Investors rank transparency and risk management as highly as returns in their decisions to retain alternative asset managers, says PwC survey

SINGAPORE, 25 March 2008 – Transparency and risk management are considered by investors to be just as important as performance in deciding whether to retain their managers of alternative investments, according to a major new report by PricewaterhouseCoopers (PwC). This finding verifies industry belief that when returns start to moderate, investors focus more intently on operational infrastructure. Indeed, the survey, entitled ‘Transparency versus returns: the institutional investor view of alternative assets’, reveals that operational infrastructure is a key ingredient and not just an element in keeping alternatives in their portfolios in a subdued environment.

A global survey of 226 institutional investors and alternative investment providers, conducted by the Economist Intelligence Unit on behalf of PwC, found that flattening returns have contributed to investor pressure for more and better governance. The quality of compliance and risk management process (41% of investors) and transparency (41% of investors) were rated higher than performance (40% of investors) among the criteria for deselecting investment providers.

Despite this, investors have been slow to adapt risk assessment processes, according to the survey. More than half (53%) say that they have made no change to their risk management policies despite an increased allocation to alternatives.

“As alternative investments become more deeply embedded in the mainstream asset class mix, there are growing calls for their providers to step up their levels of transparency, disclosure and risk management,” says Justin Ong, Leader of Wealth Management Practice at PwC Singapore. “Investors have tolerated weak governance and risk management in the past few years as returns have been good and the sector has been evolving. Now that returns are moderating and the sector has matured somewhat, the investors are going to be more exacting.”

The study, which covers hedge funds, private equity, real estate and infrastructure funds, also reveals a gap in perceptions between investors and providers. Investment firms largely believe they are good at managing risk. They rate themselves ‘effective’ in the accounting and reporting of transactions (67%) and policies to protect against fraud (65%). Investors largely disagree. For instance, just 18% of hedge fund investors think valuation policies are effective and only 16% think IT security is good.

“While the alternatives industry has grown at an astonishing rate, the development of the infrastructure that supports it does not appear to have kept pace, and the channels of communication between providers and investors are not always as open and effective as they could be. When returns start to flatten, as they have in many asset classes, investors are going to focus more on operational infrastructure. Providers need to do more to reassure and communicate with their clients. In addition, clients would do well to engage better with investment firms and to ask the appropriate questions,” says Mr Ong.

Although many alternative investment providers are suffering from the effects of the global credit crunch, the report predicts the industry will enjoy rapid growth over the next three years. Among investors, 41% expect to increase their allocation to real estate, 40% to private equity, 35% to commodities and 33% to hedge funds. Very few plan a smaller allocation to any of these sectors.

‘’Post credit crunch, it is reasonable to assume that investors will be looking for a much greater focus on governance, while levels of disclosure of processes and procedures will also accelerate. In a relatively young industry, it might be expected that participants will not have worked through all the difficulties implied by a whole new set of business relationships. It is therefore crucial for them to put outstanding systems and processes in place, so that they will be better placed to convince regulators and investors alike of their credibility in the longer run,” concludes Mr Ong.

• Hedge funds have come under particular pressure as returns have fallen. Less than half of respondents are satisfied with the performance of hedge funds (46%). Private equity and real estate fare better at 67% and 57% respectively.
• North American alternative investment firms are rated higher by investors for the quality of their governance, risk management reporting and levels of transparency. Asian firms are generally adequate in their breadth of reporting. European firms are found wanting in some areas.
• Many investors would like to see more guidelines and regulation. Nearly half of all hedge fund industry participants would support guidelines on reporting to investors and 41% would support formal disclosure to regulatory bodies.
• There is also a push for greater oversight of the private equity industry. This is particularly evident in Asia, where 55% of investors would like to see guidelines on reporting and 48% want formal disclosures to regulatory bodies. This clear desire for a strong framework is suggestive of an emerging regional industry seeking a fast-track route to global recognition.
• The more mature economies are least in favour of regulatory moves, with 43% of US private equity participants supporting guidelines on reporting and just 35% in Europe.

• The EIU and PricewaterhouseCoopers conducted a special online survey of senior executives from institutional investors and alternative investment providers. Over 220 executives from the Americas, Asia and Europe participated in the survey, which was conducted between December 2007 and January 2008.
• The EIU held 30 one-to-one interviews with senior executives from institutional investors and alternative investment providers in the Americas, Asia and Europe.