institutions reacting to poor hedge fund/private equity returns

A couple of days ago, the Dealbook section of the New York Times reported on a recent meeting of the Institutional Investors Roundtable in western Canada.

The purpose of the organization, founded in 2011, is to help large government-linked investment bodies, like sovereign wealth funds and managers of government employee pension plans, cooperate to solve common problems.

According to the NYT, the agenda of the latest meeting was hedge fund and private equity investments.  Although the proceedings are secret, it doesn’t take a genius to figure out what went on.

The institutions’ dilemma:  on the one hand, they want and need the diversification and the high-return investment opportunities that hedge funds and private equity promise.   On the other, despite their colorful brochures and persuasive presentations, many hedge fund/private equity ventures produce pretty awful returns.

There are two main reasons for this:

–some hedge fund/private equity operators are brilliant marketers and well-connected politically, but that’s it.  They’re not great investors.  It doesn’t help matters that academic research shows a significant number of them bend the truth in stating their qualifications, track records, assets under management…

–the hedge fund/private equity fees are so high that there’s little extra return left over for the institutions who supply the investment capital.

The IIR solution?

It’s to try to develop hedge fund/private equity projects among the members themselves, thereby cutting out the fees charged by third parties.  One institution cited in the NYT article says doing so adds 5 percentage points to the annual returns it received from such projects.  On a world where bonds yield next to nothing and where stocks may produce 6%-8% annual returns, a 5 percentage point pickup is enormous.

This movement is in its infancy.  Not every institution will be able to participate, either because of political pressure at home or lack of even minimal expertise.  But even that may change in time.

The most important thing to notice, I think, is the evolution away from traditional Wall Street practices that make the financiers–and no one else–rich.  I think that sovereign wealth funds, bot from China and the Middle East, will take leading roles in this development.