Alternative Funds 2024

A Global Overview of Alternative Funds

Alternative investments diversify portfolios and can generate returns less correlated with standard measures of market performance, which is increasingly important in the current environment – one defined by rapid change and increased risk. While global markets enjoyed a strong start to 2024, change is occurring at an unprecedented velocity. Although 2024 has seen good results for alternative fund investments on the whole, flows into alternatives slowed as exits from private markets continued to lag. Perhaps 2025 is the year that will see increased deal flow resulting from the “dry powder” that has been stored up across the alternative funds industry.

Family offices and sovereign wealth funds are increasingly active both as direct investors and through joint ventures, co-investments and general partner (GP) stakes investors working with alternative fund managers. Meanwhile, technology is advancing with rapid developments in artificial intelligence (AI), cybersecurity, sustainability and other areas. Regulators around the world are striving to stay ahead of these trends, through both the development of new regulation and the pursuit of enforcement matters. These trends have spurred sponsors and investors in alternative investments to be nimbler and more creative, but also more resilient, and they require (i) an increased focus on a strong compliance culture (ii) careful attention to tax and legal structuring and (iii) clear communication and transparency with investors and regulators.

Global economic and political context

September 2024 saw interest rate cuts from key central banks, including the European Central Bank, the US Federal Reserve Bank and the People’s Bank of China. While many economies remain fragile and interest rate cuts do not guarantee a soft landing for the globe’s economies in which inflation is held in check without significant deterioration in labour markets, lower interest rates tend to spur deal flow. Reductions in interest rates represent a welcome reversal of the trend of higher costs of capital/financing in recent years.

The geopolitical environment includes war in Ukraine and fighting in the Middle East, with questions about the continued engagement of the United States and the influence of China. Almost half the world’s population is participating (or has already participated) in general elections in 2024, including Taiwan, Indonesia, India, Mexico, the European Parliament, the United Kingdom, France, Rwanda, Venezuela, Austria and the United States. The political landscape will continue to shift, with economic hardship being the focus of many voters and immigration a political hot button.

Finally, regulation continues to increase at an unprecedented pace, with enforcement poised to back it up and, in some cases, to lead the way. The US Securities and Exchange Commission (SEC) was dealt a significant setback when the Fifth Circuit Court of Appeals ruled in favour of a coalition of industry groups that was challenging rules that could have reshaped the private funds industry even beyond US borders. Litigation challenging other recent SEC rule-making is still in process. Global regulators continue to focus on non-bank financial institutions, crypto-assets and the emerging area of AI, while environmental, social and governance (ESG) investing factors remain a more prominent consideration in Europe and a political battleground in the USA. Financial markets need stable and predictable regulations and a legal framework that is consistently and fairly enforced and that has become increasingly harder to find in the current environment.

The bright spot of credit

For over a decade alternative investments have filled gaps as banks retreated following the 2007–2008 financial crisis. Credit funds, particularly those engaged in direct lending, have been growing in size and stature. As a result, regulators are increasing focus on “non-bank financial institutions”, which could significantly curtail investment activity and limit access to financing.

A key trend in the credit funds space remains the hybrid or evergreen structure, which is a deliberate structuring to match the liquidity of the fund with the liquidity of the portfolio assets. Increasingly, the goal is to allow deployment of capital into a single fund rather than multiple vintages, even if redemptions are met under a “slow pay” or “liquidating account” structure, or are subject to gates. In the USA, fund structures may include those electing to be treated as “business development companies” under the Investment Company Act of 1940, and in the case of mortgages and other real-estate related debt, non-traded real estate investment trusts.

These products offer favourable tax treatment to many (often with treaty-based advantages from organising in Luxembourg, Ireland or (using the UK’s relatively new qualifying asset holding company) the UK). Alterative fund managers would be well-advised to stay abreast of developments in global finance as they chase both investors and investment opportunities.

Fund and fee/expense structures

One overall positive trend in the current environment is the increasing creativity employed both when establishing investment strategies and when structuring funds. In private equity, managers are looking at how to add value to existing portfolio companies, add-on deals, continuation fund and secondary transactions. They are considering credit opportunities, and looking at the infrastructure, energy, healthcare and life sciences sectors. Infrastructure transition, including energy transition and decarbonisation, is a fundamental restructuring that is happening quickly but amidst a variety of challenges and policy issues, although the transformation appears to be generating significant opportunities for alternative investment managers who can adapt and adjust to a changing world.

On the structuring side, nimble managers are seeking co-investments, offering tailored fees and services (including separate account management), and considering evergreen models and even retail products. Fees and expenses are an area of focus, both as investors seek to target better net returns in tough markets and as regulators focus on transparency.

Given increasing costs, expenses are more likely to be passed through (including manager costs such as internal legal and accounting, and the use of affiliated service providers) but there is significant regulatory focus on clear authorisation, proper calculation and transparent reporting. The multi-strategy “pass-through” model has produced some of the strongest returns in recent years, with the pass-through model offering both the opportunity to compete for talented investment teams and the ability to develop or acquire and deploy innovative technologies that can enhance investment and operations.

