BHA recently attended an industry conference devoted to family offices and their role in hedge fund investing in 2010. More than 200 single- and multifamily offices were in attendance as well as 250 alternative fund managers. Speaking to numerous family office investment teams and sitting in on a handful of panel discussions, analysts gained considerable insight into how family offices have evolved and how their focus has changed.

To start, the number of family offices in the U.S. and abroad has grown considerably over the past few years. The main reason for this a need for services. Large institutions are not offering affluent investors highly personalized financial services.

Services vary from office to office, however, most are providing investment and finance-related services, such as tax management and advisory services, political donation management, cash flow management and budgeting, and multigenerational wealth transfers. These services are not available in a private banking or traditional wealth-management setting, simply because they are affordable for only the most affluent individuals. During these uncertain and volatile economic times, the demand for highly sophisticated and personalized finance and investment services has increased significantly, and paved the way for teams to spin out and open shop.

Family offices have also increased their activity within the hedge fund space considerably over the past few years. After a disastrous 2008 and an extremely volatile 2009, the need for exposure uncorrelated to the market has become more and more apparent to single family and multifamily offices. Of the roughly 7,000 mandates published on the BHA platform, nearly 1,000 are family offices around the globe actively seeking new investment opportunities.

The three major themes discussed throughout the conference were better liquidity terms, typically at least quarterly; more transparency, including insight into how managers run their strategies and direct access to portfolio managers; and investing through managed accounts.

Although family offices are increasing their activity in the alternative space, they are becoming much more cautious in their approach to new investment opportunities. Furthermore, family offices are increasingly adopting institutional investment practices when conducting due diligence. Track records and performance are no longer enough to justify an allocation; it takes much more to earn the trust of these coveted investors. They are putting more emphasis on operational due diligence, including risk management analysis, administrator reviews, and even manager background checks. Funds with a stable infrastructure and a cohesive team are now the most eligible bachelors.

It is apparent that money is gradually flowing back into the alternative industry, specifically in the family office circle. However, with that also comes a change in perspective and process. Managers will find that they must be much more accommodating if they want to get on the radar screens of an ever-growing segment of the investor market.

Since October 2009, BHA analysts have spoken with over 40 endowments. Of those, 26 have recently decided to begin investing in or make larger allocations to single-manager hedge funds.

The investment staffs of the endowments cited various reasons for the shift. Some emphasized interest in single-manager funds that were uncorrelated to equity market indices. Other endowments who had traditionally invested in funds of funds noted the cost-effectiveness of these funds when compared with fund of funds for their increased allocation to single-manager hedge funds.

Since the financial crises, an increasing number of endowments have been asking their investment committees to conduct more stringent due diligence and secure access to more information, such as reports on portfolio holdings and exposure. In response, the committees have augmented their staffs, hiring sophisticated analysts. Therefore, today, many committees have the staff necessary to research and evaluate single-manager funds.

A $500 million endowment based in the U.S. recently decided to invest in single-manager funds. The institution has typically gained hedge fund exposure through funds of funds; however, it believes that single-manager funds will provide more information about their strategies and more access to their portfolio managers than funds of funds. The endowment has decided to divest itself of its long-only portfolio and reallocate that money to single-manager hedge funds. It is seeking emerging managers, which it believes can access less saturated segments of the market and provide returns that a much larger fund may not be able to offer.

A multibillion dollar endowment in Canada has also decided to allocate to single-manager hedge funds, chiefly global macro or global technical asset allocation (GTAA) funds. To date, the institution has only invested in fund of funds. However, funds of funds’ double layering of fees and limited access to underlying managers makes increasing its single-manager exposure a more cost-effective and more transparent way of investing. Unlike the U.S. endowment, this fund is seeking highly experience managers and much larger funds for its foray into direct investing.

Endowments rely heavily on alternative investments, mainly hedge funds, to be able to support the operational and accrued costs of running their institutions. Now that the economic environment has improved and endowments are recovering, they are beginning to actively invest again and placing more emphasis on their ability to seek out, evaluate, and monitor investment opportunities internally. This shift in strategy has increased the investment activity in single-manager funds over the past two quarters and most likely will throughout the remainder of 2010.

