The Distribution Layer
The Distribution Layer
The Market Structure & Evolution of Alternative Investments
I believe the future of alternative investments is meaningfully in flux. These thoughts are based on my own participation in the market, as well as conversations with emerging managers and associates at the largest alternative managers. I should also note that much of my time is spent in the real estate sector and many of these views are shaped by trends in that particular asset class. Nonetheless, private equity, credit, and to some degree hedge funds, are navigating changing end markets for their products. Those closer to the ground may disagree with this assessment and I’d be eager to hear an alternative narrative of how the next decade may play out. My view focuses largely on how the market structure will change with regard to investment managers, allocators, and ultimately the owners of capital.
A new BCG report ominously titled “The Tide Has Turned” points out that 90% of the asset management industry’s revenue growth has come from market performance versus inflows. Alternative investments offer an irresistibly hot dot of growth that promises large greenfield retail markets and less fee compression.
BCG recommends traditional asset managers internally build or buy alternative investment platforms. I believe they are looking for growth in a market that has already outgrown itself in many ways. The largest managers have provided a release valve for unprecedented liquidity but now find themselves with a similar deployment challenge as the capital they manage. The top five public pensions have over $1.5 Trillion in total assets, while the Top 5 U.S. alternative managers have $2.6 Trillion of assets under management. That is only to say that to the degree that investment returns come from exploiting inefficiencies, massive capital deployment begins to degrade forward returns.
To this point, the largest alternative managers have been able to capture a consistent flow of these assets precisely through their ability to deploy capital at scale. That enviable product is possible only through the magic of manpower. At Blackstone, the real estate investment headcount alone is over 1,000 professionals, a number that understates the true scale of the operation as model maintenance and other rote underwriting tasks are outsourced to cheaper labor in developing markets.
The hand-in-hand growth of pension and endowment assets and large alternative asset managers now faces a triad of headwinds. High and rising rates are changing the role of alternative strategies at defined benefit plans, mid-career investment talent is looking at crowded, relatively younger, upper echelons of their organizations, and asset growth via high-net-worth and private wealth channels requires larger and more developed investor relations functions.
Greater Intermediation of Capital
Despite weakness in traditional markets, the “denominator effect” has been muted, if not non-existent, at large pools of capital. The structural dominance of alternatives and the glacial pace of change at public bureaucracies is working in favor of the largest managers for the moment. However, performance faces its own rate-driven headwind and will eventually cause a reevaluation of investment policies, and ultimately, greater intermediation of capital allocation. Institutional capital will go in search of the inefficiencies large alternative managers can no longer provide. This is an important development because simultaneously the top mid-career talent at large alternative managers will leave to start their own firms in an effort to make more interesting investments and to access more remunerative general partner economics. The layers between capital and assets are going to increase and specialize.
This will open up capital to emerging managers across asset classes, but today’s managers must start with a more diverse capital base that includes institutional capital, HNW/Private Wealth, and OCIO relationships. Absent a change to the market structure, alternative managers face one of the classic business challenges: Selling into multiple markets at once without sacrificing product quality or brand.
Today, you have emerging alternative managers building what are essentially DTC brands on social media, established firms utilizing crowdfunding sites to diversify their capital bases, and independent advisors getting aggressively marketed alternative strategies by their traditional investment providers. The challenge of a more fragmented, or intermediated, market of capital providers is that the investment business begins to demand increasingly sophisticated “distribution.”
Distribution is a bit of an anachronistic term in asset management that harkens back to a Golden Age of Wirehouses. Distribution is, in fairness, still regulatorily captured by broker-dealers. For the largest asset managers, this regulatory relic is a trivial detail and an even more de minimus cost of rolling out retail-ready products that can profitably accept smaller checks1.
For smaller managers though it can be both a significant cost and meaningful distraction, especially if their AUM does not support a large organization. Firms like iCapital and CAIS have tried to fill this void by taking on some of the administrative and marketing burdens of accessing more retail dollars. But these platforms still lean heavily on the brand strength of “Blue Chip” alternative asset managers, while respected, but not-yet-household-name, firms struggle to attract assets.
These disjointed sales channels and access points are clearly not an end-state for the market. The current fragmentation is creating temporary profit pools for those offering “access” to something that is already broadly accessible, just confusing and poorly mediated. Marketing to retail investors is costly and risky without more certainly around customer lifetime value. Retail capital is notoriously fickle and running illiquid strategies that rely on it has a long history of failure.