Alternative Investments 2020

Regulatory Reform and

Alternative Investments

October 2015
 World Economic Forum
2015 – All rights reserved.

No part of this publication may be reproduced or transmitted in any form or by any means,
including photocopying and recording, or by any information storage and retrieval system.

B Alternative Investments 2020: Regulatory Reform and Alternative Investments

Contents Executive summary

Executive summary The alternative investment industry, which now manages trillions of dollars, plays an
Introduction and scope increasingly critical role in society. It supports global capital markets, steers money
towards attractive long-term and high-risk investments, promotes innovation, and
4 1. Overview of regulatory changes
improves how companies are governed and run.
7 1.1. Overview of bank and market regulations
8 1.1.1. Bank capital and leverage
requirements Institutional and retail capital providers have increased their allocations to alternatives
8 1.1.2. Bank liquidity and collateral in the post-crisis years, whilst the industry has deepened its engagement with the
requirements wider financial sector in areas such as:
9 1.1.3. Over the counter derivatives
9 1.1.4. Money market funds — the provision of debt capital (e.g. leverage for private equity buyout deals)
9 1.1.5. Financial trading tax
9 1.1.6. Transparency — the supply of market counterparties (e.g. for hedge funds executing
9 1.1.7. Incentive within banks trading strategies)
10 1.2. Overview of investment regulations — essential services such as prime brokerage, record-keeping and M&A skills
11 1.2.1. Transparency and reporting
(e.g. for venture capitalists looking to exit a deal)
11 1.2.2. Institutional governance
11 1.2.3. Risk reduction
11 1.2.4. Consumer protection The complex set of relationships and dependencies within the financial sector
mean that alternatives are impacted by regulations targeting both traditional
13 2. Impact of regulations financial institutions and alternative investment managers. Intended and unintended
14 2.1. Impact on the financial economy consequences for the industry, its beneficiaries, and society are the result.
14 2.1.1. Market liquidity
15 2.1.2. Innovation
For example, increased capital and liquidity requirements for banks and insurance
16 2.2. Impact on the investment system companies have made it more expensive for them to hold risky assets on their
16 2.2.1. Innovation
16 2.2.2. Operational cost
books. As a result, alternative investors focused on infrastructure assets are finding
17 2.2.3. Barriers to entry that banks have a lower appetite for lending to such projects. Similar reasons have
18 2.2.4. Access to capital led banks to reduce their lending to small- and medium-sized enterprises (SMEs),
19 2.2.5 Returns a critical source of jobs. The result has been a growing number of alternative
20 3. Implications and recommendations
investment firms that raise private debt funds to supply SMEs with capital.
21 3.1. Implications for alternative investment
firms (GPs) New bank capital and collateralization rules mean that it is more complex and
22 3.2. Implications for investors in expensive for banks to provide hedge funds with short-term financing. Together
alternatives (LPs) with reforms intended to shift over-the-counter (OTC) derivative trading onto
22 3.3. Implications for the public exchanges and impose additional reporting requirements in pursuit of greater
23 3.4. Recommendations for policymakers market transparency, this has made certain hedge fund strategies much less
and regulators tenable. Proposed market reforms such as the financial transaction tax (FTT) in
24 Conclusion Europe and a number of other reforms that impact market liquidity have the
25 Appendix potential to adversely affect alternative investment strategies.
36 Acknowledgements
37 Endnotes Regulators have also seized the moment to reshape and strengthen the laws that
directly govern the investment industry, including alternatives, in two important ways.

First, regulators have sought to improve the internal infrastructure and governance
of investment managers, with increased institutional transparency being one of the
primary objectives. New laws in the US and Europe require firms to report critical
financial information, upgrade their operational and governance structures, use
independent custodians for managing their assets, and maintain separate risk and
valuation functions.

Second, regulators have sought to strengthen investor protections and increase

product level transparency – concerning both risks and fees – for unsophisticated
retail investors. These changes are important because the amount of capital flowing
to alternatives from retail investors is predicted to grow sharply over the next decade.
The new reforms are affecting many aspects of the alternative investment ecosystem.

Alternative Investments 2020: Regulatory Reform and Alternative Investments 1

Executive summary

— Market liquidity: Overall market liquidity will fall as a result of — The broader economy and the public: The increased
the regulations, which will negatively affect many alternative transparency of the industry will improve the understanding
investment firms. However, in relative terms, they may be able of alternatives and support a reduction in fees, whilst a
to supply market liquidity, particularly during volatile periods. reallocation of talent away from the financial sector might
benefit the broader economy. However, increased
— Costs: New regulations are imposing significant new
transaction costs may offset some of the reduction in fees
operational, administrative, and transaction costs on
for LPs. In addition, SMEs and infrastructure may struggle
alternative investment firms. Many of these will ultimately
to raise capital if new alternative investment funds are unable
be passed on to institutional investors in the form of lower
to fill the gap left by banks.
effective returns.

— Innovation: Regulations will reduce the quality and quantity

The largest and most complex overhaul of financial regulations
of talent attracted to the traditional financial sector, with a since the 1930s has benefited society in many ways. It has also
resulting decline in innovative products and labour for the had a range of intended and unintended consequences for the
alternative investment industry to use or draw on. alternatives industry, its beneficiaries, and society overall. The
— Transparency: The industry will be less opaque, improving the importance of alternatives to the global economy means that
quality of decisions made by its capital providers and allowing policy makers may wish to explore these consequences further,
the public to better judge how it should engage with alternative and mitigate undesirable outcomes wherever possible.
investment firms.
This means improving awareness of the connections between the
— Barriers to entry: Cost and regulatory complexity will create alternatives industry and the wider financial industry, monitoring
new barriers to entry for small and start-up firms that do not changes that occur as a result of regulatory reforms, and
enjoy economies of scale in managing compliance expenses. refining reforms where they negatively impact areas such as
innovation, long-term investment, access to capital, or returns
— Access to capital: Insurance companies and banks, may be
to capital providers.
constrained in their ability to provide long-term capital to the
world economy. In addition, SMEs may struggle to access
capital from traditional channels, though alternative investors
are seeking to fill this gap.

— Returns: The new regulations have the potential to depress

the profits available to the industry, potentially negatively
affecting returns for its investors. However, the laws might
spark business model innovation which could counter-balance
this trend.

The effects will impact key stakeholders in different ways.

— Alternative investors (GPs): The new laws will increase the

cost structure for most GPs, but the industry will benefit in the
form of deeper relationships with LPs and potentially greater
understanding and trust by the public. The business models
employed by some hedge funds will be challenged, but the
laws are also creating new opportunities for alternatives to
expand, particularly within the private debt space.

— Investors in alternatives (LPs): Some traditionally active

LPs (insurance companies and banks) will find it increasingly
difficult to invest in alternatives, but most LPs will benefit from
reforms that enable them to make better investment decisions,
deepen their relationship with the industry, and reduce their
cost of investing in alternatives.

2 Alternative Investments 2020: Regulatory Reform and Alternative Investments

Introduction and scope

Over the past thirty years, the alternative investment industry

has grown to become an important part of the global financial 1. Overview: We review the new regulations that affect the
banking and investment industries. We explain why the
system and economy. The process of investing requires engaging regulations were introduced, what they hope to achieve,
with investment banks, insurance companies, wealth and asset and what aspects of the traditional and alternative
managers, rating agencies, exchanges, and custodians, and investment systems will be affected by the changes.
clearing houses. The outcome of the investments they make
affect the funding levels of pension funds, sovereign wealth funds,
endowments and foundations, and the millions of individuals on 2. Impact: We analyse how regulations have already
impacted the alternative investment ecosystem and how
behalf of whom these institutions invest. they may affect it in the future. We focus on changes
that affect topics such as liquidity, barriers to entry,
The industry proved resilient during the financial crisis and operational costs, transparency, innovation, and returns.
emerged stronger than before, but the same cannot be said
for the traditional financial sector. Governments across the
world responded by overhauling regulations governing the 3. Implications and recommendations: We assess what
the changes mean for stakeholders such as alternative
global financial system. It is too soon to fully tell how effective investors, capital providers, and the public. We conclude
they will be or what unintended consequences they will have. with recommendations for policymakers on how
regulations could be refined in order to benefit society
The goal of this report is to provide readers in the regulatory and as whole.
policymaking communities and financial and investment industries
with a perspective on how the new financial regulations have This report assumes a familiarity with alternative investments,
affected alternative investors and its beneficiaries thus far and how they connect with the financial system, and their importance
how they may impact the industry going forward. The report is to society. However, for those more familiar with the traditional
broken into three parts. financial sector, we have included excerpts that cover these
aspects from another report in the Alternative Investments 2020
series, An Introduction to Alternative Investments. Readers
interested in an-depth overview of the industry are encouraged
to read the full report.

For the sake of clarity, we will use the nomenclature below to

describe key stakeholders:

Term Description

LPs (Limited partners) Asset owners that provide capital to alternative investment firms or divisions to invest
on asset owners’ behalf

GPs (General partners) Firms that deploy capital in companies or securities on behalf of LPs/capital providers
(such as private equity buyout or venture capital firms, or hedge funds)

Institutional investors A subset of LPs comprised of institutions that invest capital with GPs
(such as pension funds, endowments and foundations, and financial institutions)

Retail investors A subset of LPs comprised of individuals that invest capital with GPs
(such as high net worth or non-wealthy individuals or family offices)

Investors An inclusive term that includes both GPs (who invest in securities and companies)
and LPs (who may invest with GPs or directly in securities or companies)

Alternative Investments 2020: Regulatory Reform and Alternative Investments 3

Section 1

Overview of
regulatory changes

The US and Europe are nearing the

completion of the largest overhaul
of financial regulations since the
“
Banks are being incentivized
to hold lower-risk assets that
are more likely to hold their
Great Depression. The changes affect value during a crisis, thus
every aspect of finance (Figure 1) and “
preventing liquidity or solvency
collectively they seek to ensure a issues for the institution.
more stable global financial system.
This section provides an overview of
how the new laws directly (investment
regulations) and indirectly (bank
and market regulations) affect the
alternative investment ecosystem
(Figure 2).

4 Alternative Investments 2020: Regulatory Reform and Alternative Investments

 Overview of regulatory changes

Figure 1: Overview of financial reforms in the United States and Europe by area

Collateral requirements

Deposit and reporting

Liquidity requirement

Compensation limits
Brokerage fee limits
Proprietary trading /
private equity limits
Legislative region

Central clearing
Leverage limits

requirements
Trading tax
Regulatory reform

Dodd–Frank Wall Street Reform and

Consumer Protection Act, (Dodd-Frank)
§ 619 (12 U.S.C. § 1851) of the Dodd-Frank Act
(Volcker Rule)

Foreign Account Tax Compliance Act (FATCA)

Third Basel Accord/Capital Requirements

Directive (Basel III/CRD IV)
Undertakings For The Collective Investment
of Transferable Securities V (UCITS V)

Alternative Investment Fund Managers Directive (AIFMD)

Solvency II Directive (Solvency II)

Markets in Financial Instruments Directive II (MIFID II)

European Market Infrastructure Regulation (EMIR)

European Commission’s Liikanen proposals

(Liikanen proposals)

Financial Transaction Tax (FTT)

Packaged Retail Investment Products (PRIPS)

International Financial Reporting Standards (IFRS)

Retail Distribution Review (RDR)

Source: World Economic Forum Investors Industries Areas affected

Alternative Investments 2020: Regulatory Reform and Alternative Investments 5

Overview of regulatory changes

Figure 2: Implications of regulatory changes for different actors

High-net worth / Retail investors

Insurance companies
Legislative region

Asset managers

Venture capital
Pension funds

Private equity
Hedge funds
Banks
Regulatory reform

Dodd–Frank Wall Street Reform and

Consumer Protection Act, (Dodd-Frank)
§ 619 (12 U.S.C. § 1851) of the Dodd-Frank Act
(Volcker Rule)

Foreign Account Tax Compliance Act (FATCA)

Third Basel Accord/Capital Requirements

Directive (Basel III/CRD IV)
Undertakings For The Collective Investment
of Transferable Securities V (UCITS V)

Alternative Investment Fund Managers Directive (AIFMD)

European Commission’s Liikanen proposals

(Liikanen proposals)

Solvency II Directive (Solvency II)

Markets in Financial Instruments Directive II (MIFID II)

European Market Infrastructure Regulation (EMIR)

Financial Transaction Tax (FTT)

Packaged Retail Investment Products (PRIPS)

International Financial Reporting Standards (IFRS)

Retail Distribution Review (RDR)

Source: World Economic Forum Investors Industries Primary target Also affected

6 Alternative Investments 2020: Regulatory Reform and Alternative Investments

 Overview of regulatory changes

1.1. Overview of bank and market regulations

Bank and capital markets focused regulations

EU: European Market Infrastructure Regulation (EMIR)

The EMIR was established to govern the over the counter (OTC) derivatives market in the EU.
It introduced a series of new rules and reporting requirements for how bilaterally and centrally
cleared derivatives should operate.