Co-investments

Co-investment opportunities remain a popular strategy to attract investors and lower investors’ overall costs. Managers in this context must be attentive to appropriate tax and legal structures and whether to create a vehicle and/or run a formal programme, as well as to disclosure of conflicts of interest both to the co-investors and the main fund investors, which requires anticipation of issues when raising a closed-end fund. Navigating co-investment opportunities requires clear communication, transparency, and a thorough understanding of the legal and regulatory implications to manage relationships with investors successfully and avoid regulatory issues.

“Retailisation”/democratisation

High net worth investors present an opportunity for alternative fund managers facing challenges in institutional fundraising, particularly as the economy has not been kind to traditional 60/40 stock/bond portfolios. The widely held view is that financial advisers to wealthy individuals have offered portfolios that are significantly underweight in alternatives, suggesting that there may be a large appetite for additional products in this constituency – through both new products and distribution.

Distribution opportunities arise when platforms offer as a placement agent or through access funds operating as feeders. The existing fund is offered through a disintermediated channel with less control over the sales and investor communication process. Alternatively, managers create new products, such as registered interval funds, business development companies or European long-term investment funds (ELTIF) that may not be subject to the same regulatory regime as retail products, but are more regulated than alternative funds. Manager must consider the relative benefits, costs and risks of these differing approaches. Regulators are also considering these issues, and we can expect additional regulatory focus through new requirements, enforcement action or both.

Artificial intelligence, alternative data and technology

AI and alternative data are areas in which managers need to keep a watchful eye on compliance and regulation. In some cases, AI or alternative data are inherent to an investment strategy and in other cases they are part of a research or trading process. A key issue is understanding the capabilities and weaknesses of the technology being used, and ensuring that the manager is nevertheless fulfilling its duties and responsibilities to clients. Managers are increasingly transparent about both the benefits and risks of the use of new technology as part of their investing process or operations, and should be mindful that digital transformation, technological advancements, and cybersecurity all create risks that require legal and compliance diligence.

ESG considerations

Europe remains ahead of Asia, Latin America, the Middle East and the United States in pursing ESG principles and in related regulation. In the USA the issue has become highly politicised with the pension and other investment funds in some states mandating an ESG focus and others prohibiting consideration of ESG factors. Managers continue to struggle with the accessibility and reliability of ESG-related data, and key themes include ensuring a manager is doing what it has said it would do from an ESG perspective. Here too, regulators in the United States and Europe have pursued enforcement and litigation claims.

Regulation and compliance

As the markets and technology are accelerating, so too is the regulatory environment. In the United States, even though recent SEC rule-making (some of which has been rejected by the courts) has been a focus, the SEC and other regulators are also seeking to enforce principles through litigation and enforcement actions, even in the absence of regulation. But there are numerous issues beyond the regulation of managers and funds, including:

• review of merger transactions by the US Federal Trade Commission (FTC) and the US Department of Justice (DOJ) as well as non-US antitrust agencies;
• increasingly stringent anti-money laundering and know your customer requirements;
• the US Corporate Transparency Act of 2024, which requires certain entities to file beneficial ownership information with the Financial Crimes Enforcement Network;
• the Committee on Foreign Investment in the United States (CFIUS) and foreign direct investment requirements; and
• amended beneficial ownership reporting under Sections 13(d) and 13(g) of the US Securities Exchange Act of 1934, as amended.

Furthermore, numerous other global regulations that are pending or recently adopted are increasing the regulatory and compliance obligations for alternative investment funds and their managers.

Where to organise/operate?

In this environment, selection of a jurisdiction in which to organise and operate a manager and its funds is increasingly important. This Practice Guide is designed to give an overview of various jurisdictions and provide a broad overview of key considerations. At the highest level, a prospective fund manager will want to consider both the investment strategy and expected jurisdiction of portfolio investments, and the location and type of prospective investors. Certain strategies, such as private credit, entail significant tax considerations, and careful planning is essential. Increasingly, the regulatory regimes in which a manger and its funds operate and invest generate compliance costs and restrictions requiring detailed legal analysis. Carefully tailoring jurisdictional choices to the needs of the business and investors, rather than relying exclusively on past practice or trends, is essential to building a successful alternative investments business.

GP stakes and other transactions or partnerships

This environment has proven rewarding for larger and more established managers (and well credentialed new managers/spin-outs). Accordingly, the industry is seeing more consolidations and acquisitions of managers, with banks and other traditional asset managers acquiring teams and capabilities including on a cross-border basis. There is also increased activity in the global “GP stakes” markets where managers can sell a portion of the firm and general partner (hence the term “GP Stakes”) and raise additional capital for new initiatives, secure anchor investments for their funds/strategies or facilitate a generational transition of the firm. In some cases, a GP Stakes or other third-party investor can also provide strategic guidance or access to new channels for distribution or investing. Strategic partnerships are emerging as a new strategy to couple alternative investing strategies with retail or high net worth distribution capabilities, and more traditional portfolios. These transactions require careful structuring and negotiation but can offer opportunities for alternative fund managers seeking to plan for the future in an increasingly competitive and fast-moving environment.