Alternative Investments: A path to transparency

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Capital has been flowing into the alternative investment industry over the past few years, with sources projecting that money invested in private funds will reach as much as $20 trillion by 2020. Preqin recently published a study stating that there are as many as 17,000 private funds open for investment.

Strong returns and opportunities for diversification have attracted High Net Worth (HNW) and institutional investors, who can invest in exponentially larger quantities than the average investor. Though these investors come with a greater ability to deploy capital, their size and influence translate into greater expectations and hurdles to meet in order to invest.

The word that best sums-up these growing expectations and hurdles is “transparency”, and this word has become a lightning rod when it comes to alternative investments like hedge, private equity, venture, special purpose vehicles and real estate.

As alternative assets have become a more common avenue for investment, transparency has correspondingly grown in importance for investors. A 2017 study titled “Alts Transparency: Finding the Right Balance” by the Economist Intelligence Unit (EIU) highlights this growth. Sixty three percent of respondents listed “degree of transparency” as “very important” for alternative investments, which was ahead of all other considerations. Another statistic showed that the importance of transparency as a key issue for private fund managers increased almost six-fold since the 2008 financial crisis.

Breaking this down further, I separate transparency into 2 different types: (1) information about the fund, and (2) information about investors’ holdings within that fund. The first type deals with greater transparency of the overall performance of the fund, which includes the underlying assets in which that fund is invested, how risk is assessed and managed, and more. The second type deals with greater transparency relating to investor-level performance. This includes metrics like investors’ allocation and return, how fees are calculated and more.

There are a few reasons why the industry has struggled to deliver this type of information:

  • Complexity of private funds
    There are key differences in reporting metrics between the various types of private funds. Performance metrics shown to an investor in a more liquid fund, such as a hedge fund, should be different than those reported for less liquid vehicles, such as private equity funds. Adding to the complexity, investments in alternatives can come in the form of limited partnerships, co-investments, and direct holdings.

  • Outdated technologies that effectively “trap” data
    Many of the widely used technologies for portfolio and investor-level accounting were created several years ago and because they lack APIs, they cannot integrate with each other or other systems. This effectively “traps” the data contained within these systems, thereby restricting the usefulness and portability of this critically important data.

    In turn, this has curtailed the ability to provide transparency to investors, as it restricts and/or prevents the necessary type of analysis, aggregation and modern presentation of data. A good example of this would be in the area of portfolio risk management, which was cited in the EIU study as the biggest driver for transparency by nearly three quarters of respondents. Providing perspective on fund exposure by geography, sector, and type along with benchmarking in a manner that is digital, interactive and actionable is critical to delivering the transparency.

  • Lack of leadership and reporting standardization
    There is a lack of uniform reporting standards within the alternative investment industry. Although an increase in regulation along with the presence of organizations like Institutional Limited Partners Association (ILPA) have helped advance standards in private equity, there is no current reporting standard across all types of private funds. Additionally, the party that should be responsible for delivering on transparency is unclear. As it stands today, responsibility for transparency can ping-pong between the fund manager and the fund administrator. Even within these organizations it is often unclear who is responsible for transparency; sometimes it sits with the investment committee, sometimes compliance/risk, sometimes operations.

Despite these hurdles, the alternative investment industry must evolve and adapt. I would argue there are two key steps the industry must take to be able to deliver on investor demands for transparency and keep new capital flowing into private funds:

a) Embrace new technology to move away from PDF-based reporting to truly digital reporting

As it stands today, much of the industry reports performance information via static documents/PDFs, but this method traps data and inhibits interaction. By embracing new technology, the industry can move toward the type of dynamic, digital presentation of data that is experienced in brokerage and personal banking accounts. Since much of the data needed to accomplish this is stored in accounting systems, industry stakeholders should seek out cloud-based technology offerings that can integrate with accounting systems and thereby liberate the data contained within for purposes of data mining, analysis and presentation. An alternative would be to find API-based portfolio and investor-level accounting systems that can also handle modern reporting, but there don’t seem to be many available.

b) See fund administrators take a stronger leadership role

Fund administrators are best positioned to deliver on transparency needs given their role as an independent 3rd party. They are typically subscribers of the accounting systems that house this data and therefore have access to or create much of the analysis & reporting that is needed to deliver on transparency demands. Fund administrators are also typically the party that provides investors with performance reporting in the form of documents like capital statements. Furthermore, regulatory requirements, which were listed in the EIU study as the second most important driver for transparency, are already an important area being serviced by fund administrators.

Helping their fund manager clients with transparency is good business for fund administrators, as it improves their overall quality of service to clients. Just last year, Preqin published a study showing that the “dissatisfaction with quality of service” was the primary driver in fund administrators getting fired by their clients. Fund administrators have already come under pressure to adopt new technology to improve their operations and service, so they are well-suited to utilize and benefit from technology that also helps deliver transparency.

Given their exposure and handling of funds across the alternative investment industry, fund administrators are best-equipped to help drive the standardization of reporting across the various types of private funds, as well.

All indications point to another banner year for alternative investments in 2018. The asset class has offered investors with impressive returns and coupled with general interest in diversification, this will likely result in continued capital inflows. Further evolution of the industry, such as the emergence of crypto funds, will add more fuel to the fire. 
That said, investor demand for transparency will only continue to grow as alternative assets become more commonplace. The industry must modernize and adapt in order to stay ahead of the curve in the race for assets.

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