EU: European Commission Financial Transaction Tax (FTT)

The FTT, which would apply to 11 nations within the EU, is still being negotiated.
The proposed legislation would institute a tax on financial transactions, such as the
sale of stocks, bonds, or derivatives.

EU: European Commission’s Liikanen proposals (Liikanen proposals)

The Liikanen proposals focus on establishing regulations that determine the scope of activities
that the 29 largest banks in the EU can engage in. Similar to the Volcker Rule, if adopted, the
Liikanen proposals would restrict these banks from engaging in proprietary trading and prevent
them from owning internal investment arms.

EU: Third Basel Accord / Capital Requirements Directive IV (Basel III/CRD IV)

Basel III and the related implementing legislation, known as CRD IV in the EU, introduce a wide
range of updated standards for the global banking system. Areas of focus include new capital,
liquidity, leverage, collateral, and reporting requirements and new compensation guidelines.

Global: International Financial Reporting Standards (IFRS)

IFRS are the global accounting standards that determine how most companies and financial
transactions are reported. A number of standards, including those relating to collateral, were
updated following the financial crisis.

US: Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank)

According to US President Barack Obama, the Dodd-Frank Act, is a “sweeping overhaul

of the financial regulatory system…on a scale not seen since the reforms that followed the
Great Depression.”1 The legislation focuses on the traditional financial system and includes
regulations that govern capital markets, the banking system, and consumer finance and
investments in the US.

US: Volcker Rule (part of the Dodd-Frank Act)

The Volcker Rule, part of the Dodd-Frank Act, restricts the ability of banks to use client capital to
generate profits for the bank through investment or trading related activities. It also limits their
ability to own internal investment arms, which historically included private equity buyout, venture
capital, or hedge fund arms.

Alternative Investments 2020: Regulatory Reform and Alternative Investments 7

Overview of regulatory changes

1.1.1. Bank capital and leverage requirements Figure 3: Minimum risk weighted Tier 1 capital ratios2

Following the financial crisis, regulators have sought to increase Basel III + US capital ratios, % of assets
the amount of capital held by financial institutions, which reduces 15%
the risk of an institution failing during a future financial crisis. The
US (Dodd-Frank) and Europe (Basel III/CRD IV) accomplished 12% Basel III = 1-3.5%
US = 1-4.5%
this by increasing Tier 1 capital requirements. The concern that
large and interconnected institutions may be “too big to fail” also 9% 0-2.5%
led regulators to identify systemically important institutions and
impose additional capital requirements (Figure 3), with different 6% 2.5
G-SIB/SIFI buffer 1
levels determined by Basel III and the US Federal Reserve for Countercyclical buffer
each institution based on a range of risk factors. Regulators are 3%
4.5
Capital conservation buffer
(common equity)
also requiring banks in the US and Europe to adhere to leverage
0% Minimum Tier 1 capital
ratios (Figure 4). Unlike Tier 1 capital requirements, which use
risk-weighted assets as part of the formula for computing bank
Source: Basel Committee on Banking Supervision, US Federal Reserve Board
capital, leverage ratios are driven by simple asset volume and are
thus unaffected by banks’ internal risk models.

1.1.2. Bank liquidity and collateral requirements towards the liquidity requirements (Figure 5). The new rules are
stricter than before and reduce the credit given to structured
Banks are being incentivized to hold lower-risk assets that are
products, which played an important role in the recent crisis.
more likely to hold their value during a crisis, thus preventing
Similarly, the risk weightings applied to collateral have been
liquidity or solvency issues for the institution. In the US and
tightened, with regulators incentivizing banks to hold instruments
Europe banks are now required to maintain a 30-day supply of
that are considered to be both liquid and low risk (Figure 6).
cash and liquid securities. They must also adhere to updated
IFRS guidelines that define whether assets can be counted

Figure 4: Leverage ratio (unweighted Tier 1 bank capital required)

Leverage ratio – Unweighted Tier 1 bank capital, % of assets

US (subsidiaries of parents) 6%

United States 5%

United Kingdom 4%

European Union 3%

0% 1% 2% 3% 4% 5% 6% 7%

Source: World Economic Forum Investors Industries

Figure 5: Overview of how different kinds of assets count towards liquidity requirements
30-day supply of cash/liquid assets

Tier Tier 1 Tier 2a Tier 2b

Coverage Full credit Partial credit Lowest credit

Asset covered Cash and sovereign debt GSE securities1 Other assets

1 GSE = Government sponsored entity (e.g., Fannie Mae, Freddie Mac)

Source: World Economic Forum Investors Industries

8 Alternative Investments 2020: Regulatory Reform and Alternative Investments

 Overview of regulatory changes

Figure 6: Risk-adjusted weighting as a percentage revising rules for money market funds, with similar liquidity,
of different types of assets accounting, and transparency requirements – though there
Risk-adjusted weighting, % of asset value will likely be three different categories of money market funds,
with slightly different rules for each type.4
100%

80%
1.1.5. Financial trading tax
60%
Following the crisis, the EU’s European Commission (EC)
40% proposed a financial transaction tax, with three objectives. It
would harmonize indirect tax legislation, ensure that the financial
20% industry made a “fair and substantial contribution,” and “create
100

100

100

100
20

55

0 appropriate disincentives for certain transactions,” a reference to

9

0%
high-frequency trading firms.5 It would also generate an estimated
Traditional commercial loans
Residential mortgages

Structured products

(e.g., infrastructure)
Project finance
Cash

Average repo asset

sponsored entities
Government

Alternative investments

€30 billion 6 in taxes. The original scope of the proposal has been
narrowed due to legal concerns that it could not be applied to
transactions outside of the EU. In addition, the number of nations
within the EU that would be party to the proposed framework
has fallen to 11, with countries such as the UK, Sweden, the
Netherlands, and Denmark expressing their concerns that it
would prove detrimental to financial markets. The passage of
the 11 nation proposal may remain pending, but Germany has
Source: World Economic Forum Investors Industries
elected to move forward with related legislation that requires
high-frequency trading firms to register with and receive approval
1.1.3. Over the counter derivatives from the national regulator, BaFin in order to operate.7

Regulators have tried to reduce the risk associated with the

opaque and bespoke market of OTC derivatives. In the aftermath 1.1.6. Transparency
of AIG’s sudden and immense losses tied to derivatives contracts,
the US passed the Dodd-Frank Act and Europe introduced the Regulators are further trying to reduce systemic risks by increasing
EMIR. The new laws resulted in the standardization of many the level of transparency throughout the financial system. Laws
contracts, an increase in the number traded on third-party and such as Dodd-Frank in the US and Basel III and EMIR have
central exchanges, and extensive new reporting requirements. introduced a series of new reporting requirements that help
Derivatives must now be marked to market each day and firms regulators assess the stability of individual firms and the system
are required to post collateral that meets requirements similar to as a whole. In the US, efforts are led by the Federal Reserve and
those imposed on banks. The aim is to reduce counterparty risk the newly created Financial Stability Oversight Council, whilst the
and provide greater transparency into the market, preventing the European Banking Authority and the recently formed European
build-up of large and systemically important positions that are Systemic Risk Board engage in similar work. The introduction
unknown to regulators or the market. of bank stress tests in both the US and Europe, which resulted
in many institutions needing to raise additional capital, is one
example of how this new information is being used.
1.1.4. Money market funds
Money market funds are another area where regulators are 1.1.7. Incentives within banks
seeking to reduce systemic risk. During normal times these funds
represent a relatively anonymous, highly liquid, and critical source Governments in Europe have sought to address concerns
of short-term capital for the banking system and hedge funds, that bonuses based on short-term profits result in banks
which is typically accessed through repo agreements. However, taking excessive risks over the mid-term, underwritten by the
during a crisis, mark to market losses suffered by funds holding public purse. CRD IV introduced limits on the type and nature
illiquid assets can result in runs, and at worst a liquidity crisis in of compensation provided by banks, capping bonuses to no
the financial system. The US Securities and Exchange Commission more than 100% of the fixed salary or up to 200% if the majority
(SEC) adopted new rules aimed at improving the stability of the of the board approves. The United Kingdom remains opposed
system. They require institutional prime money market funds to to any such limits, but it appears that the compensation limits
use market based floating net asset values (government and retail will remain in the final language. No such limits exist in the US,
funds will be exempt from this rule), allow funds to impose liquidity making compensation one of the few areas of financial reform
fees and suspend redemptions during periods of market upheaval, where there is no broad agreement in principle between
and require funds to provide greater transparency to investors European and US approaches.
with regard to the assets held.3 Europe is also in the process of

Alternative Investments 2020: Regulatory Reform and Alternative Investments 9

Overview of regulatory changes

1.2. Overview of investment regulations

Investment focused regulations

EU: Alternative Investment Fund Managers Directive (AIFMD)

AIFMD introduces new reporting requirements for alternative investment firms that manage,
invest, or market funds in Europe must adhere to if they wish to operate in the EU.

EU: Markets in Financial Instruments Directive (MiFID II)

MiFID II is the newly revised regulatory framework that governs how financial intermediaries and
service providers manage, trade, and reports their handling of financial instruments on behalf of
clients in the EU.

EU: Packaged Retail Investment Products (PRIPs)

PRIPs sets the documentation standards for packaged investment products that asset or wealth
managers, banks, insurance companies, or other financial institutions must provide to retail
investors within the EU.

EU: Solvency II Directive (Solvency II)

Solvency II is the updated version of the regulations that govern the insurance industry in the EU.
A primary focus of the legislation concerns the capital requirements that companies must adhere to.

EU: Undertakings for Collective Investment in Transferable Securities V (UCITS V)

UCITS V is the latest update to the reporting and operating regulations that govern
how traditional investment funds are permitted to operate across the EU.

UK: Retail Distribution Review (RDR)

The RDR is a new law that establishes the guidelines for how investment advisors in the UK
can engage with retail investors and how they are allowed to be compensated for their services.

US: Foreign Account Tax Compliance Act (FATCA)

FATCA requires individuals and financial institutions across the world to report the assets held
by US persons (resident and non-resident) on an annual basis, with the objective of minimizing
offshore tax evasion.

US: Jumpstart Our Business Startups Act (JOBS)

The JOBS Act sets new and reduced regulatory requirements for companies in the
US seeking to raise capital, go public, or remain private.

