One of the long standing themes of this blog has been to examine the changing role of so-called “alternative investments” on the capital markets. Hedge funds, private equity and venture capital have over the past decade grown from niche industries to the primary market movers. In retrospect this should not be an altogether surprising development.
The 1980s and 1990s were an exceptionally fat period for both the equity and fixed income markets. The bursting of the Internet bubble and the normalization of unexpected inflation had taken the winds out of the easy money trades. Institutional investors were forced to look elsewhere for sources of “alpha.”
This point was driven home in a piece by David Wessel in the Wall Street Journal. In it he discusses the fate of a pension fund bill in Congress. A combination of factors, including lower returns, have put the whole ideas of defined benefit funds into question.
But if Congress makes offering defined-benefit pension plans too onerous, companies will abandon them. Many have already. Only one in five private-sector workers is covered by a defined-benefit pension, the sort that pays a set sum each month. That fraction is shrinking.
The bottom line is that is has become increasingly clear to company management that these types of plans that guarantee a stream of benefits is simply too onerous to maintain. While the bill Wessel cites may may clear up some regulatory issues it is unlikely to markedly affect this trend.
One reason why seemingly every institutional investor wants to get into private equity and hedge funds is that venture capital returns have become increasingly scarce. Rebecca Buckman also in the Wall Street Journal reports on the difficult environment that is venture capital. The article is noteworthy in a couple of ways. First Buckman documents the increased competition for deals and the commensurate decrease in returns to many venture capital firms. Second, it is also clear that only a small percentage of the venture firms and their elite investors really profit from the industry as a whole. While many venture firms are adapting to this more difficult environment these adaptations are not at all obvious or easy to implement.
Since we have writing extensively on private equity, let us not neglect the world of hedge funds. Susanne Craig in in the Wall Street Journal (a trifecta!) examines the consequences for investment banks and their advocacy of investments in the funds of their hedge fund clients. While brokers are not allowed to directly market interests in hedge funds there is a murky middle ground where less than scrupulous individuals can cause headaches for their firms.
Prime brokerage has become an important profit center for all of Wall Street. DealBook reports on a new “hedge fund services platform” from Citibank (C). While the specifics are not all that important it does underline the fact the importance of the hedge fund clientele to investment banks and the need to continually upgrade your menu of services. Hedge funds are now a primary revenue generator for these firms and they would be derelict in not trying to capture some of that revenue flow.
The bottom line is that this insatiable desire for alpha has consequences. There is only so much in the way of excess returns, in theory, to go around. As these industries grow they necessarily attract new entrants. This does two things, first the proliferation of alternative investment vehicles necessarily dilutes the potential gains. Second, high profitability attracts a wave of investors who may not have the moral scruples of the pioneers. In addition it may also tempt established firms to “push the envelope” in a rush to capture some of these high profile profits.
In each of these fields the most accomplished firms who have demonstrated an ability to generate gains and keep their fickle investors happy will continue to get bigger and more influential. While individual investors cannot, in most cases, directly profit from alternative investments it is important to stay up-to-date on the progress of these industries, just in case.