Convergence between hedge funds, private equity and private credit is not a new phenomenon but it is a market dynamic which has been accelerated by COVID-19. In particular, a growing number of alternative asset managers are now launching debt strategies, conscious of the lucrative returns on offer at the moment in distressed credit, syndicated loans, and structured credit. This increased cross-pollination between hedge and private capital strategies shows no sign of losing momentum.
Returns and diversification
Post-financial crisis, hedge funds looked over in awe at their private equity/debt peers, many of whom were raising huge amounts of institutional capital and delivering excellent returns off the back of it. In contrast, hedge fund performance had slipped, resulting in significant outflows and client pressure on fees. In order to strengthen their appeal to a wider range of investors and simultaneously diversify their return streams, many hedge funds launched private equity or credit strategies. It is a gamble that has paid off, particularly during the COVID-19 volatility in the Spring.
Be wary of the risks
Although returns have been strong and investors are piling into hybrid funds, a handful of industry experts are alarmed that some hedge fund managers might not fully appreciate the risks that come with credit and other illiquid strategies. The pick-up in asset backed securitization (ABS) volumes – principally collateralized loan obligations (CLOs) – is indicative of this challenge. Some commentators warn that hedge funds need to make material changes to their compliance and risk management frameworks by conducting coverage tests to insulate themselves against collateral deterioration. Similarly, revisions to their valuation modeling are also required if firms accumulate exposures to illiquid assets. A failure to factor in these new risks could lead to serious losses and client outflows.
Entering into a new asset class like credit or private equity is not straightforward. At the most rudimentary level, hedge funds need to appoint suitably qualified people with a deep pool of expertise in these asset classes before making the jump. They will also have to recalibrate their internal technology and operational infrastructure so that they can process private capital-type assets. Alternatively, some firms may choose to outsource these activities to third parties – including technology vendors or fund administrators whose systems can support multi-asset class portfolios.
By outsourcing, hedge funds will be able to incur major cost savings and achieve greater scalability.
Material benefits laid bare
Although running a hybridized fund strategy creates additional workstreams and costs for managers, the benefits of diversification far outweigh the disadvantages. Firstly, operating a multi-asset class portfolio can shield managers against market disruption or black swan events, acting as a performance hedge. It also gives firms access to a wider demographic of investors, many of whom are themselves looking to diversify their portfolio returns. At a time when markets are volatile, diversification – both in terms of strategy and client base – could prove to be pivotal. Just as the 2008 crisis prompted a number of hedge funds to pivot into private equity, so too will COVID-19.