10 Alternative Investments 2020: Regulatory Reform and Alternative Investments

 Overview of regulatory changes

1.2.1. Transparency and reporting generate short-term returns at the expense of long-term risks.
However, unlike the limits governing European banks or their asset
Regulators in the US and Europe are seeking to improve the
management arms, senior managers at stand-alone investment
transparency of the investment industry. Their intention is to
firms will not be subject to any hard caps on compensation.
protect consumers and prevent systemic risks from building
up in an opaque fashion. Historically, alternative investors have
not been subject to the same level of reporting requirements as
1.2.3. Risk reduction for institutional investors
traditional investment firms, but that changed with passage
of Dodd-Frank and FATCA in the US and AIFMD and EMIR in The near-collapse of AIG in 2008 during the global financial
Europe. The laws are broad in scope and affect most alternative crisis gave EU regulators the impetus to update laws governing
investors across the world. insurance companies into a single European-wide set of
regulations under Solvency II that aims to boost resilience of
Dodd-Frank requires all alternative investment firms operating in insurance companies. The law updates the absolute levels of
the US register with the SEC, providing detailed information on capital required and the risk weightings associated with each
how the firm is organized and operates and who invests with the type of asset, reducing the risk profile of insurers by incentivizing
firm.a However, unlike for listed companies, the SEC does not them to hold investments perceived to be liquid and low risk.
make information provided by alternative investors available to Sovereign debt will require far less capital than alternative
the public. FATCA is even broader in scope, requiring all GPs in investments such as private equity or hedge funds (Figure 7).
the world that manage money on behalf of US persons to track Similar requirements were proposed for pension funds, in the
and report the value of their investments to the US government. form of the Institutions for Occupational Retirement Provision
Outside the US, 42 other governments, including the EU and II (IORP II) directive, but they were ultimately not enacted in
the United Kingdom, are seeking to enact laws that mirror the response to concerns that such risk restrictions would prevent
standards listed in FATCA.8 pension funds from garnering the returns necessary to meet
their liabilities.
AIFMD requires that any fund seeking to invest or raise funds
from individuals or institutions based in Europe must be Figure 7: Amount of Solvency capital required (SCR)9
domiciled in the EU or in a country that has been approved Standalone capital requirements, %
by EU regulators to participate in the passport process. Funds 60%
must track and provide the EU with a wide range of critical
organizational and operational information. EMIR is much 50%

narrower in scope, primarily affecting hedge funds. The law 40%

requires that all over-the-counter derivative contracts are
30%
reported to regulators by both counterparties.
20%

10%
1.2.2. Institutional governance
49

49

49
39

0
0%
Private equity
OECD equity

Hedge funds
Sovereign debt

market equity
Emerging

Regulators in the US and Europe are pushing alternative

investment firms to upgrade their governance structures and
operating procedures. Dodd-Frank and AIFMD require them
to appoint a chief compliance officer, implement a compliance
program with formal policies and procedures, and conduct
Source: Allianz
regular risk assessments and stress tests. AIFMD also mandates
firms to use independent depositories when managing client
funds, which in turn have their own governance and record
1.2.4. Consumer protection
keeping requirements.
Historically, the alternative investment industry has not had
European regulators are instituting compensation limits for to concern itself with consumer protection laws. However,
stand-alone asset managers, in an effort to better align the consumers are increasingly seeking to invest in alternatives
interests of investors and traditional asset managers. AIFMD through mutual funds or related products, such as liquid
and UCITS V would delay receipt of 40-60% of any bonus for alternatives. This retailization trend, described in detail in a sister
three years, depending on the size of the bonus, and require report, Alternative Investments 2020: The Future of Alternative
50% of bonuses to be paid in units of the fund overseen by Investments, means that alternative investors need to monitor
the manager. The multi-year horizon reduces the incentive to the efforts of regulators to strengthen the laws governing
retail investors and investment products. The EU, UK and
a Operating in the US includes marketing to investors, maintaining staff in, or investing US have recently passed laws that will likely affect the
in the US; exemptions exist for venture capital firms, US based non-VC alternative
investment firms with less than $150 million in AUM, and foreign non-VC alternative alternative investment ecosystem.
investment firms with less than $25 million in AUM are exempt from registration.

Alternative Investments 2020: Regulatory Reform and Alternative Investments 11

Overview of regulatory changes

In the EU, the PRIPs reform introduces greater transparency

into the retail investment market. A critical component of the
proposal is the requirement that all packaged investment
products include a Key Information Document (KID). This is a
standardized non-technical document designed to allow retail
investors to easily compare investment costs, expected risks,
and performance data. An additional proposal covers the
provision of an online calculator, enabling retail investors to easily
compute, compare, and understand the fees charged for any
given investment product. The act does not directly apply to
alternative investment products, but the increased requirements
and heightened regulatory activity will be of note to the industry
as it expands into the retail space in the future.

Parts of the UK asset management industry are already being

reshaped as a result of the passage of the RDR, which requires
that investment firms unbundle fees and charge for their services
upfront. Historically, retail investors were not charged for receiving
investment services from a broker, but instead were charged fees
on the products they invested in. A share of these fees was then
refunded to the broker, which provided an economic incentive
to encourage clients to invest in the products that yielded
the highest rate of return for the broker. The misalignment in
incentives meant, for example, that brokers had little incentive
to offer low-cost ETFs relative to higher margin products.
The RDR increases transparency in the industry, helping retail
investors to compare products and firms and understand the
cost of investing in each. The RDR, like PRIPS, does not yet
have much impact on the alternative landscape, but it does
demonstrate a trend towards increased transparency that the
industry will need to consider in the future.

In the US, the impact of consumer protection laws is having a

more immediate effect on the alternative investment industry. The
JOBS Act removed restrictions that had prevented alternative
investment funds from advertising to the general public or the
accredited investors that are permitted to invest in such funds.
Simultaneously, the SEC opened an investigation into the rapidly
growing market for liquid alternatives and alternative mutual
funds.10 Many of the products and distribution channels that
alternative investors might use to access retail capital in the future
are covered by the investigation. Its conclusions may therefore
be of direct relevance to alternative investment firms’ strategies.

12 Alternative Investments 2020: Regulatory Reform and Alternative Investments

Section 2

Impact of
regulations

Having reviewed the intent of the

various financial reforms, we now
turn to assess their direct and indirect
“ New regulations have
resulted in banks
significantly reducing
impact on the alternative investment the amount of liquidity
ecosystem. First, we will focus on how “that they provide to
the reforms affect the broader financial the market.
system and its interface with alternative
investors. Second, we will review
how the reforms directly affect the
alternative investment ecosystem.

Alternative Investments 2020: Regulatory Reform and Alternative Investments 13

Impact of regulations

2.1. Impact on the financial system The fall in liquidity is due to several reasons. First, the Volcker Rule
forced banks in the US (and potentially Europe, if the Liikanen
proposals are adopted) to disband their proprietary trading units.
2.1.1. Market liquidity Second, Basel III and Dodd-Frank made it notably less profitable to
Many alternative investors rely on liquid markets to operate. For hold many types of assets on their books. Third, banks reduced
example, hedge funds are an important user and provider of the risk of not having enough Tier 1 capital during future crises by
liquidity for a wide range of assets, whilst many different types of reclassifying assets as “held to maturity”, instead of as “available
private equity and venture capital firms rely on capital markets to for sale” (Figure 10). The former cannot be easily traded, whilst the
fund their acquisitions or provide exit opportunities when they sell. latter need to be marked to market and thus increase the risk of
Yet recent regulations had the effect of reducing market liquidity creating capital shortfalls during turbulent periods.
in several areas.
Recognizing the underlying market need and the opportunity that
it presents, hedge funds have responded by establishing liquidity
2.1.1.1. Impact of capital requirements on provision platforms. Citadel, a large hedge fund, has built a platform
of liquidity by banks capable of serving as a market maker for many securities. It now
New regulations have resulted in banks significantly reducing the accounts for 14% of US daily stock volume, 20% of US listed
amount of liquidity that they provide to the market. For example, stock options volume, and it is a top five firm in US Treasury
the primary dealer inventory of US corporate bonds held by banks futures and US interest rate swaps.12 Hedge funds have also
has fallen by more than 80% since 2008 (Figure 9), whilst their provided liquidity during periods of stress. US regulators,
share of the US Treasury market has fallen more than 50%.11 investigating wild swings in the US Treasury market in October

Figure 9: Inventory has declined significantly, whilst outstanding debt continues to rise 13
Outstanding and inventory of US corporate bonds1, $ billions

9,000 300

7,500 250

6,000 200

4,500 150

3,000 100

1,500 50

_ _
2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

Outstanding US corporate bonds (L)

US dealer’s inventory of corporate bonds (R)
1 Primary Dealer Statistics, Net Positions in Corporate Bonds as of June 3, 2015. Outstanding U.S. Corporate Bonds as of March 31, 2015.

Source: Federal Reserve Bank of New York, SIFMA

Figure 10: Inventory of assets marked as “held to maturity” by banks soars

Total held-to-maturity securities for commercial banks in US, % of all securities

25%

20%

15%

10%

5%

0%

2009 2010 2011 2012 2013 2014 2015

Source: St. Louis Federal Reserve Bank

14 Alternative Investments 2020: Regulatory Reform and Alternative Investments

 Impact of regulations

2015, discovered that hedge funds accounted for more than 70% While the new regulations obviously impact on liquidity and
of all trading activity during a crucial period of stress in the market, collateral availability for short-term lending markets, they also
a time when many other providers reduced their participation.14 have served to increase market stability and confidence. This
might ultimately mitigate their adverse impact for the across-cycle
benefit of market participants. In the eyes of prominent regulators,
2.1.1.2. Impact of capital and collateral requirements
it is a short-term price worth paying for the long-term good.
on short-term lending markets
The impact of regulations such as Basel III, EMIR, Solvency II, 2.1.1.3. Impact of trading tax on liquidity provided
and Dodd-Frank on liquidity in derivatives markets is less clear. by alternative investors
The new regulations resulted in far more derivatives being traded
The proposed European FTT also has the potential to significantly
on central exchanges, which have rigorous capital and collateral
reduce the liquidity that hedge funds provide to many markets,
requirements. The availability of the high quality collateral required
in addition to affecting interbank markets. The impact on equity
for such platforms has been affected by the quantitative easing
markets in Europe could be substantial, as hedge funds utilizing
policies of central banks, with the European Central Bank alone
high frequency trading techniques account for up to 50% of
scheduled to acquire €60 billion of high quality collateral each
all trades on European stock exchanges.23 Moreover, the
month until September 2016.15 It is estimated that the industry
International Capital Markets Association found that it could
has a collateral shortfall against upcoming regulatory requirements
result in a 66% decline in the repo market 24 and the European
of some $4-5 trillion globally and that number would double to
Commission estimated that derivatives trading would fall by
$9 trillion with ratings cuts.16
75%.25 The former was of particular concern, as a member
In 2014, researchers at the London School of Economics found of the governing council of the European Central Bank, Christian
that tighter collateral requirements could make it difficult for Noyer noted that: “The most important concern for the central
investors to maintain their current levels of trading.17 Earlier this banks [is] the risk of the total drying up of repo markets.
year, Dennis McLaughlin, the chief risk officer for LCH.Clearnet, That means the transmission of our monetary policy would
the largest interbank swaps clearer in the world, warned that be seriously impaired and the risk in terms of financial stability
LCH.Clearnet “could reach a point at which it has to stop would not be negligible.”26
accepting new trades for clearing, as they will be unable to
conduct some $150bn of client funds through the market
2.1.2. Innovation
each day.”18
The creation of long-term value in any industry ultimately stems
The ability of hedge funds to provide liquidity is also undermined from its ability to attract and retain the best and brightest and for
by new capital and leverage requirements imposed on banks. new ideas to be tested in the marketplace, either within an existing
The laws increased the cost to banks of providing repo firm or by the creation of a new one. The new regulations seek
agreements, which has led to banks such as Goldman Sachs, to create a more robust and stable financial system that explicitly
Barclays, Bank of America, and Citi reducing their repo activity should be more “boring” than in the past. In doing so, they may
(Figure 11).19 Such funding is critical for hedge funds, as repo impair the ability of the traditional financial sector to attract the
agreements account for 47% of the capital that hedge funds talent required for innovation. This is relevant, as historically
borrow.20 Barclays estimates that the changes increase the cost alternative investors have made extensive use of innovations
of funding for hedge funds in general by 10-20 bps, but highly tested by investment banks such as commodity-driven
leveraged strategies, such as fixed income arbitrage, can expect derivatives, interest rate swaps, and credit default swaps,
costs to increase by 40-80 bps.21 Obviously, this would reduce high yield bonds and leveraged loans, and the repo market.
the profitability of trades, in turn reducing their volume.
Compensation is a critical component for attracting and retaining
Figure 11: Repo volumes have fallen in recent years22 human capital, which is why industry participants question the
Tri-party repo collateral value, $ billions 2000 wisdom of placing hard limits on how banks can compensate
their employees, which is what Basel III does. The limits only
1900 apply to banks in the EU, but not to stand-alone EU asset
managers or financial institutions in the US or elsewhere. Even
1800 within the EU, there is discord, as asset managers at EU based
banks are subject to a different set of compensation limits than
1700 their peers at stand-alone asset managers, which are governed
by new limits proposed in UCITS V. The lack of consistency
1600 leaves EU banks and their asset management divisions at a
disadvantage when competing for talent, the most important
1500 source of innovation.
2010

