Opportunistic hedge funds fill a void

VARIOUS degrees of upheaval and widespread deleveraging in the global financial system since 2008 have left no shortage of interesting opportunities for hedge fund managers who know where to look.

Banks and traditional middle-market lenders continue to roll back lending activity in response to deteriorating balance sheets and tightening regulatory restrictions. Traditional sources of capital have largely gone out of business or substantially reduced their activity.

Investors also continue to display a fragile confidence in markets, leading to volatile "risk-on, risk-off" periods and a strong preference for liquidity.

Changes in banking rules such as the Basel III capital standards and the required increase in US bank deposit insurance are making lenders conservative on their decisions to lend. Large European banks, for example, are expected to shrink their balance sheets by as much as two trillion euros through the end of 2013, or 7 per cent of total assets. A quarter of this reduction will probably come as a result of lending less and the rest from sales of securities and non-core assets.

Meanwhile, borrowers shut out by banks - particularly smaller businesses and firms in cyclical industries - are in need of alternative sources of capital.

Also, finding enough buyers for large-scale sales of complex structured securities is difficult, now that investment bank proprietary trading desks have been downsized. Origination and market-making activity by traditional lenders and prop desks has been greatly diminished in the post-crises world, creating a supply-demand imbalance.

Enter hedge funds. Some investment managers have opportunistically been able to bypass securitised asset markets and effectively taken on the role of a middle-market lender, providing capital directly to underserved businesses in a variety of industries.

Other hedge funds have managed to isolate potential value within a pool of illiquid assets and have used long and short positions to realise gains as liquidity conditions change.

Hedge funds involved in these types of directly-sourced investments have faced few competitors, especially for small deals where complexity is high, sourcing difficult and liquidity may be thin.

This has enabled smaller, highly specialised funds to target deals that have the potential to produce double-digit returns, often over two to three years.

Over the past two years, these kinds of highly specialised hedge fund strategies that capitalise on financial system dislocations have a relatively low beta of 0.12 against the S&P 500 Total Return Index.

These strategies may be especially attractive to institutional investors in Asia, who are becoming increasingly interested in custom and specialised hedge fund investments.

Asia's evolving use of hedge funds

Faced with persistently high correlations in traditional markets, Asian investors are more and more turning to hedge funds as an alternative source of return. In fact, over the past two years, investors in the Asia ex-Japan region have been cutting their allocations for fixed income and gradually increasing their exposure to alternative investments.

Special situation hedge fund strategies dealing in less liquid assets offer a unique way for Asian investors to enhance returns.

Access to these types of hedge funds can be tricky, though. Because of the challenges of directly investing in hedge funds focused on less liquid strategies, a multi-manager approach may be a more effective way for Asian investors to gain access to these opportunities.

As Asian investors develop their hedge fund investing capacity, their preferred way to access hedge funds in general has been evolving toward more customised approaches rather than a strictly one-size-fits-all solution.

Until only a few years ago, many institutional investors considering investments in hedge funds had neither direct contacts within the hedge fund manager community, nor much experience with low beta investments.

Funds of hedge funds had been a prime choice for less experienced and institutional investors who were less open to taking big risks to achieve diversified exposure to hedge fund strategies.

Investors have been developing more sophistication though, and looking for more chances to exercise greater control over manager selection, risk and return objectives.

However, for most Asian institutional investors, funds of hedge funds today still remain a core part of an increasingly tailored approach to alternative investments; 61 per cent of Asian investors use a co-mingled fund of funds in their hedge fund portfolios, and nearly 90 per cent of Asia-Pacific pension funds use either a blend of funds of funds and direct investing, or just funds of funds.

Funds of hedge funds have the advantages of being able to give investors diverse exposure to investment strategies and - depending on the platform - connection to professional networks that can grant investors access to successful funds that may be technically closed to outside investors.

A fund of hedge funds solely focused on niche opportunities arising from deleveraging activity will have to provide investors with a firm sense of oversight and clarity about the positions that hedge fund managers have taken in their portfolio and their liquidity risks. In other words, risk management needs to be robust.

In conclusion, a multi-manager approach focused squarely on these unique strategies and backed by a robust institutional structure may be a way for Asian investors to gain access to investments with attractive liquidity premiums and achieve much greater diversity in their traditional and alternative portfolios.

Joseph Pacini is the managing director and head of BlackRock's Alternative Investment Strategy Group in the Asia-Pacific. Alasdair Riach is managing director and country manager for Singapore