I.                  Introduction

Hedge funds were down 5.0% in 2011, making it the second worst year on record and the third consecutive year that hedge funds lagged the S&P500.¹

Some claim too much capacity exists in the hedge fund industry – too many hedge funds, too many large hedge funds and too many managers chasing too few opportunities – have resulted in overcrowded trades and lackluster results.

 There lies the opportunity. Good hedge fund managers that can produce alpha are becoming separated from the rest of the crowd. If a manager was up in 2008, 2010 and 2011, it is evident that he understands both the long and short side and can find good uncorrelated investment opportunities.²

 Based on interviews with over 25 managers, investors, consultants and service providers as well as a number of proprietary surveys, Infovest21 concludes the major trends and themes expected to play out in 2012 will include:

 Asset flows

• Wide dispersion of manager performance is resulting in considerable asset rebalancing. Institutional investors are redeeming from one manager and reallocating those assets to other managers who have exhibited strong risk controls and whose strategies are non-correlated to equities.
• Pension bias towards large hedge funds is resulting in more money concentrated in fewer hands, muted returns, less nimble trading activity and more crowded trades.
• As top managers close to new investment as they reach capacity limits, assets will trickle down to medium-sized managers.

New launches

• Growing regulatory and taxation burdens weigh on managers, particularly start-ups and smaller managers. A manager starting a fund today needs about $50-$100 million to launch, depending on the size of the team and the strategy.
• Most new funds launched in 2012 will be relatively small. The larger fund launches will be those seeded or those spinning out of larger more established funds.
• The number of seeded deals over $150 million to $250 million will be limited.
• Hedge fund fees are generally holding. Some creativity is seen with start-ups and those trading longer term strategies e.g. distressed, event driven and activists.

 Retail products

• Globally, institutional capital invested in hedge funds and funds of funds represents about $1.1 trillion. However, in the retail world, the amount in hedge funds is very small. Of the $11 trillion in the US retail market, only about $100 billion is in alternative 40 Act funds. While there is still growth potential in the institutional space, tremendous growth potential exists in the retail space.³
• Since 2008, registered investment advisors and big retail intermediaries have been clamoring for the same product features for their clients that institutions have – less correlation to equities. In the independent registered investment advisory world, tremendous demand exists for alternative-like product. Many long-only firms are creating mediocre quasi-alternative products that are not truly long/short. Hedge funds should be filling this need but few are.⁴
• Funds of funds have been more creative in terms of 40 Act funds than hedge funds.

Funds liquidating

• Some funds are liquidating due to poor performance, frustrating markets, random volatility as well as excessive regulation and increasing demands from institutional investors. As assets flow primarily to the largest managers, some smaller and medium-sized managers cite the inability to raise assets as preventing them from reaching critical mass. 
• Excess capacity is being squeezed out of the system. Those firms that don’t have an edge are at a big disadvantage.

Funds of funds

• Even the most successful funds of funds are under pressure to provide more customization, more client interaction, more transparency – information about their underlying allocations, risk, operations, compliance – and all for lower fees.
• Funds of funds’ target audiences are becoming more focused and segmented. Some funds of funds will focus primarily on the large US public pension funds while others will focus on small to medium-sized institutions. Others are finding growth potential on the retail side while others are doing customized work. Others are getting into the advisory business.
• Funds of funds’ fees vary depending on the target audience.⁵  For example:
• In the institutional market, room exists to negotiate for investments in the $50 million to $100 million range but not for those in the $20 million and lower range
• Small to medium-sized institutions can be classified as a quasi-retail buyer. They tend to pay the full 1/10 fee. A commingled product is easier for the fund of funds to put together.
• Fees are healthy for retail products e.g. registered funds, 40 Act funds.
• Funds of funds focusing on customization i.e. providing value added via a specific strategy or through emerging managers have been generally able to hold the line on fees.
• Funds of funds going into advisory businesses find the business is not scalable. Rather than being the main fiduciary, the fund of funds has become another investment consultant.
• Those funds of funds organizations with less than $2 billion in assets are most vulnerable to acquisition.

Strategic stakes

• Banks are no longer taking strategic stakes in hedge funds due to the Volcker rule, higher capital requirements and lack of monetary resources. Financial investors and strategic buyers have stepped in as the new acquirers. Financial investors, who have traditionally bought long-only businesses in the past, are now becoming more comfortable with hedge funds. Strategic buyers are long-only businesses who want to add hedge fund skills in house. Considerable interest exists for the latter though few deals have yet been consummated.⁶

 Excerpt from White Paper