Can resilience shape a shifting landscape?

During 2022, we experienced a combination of macroeconomic, geopolitical and regulatory headwinds that challenged financial markets in a way unseen perhaps since the global financial crisis of 2007–08. Significant market declines across almost all asset classes resulted from the ongoing repercussions of the COVID-19 pandemic, instability in global economies, central banks’ actions to address rampant inflation, and geopolitical conflicts.

It comes as no surprise that managers and investors alike identified their top business challenge as responding to the various market risks, with managers and investors viewing public market volatility, changing interest rates and talent management as leading concerns. In addition, both managers and investors expressed recessionary concerns in their 12-month economic outlook, with marginally heightened concerns noted for global economic indicators as compared with those specific to the US economy.

This year’s survey results reflect the strength of investors’ appetites to invest in alternative funds, with managers (especially more established ones) continuing to pivot to diversifying product offerings and expanding their business models. The majority of investors surveyed expect to hold their alternative allocations constant, but of those expecting changes, most state they will increase their allocations in the next three years. Private credit was identified as the largest expected beneficiary, as many investors believe that this period of rising interest rates and deteriorating economic conditions will create a credit cycle that allows for interesting and lucrative investment opportunities in this space.

The ongoing economic instability, coupled with an industry that continues to mature, has prompted a significant increase in the number of alternative fund managers who are adopting a more long-term view of their overall business positioning. The industry’s maturation can be illustrated by managers’ pursuit of strategic transactions with both internal and external partners. Their goals are twofold: to provide short-term resources to see the business through this economic cycle, and to solidify the long-term strength and viability of their business, including preparing for succession and transference of control.

Deal value is always a key consideration, but the top factor identified by 51% of managers considering potential transactions is aligning with a partner who will be additive to the business moving forward. This may come in various forms: supplying financing to allow the business to pursue long-term growth objectives; providing relationships the partner may make available to the firm; or dispensing strategic insights and advice the partner may be able to lend to the business. Also significant is ensuring that the firm culture remains intact and that employees continue to have opportunities.

In the current competitive talent environment, alternative fund managers have to be laser-focused on talent management, and 75% reported that talent retention is their primary goal, with hiring, recruiting and onboarding talent and ensuring an inclusive culture their second and third top talent management priorities. And as talent management continues to play a much larger role in investors’ evaluations of their managers, over 55% of investors stated that relative to two to three years ago, scrutiny of their fund managers’ talent programs and policies has increased.

No conversation around talent management would be complete without a discussion about how the industry is returning to work post-pandemic. The industry’s workplace flexibility policies are changing, with more structured return-to-office policies becoming the norm. With such policies resembling a pre-COVID-19 working environment and structure, firms’ management styles need to balance competing stakeholder expectations around in-person engagement with employee flexibility desires.

“Expanding your strengths” could be the catchphrase for alternative fund managers this year, as they currently offer or plan to offer products across hedge, private equity, credit and real estate, similar to the offerings they reported three years ago. A notable exception relates to private equity’s expected incursion into opportunistic and special-situation investments. One-third of private equity managers anticipate increasing these offerings, with a smaller number of investors indicating they too would increase their allocations to take advantage of expected market dislocations.

Awareness is growing among companies, investors and shareholders that for businesses to remain viable, they must think about and manage their impact on the planet and society in new ways. This includes managers being responsive to investors’ expectations of increased integration of ESG and sustainability across their corporate policies and investment portfolios.

Many of the largest alternative investors are public pensions, endowments and foundations that have their own environmental and socially responsible commitments and requirements to meet. With 14% of investors required to invest in these products and 29% anticipating being required to invest in these products in the next two to three years, this relatively new trend is expected to continue to grow, with governance and climate risk being top areas of interest, followed by human rights and DEI.

Investors are gaining exposure to these socially responsible offerings via a variety of products, including socially responsible funds or separately managed accounts (SMAs); funds that have some portion of their assets dedicated specifically to investing to address ESG issues; and impact funds. Investors are typically accessing these structures via traditional asset managers, but this presents an opportunity for alternative fund managers, as expanding their ESG offerings is part of their growth agenda.

As output from the global regulatory pipeline begins to increase, the SEC and other global regulators have rolled out several significant proposals that affect the alternative fund industry ranging from regulations on private funds to reporting private fund activity, and from ESG disclosures for investment advisors and investment companies to climate-related disclosures. The proposals have contributed to a recent trend of increased investor scrutiny of managers’ ESG-related corporate and investment policies and processes. Hedge fund and private equity managers alike are responding to the increased pressure by developing corporate ESG policies. Some 57% of firms have a governance structure, and 53% have embedded ESG into their investment decision-making.

Although most managers are providing their ESG policies and procedures upon request, investors want increased transparency in reporting to demonstrate that their managers are meeting their ESG requirements. It’s interesting to note that 56% of private equity managers provide reporting on these initiatives, as do 19% of hedge fund managers.

Summary

With increased regulatory reform on the horizon, alternative fund managers are preparing their operations and infrastructure to meet their growing compliance burden. And with investors increasingly scrutinizing fund managers’ talent management programs and ESG policies, investments and reporting, managers are responding by taking measures to improve talent retention and prioritize DEI. In tandem, they’re developing ESG policies and governance structures to set policy and embed ESG into their corporate governance and investment decision-making.