2018 was a tale of two halves for alternative funds. In private equity (PE), the first half of the year was defined by tepid fundraising in the US and Europe with firms raising fewer funds and less capital overall than in 2017. But Q3 reversed course: PE fundraising picked up with a total of $1211 including several record closings from large, global managers. PE growth in the second half of the year may also be indicative of the wider and growing interest in illiquid funds in general, such as private debt and real assets. Hedge funds, however, did not fare as well: assets under management plummeted by $88 billion in 2018, the deepest decline in assets in several years.2 So, what does 2019 have in store for alternatives? Here are five themes to follow this year:

1.    Trading Liquidity for Returns
The growth of private equity in recent years has been driven, in part, by outsized fundraising among many of the largest global fund managers – KKR, Ares, and Carlyle, for instance, raised funds in the $30 billion range in 2018.3  The industry also got a boost from several large asset managers, many of which raised their first PE funds in 2018 or increased commitments to illiquid alternatives. Consider Japan Post, which in March 2018 raised a $1.1 billion fund (the firm’s first proprietary PE vehicle) to pursue buyout opportunities in Japan alongside KKR, Blackstone, and Permira. Insurers are also ramping up on illiquid alternatives. Aflac, the US insurance company, recently increased the PE allocation in its general account and doubled down on its affiliated venture fund, moving from $100 million to $250 million over three years.

The recent interest by asset managers in PE (and other illiquid alternatives) underscores a shift within the asset management com­munity. By increasing investments to illiq­uid alternatives, asset managers are favoring returns over short-term liquidity. We expect this theme to continue to play out this year, especially if volatility becomes the new norm. With fund lockup periods for illiquid strategies typically in the 7- to 10- year range, it appears some asset managers are intent on playing the long game and using illiquids as a way to either wait out market fluctuations or capital­ize on distressed valuations.

2.    Globalization in Reverse

Global alternative shops have deployed capital to nearly every corner of the world. In the long term, we expect the global growth of alternative asset managers to continue, but the short-term horizon looks a little cloudier.

Brexit and other protectionist behavior on the world stage is likely to slow down harmonization efforts of US and European regulations and may prompt asset managers to take a more regional view of their short- to medium-term prospects.

The uncertainty around Brexit and tightening substance rules in various countries has caused asset managers to reevaluate location strategy for people and fund domiciles, trending towards Luxembourg, Dublin, and other European cities for European demand, and Singapore and Hong Kong for Asia demand (in addition to the mainstay of Cayman domiciled funds).

National private placement regimes vary across countries and continents, as do tax codes, regulatory, and investor disclosure requirements, and requirements on marketing funds. For large managers, it is becoming increasingly common to launch multiple funds for a single strategy in different domiciles such as US, Cayman Islands, Ireland, Luxembourg, and Hong Kong to sate the appetite of their global investor base.

3.    AI, Data Analytics, and the Digitization of Alternatives

Asset managers, banks, and other financial institutions are now using AI, software-based automation, and digital solutions to stream­line operations, manage assets, and bolster cyber security efforts. But it is alternative as­set managers — especially hedge funds — that have been at the forefront of these tech­nologies as they seek to boost investment returns and gain competitive advantages. This includes areas such as next-gen trad­ing systems and tools, algorithmic trading, research, data analytics, risk management, and accounting. AI and automation may also be a powerful pull to hedge fund investors, many of whom are buying into the idea that sophisticated technology, when used cor­rectly, can help deliver alpha.

Many large alternative asset managers are using big data to source investments, streamline analysis, value deals, and stress test potential opportunities. We expect the use of data science to increase in the com­ing years. AI seems to have less obvious applications for illiquid strategies that rely on people networks to find deals. However, digital platforms which match investors to investments are on the rise. Examples of these include: co-investment platforms offering due diligence and data analysis, high net worth investors and family office digital networks, direct lending platforms, or platforms which allow smaller investors to access funds with high minimum investment thresholds.

In the back and middle office, AI, digitization, and software-based automation have created powerful efficiencies. Many are accelerat­ing investment in digital technology for NAV production, reconciliation, tax reporting, and data synchronization. Machine learning — the use of algorithms to identify patterns in structured and unstructured data — also has huge potential in the back and middle office, particularly in the areas of fund valuation con­trol and daily position processing.

4.    SMAs Gain Favor

Separately managed accounts (SMAs) are hardly new, but the balance of power has shifted such that institutional investors are increasingly requesting to invest in alterna­tives via SMAs instead of traditional funds. Why the recent shift? It boils down to effi­ciency and flexibility. By investing through an SMA, institutional investors can deploy capital quickly — no need to wait for an al­ternative manager to raise a fund. In a private equity or real estate fund, the lifecycle of a fund usually spans a decade. That can place limitations on long-term institutional inves­tors, who may want the flexibility to either sit on an investment longer (thus allowing a cash generative portfolio company to com­pound) or exit earlier. Further, by going the SMA route, institutional investors can create bespoke strategies by fine-tuning risk expo­sure to certain asset classes, currencies, or cash flow patterns. SMA fees are also typi­cally based on NAV of invested capital rather than notional committed capital, which can mean serious cost savings. Sounds like a win for institutional investors, but what about fund houses?

For managers, SMAs may introduce a new level of operational complexity. From an ad­ministrative standpoint, SMAs are not near­ly as scalable as a traditional fund structure, where the terms of each Limited Partner (LP) are identical to the next. The cost structure can also weigh heavily on margins, so SMAs normally need to be of a certain size to be viable, but can be quicker to market com­pared to a fund structure. We expect interest in SMAs to grow among alternative manag­ers and asset owners.

5.  All Eyes on Asia

Private investments in Asia was at near re­cord levels in 2018 with $92 billion in deals.4  The growth appears to be two-fold: Global alternative managers that were investing into Asia via satellite positions in their global funds are now setting up Asia-specific funds sole­ly dedicated to sourcing Asian investments. They are doing so on a massive scale: both Blackrock and Bain Capital raised their larg­est ever Asia-focused private equity funds in 2018. Carlyle Group closed a $6.55 billion Asia fund in 2018, up more than 65% from its previous Asia-focused fund. This all rep­resents a firm commitment to a region that seems poised for serious growth. From an in­vesting standpoint, China’s rapid urbanization and emerging middle class are expected to drive demand for infrastructure, real estate, transport, and utilities projects over the next 20 years — a perfect feeding ground for PE and infrastructure capital deployment.

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1Preqin; Q3 PE Fundraising, 2018
2 eVestment
3 FundFire, For Carlyle, KKR, and Ares, $30B is the New $20B, November 7, 2018
4 Morningstar