2011

2012

2013

2014

2015

Source: Federal Reserve Bank of New York

Alternative Investments 2020: Regulatory Reform and Alternative Investments 15

Impact of regulations

The impact of new regulations can already be seen in the 2.2.2. Operational cost
marketplace. The reduction in risk appetite and profitability has
led the five largest US investment banks to reduce staff by The cost of operating an alternative investment firm has increased
40,000 since the financial crisis, a decline of nearly 30%.27 as a result of regulatory changes and demands by LPs. Increased
Asset managers and recruiters have noted a significant shift in demand by institutions and regulators for greater transparency into
talent from investment banks towards stand-alone traditional the risk and performance of GP’s funds routinely tops GP surveys.
asset managers, which have had few new restrictions added to Fund managers believe this to be the most important driver of
them since the financial crisis.28 Moreover, the share of talent industry change and fund raising.36, 37, 38 Moreover, 44% of GPs
entering investment banks from top MBA programs such as responded in a recent survey that they report more information to
Harvard, Wharton, LBS, Booth, and INSEAD have fallen by their LPs now than before the crisis and 32% do so more often
more than 50% from 2007 to 2013 29 and many banks have than before, with both totals expected to increase over the next
felt obliged to improve the work/life balance of junior banking five years, particularly given that 48% of institutional investors are
staff in order to attract new hires.30, 31 still dissatisfied with the level of reporting by their GPs.39, 40

Adhering to the new reporting and operational requirements set

by regulators and desired by LPs will increase the cost and
2.2. Impact on the alternative complexity of operating in the alternative investment industry.
investment ecosystem In order to conduct business, firms must now assess which
reporting, depository, and clearing statutes they need to comply
within Dodd-Frank, Basel III, FATCA, AIFMD, UCITS V, EMIR,
2.2.1. Innovation
and MiFID II and other regulations. Meeting all of the requirements
The decline in the quantity and quality of talent flowing into the is a costly endeavour, particularly affecting small firms and those
banking sector noted earlier may also reduce the degree of seeking to enter the industry.
innovation that takes place within the alternatives industry. The
industry has long relied on the traditional financial sector and The act of providing information to regulators on the actions and
investment banks in particular as a critical source of talent. operations of an alternative fund is far from trivial. The banking
Having worked at the heart of the financial system, new hires industry has already provided evidence: Andy Haldane, head of
bring specific, relevant, and timely knowledge and ideas to financial stability at the Bank of England, noted in his “Dog and
an existing fund or start their own. Individuals who move are Frisbee” speech that banks in Europe alone would likely need to
rewarded with nimbler and leaner organizational structures in add some 70,000 new full-time employees to meet the new
which to utilize their ideas and compensation structures that regulations.41 Recent research by BNY Mellon estimates that to
allow them to capture a greater share of the value they create set up the infrastructure necessary to comply with AIFMD will
than would be the case at a bank. This benefits even the financial cost funds US$ 300,000 to US$ 1 million.42
institutions losing talent, as the alternative investment industry
typically outsources a significant amount of their operations to KPMG estimates that the new rules will increase the operational
banks, paying high fees.32, 33 cost of fund management by 10%, costing funds $700,000 to
$14 million depending on the size of the fund, on top of the $3
The influence of experience in banking is particularly strong billion it estimates the industry has already spent to meet new
amongst hedge funds and private equity firms. Most of the largest regulations since the financial crisis.43 The relative cost structure
private equity firms in the world, including the Blackstone Group, within fund management firms is also likely to change, as Capco
KKR, Apollo Global Management, and TPG Capital, and more finds that compliance historically accounts for 10-20% of internal
than half of the 25 largest hedge funds, include founders with budgets – a figure that has increased to 50%.44 To reiterate, these
prior experience in banking.34 Given that most alternative changes in both absolute and relative cost allocations will be
investment firms have fewer than 100 investment professionals,35 disproportionately hard for small and start-up funds to navigate.
the industry has long relied heavily on hiring pre-trained staff at
all levels of the organization (Figure 12). 2.2.3. Barriers to entry
Figure 12: Talent sourcing flow for alternative funds Scale matters and nowhere more so than in asset management,
where investment margins can be slim. Increasing the cost of
Bank Division Alternative Fund fund management disproportionately affects new and small funds,
Private equity related which cannot spread the cost across a large existing base of
Investment banking asset classes1 assets under management (Figure 13). As a percentage of assets,
compliance costs are four times higher (0.4% of AUM) for $100
Sales & trading Hedge funds million fund as for a $5 billion fund (0.1% of AUM).45 A cost
differential of 0.3% may sound trivial, but it is approximately 10%
Research & asset of the alpha (the risk-adjusted returns in excess of the given
Hedge funds
management benchmark) that a typical hedge fund provides.46, 47 The effect is
1Includes private equity buyouts, real estate, infrastructure, and private debt
not simply theoretical, as Citi estimates that hedge fund managers
Source: World Economic Forum Investors Industries now need some $300 million in AUM just to break even.48

16 Alternative Investments 2020: Regulatory Reform and Alternative Investments

 Impact of regulations

Figure 13: The relative cost of meeting regulatory thority] or the SEC, if you meet all the requirements of AIFMD [the
requirements is much higher for smaller funds 49 EU directive on fund managers], then you’re much more likely to
get that cheque.”54
Estimated cost of compliance for North American hedge funds,
% of AUM
The combination of increased demands by regulators and
0.50% institutional investors is already driving industry consolidation,
with the top 5% (389 firms) of firms managing 87% of all global
0.40%
hedge fund assets under management.55 This may not matter
0.30% so long as new and innovative firms retain the ability to enter
and challenge the incumbents. However, the increased cost of
0.20% compliance may be fundamentally undermining that proposition.
Ed Lopez, executive vice-president of SunGard’s asset
0.10%
management business, sums up the trend: “While the ‘too big to
0.30
0.40

0.10

0.00% fail’ firms continue to raise assets, boutiques run the risk of being
>$5B AUM
<$1B AUM

$1-58B AUM

‘too small to succeed’.”56 The effect can be seen in a decline in

the number of new private equity firms (Figure 14) and hedge
funds launched (Figure 15a), an increase in the number of hedge
funds that liquidate each year (Figure 15b) and the resulting
Source: KPMG
increase in the share of hedge funds that have more than five
years of experience (Figure 15c).

Smaller funds might find that they are penalized by banks who Figure 14: The absolute and relative share of capital raised
no longer find them economical to serve, given new capital by first-time private equity funds has fallen 57, 58, 59
requirements. Robin Grant, chief operating officer at RS Platou Funds raised by start-up private equity buyout firms, $ billions and %
Asset Management, notes that “smaller hedge fund managers 18%
120
may eventually have prime brokerage relations unilaterally
severed, while others will face higher financing costs.” 50 100 15%

All non-EU funds and new funds in particular will also be 80 12%
constrained in their ability to raise capital from EU based LPs due
60 9%
to AIFMD restrictions, which requires that funds be domiciled
in the EU or an approved jurisdiction and that they meet any 40 6%
additional registration requirements established by individual
countries. The European Securities and Markets Authority 20 3%
(ESMA), which is responsible for proposing AIFMD guidelines 0%
0
for adoption, identified 22 countries that it will consider including
2006

2007

2008

2009

2010

2011

2012

2013

2014
in the AIFMD passport, but only 3 have been approved thus far
(Guernsey, Jersey, and Switzerland). 51 The impact is clear, as a
Capital raised by first-time private equity funds, $ billions (L)
recent survey found that 85% of US based GPs and 75% of GPs Share of capital raised by first-time private equity, % (R)
in non-EU/UK/US jurisdictions were not compliant with AIFMD,
Source: Preqin
with 42% of all GPs saying they will not try to market in the EU at
all. 52 The result is another barrier for small or large funds seeking
Figure 15a: The number of hedge funds launched per year
capital from one of the largest pools in the world (European LPs).
has fallen by nearly 30% since before the financial crisis 60
The increasing demands of institutional investors exacerbate the Average number of hedge funds launched each year
situation for new funds, as they often want firms to invest in an 1,800
extensive institutional architecture before they are willing to invest
with them. Small or new funds may receive a slight reprieve in the 1,350 - 28%
cost of compliance in Europe, as AIFMD does not apply to funds
with below €100 million in assets under management, but they 900
must still bear the cost of all the other regulations. Moreover, the
exception may be a moot point. Institutional investors, the source 450
1,463

1,051 Post-crisis

of an estimated 74% 53 of hedge fund capital, often require a

722

minimum investment in a fund of $10 million and stipulate that _

(2003-07)
Pre-crisis

(2010-14)
(2008-09)
Financial crisis

this sum should not constitute more than 10% of the fund.
The result is a threshold high enough to require virtually all funds
receiving institutional capital to meet all the existing and new
regulatory burdens. The head of one big hedge fund allocator
notes that: “if you’re regulated by the FCA [Financial Conduct Au- Source: HFR

Alternative Investments 2020: Regulatory Reform and Alternative Investments 17

Impact of regulations

Figure 15b: The rate at which hedge funds close has risen Figure 15c: The share of young and mid-age hedge funds
by 40% since the financial crisis 61 has fallen significantly since the financial crisis 62
Average number of hedge fund liquidations each year, Share of hedge funds by age, %
% of total number of hedge funds
60%
20%
50%
16%
40%
+ 40%
12%
30%

8% 20%

4% 10%
10.3
18.2
7.4

0%
0%

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014
(2010-14)
Post-crisis
(2003-07)
Pre-crisis

(2008-09)
Financial crisis

Young (< 2 yrs of experience)

Mid-age (2-5 yrs of experience)
Tenured (> 5 yrs of experience)
Source: HFR
Source: Evestment

2.2.4. Access to capital sheets and incentive them to hold lower risk assets such as
sovereign debt.63 PWC estimates that EU banks have lost €408
The wave of new financial regulations and proposals is reducing billion in lending capacity due to the need to hold €85 billion extra
the ability of small and medium sized enterprises (SMEs) and in high quality assets.64 Bain and the Institute of International
infrastructure providers to obtain the capital they need. Few Finance find that lending to SMEs in leading European countries
doubt that investments in new technologies, infrastructure, or fell by 47% from 2008 to 2013.65
operational processes benefit society in the long-term. However,
such investments require prolonged investment periods, Packaging and distributing debt into structured products is also
limited liquidity, and entail more risk than investing in a typical problematic due to both dried up securitization markets and
government bond. Yet banks and some institutional investors are increased regulation. Completing complex deals that require the
incentivized by new laws to reduce the capital they provide to use of derivatives to manage and distribute risk is harder than
such investments. The changes are also affecting the alternative before the crisis, since such deals must also adhere to the new
investment industry, with the laws creating new hurdles for some derivative related capital and collateral requirements. While this
types of firms, whilst creating new opportunities for others. is beneficial in curbing some of the more opaque pre-crisis
structures, it also has effects on transactions in other asset
2.3.4.1. Direct financing of small and medium enterprises classes, such as infrastructure.
(SMEs) and infrastructure
Banks are critical sources of capital for SME businesses and The shift towards safe assets can already be seen. One example
project finance. However, the new capital, collateral, leverage, and is the increase in the holdings of government backed securities
liquidity requirements in the US and Europe effectively penalize by US banks (Figure 16), with a similar rise in cash or equivalent
banks for underwriting and holding such loans on their balance holdings by European banks.66 In contrast, the number of UK
banks providing financing for public-private partnerships fell
Figure 16: US banks have increased their absolute around 90%, from 60 banks before the crisis to only a handful by
and relative holdings of safe assets 2013, with total financing falling 75% from £8 billion to £2 billion
US Treasury and agency securities held by US banks, % of over the same period.67
all securities held by banks and $ billions

