produce opportunity for active managers. Good value managers and stock pickers should still be able to generate opportunity on the short side and the long side, delegates heard.

There is also an opportunity to review traditional fee sharing perspectives by adjusting share ratio of fees among partners. “The biggest issue is alignment of interest – how do we make sure when institutional investors allocate for the longer term that there is alignment of interest e.g. a deferral of incentive fees and capping fees,” said one active manager. “This is particularly visible on managed accounts.”

The changing infrastructure landscape was also a key topic at CAIS. In 2016, according to figures from Preqin, $645bn was invested in 1774 infrastructure deals, while $30bn of capital was distributed in infrastructure projects in the first half of 2016 and 52 unlisted infrastructure funds raised $59bn. In real estate, $108bn was raised for 225 real estate deals in January 2017, 117 assets were targeted in the real estate space and private equity assets totalled $2.49trn in assets under management as of June 2016, with $839bn of dry powder waiting to be deployed. A panel titled ‘Building a bigger industry: real assets in infrastructure’ begged the question where do these investors look to commit this capital given the political and economic uncertainty?

One institutional investor panelist shared that they are focused on energy infrastructure investments. “With the downturn in oil, the volatility has created opportunity for investors to take a look at oil and gas investment. On real estate it’s a more defensive play with a focus on debt and high yielding strategies,” he said.

Infrastructure has become the flavor of the month since it provides a lot of protection with inflation linked to GDP. Pension funds are looking to deploy 10 % of their portfolio in energy utilities and transport – core infrastructure. Moving further up the spectrum is enterprise driven infrastructure such as airports and at the very end is the ‘core plus-plus’ e.g. a chain of funeral homes. There’s a huge amount of money chasing these assets for two reasons: first, brownfield infrastructure is moving from public to private ownership and second, a vast amount infrastructure is needed for greenfield projects. Investors tend to favour brownfield because of the revenue stream. 

Melanie Cohen, head of Private Equity Real Estate Fund Services at Deutsche Bank, said service providers can help to find a balance for these oversubscribed managers by not alienating their investors, but also by not increasing the size of their fund upfront where they do not know if they can spend the oversubscriptions quick enough in the time frame they cover. “So they keep it at the size it is and set up a co-investment vehicle for the extra commitment,” she says. “This gives the investor more - their fees go down on average and it allows the funds themselves to have a greater play in the investment. Also complexity of fund structures means fund administration becomes more important –it’s about how we can help managers to be on top of all the entities in the structure, helping with regulation etc.”
What are the risks?   PE investors in infrastructure need to look at demand, revenue risk and the massive disruptive technology. This includes land use changes, the desire of millennials to live in cities and walk/ bike to work, which have massive implications for people to invest. “Revenue risk and regulatory risk – are playing out as we speak – uncertainty is never good - what are the rules that will govern my assets because these investments are not easy to get out of,” said one asset manager. “There is no Trump infrastructure policy but there is a list of projects in transportation, grids and pipelines. These are all good projects but they’re not suitable for private investments and they’re not designed for returning capital. Those projects will need to be redesigned because they will not yield a dividend as they are currently structured.”

Meanwhile infrastructure PE funds continue to form, observed Cohen. “Where it may take five years to raise capital it now takes a year and a half to set up a fund and they’re immediately onto raising the next one. That will continue. We’re seeing fewer managers but more funds per manager. They’re raising funds of funds that will invest across all of their infrastructure funds, giving them the risk and exposure they need.”

The rise of the machines

A panel titled ‘Alternative Investment: Advancing in the digital age’ featuring Suryanshu Mishra, Deutsche Bank’s Head of Hedge Fund Services, explored enhancing client proximity, embedding technology into product development and investment processes, exploring block chain technology, robo advisors and artificial intelligence. “With the increasing usage of diverse languages, with examples like R and Python, fund managers who develop their own proprietary and differentiating applications inhouse need to keep an eye on the inter-operability of platforms,” Mishra said, as he speculated that the industry needs to get more efficient in data management. As the discussion touched on the potential of concepts like blockchain in the alternative investments industry, a number of use cases close to home were explored – such as instant cross-border payments, smart contracts, public registry of asset ownership, and AML/KYC. Mishra pointed out that these use cases need to be invested into, but a parallel path of investment needs to be made into ensuring that either societies can cope with the enormous computing demands that will arise, or alternatively that research and development makes the construction and sustenance of blockchains much cheaper. Distinguished experts from Animal Ventures and Stripe, along with The Global Macro Investor and KPMG joined Mishra on the panel.

The focus on the impact of machine learning and artificial intelligence on the beta elements in the investing sphere were top of mind for many at CAIS: “There is talk of barbelling those beta tracking products to the lowest cost denominator while on the other end are the actively managed high risk products – clients are willing to pay for the performance but not things that are factor based and can be treated as algorithmics,” noted Rhydderch. “They will pay for value but they won’t pay for beta. Technology also presents opportunities to make speculative gain.” The disruptive ability of that technology was heavily discussed, with activity on both sides of the barbell (both beta or actively managed), Mishra noted.

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