A growing number of hedge funds are allocating larger chunks of their portfolios to private market assets, chasing compelling opportunities and competing for many of the same investments traditionally pursued by private equity and venture capital funds.

Once they have decided to invest in private assets, hedge funds are likely to encounter a number of unfamiliar operational challenges. In areas like data collection, valuation, and portfolio monitoring, they will need new approaches to avoid being swamped by the complexity of their new investments. Hedge funds can learn a lot from their private equity and venture capital peers about how to effectively manage a portfolio of private assets.

The hedge fund pivot to private assets

Hedge funds have made nearly 800 private deals so far in 2021, nearly quadruple the annual number of such deals they made between 2010 and 2015, according to research by Goldman Sachs. And the size of those investments is impressive: while hedge fund deals make up about 4% of the estimated total volume of private asset deals this year, the money they've spent on those deals represents 27% of the total capital deployed into that market, or roughly $153 billion.

As hedge funds increasingly chase the same private investments as PE and VC firms, their differentiated investment approach is changing the fundraising paradigm for companies. Hedge funds are often willing to invest at higher valuations, and in some cases they are leading or acquiring entire rounds, streamlining the due diligence process and getting checks to the companies faster. Hedge funds also tend to be less involved in portfolio companies' operations, rarely seeking board seats or strategic changes.

Their focus is squarely on the investment opportunity, which has grown sharply as private companies stay private longer by increasingly raise more capital--and create more value--prior to seeking an IPO. The number of unicorns, or private companies valued above $1 billion, has shot to over 800 globally.

Confronting the data collection challenge

A hedge fund investor is accustomed to having public market data at their fingertips; this stands in stark contrast to the complex and cumbersome process of accessing private company financials. Deal teams will have to collect company financials themselves, then spend hours extracting financial metrics from a wide variety of reporting formats.

Instead of dedicating expensive analyst resources to this task, many private equity fund managers rely on third-party help to extract important data and KPIs. IHS Markit streamlines this process on behalf of investors by collecting source financials, cap tables and articles of incorporation, then utilizing technology to extract data directly from the documents. The use of technology minimizes the reporting effort for portfolio companies and ensures that investors get clean, auditable data from as-reported financials in a timely fashion. IHS Markit has now done this for more than 3.5 million data points across more than 16,000 unique portfolio companies.

Re-tooling portfolio valuations

Marking liquid assets to market for reporting is relatively straightforward for publicly traded assets, but as hedge funds augment their holdings of complex illiquid ("Level 3") assets, they may have to re-engineer their processes.

In private markets, hedge fund managers may confront new choices about the appropriate methodology and the required frequency of valuations. Depending on the company's stage of maturity, should they use a discounted cash flow, option pricing model, or backsolve? Should valuations be updated quarterly or annually? What other factors should they consider as part of a valuation policy on private assets? These and other questions have led some hedge funds to augment their internal valuation teams.

Insourcing and leveraging technology can both be economical options for a fast-growing portfolio. Many venture capital and growth equity firms use IHS Markit's Qval software solution to automate their valuation process, and to solve for some of the specific problems of growth-phase investments.

Adapting portfolio tools to new asset types

Hedge funds may have sophisticated tools for portfolio monitoring, but systems focused on trading, clearing, and reconciliation for public markets may struggle with private company data. Shoehorning private asset information into existing portfolio management systems may require time-consuming and error-prone manual effort. For example, private asset reporting periods, asset characteristics, and liquidity profiles may be difficult to model without significant customization.

Most PE and VC managers use a built-for-purpose portfolio monitoring tool like iLEVEL, which is constructed around the data workflows of private assets. With its easy-to-use dashboards, data collection modules, visualizations, and easy data portability into and out of the platform, iLEVEL offers fund managers a flexible way to manage private assets alongside other asset types.

A growing trend

With companies producing an ever-increasing larger proportion of their value during the private stage, hedge funds' pursuit of private asset is likely to continue. The opportunities are tremendous, but navigating the nuances of managing these investments - and avoiding the costly operational pitfalls - will be key to creating value for investors.

Learn more about IHS Markit's solutions for private markets.