72% 2,400

69% 2,100

66% 1,800

63% 1,500
Value of securities, $ billions (R)
60% 1,200 Share of all securities held by US banks, % (L)

2010 2011 2012 2013 2014 2015, H1 Source: St. Louis Federal Reserve Bank

18 Alternative Investments 2020: Regulatory Reform and Alternative Investments

 Impact of regulations

2.3.4.2. Indirect financing of small and medium Figure 17: A range of crowdfunding models have grown
(SME) businesses and infrastructure rapidly in recent years 78, 79, 80, 81, 82
The demand for private debt and alternatives more broadly Global crowdfunding new issuance by type, $ billions
will also be negatively impacted by regulations that create 3.0
disincentives for financial institutions to invest in alternatives.
The laws affect banks and insurance companies in Europe
2.5 50
in particular. Banks, through their balance sheets, have
historically accounted for 6% 68, 69 of all alternative assets,
which amounts to ~$400 billion. However, the capital 2.0
requirements set forth in Basel III make it prohibitively
expense for them to hold such investments. 1.5
25
Solvency II imposes similar capital related requirements on
1.0
insurance companies in Europe that will significantly reduce
their willingness to invest in alternatives. Insurance companies
are the largest institutional investors in Europe, managing some 0.5
€12 trillion,70 and account for 10% of the private debt market.71
With their long-term and stable investment horizons, they would 0.0 0
seemingly be the ideal holder of pools of risky and illiquid 2010

2011

2012

2013

2014

2015
est
securities, but the new laws constrain their ability to provide
long-term capital to the global economy.
Lending
Equity
With Solvency II in its current form, alternative investment funds Donation
will find access to the largest pool of savings in Europe much Reward
Real estate
more difficult. Saker Nusseibeh, chief executive of Hermes, Royalty
the fund manager of the BT pension scheme, notes that EU
Source: Massolution, Wangdaizhijia, Morgan Stanley,
regulators have, “forced the savings industry not to invest in the
World Economic Forum Investors Industry analysis
long term in Europe” and that “if regulation in Europe forces the
industry not to invest for long-term growth, I am not sure how
they expect the industry to find another way forward.”72 That
said, it is worth nothing that European regulation is still evolving – 2.2.5. Returns
and as an encouraging development, infrastructure assets have The collective impact of new regulations, in the absence of
recently been given more lenient capital treatment in the context business model innovation by the alternative investment industry,
of the European Capital Markets Union.73 is likely to reduce industry returns. Transaction, operating, and
administrative costs are likely to increase at a firm level. The
2.3.4.3. Growth in financing from non-traditional providers recent decline in fees, from the traditional 2% in management
The decline in lending activity by traditional financial players fees and 20% in performance fees, to today’s actual average of
is creating new opportunities for entrepreneurs, GPs, and 1.6% and 18%, may well be stopped by this secular increase in
institutional investors. An example is the global crowdfunding cost structure, resulting in lower net returns than would otherwise
industry, which uses technology driven platforms to connect be the case.83
savers and borrowers and reduce the cost of doing so. The
nascent industry is growing rapidly and is expected to supply The increase in costs varies by asset class. Hedge fund returns
entrepreneurs and businesses with more than $50 billion of will suffer the most due to their trading related activity. Transaction
capital in 2015 (Figure 17). The alternative investment industry costs for trading corporate bonds will rise by an estimated 0.12%
is also seeking to address the SME financing gap, with private as a result of reduced liquidity and higher bid/ask spreads, which
debt AUM tripling from 2006-2015 to $465 billion.74 reduces the total investment value by up to 5% over a 40 year
investment horizon according to PWC.84 The consultancy also
Institutional investors are also seeking to fill the gap, both directly estimates that the loss in liquidity would increase corporate yields
and indirectly. Large LPs, such as sovereign wealth funds and by 0.3%, which could result in mark to market losses on existing
pension funds, provide capital directly to crowdfunding platforms corporate debt holdings of €82 billion for institutional investors
to invest in loans,75 with 80-90% of all funding for Prosper and based in Europe.85
the Lending Club, leading marketplace lending platforms, coming
from institutional investors.76 In fact, they now allocate an average
of 5.6% of their portfolio to private debt firms, with 54% currently
investing in it and another 13% considering it.77 For an in-depth
review of non-bank financing, please refer to our sister report
Alternative Investments 2020: The Future of Capital for
Entrepreneurs and SMEs.

Alternative Investments 2020: Regulatory Reform and Alternative Investments 19

Section 3

Implications and
recommendations

In this section we shift from assessing

the impact of new regulations on the
financial system to how they impact
“
The financial regulations
may help the industry
to grow in the long-term,
specific stakeholder groups, including in spite of the challenges
GPs, LPs, and the public. We conclude “
that it creates along
by providing recommendations for policy the way.
makers with regard to how certain
regulations could be improved upon
and why society would be better off as
a result. Figure 18 summarizes the key
implications for stakeholders and the
potential impact on each of the core
alternative asset classes.

20 Alternative Investments 2020: Regulatory Reform and Alternative Investments

 Implications and recommendations

Figure 30: Impact of new financial regulations on alternative investment actors

Scale of impact: High Moderate

GPs LPs Society

Impact on the stakeholder (positive/negative) Venture Private Hedge Other Primary Banks/
capital equity funds GP1 LPs2 Insurance Co.’s Individuals Business
Implications for: Description
Reforms could depress trading
Market volumes and increase volatility – + – – + – + –
liquidity during a financial crisis
Bank

Banks play a reduced role

Innovation as a source of innovative – – – +
products used by GPs

The pool of innovative talent – – – + +

Innovation
flowing from banks to GPs falls

Operational Reforms impose significant – – – + +

cost new costs on GPs
Investments

Barriers Cost and regulatory complexity will – – – – –

to entry form new barriers to entry for GPs

Access to LPs that could benefit from alternative

– – – + – – –
capital investments may be denied access

Reforms require greater transparency

Transparency by GPs and creates pressure for more + – + – + + – + +
in the future

The cumulative impact of these

Returns challenges is likely to be a fall in – – – – + – + –
returns to investors

1 Includes GPs such as private debt, infrastructure, and real estate funds
2 Includes LPs such as pension funds, sovereign wealth funds, and endowments and foundations

Source: World Economic Forum Investors Industries

3.1. Implications for alternative liquidity and funding from banks, depressing returns. At the firm
level, operational and compliance related costs have increased
investment firms (GPs) significantly, with the smallest funds shouldering the largest
The financial regulations may help the industry to grow in the relative burden. The ability of new firms to both form and survive
long-term, in spite of the challenges that it creates along the way. will prove more difficult than in the past, which will spur further
The need for most firms to upgrade their institutional architecture consolidation amongst the largest and most experienced firms.
and provide greater transparency into their operations will likely In the near term, the industry may benefit from an inflow of
enable them to attract more capital from institutional investors talent from banks, as they disband their proprietary trading arms.
and increase the level of trust in the industry by the public. It will However, firms will need to upgrade their talent sourcing model
make it possible for more firms to develop deeper relationships in the future, as they will no longer be able to rely heavily on
with their LPs, a trend that we discuss in more detail in our sister banks for talent and innovative ideas. This will further drive
report Alternative Investments 2020: The Future of Alternative consolidation, as larger firms will be in a better position to
Investments. The changes will also continue to provide the deploy internal development programs.
industry with growth opportunities in the form of private debt.
Private equity is also affected by the new regulations. The most
However, the impact of the new laws on GPs will vary widely by immediate impact will be the increased transparency that comes
asset class and size, with benefits and costs spread unevenly with new reporting requirements. In 2014, the US SEC found
throughout the industry. For example, venture capital firms are not that more than 50% of PE firms were not in full compliance with
affected by many of the regulations and exempted from others. regulations or had illegally collected fees.86 It later settled lawsuits
The same cannot be said for private equity firms or hedge funds. brought against firms related to collusion 87 and misallocating
expenses88 and noted that the industry can expect more such
Hedge funds are affected by the widest array of new regulations actions in the future.89, 90 The result has been increased disclosure
and proposals, as most make extensive use of capital markets. for existing firms, more transparent terms for new funds,91 and
They face higher transaction costs as well as reduced access to calls for even more disclosure by senior US elected officials.92

Alternative Investments 2020: Regulatory Reform and Alternative Investments 21

Implications and recommendations

The impact will be a reduction in profitability for most GPs, as Translating the new data that LPs will get from GPs and regulators
they will eventually internalize many of the expenses that they into better investment decisions and lower management fees will
currently pass on to LPs (though the impact on net returns will not come for free. Rather, LPs will need to either devote resources
likely be not material). developing the internal capacity to analyse the data or pay a
consulting firm to do so on their behalf. Even veteran investors
New regulations are also enabling private debt to become one such as CalPERS have been struggling with this for some time
of the fastest growing segments within the alternatives universe. and recently acknowledged that they “can’t track it today.”93
Such funds are filling the gap left by banks that have reduced
their loan books in order to meet new regulatory requirements.
The structural reduction in loan capacity bodes well for the future 3.3. Implications for the public
growth of the segment. Though such loans are not as highly
regulated as those made by banks, they are unlikely to prove Similar to other stakeholders, the public will broadly benefit from
systemically relevant for two reasons. First, they are not based the financial reforms, but there remain areas where specific
on fractional reserve lending and thus are not highly leveraged. groups may bear the unintended costs of the regulations. The
Second, LPs cannot engage in a “run on the fund,” since the topics most likely to affect the public concern innovation, market
underlying capital is locked up in an illiquid vehicle. liquidity, transparency, access to capital and portfolio returns.

In contrast to the financial community, the public may well benefit

from regulations that make the real economy more attractive
3.2. Implications for investors to talented individuals. A similar period of financial regulatory
in alternatives (LPs) tightening took place in the 1930s and academics find that the
best and brightest in society shifted their attention to non-finance
New regulations will have a mixed effect on LPs and institutional
industry endeavours.94 Recent research also finds that financial
investors in particular, but overall, they should benefit from the
deregulation in the US led to labour productivity declines in
changes. However, doing so will not come without costs and
non-financial industries 95 and additional research finds that it
the ability of LPs to capture these benefits will vary markedly.
particularly affects research and development heavy industries.96
Moreover, some LPs may find it difficult to invest in alternatives
Thus, the regulations may result in a more optimal balancing of
all together due to regulatory changes.
talent in the economy.

