How investors source and select hedge funds

In this excerpt from Preqin Investor Outlook: Alternative Assets, H2 2015, we take a closer look at how investors source and select new investment opportunities, based on the results of our interviews with over 100 investors in hedge funds.

As our extract from the Preqin Special Report: Hedge Fund Manager Outlook reveals, fund managers are finding the fundraising environment more competitive. Therefore, it is more important than ever to understand how investors source and select new investment opportunities, in order to be in with a greater chance of gaining some of the capital earmarked for new investment.

With this in mind, Preqin turned its attention to the investment process, and asked investors to explain in more detail how to gain their attention during the marketing process. This article reveals the results of surveys with over 100 investors on how they source and select funds.

Investor activity

51 per cent of the institutional investors that participated in the Preqin survey typically make one or two investments each year. Some institutions make significantly larger numbers of investments, for instance, 20 per cent of the surveyed investors add five or more new hedge funds to their portfolio on an annual basis.

With the greatest number of institutions making just a modest number of investments each year, fund managers need to find out how to gain their attention in the first place in order to have a chance at winning a mandate. Getting on the radar of investment consultants is a good step to being noticed by institutional investors; nearly half (47 per cent) of investors source new investment opportunities through recommendations made by their consultants. Investors are also proactively searching for hedge funds, with 36 per cent of the participants in the Preqin study sourcing new funds through their investment teams reaching out to the industry. In addition, 25 per cent of institutions find funds through peer networks and the recommendations of other investors, and 21 per cent use industry databases, such as Preqin’s Hedge Fund Analyst, to find and review new funds.

Fund proposals and motives for rejection

There are currently over 15,000 hedge funds open to investment globally. With such a large number of funds in the marketplace, investors face a challenging job to find the best and most suitable investment opportunities. Investors are receiving varying numbers of proposals each month. Just over a third (34 per cent) of institutional investors receive fewer than 10 fund proposals on a monthly basis. However, over half (51 per cent) receive 15 or more hedge fund proposals. A notable proportion (12 per cent) receive 100 or more fund proposals each month.

Investors certainly face a difficult task in sorting through the large number of proposals they receive to select funds that they might want to investigate further. Fifty-nine percent of investors reject 95 per cent or more of the fund proposals they receive in the first round of screening. Ninety-eight percent of investors reject at least three-quarters of the fund proposals they receive when they initially screen the opportunities. Most commonly, investors reject funds because the strategy is not of interest to them, with 36 per cent of investors stating this as a reason why a fund is rejected in the first stages of screening. The results also highlight the continued challenge that emerging fund managers face in terms of raising capital; the next leading two reasons why funds are rejected are that the fund is either too small or the track record too short. Other reasons investors highlighted included the fund strategy not being differentiated enough from others in the market, and various factors related to the fund’s performance, notably large drawdowns, poor performance relative to its peers and poor absolute returns.

Preqin’s survey reveals that across all of the investors interviewed, institutions receive, on average, 13 hedge fund proposals each month. This equates to more than 150 funds on an annual basis. With most of these proposals being rejected at the first stage, the majority of investors (57 per cent) are only monitoring 10 hedge funds or fewer on a pre-investment basis. The institutions surveyed by Preqin vary in the amount of time it takes to evaluate each new fund opportunity and to make an investment decision. A third of investors take up to three months to make a decision to invest in a fund from the day the initial proposal was received. Other investors take more time in evaluating a potential new fund investment; 38 per cent of investors spend at least six months evaluating a fund before they make an investment.

Time invested in a fund

Sourcing and selecting new hedge funds for investment is a resource-intensive activity for institutional investors and as a result, once they have decided to commit to a new fund, which capital is likely to stay invested for a series of years. In fact, two-thirds of institutions will remain invested in a fund for at least three years (Fig 4). Therefore, although gaining the attention of institutional investors is difficult, the efforts involved in providing the right information and meeting the requirements of institutions can have a significant effect on the success of a hedge fund. Not only do institutional investors invest significant sums, but their capital is ‘sticky’ and remains invested for long periods of time.

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