It seems like everyone is talking about liquid alternatives. If you read the news or listen to industry pundits, you can’t help but hear about their momentum. While not everyone agrees on how big the market will be, there is a general consensus that liquid alts are one of the fastest growing asset classes in the industry. A recent survey from Barclays showed that liquid alts grew at a significantly faster pace than hedge funds last year, and Barclays and Citi both project assets in the space will reach nearly $1 trillion by 2018.
With more retail investors and retirement plans looking for the diversification benefits of alternative strategies with the safeguards of a ‘40 act structure, there doesn’t seem to be any slowdown in sight. And while the demand is strong and seemingly only getting stronger, managers who think they can simply launch a fund and expect investors to come with assets in tow could be in for a rude awakening. Being in the space and being successful in the space are two different things all together.
The reality is that a small number of funds are gathering the lion’s share of the assets, while the overwhelming majority of funds are launching with limited success. In fact, according to Strategic Insights, 25 funds accounted for 71 percent of all inflows into the liquid alts space last year; another 36 funds accounted for 30 percent of inflows; and 438 funds accounted for just 6 percent of 2013 inflows. If those numbers seems off, it’s because another 38 funds accounted for negative flows of 7 percent.
Based on the current asset flows, it’s clear that success in the early stages of the liquid alts lifecycle has been defined by size, scale and distribution heft. While those elements will always be important, other success factors will emerge as the market matures. Things like operational excellence, investor education and service provider proficiency will be equally essential to success moving forward. To help managers looking to stand out and gather assets in the increasingly crowded liquid alts market, below is a set of critical but often overlooked insights necessary for achieving long-term success.
Education Drives Distribution – As the liquid alts market has developed, the role of distribution has evolved from sales to education. Given the increasing complexity and diversity of product options, the best liquid alts wholesalers are the ones who are the most financially savvy. In fact, more often than not they’re CFAs who can talk about strategy, alpha, Sharpe ratios and other factors in terms that are understandable and meaningful to advisers and intermediaries alike. The managers who understand this changing distribution dynamic and identify partners that can educate their end audience about their offering and its advantages will be the ones who gain assets and traction in the maturing liquid alts landscape.
Dabblers Don’t Succeed – Managers who think they can dip their toe into the liquid alts pool and succeed are sorely mistaken. Success requires dedication to the product, relationships with experienced business partners who understand the strategy, and a commitment of resources to build out the infrastructure it takes to meet regulatory requirements and investor expectations. Remember, the revenue and expenses will look much different because a performance fee is nearly impossible to achieve in a ‘40 Act structure. So commit to the strategy and fund the business because savvy investors can sniff out a dabbler miles away. There are too many options for an investor to commit their assets to a manager who won’t commit themselves.
Illiquidity Breeds Complexity – Alternative managers invest in illiquid assets all the time, but when they move to the ’40 Act world they have to deal with hard limits and reporting requirements that create levels of complexity they are not accustomed to performing. For example, a manager may have a $200 million portfolio with $30 million in illiquid assets. That’s in line with the ’40 Act’s 15 percent illiquidity cap, but if there’s a market selloff and that $200 million declines to $130 million with $30 million in illiquid assets — there’s a problem. Beyond that, basic alts strategies like shorting can create accounting and record keeping requirements that some systems or providers aren’t equipped to handle. It’s critical that liquid alts managers choose a service provider that has the expertise and the technologies to support their strategy and guide them through the process of meeting liquidity requirements. Managers who don’t have a firm understanding of liquidity requirements will inevitably increase risk, increase cost and decrease the chances of success.
Some Strategies Are Too Costly – The first question managers need to ask is, “will my strategy work in a ‘40 Act structure?” If the answer to that is yes, the next question should be, “will it be viable from a cost standpoint?” That’s where the process may get a bit more complicated. There are plenty of strategies that technically work in a mutual fund structure, but the operational needs and associated costs may make the fund’s cost structure too high to be attractive to investors – and the more complex the strategy, often the more cost involved in executing. For instance, some multistrategy funds require more extensive risk processes, demand multiple custodians or increased fund accounting needs. All those come with additional costs. Managers must consider costs, processes and resources in a competitive context because while some strategies may work in theory, they can be too expensive to gather assets in reality.
Successful Managers Think Long-Term – The most successful managers think not just about the needs of their fund today, but what their business will look like in the future. They take the time to understand their options and work with partners who can help them make smart decisions that align with their long-term business goals. For instance, if they are going to have a straight forward strategy, using a series trust to launch their fund will likely be fine. But if they are going to have multiple strategies or they need more flexibility or control, they will likely want to establish their own trust and their own board. If they’re executing in a Master Limited Partnership strategy, it’s important to work with a provider that has expertise with that structure. There are many options to consider from an operational standpoint, but the more a manager can think long-term the more likely they will be proactive in setting up the right partners and processes. Following through on that will lower costs and increase the chances of sustaining success over the long haul.
Closing Thoughts
When it comes to succeeding in the liquid alts business or any business for that matter, the devil is often in the details. While some of the points above may seem like common sense considerations, unfortunately many managers don’t know what they don’t know. There’s no question that the opportunities in the liquid alts market are abundant and only getting greater, but the competition is getting stiffer as well. As convergence takes hold, competition is ramping up and managers’ margin for error is shrinking. The factors outlined above will likely be the difference between gathering assets or getting left behind. So take advantage of the insights many new entrants to the retail space overlook and create a clear site line to success in the booming liquid alts market.
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