The impact of new regulations will affect insurance companies

Pension fund beneficiaries, high net worth individuals, and taxpayers
in Europe and banks in the US and Europe more than any other
should expect to benefit from new transparency and reporting
type. The former face new Solvency II capital requirements that
requirements in several ways. First, it can improve the net returns
make it costly for them to invest in alternatives all together.
of investing in alternatives by enabling LPs to pressure GPs to
The latter must contend with laws that collectively make it very
reduce otherwise opaque fees or expenses. The process can be
difficult for them to invest in alternatives as LPs (and not at all
slow, as we discuss in a related research paper,97 but over the
as a GP). Moreover, AIFMD will affect all LPs in Europe, as it will
mid to long-term fees do tend to fall. Second, it enables LPs to
limit their ability to invest in GPs that are not domiciled in Europe.
make better decisions on behalf of the public and increases the
Collectively, LPs may find it difficult to access top GPs and may
trust of the public in both the LPs that represent them and in the
see a reduction in expected returns and the overall diversification
industry they are indirectly investing in. Third, the volatility and
of their portfolios as a result.
demands made on the public purse are reduced, to the extent
that fees fall (and returns commensurately increase) and better
Other LPs will be able to reap the benefits of the new regulations,
investment decisions are made.
including lower management fees, greater transparency, and
potentially deeper relationships with preferred GPs. The increased
Unfortunately, regulations could also impose new costs on
transparency will make it easier for institutional investors to
businesses and LPs and their beneficiaries in the form of new
garner support from the public and governing boards to invest
capital markets related transaction costs. The reduction in market
in alternatives. Large and sophisticated LPs that invest directly
liquidity, as mentioned earlier, might potentially reduce the total
with GPs, such as pension funds and sovereign wealth funds,
investment value of retirement portfolios by an estimated 5%.98
will benefit the most. Their scale, sophistication and relationships
It could also increase the risk and cost of trading investments
will put them into a favourable negotiation position to further
during turbulent times. Businesses could face relatively higher
their interests.
borrowing costs due to an increase in borrowing spreads related
to reduced liquidity.
The increased institutional sophistication of LPs will also make
it easier for them to develop new investment relationships with
In the near term, SMEs will struggle to obtain financing from the
GPs, which include co-investing, separately managed accounts,
traditional financial system. The funding shortfall has led to the
and joint-ventures. Smaller and less sophisticated investors will
creation of a range of innovative new products and platforms.
also benefit indirectly, as pressure on GPs to reduce the fees they
The growth of non-traditional forms of lending, with alternative
charge often results in a lower level of fees for all LPs.
investors playing a key role, could provide a range of new

22 Alternative Investments 2020: Regulatory Reform and Alternative Investments

 Implications and recommendations

channels for SMEs to access capital. Shadow lending at afield. It also reduces the ability of European based LPs to
present remains lightly regulated, so the growth of this segment diversify their portfolios or invest with top non-EU based GPs.
will depend in large part on how aggressively governments seek All stakeholder groups involved would benefit if the passport
to regulate it. process was streamlined so that non-EU GPs could raise
capital from EU based LPs.

4. Consider long-term investment needs when finalizing

3.4. Recommendations for policy-
Solvency II capital requirements
makers and regulators The financial crisis highlighted the risks that can be created
The overhaul of global financial regulations has led to a more when long-term investments are funded with short-term and
transparent and less leveraged financial system. The risk of the liquid capital. European insurance companies are long-term
financial crisis repeating itself, at great cost to society, has been and patient investors that manage one of the largest pools of
reduced and regulators around the world should be commended capital in the world, but Solvency II is incentivizing them to hold
for their efforts in achieving this. This report has highlighted such liquid and often short-term oriented assets. Society would be
efforts in relation to the alternative investment industry and noted better off if large LPs like insurance companies were able to
how many stakeholders, including institutional investors and their provide capital to long-term oriented alternative investments.
beneficiaries, are better off as a result. Given the immense scale The recent announcement of changes to the Solvency II
of the regulatory reforms, it is inevitable that some unforeseen regime for infrastructure assets in the context of the European
consequences will arise. Earlier we identified some of these issues Capital Markets Union is a step in the right direction.99
and now we would like to provide some recommendations for
regulators to consider as they refine and revise existing laws 5. Establish a tiered system for complying with
and proposals. regulatory requirements based on AUM
End users and society benefit from innovative and competitive
1. Incorporate secondary effects on the alternative
industries. Recognizing the disadvantages that small
ecosystem when crafting bank regulations
companies and start-ups face when seeking to compete with
Alternative investors have become an important part of the incumbents, regulatory requirements often increase in line
global economy and financial system and a key provider of with the scale and complexity of the business. The alterna-
liquidity for markets, capital for infrastructure, technology, tive investment industry would benefit from a similar scaling
and operational improvements that support the economy, of regulatory requirements based on the total AUM of a firm,
and returns that fund retirement systems. Regulators should potentially adjusted for the amount of leverage employed.
recognize the importance of alternatives by explicitly including Doing so would reduce barriers to both entering and surviving
a cost/benefit analysis of the impact on alternative investments in the industry. It would also reflect the potential risk associated
when drafting regulations intended for other parts of the with the firm.
financial system. Regulations should also acknowledge and
adjust for the heterogeneity of the alternative investment 6. Standardize reporting guidelines for private
industry, particularly with relation to capital, leverage, liquidity, equity related asset classes
and collateral requirements.
New laws require private equity firms to disclose more
organizational and operational details to regulators than ever
2. Conduct a cost benefit analysis that incorporates
before. However, the ability of LPs to audit, analyze, and
the likely impact on end users (LPs)
compare data across firms, funds, and the underlying
Often lost in the complexity of the global financial system are companies and assets that they indirectly own remains
the retirees, employees, and citizens that trust their capital to challenging, given that the information provided is not
LPs to manage on their behalf. These parties may be multiple standardized. Establishing standard industrywide reporting
links removed from the target of a new law or proposal that guidelines would allow LPs of all sizes to easily compare one
reduces liquidity, increases funding costs, or increases investment with another, which would enable them to make
transaction, operational, or administrative costs for financial higher quality decisions on behalf of their constituents.
actors. However, such actions often translate into lower returns
for the ultimate beneficiary, which is why any new law that 7. Withdraw financial transaction tax
targets GPs should explicitly consider the expected impact
Liquidity is critical to the proper functioning of markets.
on LP returns.
Reduced liquidity results in higher transaction and funding
3. Streamline the AIFMD passport requirements process costs, and increased volatility for market participants. Enacting
a financial transaction tax would ultimately prove detrimental
Restricting the ability of GPs outside the EU to raise capital to financial actors and the beneficiaries that they act on behalf
from EU based LPs is detrimental to GPs and LPs alike. The of and offer few benefits in return. Many nations in Europe,
constraints reduce the amount of capital that GPs based in such as the United Kingdom, Ireland, the Netherlands,
countries such as the US, China, or Brazil can raise from LPs Poland, and Sweden have already opted out of the legislation.
to invest in businesses or assets in their country or further The remaining 11 might consider doing the same.

Alternative Investments 2020: Regulatory Reform and Alternative Investments 23

Conclusion

The financial industry is in the midst of implementing a series of

regulatory reforms that, while critically important for the security
of the global financial system, will have intended and unintended
consequences for the alternatives industry.

Banking and financial industry reforms will affect the capital

flows into alternative investments (e.g. reducing flows from the
banking and insurance sectors) and also affect the services that
support and sustain alternative investors (e.g. the provision of
counterparties for many hedge funds).

Meanwhile, investment industry reforms that improve investment

firm infrastructure and transparency may also substantially
increase compliance costs and create barriers to entry to the
alternatives industry.

Policy makers face a challenge in assessing the wider impact

of regulations because their attention is often focused on a
particular industry (e.g. banking, or insurance) or region (e.g. the
US, Europe). However, the alternatives industry is composed of
a heterogeneous set of global players which use a diversity of
strategies, particularly in the case of hedge funds.

It is not easy for policy makers and regulators to foresee how a

single regulation will impact alternatives. Even when a new rule
is aimed squarely at the industry, it is not easy to quantify the
potential consequences, e.g. in terms of increased costs and the
degree to which these will be passed through to end investors.

For example, investors disbarred or discouraged from investing

in alternatives cannot benefit from the above-average long-term
returns or diversifying effects of various alternative asset classes
and may struggle to meet important long-term commitments and
liabilities as a result. Similarly, increasing reporting requirements
may directly benefit the financial system and indirectly benefit
LPs, but it may also make it more difficult for new and potentially
innovative firms to form and survive.

Regulators face particularly tough choices in balancing the

management of risks made visible by the global financial crisis
against the more opaque risk that regulation will reduce the future
economic benefits flowing from alternative investing, such as the
ability to fund infrastructure or transformative new technologies
or industry practices. Over the last three decades the economic
benefits flowing from alternative investments have helped to
shape the global economy and the industry is part of the solution
to many of tomorrow’s most intractable economic problems.

Thinking through these issues will only become more urgent

over the next few years as demographic demands on retirement
systems grow and capital begins to flow in earnest from retail
investors around the world into the global alternatives market.
Increasingly, constructive solutions will have to account the
connected nature of the financial system as well as the multitude
of stakeholders involved.

24 Alternative Investments 2020: Regulatory Reform and Alternative Investments

Appendix

1. What are alternative investments 1.2. Investment characteristics

Alternatives offer investors a distinct set of attributes that are
1.1. Definition of alternative investments not commonly found in mainstream investments such as public
stocks or government or corporate bonds. These typically include
In its broadest definition, alternative investment assets – are one or more of the following attributes: long term, high risk, or
those which are not part of traditional asset classes such as cash, illiquid investments that are associated with higher returns; low
stocks, or bonds that retail investors are most familiar with. Such correlation with traditional assets to deliver diversification benefits;
a definition would encompass investing in mainstream assets inflation-hedging benefits; and scalability (the ability to absorb
such as real estate or commodities or luxury goods such as art large investment sums). Figure A3 shows the degree to which
or wine. However, for this report, alternatives will be those which these and other investment attributes are available to investors in
have historically utilized distinctive fund structures and which each of the three core alternative asset classes.
only wealthy individuals and institutions have had access to.
Alternatives will thus encompass a wide range of asset classes,
including private equity real estate and private equity infrastructure
funds, secondary funds, and private debt funds. In particular, this
report will focus on three asset classes: private equity buyouts,
hedge funds, and venture capital. Historically, these three have
played the most important role in the evolution of the industry and
have accounted for the vast majority of the capital allocated to
alternatives. Figure A1 provides an overview of different types of
mainstream and alternative investments, while Figure A2 shows
how alternatives fit into the broader cycle of investing savings into
businesses or assets.

Figure A1: Overview of different types of investments

Traditional investments
Cash
Government and corporate bonds
Public stocks

Tangible investments
Commodities
Real estate
Infrastructure

Other investments
Art
Antiquities
Wine

Core alternative investments

Private equity buyouts
Hedge funds
Venture capital

Other alternative investments

Private equity infrastructure
Private equity real estate
Private debt funds
Widely used and accessible Selectively used Other alternative funds
to all investors (including retail) and only accessible to
wealthy individuals and
institutional investors

Source: World Economic Forum Investors Industries

Source: World Economic Forum Investors Industries

Alternative Investments 2020: Regulatory Reform and Alternative Investments 25

Appendix

Figure A2: The investment cycle

• Personal savings • Cash

• Retirement plans ...can be saved • Bank accounts
• Inheritance Savings... • Money market funds
• Investment income
• Company earnings
• Taxes
• Retirement accounts
• Pension funds
…can be invested • Foundations
• Individuals with managers... • Asset managers
• Companies …which generates • Treasuries
• Non-profit excess cash...
• Governments

• Companies
• Start companies
• Governments
Acquire companies
• Real estate
•
…to invest in …in stocks, bonds, • Infrastructure
• Invest in companies securities and or tangible assets • Natural resources
• Invest in securities assets...
• Build tangible assets

• Provide debt
• Underwrite IPOs • Venture capital
…who use invest- …in alternative
• Advise on acquisitions • Private equity buyouts
ment banks... investments...
• Support trading • Hedge funds
• Other (private debt,
infrastructure, etc.)

