Investors Are Taking Money Out of Hedge Funds and Putting It in Private Equity

Even as allocators increase their investments in alternatives, hedge funds are losing out, according to a new study from EY.

Illustration by II

Illustration by II

Private equity firms are raking in the cash that investors are redeeming from hedge funds.

In 2019, hedge funds made up 33 percent of institutional investors’ allocations to alternatives. That’s a 7 percentage point drop from 2018, according to EY’s 2019 global alternative fund survey released Wednesday. Private equity was the big winner, growing to 25 percent of investors’ alternatives bet from 18 percent the year before, EY reported. Alternatives as a whole made up a quarter of investors’ portfolios, up slightly from 24 percent last year.

One reason for the big shift is that hedge funds can be more easily replaced than private equity, according to EY. Although high-fee hedge funds have been a sore point with investors, private equity also comes with a luxury price tag. Price, then, can’t be the sole driver of the move.

“We’ve seen that hedge fund offerings have been challenged on a number of fronts. Your long-only and long-short equity managers are continuing to face pressure from ETFs and institutional investors that can do that on their own,” Ryan Munson, a partner in EY’s asset and wealth management practice and an author of the report, said in an interview. “But with private equity, there isn’t a comparable competing offering. There is a different infrastructure that allocators have to set up if they want to go direct.”

[II Deep Dive: Investors Have Pulled $63 Billion From Hedge Funds This Year — But These Strategies Are Raking in Cash]

The EY survey also found that investors have increased their allocation to real estate, from 20 percent of their alternatives investments in 2018 to 23 percent in 2019. Over the next two to three years, the polled institutions said they expect to grow both their private equity and real estate allocations. The survey included feedback from allocators as well as private equity firms and hedge fund managers.

According to the report, private equity firms are increasingly competing with hedge funds for assets. More than a quarter of hedge funds reported to EY that they have either a private equity or venture capital fund, while a number of private equity managers said they offer liquid hedge fund strategies.

Forty-one percent of private equity firms said they offered or plan to offer private and other alternative credit funds, according to the report. Only 37 percent of hedge funds had similar funds or plans for such funds in their lineups. Meanwhile 23 percent of private equity firms said they offer or plan to offer real assets and infrastructure funds, compared to 17 percent of hedge funds that currently or will offer these types of products.

“Each are trying to compete in expanding, but private equity is further along than their hedge fund peers,” Munson said.

Hedge funds are, however, significantly increasing their co-investment capability. “Picking up on a trend that has long been popular in the private equity industry, nearly half of managers have identified that investors have an appetite for targeted investment exposures and best ideas outside of the traditional commingled offering,” the report’s authors wrote. “This represents a staggering increase from 2018 where only 21 percent of hedge fund managers offered this type of product.”

Hedge funds might be losing some share of institutional investors’ portfolios, but they are prepping for the future in meaningful ways.

EY’s study found that hedge funds facing fundraising challenges are working on cutting costs and other initiatives.

“Fee pressures are more acute among hedge fund managers who continue to struggle defending their business model amid lackluster performance and significant competition within certain investment strategies,” according to the report.

Half of the surveyed hedge funds said cost management was either their top priority or among their top 3 priorities. That’s up from 41 percent last year. In contrast, only 29 percent of private equity firms said costs were in their top 3 priorities.

They’ve had the luxury of not worrying about costs.

“Private equity has been growing so much, that they haven’t been able to focus on these secondary priorities,” Munson said.