Hedge funds focused on merger arbitrage were up almost 8 percent in 2009, according to data from Hedge Fund Research. Perhaps not surprisingly, investors looking to diversify their portfolios and achieve reasonable returns increasingly mentioned their interest in these funds during the first quarter.

A merger arbitrage strategy seeks to take advantage of the price movements of a company’s stock after a merger is announced. Specifically, traders will buy the target company’s stock with the expectation that it will increase in value when the deal closes. Generally that happens, but the stock doesn’t usually rise as high as the acquiring company’s offer price. The spread between the two prices reflects the risk that the deal may not be completed.

Investors are telling BHA analysts that they believe merger arbitrage funds are a good way to diversify a portfolio because they are not affected by the market’s ups and downs. Additionally, because of the recent economic downturn, investors say there are numerous opportunities for the sophisticated arbitrager.

A U.S.-based endowment that has traditionally invested in hedge funds through funds of funds has recently decided to allocate directly, with a specific emphasis on merger arbitrage and event-driven funds. The endowment believes that M&A investment opportunities will continue to expand, and it is looking to capitalize on this trend by committing to a manager before year-end. The endowment also is looking to diversify its portfolio with highly uncorrelated strategies, and it believes merger arbitrage funds are an essential piece of this asset allocation strategy.

A fund of funds based in the Midwest is specifically seeking opportunities with special situations, fixed-income arbitrage, and merger arbitrage funds, but merger/risk arbitrage is its primary focus. The firm is seeking managers that have experience in arbitrage strategies and have been investing in these strategies for at least three years. The firm does not want to miss out on the countless opportunities it believes exist in the M&A space, and is planning to make an allocation by the fourth quarter.

M&A activity has grown tremendously over the past two years, giving hedge fund managers and portfolio analysts many deals from which to choose, and allowing them to be more selective. With the growing M&A activity and the increasing number of investors looking for shelter from a volatile equity market, merger arbitrage is a strategy likely to rise in importance with investors seeking absolute returns.

Over the past few weeks, BHA analysts have noticed a considerable increase in investor interest in boutique, single-strategy funds of hedge funds. Of the 58 fund of funds mandates BHA has received, 30 have been for single-strategy funds.

Among both large, seasoned alternative investors and small, less sophisticated ones, there has been a consensus about their investments: what they thought were unique, uncorrelated, and specialized funds turned out to be slow and cumbersome juggernauts that were chiefly designed to gather assets rather than generate alpha.

In response to this revelation, investors are turning to highly focused and more nimble funds of funds that are built upon a track record of execution rather than a track record of fundraising. They are seeking specialized management teams that possess the proven ability to understand the underlying strategies and funds they evaluate, as well as the expertise to identify potential red flags.

An investment consultant based in Australia is currently seeking opportunities from funds of long/short equity funds. The firm’s clients have increasingly abandoned the multi-strategy approach for specialized, niche opportunities. The consultant is seeking teams that have experience in both fundamental and quantitative approaches. It believes that such teams have the knowledge necessary to understand funds’ strategies and how they are being executed, which in turn will help managers identify potential problems before they affect the portfolio in its entirety.

A large tax-exempt investor based in the U.S. is also seeking single-strategy funds of funds but in the fixed-income space. To qualify, managers must have more than three years experience operating a single-manager fund because the organization believes that only tested managers understand how to build out a clear and concise portfolio of underlying funds. There is more to a fund than just returns and volatility according to this investor; the details of a strategy, the level of risk management, and the cohesiveness of a team also determine if an investment will be a sound one.

Alternative investors are seeking experience and competence when evaluating funds of funds teams. The days of pumping capital into bulky, asset-gathering machines are over and small, specialized, and sophisticated investment managers are taking center stage.

During the past eighteen months, the tumultuous economic environment has forced many companies to restructure, divest themselves of assets, merge, or search for new business partners. As a result, many hedge fund managers that have been operating event-driven, distressed, and special situations strategies are now seeing prolific returns on their investment models—and alternative investors have taken notice. During the past four weeks, 75 of the 190 hedge fund investors interviewed by BHA analysts expressed increased interest in researching these investment strategies for possible allocation.