Source: World Economic Forum Investors Industries

Figure A3: Expected investment attributes for core alternative investment asset classes

VC Venture capital PE Private equity buyouts HF Hedge funds Very low Very high

Implications for: Description VC PE HF

Target returns1 Produces net returns to investors

Performance
Risk Variance in returns and risk of losing capital

Correlation with
Correlation with other assets (lower is better)
other assets 2

Inflation-linked The asset typically adjusts for inflation

Investment
attributes
Liquidity Ability to easily sell the asset when needed

Scalability 3 Ability to deploy large sums of capital

1 Over a 10yr horizon; Very high returns = >20%, high = 10-20%, moderate = 5-10%, low = 0-5%, very low = 0%
2 Correlation with equity markets; Very high = 80-100%, high = 60-79%, moderate = 40-59%, low = 20-39%, very low = 0-19%
3 The ability of an LP to deploy large amounts of capital efficiently with fund managers and/or in co-investments

Source: Cambridge Associates, Hedge Fund Research, RREEF, JPMorgan, Coller Capital, Preqin

26 Alternative Investments 2020: Regulatory Reform and Alternative Investments

 Appendix

1.3. Different types of alternative investments 1.3.4. Other types of alternative investments
The attractiveness and success of the alternative investment
1.3.1. Hedge funds structure has led investors to apply it to a range of investments
beyond the core asset classes described above. Some asset
Hedge funds manage more than $3 trillion (40% of all alternative
classes are unique to alternative investing. Examples of this
capital), which makes them a large and important part of the
include secondary funds and growth equity funds. Other funds
industry. Geographically, the industry is highly concentrated.
apply the alternative fund structure to traditional investments.
Most of the capital is managed in the US (70%) and Europe
Examples of this include private equity infrastructure funds,
(21%), with managers in the New York area (50%) and London
private equity real estate funds, and private debt funds (including
(18%) overseeing two-thirds of all global capital.100, 101 Still, hedge
mezzanine, distressed debt, direct lending).
funds make investments across the globe and in all sectors of the
economy. Overall, there are more than 8,000 hedge funds,102 with
Collectively, non-core alternative investment funds manage $2.07
the top 25 managing 29% 103, 104 of all assets under management.
trillion, with private equity real estate, private debt, private equity
infrastructure, and growth equity accounting for 85% of this.110
1.3.2. Private equity buyouts The geographic focus varies by asset class, but the majority of
capital is invested in developed countries. These funds invest in
Private equity buyout firms have been a large and high profile
all industries of the global economy and in every part of the capital
part of alternative investing since the 1980s. The asset class
structure. The size of the target company or security also varies
is the second largest segment within alternative investing, with
widely, from growth stage companies to multi-billion dollar real
private equity buyout firms managing $1.4 trillion. Firms invest in
estate portfolios or infrastructure projects. There are well over
dozens of countries across the globe, though companies in the
1,000 non-core funds and each asset class has a diversity of
US (50%) and Europe (26%) receive a disproportionate share of
funds of varying sizes and specialties.
the capital.105

They invest across a wide range of industries and in companies

ranging from small businesses to Fortune 500 companies worth
billions. Globally, there are approximately 1,000 firms, with the 25
largest managing 41% of the total assets under management.106

1.3.3. Venture capital

Venture capital is the best known alternative asset class and
can trace its history back to 1946. Today, venture capital firms
manage more than $400 billion in assets under management.107
Geographically, investments and firms are highly concentrated in
a handful of countries, with the US alone attracting nearly 70% of
global investments.108 Investments are concentrated in industries
and sub-sectors that rely on the development of new technologies,
with information technology, biotechnology, internet related media
and consumer, and energy companies receiving a large share of
all annual investments. Most firms specialize in just one or two life
stages of a company, with most focusing on either seed and early
stage businesses or late and expansion stage companies. There
are nearly 1,500 venture capital firms globally, with the top 25
firms managing 25% of the global assets under management.109

Alternative Investments 2020: Regulatory Reform and Alternative Investments 27

Appendix

2. A brief history of alternative in the United States (Figure A4). The industry has since grown
from a handful of firms in the US managing a few billion dollars
investments to thousands of firms spread across the world that now manage
Private investors, largely in the form of wealthy individuals, more than $7 trillion on behalf of investors. The key drivers behind
have deployed capital in companies since before the Industrial this growth have been regulatory changes and technological
Revolution. However, it was not until the mid to late 20th century innovation in the US and global market events.
that today’s alternative investment industry began to take shape

Figure A4: Key moments in the history of alternative investments

Type of Event Regulation Technology Market event Firm event 1

1958: US Small Business Investment Act of 1958 1926: Graham-Newman partnership founded
Enables the creation of VC and PE fund structures First hedge fund
1946: American Research and Development
1972: Kenbak-1 released Corporation
1920-
First personal computer heralds the computing era First venture capital fund
60s
1973: Black–Scholes formula published 1962: Investors Overseas Services (IOS)
Enabled the pricing of derivatives IOS launches first fund of funds

1978: Update to Employee Retirement Income Security Act of 1974 1972: Sequoia Capital founded
Allows pension funds to invest in private funds 1970s Leading venture capital firm
1972: Kleiner Perkins Caufield & Byers founded
Leading venture capital firm
1981: Economic Recovery Tax Act of 1981 1975: Bridgewater founded
Made equity investments more attractive (vs debt) Leading hedge fund
1976: KKR founded
1989: Savings and loan scandal + Drexel Burnham collapsed 1980s Leading private equity buyout firm
Junk bond market collapses
1985: Blackstone founded
Leading private equity buyout firm
1999: Financial Modernization Bill (Gramm-Leach-Bliley Act)
1987: Carlyle founded
Enables the rise of large investment banks in the US
1990s Leading private equity buyout firm
1987: KKR takes over RJR Nabisco
2000: Gaussian copula function published Seminal private equity buyout deal
Enables the rise of structured products (CDO/CLO/CDS)
1998: Long-Term Capital implodes
Threatens stability of financial system
2000: Commodity Futures Modernization Act of 2000 2000s-
Enables the growth of derivatives present
2000s: Rise of sovereign wealth funds
Expedites the rise of institutionalization
2008: Global financial crisis 2007: Blackstone IPO
Start of a global recession First major IPO of a PE firm

2010s: New financial regulations

Reshapes the financial and investment industries

1 Thefirms referenced here are illustrative examples – only space constraints prevent us from mentioning the many
other outstanding firms that played important roles throughout the history of alternative investments

Source: World Economic Forum Investors Industries

28 Alternative Investments 2020: Regulatory Reform and Alternative Investments

 Appendix

2.1. Regulatory changes 2.3. Market events

Three laws supported the birth and initial growth of the Building upon the aforementioned foundations, the alternative
alternatives industry and two additional laws enabled the investment industry has grown with each passing decade.
industry to scale up dramatically in the 2000s.
1980s: The economic boom and growth of the high yield
1. US Small Business Investment Act of 1958: The law (junk bond) market proved critical to the growth of
supported private investment in small businesses and private equity buyouts, as firms used the debt to
innovation. It legally enabled the creation of venture capital acquire much larger companies than they would
and private equity buyout fund structures and allowed them have been able to otherwise.
to use leverage. Alternative investors found the legal structures
particularly attractive, as fund profits could typically be treated 1990s: Strong market returns, in large part driven by venture
and taxed at lower capital gains rates and not as income, capital backed companies, generated large amounts
which is usually taxed at higher rates. of private wealth, which served to fuel investments in
hedge funds.
2. US Department of Labor update (1978) to the Employee
Retirement Income Security Act of 1974 (ERISA): This
2000s: Investments in venture capital fell significantly following
update lifted an earlier restriction placed on pension funds from
the dotcom crash. However, the credit driven economic
investing in privately held securities, thereby enabling them to
resurgence allowed private equity buyouts and hedge
invest in alternative investments.
funds to scale up to new heights.
3. Economic Recovery Tax Act of 1981: The law reduced
capital gains taxes, which increased the attractiveness of 2010s: Alternative investments performed well relative to
equity investments relative to debt. As a result, institutional traditional investments during and after the financial crisis.
investors, such as pension funds, increased their allocation The result was an increase in demand for alternative
to alternative investments. investments, which enabled the growth of non-core
alternative investments.
4. Financial Services Modernization Bill (Gramm-Leach-Bliley
Act) of 1999: The law effectively repealed the U.S. Banking
Act of 1933 (Glass-Steagall Act) and enabled the creation of
large universal banks in the US, whose activities supported the Today, the alternative investment industry is truly global in both
dramatic increase in the scale of private equity buyouts and breadth and depth. More than 10,000 firms (Figure A5) mange
hedge funds in particular. some $7 trillion in assets under management (Figure A6).
The capital is invested across the globe in companies at every
5. Commodity Futures Modernization Act of 2000: This stage of development and in every imaginable industry sector.
law clarified that most types of over-the-counter derivatives, The industry has expanded beyond the core and now includes
which are not traded on exchanges, would not be subject a range of additional asset classes. Some are specific to
to government oversight. The law enabled the growth of alternatives, such as secondary funds, which seek to acquire
derivatives, used extensively by hedge funds, to grow stakes in existing alternative funds, while others utilize private
unchecked by any regulatory constraints. equity style fund structures and investment techniques to target
traditional asset classes such as real estate, infrastructure, or
private debt.
2.2. Technological change
The technology revolution, in part funded by alternative investors
(venture capital), and innovative ideas by academics also played a
pivotal role in the history of alternative investments. The dramatic
increase in computing power transformed financial markets and
made it possible to record, track, move, store, and analyse
previously unmanageable and unthinkable amounts of data. In
addition, academic innovations in the form of the Nobel Prize
winning Black-Scholes options pricing formula (1973) and the
application of the Gaussian copula theorems to financial
instruments (2000) enabled investors to quickly and easily price
complex financial products such as derivatives and structured
securities, which supported their rapid growth and increased
liquidity in markets overall.111, 112 Hedge funds benefited immensely
from these changes, as their business models often rely on the
large and liquid markets and/or accessing, analysing, and valuing
large amounts of data or complex financial instruments.

Alternative Investments 2020: Regulatory Reform and Alternative Investments 29

Appendix

Figure A5: Growth of core alternative asset classes 113

Total number of hedge funds, private equity buyout, and venture capital firms

1,600 9,000

1,400 8,000

1,200 7,000

6,000
1,000
5,000
800
4,000
600
3,000
400
2,000

200 1,000

_ _
1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013
Venture capital (L) Hedge funds (R)
Private equity buyouts (L)

Source: Preqin, HFR

Figure A6: Growth in assets under management by asset class114, 115

Total alternative assets under management, $ billlions

8,000

7,000

6,000

5,000

4,000

3,000

2,000 Other
Private equity infrastructure
Private equity real estate
1,000 Venture capital
Private equity buyouts
_ Hedge funds
1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

H1
2014

Source: Preqin, Hedge Fund Research

30 Alternative Investments 2020: Regulatory Reform and Alternative Investments

 Appendix

Figure A8: Breakdown of investors in core alternative

3. Source of capital investment asset classes by number of investors 118, 119, 120
Sources of capital for the industry have evolved over time, Percentage of the number of investors1
simultaneously supporting the rise of alternative investment and
100%
leading to changes in the industry itself. The capital base has

2 11

12
steadily shifted from small scale long-term investors (e.g. wealthy 90%

19
individuals) to the large institutional investors (e.g. pension funds) 80%

15
that provide most of the capital today. Below we discuss both

18
the different sets of drivers, as well as a number of specific types 70%

17
9
of investors.