A fund of funds based in New York said it is actively seeking new investment opportunities with event-driven funds with the expectation of allocating capital by the end of the calendar year. It will focus on distressed credit and merger arbitrage funds within the U.S. because it feels that the poor economic environment, specifically within the United States, has fostered numerous opportunities for well-performing companies to acquire smaller, more distressed firms, which in turn will offer merger arbitrage funds more opportunity to capitalize on those events.

A large family office based in London that generally seeks liquid investments has recently begun to consider event-driven and credit funds as well. Despite longer lock-up terms, the firm believes that there are considerable opportunities in this space. For credit strategies, the firm is interested in long/short credit and funds with a focus on capital structuring rather than mortgage-backed securities. With regards to event driven, the group has a preference for funds focused on special situations and on those that trade distressed debt. For similar reasons as the fund of fund, the family office believes that special situations funds are in the best position to offer solid returns in these markets, chiefly because economic downturns offer countless opportunities for funds that are positioned to take advantage of mergers, acquisitions, bankruptcies, and capital/credit dislocations within the markets.

The severe economic environment of the past few years has cultivated countless opportunities for savvy alternative fund managers. Sophisticated institutional investors that are eager to identify the upside of the economic downturn are seeking funds that can offer them that exposure.

Family offices are one of the most highly sought after investors by alternative fund managers. These private and elite investment firms are major players in the alternative investments community, and one of the few investor categories that has consistently remained active in researching and allocating capital to funds throughout 2009.

During the last 30 days, BHA analysts have cultivated over 60 active mandates from family offices from around the globe. More than three-quarters of those mandates were for single-manager hedge funds that have a track record exceeding two years. Most importantly, however, these firms are looking for prospective managers who were able to expertly navigate 2008-2009 by providing stable results for investors.

A single-family office based in Philadelphia that is actively evaluating prospective fund managers is less focused on funds’ strategies than on managerial experience and expertise. It is seeking managers that have successfully navigated the turbulent economic environment from the fall of 2008 through the summer of 2009. To date, the bulk of managers that have contacted the office have emphasized their returns from the past six months, because they performed dreadfully during the latter part of 2008. The firm wants to hear from managers that are willing to tout their performance in 2008.

A family office located in New York City is another example of a firm focused on finding managers that offer both experience and skill. It is looking for a few long/short and global macro funds that have a track of at least four years. The firm wants to see prospective funds that finished 2008 either flat or with slightly positive returns. Funds that suffered a net loss or experienced a considerable number of drawdowns will not be considered.

Family offices are currently one of the most active investor categories in the alternative investments arena. These personal wealth management firms are flush with capital and are willing to invest in more risky opportunities. Considering the inauspicious economic environment, these investors will increase their exposure only if fund managers prove to be highly skilled and seasoned.

During the past four weeks, BHA analysts have seen investor interest in Asian hedge funds increase significantly. Investors have cited three main reasons why their interest has amplified during this current economic environment. First, when compared with other regions, Asia’s regional interest rates are considerably lower. Second, the Central Bank of China has reported record loan growth. In March of this year, new loans hit a record high of 1.89 trillion Yuan ($276.6 billion). For investors, this is a sign that the economic conditions in Asia, and specifically China, may be poised to offer great opportunities. Finally, current policy actions are aimed at maintaining strong liquidity conditions and motivating domestic demand. In short, Asian economies are continuing to grow, especially the region’s two largest, China and India.

A family office based in Switzerland has realigned its entire hedge fund portfolio to concentrate solely on opportunities within Asia, specifically long/short equity funds focused on Indian equities, as well as convertible arbitrage funds that are taking advantage of the current economic environment. The firm feels that Asia is poised to present very lucrative opportunities over the next few quarters.

A large investment consultant based in the United States also sees great opportunities in Asia. The firm is researching new Asian funds to add to its portfolio by the fourth quarter, specifically emerging managers that have a new perspective on the Asian markets.

While most countries are experiencing very slow or stagnant growth if not continued economic decline, Asia has emerged as a strong and resilient region. Hedge fund investors have noticed and are willing to bet on it.