16
60%

8
11
50%

12
Three sets of drivers underpin investment demand for alternative
investments, with each seeking a distinct set of attributes that 40%

25
Other
alternatives can offer (Figure A7). Different classes of investors 30% Financial institutions

26

20
are usually aligned with one of these three groups. Fund of funds
20% Wealthy individuals2
Pension funds
10%
Figure A7: Primary drivers for investors in Endowments and

24
31

24
foundations
alternative investments 0%

buyouts
Private equity
Hedge funds

Venture capital
Investment Examples Primary attraction
drivers of investors to investors

• High-net worth individuals • High returns

Long-term • Foundations • Illiquidity premium 1 Includes institutional investors that have invested in hedge funds or that have a
Endowments preference for or previously invested in private equity or venture capital funds
• • Scalability (for SWFs)
• Sovereign wealth funds 2 Includes high-net worth investors, wealth management and family offices

Source: Preqin

• National pension funds • High returns

Liability • State/city pension funds • Inflation-linked Figure A9: Breakdown of investors in core alternative
driven Teachers pension funds • Steady cash flow
• investment asset classes by capital invested 121, 122
• Corporate pension funds • Scalability
Percentage of assets under management1

100%
1 6 11

6 6

• Banks • Diversification
• Asset managers • High returns 90%
Diversification
driven • Insurance companies • Inflation linked 80%
14

• Corporations
70%
19

13

Source: World Economic Forum Investors Industries 60%

50%
17
23

The pool of investors that allocates capital to alternative invest- 40%

Other
ments is vast and diverse, and encompasses both institutional 30% Wealthy individuals2
and retail investors. The number of institutional investors alone Sovereign wealth funds
20% Endowments and
that invest in alternatives exceeds 4,800,116 with the majority
foundations
all allocating capital to at least two alternative asset classes.117 10%
Financial institutions
40

44

A wide range of investors dedicate capital to alternative assets 0% Pension funds

(Figure A8), with a wide variance in allocations (Figure A9).
Hedge funds

buyouts
Private equity

However, over 70% of this capital comes from only three types
of institutional investor: pension funds, sovereign wealth funds,
and endowments/foundations (Figure A10).
1 Excludes fund of hedge funds, and fund of funds and asset managers
for private equity firms
2 Includes high-net worth investors, wealth management and family offices

Source: Preqin

Alternative Investments 2020: Regulatory Reform and Alternative Investments 31

Appendix

Figure A10: Average allocation to private equity buyout and hedge funds by select investor type123, 124
Average allocation as a percentage of total portfolio allocation

30%

25%

20%

15%

10%

5%
Private equity buyouts
13

12
18
19
28

19

11 Private sector

2
6

8
7

3
0% Hedge funds
pension funds
Family offices

plans
Endowment

Foundations

wealth funds
Sovereign

companies
Insurance
funds
Source: Preqin
Public pension

4. Role in the financial system critical services such as transaction support, act as counterparties,
and generate new financial products – as we describe in more
The alternative investment industry is part of a much broader detail below. Growth in the alternatives is therefore somewhat
financial ecosystem (Figure A11). Since the 1980s, the industry dependent upon the future shape and health of the wider financial
has relied on banks, insurers, and other types of financial system, which in turn is undergoing a profound set of reforms
intermediaries to supply leverage (debt financing), provide following the global financial crisis that began in 2008.

Figure A11: Alternative investment firms within the wider financial system
Regulatory/Policy/Societal Environment

Alternative investors (GPs)

• Venture capital
• Private equity
• Hedge funds
• Other

Management Fees
GP commitment Performance Fees
Return on commitment
Capital Providers (LPs) Investment destination
• Pension funds • Company (stake)
LP commitment Investment
• Sovereign wealth funds AI investment vehicle • Physical asset
• Wealthy individuals • Fund vehicle XYZ (infrastructure, real estate)
• Endowments/foundations Net return Gross return • Security (derivative or
• Asset managers / FoFs insurance contract

Fees Services
Debt Capital
Services
Rating
Regulated Service Providers Insurance
Fees
• Banks
• Rating agencies
Services • Insurance companies Fees and interest
• Money market funds

Source: World Economic Forum Investors Industries

32 Alternative Investments 2020: Regulatory Reform and Alternative Investments

 Appendix

Figure A12: The average amount of debt (leverage) used by different investment strategies 125, 126, 127
Debt as a percentage of the total deal value

100%

75%

50%

25%
29

80

90
47

60

65

68

79
74
0 0
0%
(distressed)
Hedge funds

(emerging)
Hedge funds

buyouts
Private equity

infrastructure
Private equity

(Global macro)
Hedge funds

(Fixed income)
Hedge funds
(Event driven)
Hedge funds

(10% down)
Home mortgage
Venture capital

(Long/Short)
Hedge funds

(20% down)
Home mortgage
Source: Preqin, Citi, William Blair

4.1. Leverage 4.4. Product innovation

A critical way in which the financial industry supports alternative Innovation by the financial sector has influenced the rise of the
investing is through directly and indirectly providing loans in alternative industry, particularly over the past decade. The
the form of debt financing. The impact of this can hardly be creation of structured products such as CDO’s and CLO’s that
overstated, with asset classes such as private equity buyouts, packaged junk grade fixed income securities into investment grade
hedge funds, and private equity infrastructure relying on debt instruments is probably the clearest example of financial innovation
financing to pay for 50% to 80% of their investments (Figure A12). that enabled the industry to grow in size and scale. The products
Their ability to apply leverage allows these firms to pursue larger enabled private equity firms to issue far more debt than they
targets and to improve returns (or reduce) returns. likely would have been able to otherwise. Many of said products
were then acquired by hedge funds, which often used additional
leverage from the banks to acquire them. The issuance of cov-lite
4.2. Services and PIK loans during the last cycle is another example of financial
Beyond services relating to the provision of debt, traditional financial innovation that benefited the industry. Historically, new financial
intermediaries and institutions also provide an extensive array of products have often resulted in asset bubbles and crises, as many
services to alternative investors. Institutional investors, financial financial actors did not understand the risk associated with them
institutions, and asset and private wealth managers help to direct or how interconnected they were to other parts of the financial
capital to alternative investors. Investment banks provide M&A and system. The crash of the high yield bond market (“junk bonds”) in
transaction support to private equity, coverage and sponsorship of the late 1980s, the Long-Term Capital Management, and the crash
IPO’s or trade sales for venture capital, and prime brokerage and of real estate related CDO/MBS securities during the financial crisis
treasury services to hedge funds. Ratings agencies rate the bonds are notable examples.
and loans that private equity firms issue. Prime brokerage and
treasury units provide the transaction services record keeping
required to track all investment flows and ownership.
5. Role in society and the economy
The alternative investment industry plays an important role in
4.3. Counterparties
society and its actions affect a wide range of stakeholders through
The role of a counterparty is a critical one, particularly for hedge their impact on the world’s capital markets and, especially, the real
funds. The creation and trading of standardized equity and economy (Figure A13). Figure A14 qualitatively summarizes the
fixed-income products, as well as bespoke derivatives contracts academic literature discussed below with regard to how each major
requires large, liquid, and sophisticated counterparties. A alternative asset class affects society (positively, negatively, or both).
significant amount of hedge fund activity relies heavily on the
availability of these services. As we discuss below, capital markets benefit through mechanisms
such as increased market liquidity and lower transaction costs,
while alternative investment drives the real economy through its
direct economic impact (e.g. improving retirement outcomes for
millions of people) and through other key mechanisms such as
the promotion of innovation (e.g. funding new technologies).

Alternative Investments 2020: Regulatory Reform and Alternative Investments 33

Appendix

Figure A13: Stakeholders affected by alternative investment strategies

Political
system Central
Start-ups banks

Hedge
funds Public
Small and
Corporate State owned Regulators actors Policy
medium sized
enterprises enterprises entities
actors

Private Alternative Venture Unions

Multi-national equity investments capital
corporations

Wealthy Asset
individuals Other managers
Investment
banks

Sovereign Sources of Financial Retail

Financial Exchanges
wealth funds institutions banks
capital system

Pension Money Rating

funds market agencies

Source: World Economic Forum Investors Industries

Figure A14: Stakeholders affected by alternative investment strategies

Negative side effects Mild High positive benefits

Description VC PE HF
•
• Enables investors to buy/sell assets
Liquidity
when they want

• Develops new and innovative products,

Financial innovation
but these can produce new risks as well

Capital
• Provides the capital needed to invest
Long-term capital
markets in long-term projects

• Provides capital to projects that are

High-risk capital
too risky for normal investors

• Supports businesses and consumers

Transaction costs
by reducing the cost of deals/trades
AI’s
contribution to • Increased GDP growth
the economy Economic impact • Increased competition within industries
• Funds the technologies that will
Innovation change the world tomorrow

Real • VC creates new employment

Employment
economy • PE slightly decreases employment2

Corporate • Strengthens governance structures

governance 1 • Reduces principal-agent issues
• Improves the productivity of firms
Firm productivity
• Invests in new research
1 Concerns have been raised that activist hedge funds may focus too much on short-term results
2 Research has shown that private equity buyouts often result in both new jobs being created and existing jobs being eliminated,
with a slight decrease in overall employment as a result

Source: World Economic Forum Investors Industries

34 Alternative Investments 2020: Regulatory Reform and Alternative Investments

 Appendix

Acronyms

PRIPS = Packaged Retail Investment Products

FATCA = Foreign Account Tax Compliance Act

AIFMD = Alternative Investment Fund Managers Directive

FTT = Financial Transaction Tax

UCITS = Undertakings for Collective Investment in Transferable Securities

RDR = Retail Distribution Review

MIFID = Markets in Financial Instruments Directive

Dodd-Frank = Dodd-Frank Wall Street Reform and Consumer Protection Act

Volcker Act = Volcker Rule within the Dodd-Frank Wall Street Reform Protection Act

CRD = Capital Requirements Directive

Basel = Basel Accord

Solvency = Solvency Directive

EMIR = European Market Infrastructure Regulation

European Commission’s Liikanen proposals = Liikanen proposals

Alternative Investments 2020: Regulatory Reform and Alternative Investments 35

Acknowledgements

Project Team Steering committee Expert committee

Michael Drexler, Senior Director, Head of Alan Howard, Founder, Brevan Howard Professor Alexander Ljungqvist, Ira Rennert
Investors Industries, World Economic Forum Investment Products Chair of Finance and Entrepreneurship, New
York University’s Stern School of Business
Michael Jacobides, Sir Donald Gordon Chair Anthony Scaramucci, Founder
of Entrepreneurship and Innovation, London and Managing Partner, SkyBridge Capital David Spreng, Founder and Managing Partner,
Business School Crescendo Ventures
Arif M. Naqvi, Founder and Group Chief
Jason Rico Saavedra, Senior Project Manager, Executive, The Abraaj Group Douglas J. Elliott, Fellow, Economic Studies,
Investors Industries, World Economic Forum Initiative on Business and Public Policy,
Professor Dr. Axel A. Weber, Chairman Brookings Institution
of the Board of Directors, UBS
Special thanks Professor Francesca Cornelli, Professor
Daniel J. Arbess, Founder, Pridelands of Finance, London Business School
We would like to provide a special thanks to Investments
Professor Jacobides. The report would not Professor John Van Reenen, Director, Centre
have been possible without the insight, thought Daniel S. Loeb, Chief Executive Officer, for Economic Performance, Productivity and
leadership, and guidance that he contributed. Third Point Innovation Programme, London School of
In addition, his willingness to leverage the full Economics and Political Science
array of resources available at the London Donald J. Gogel, Chairman and Chief
Business School was invaluable in ensuring Executive Officer, Clayton, Dubilier & Rice Professor Josh Lerner, Jacob H. Schiff
that the project had access to the research Professor of Investment Banking, Harvard
and documentation tools necessary to Hamilton (Tony) James, President and Chief Business School
complete this report. Operating Officer, The Blackstone Group
Reto Kohler, Managing Director, rjkadvisors
To members of the Investors team at the John Zhao, Founder and Chief Executive
World Economic Forum: Katherine Bleich, Officer, Hony Capital Takis Georgakopoulos, Managing Director,
Amy Chang, Maha Eltobgy, Peter Gratzke, Chief of Staff, Corporate & Investment Banking,
Alice Heathcote, Tik Keung, Abigail Noble, Paul Fletcher, Chairman, Actis J.P. Morgan
Megan O’Neill, Dena Stivella.

Production and design team

(in alphabetical order)

Adelheid Christian-Zechner, Designer

Peter Vanham, Senior Media Manager,

World Economic Forum

Robert Jameson, Editor

36 Alternative Investments 2020: An Introduction to Alternative Investments

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38 Alternative Investments 2020: Regulatory Reform and Alternative Investments

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Alternative Investments 2020: Regulatory Reform and Alternative Investments 39

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