The extent and speed of continuous change in the hedge fund world has implications for other players in the market, looking beyond the hedge fund managers and their investors. As the market continues to grow and evolve in terms of the creation of new hedge funds, and the permanent evolution of investment strategies drives forward, so does the need to service the changing requirements continue to evolve.
Even in the US, it appears, where the larger funds have traditionally looked after their own administration requirements, the industry is increasingly looking for new external solutions to ever more individualised problems, comments David Aldrich, a managing director at The Bank of New York Mellon, Europe. “In the past they would have had a McDonald’s solution. Today it is more of an á la carte menu, which gives them the opportunity to choose exactly what their business requires.”
The pursuit of increasingly sophisticated and complex trading strategies is of course at the core of what sets hedge funds apart from much of the rest of the investment management community. The philosophical, esoterical and practical differences between hedge funds and their more mainstream counterparts present certain operational difficulties and challenges, both for the hedge funds themselves and for suppliers of asset services.
“The phrase hedge fund has become almost meaningless,” observes Ian Headon, a vice president in product development at Northern Trust Global Fund Services in Dublin. “There are funds that are clearly hedge funds, with an office in Mayfair, managing money using prime brokers and derivatives, taking long-short positions and domiciled in the Caribbean. And there are funds that are clearly not hedge funds, managing money on a long-only basis. There is, however, a grey area in the middle that is growing year by year.” It is that grey area that is creating both growth opportunities and operational and product challenges in terms of addressing the evolving needs of the asset manager and how those needs can be most efficiently and most reliably met.
Should a fund build its own dedicated post-trade infrastructure? Should it tap into another institution’s existing firepower. If the latter, just who are the natural providers of the administration services that hedge funds need? The traditional custodians who have transformed themselves beyond all recognition over the past 10-15 years and continue to invest heavily in technology and other resources? Prime brokers? Software and hardware vendors? Further complicating the picture is that hedge funds, by their very nature, tend to need more day-to-day contact with human beings. This changes their reliance on service providers, which can often find themselves being asked to perform additional non-contracted services as the need arises.
The same broad arguments apply to outsourcing in the hedge funds world as apply to any other sector. In the simplest terms, outsourcing can reduce costs and increase efficiencies. It can also improve performance by allowing a hedge fund manager to focus more on the core business. In such a context, the role of external provision of infrastructure and software to hedge funds comes into greater focus, and a growing number of hedge funds are reported to be looking to outsource certain back and middle office functions. Their needs have changed significantly over the past 10 years and the way in which those needs are being met has changed, if only in terms of their look and feel, as automation has spread. “The biggest trend is convergence, which is blurring the lines between traditional long-only managers and the hedge fund-style approaching to investing,” comments Robert Caporale, Global Head of JPMorgan Hedge Fund Services. “As part of that convergence, more managers are looking for a broader range of back and middle office services.”
Aspiring hedge fund managers can virtually quit their existing jobs on the Friday, and be up and running on the Monday. “If you’re a start-up hedge fund with 1 to 20 people, we can give you access to an enterprise grade hedge fund specific infrastructure over the wire,” says Sasha Kouperman, President & Director of Consulting Services, InfoHedge Technologies, New York. “All you need is a desktop or a laptop. Everything else – servers, trading systems, compliance solutions, email archiving, fully hosted voice over internet protocol, storage and back-up with embedded disaster recovery – we can provide on a subscription basis, like a Chinese menu. We can have you up and running in three days.”
“We are being flooded with requests from hedge funds,” observes Sameer Shalaby, CEO of Paladyne Systems, New York. “Because of the volume and complexity of their business, combined with the shortage of talent, the cost of building an in-house capability is prohibitive, not just for small and medium-sized funds. Hedge funds of all sizes are increasingly interested in outsourcing everything, leaving them free to concentrate on generating alpha. This will become even more of an issue as regulators impose more reporting requirements upon hedge funds.”
According to Jayesh Punater, CEO of New York-based Gravitas, which describes itself as a leading supplier of end-to-end IT services to hedge funds and private equity firms, thinking will need to evolve on both sides of the industry if it is to keep on top of the challenges it is presenting to itself. “The sheer speed of growth and the increasing complexity of investment strategies make it impossible for either hedge funds on their own, or IT providers on their own, to keep up,” he says. “This creates new demand for customised IT applications developed in partnerships between the demand side and the supply side.”
As one of the most likely reasons for hedge fund failures is because of internal operational problems, the external provision of administrative services could become crucial as the market continues to grow and evolve. Arguments in favour of outsourcing apply even more to smaller operations for which the sheer cost and time involved taking the do-it-yourself route would be economically disproportionate. In many respects, for such hedge funds the problem is a classic ‘no-brainer’. As it is almost a ‘given’ that smaller hedge funds will NEED to outsource, the most important questions will relate to the identification and appointment of a suitable provider. Key points to take into account include the stability of the provider, and its long-term commitment to the space (i.e. will the supplier still be around in five to 10 years?).
Big is not necessarily best when making the eventual decision, observes Philippe Rozental, co-head of asset servicing at Société Générale Securities Services. “It might be a cliché, but it is nonetheless true to say that it can be better to be a more important client of a smaller provider, at the front of the queue when it comes to attention and service, than to be a small client of a big provider. Finding an external provider that can sympathise with and understand the nature of the business, and manage the contract accordingly, is essential to allow organisations to focus on the important aspects of their work, rather than the processes and architectures that keep the organisation ticking over. Rather than think about insourcing, it would be better instead to ponder the attractions of quality service, brand protection and the customer experience that outsourcing will help deliver, linked to longer term contracts that will allow the outsourced service provider breathing space to invest and develop its staff to a higher level.”
Surprisingly, perhaps, some feel the segment is under-served, partly because of the complexity, partly because of the difficulty in retaining good staff, notes Akshaya Bhargava, CEO of Fulcrum, a Bermuda-based hedge fund services provider in which the UK’s 3i recently took a stake. The landscape has changed dramatically in recent years, adds Gary Enos, head of hedge fund servicing for State Street Corporation. “The purchase of a number of companies by larger institutions has reduced the number of providers, and we expect that trend to continue, albeit at a slower rate.”
In the meantime, the industry is studying with interest recent guidelines issued by the Alternative Investments Management Association AIMA on valuation principles for hedge funds, and by IOSCO on best practice in the valuation of illiquid securities, matters highlighted by the credit crunch. “We welcome both documents quite strongly as the first independent, industry-level documents to provide a certain degree of clarity in this area,” says Ian Headon. “The industry has been accused of lack of clarity around best practice concerning who is the most appropriate person to determine security valuations. Compliance with these papers will help resolve this question with investors, asset managers, the media and others, by making it plain that the responsibility ultimately lies with a fund’s governing body – typically a Board of Directors or General Partner. It is up to them to appoint an independent administrator or valuation agent to capture security values in accordance with a pricing policy document together with appropriate points of escalation and resolution procedures.”
As the market continues to grow and evolve, administrators and other service providers must continually adapt continually adaptable to managers’ servicing requirements, notes Derek Buntain, Chairman & Director of Bermuda-based Dundee Leeds Management Services. “Increased demands for greater transparency and clear valuation processes, as well as administrators’ move into middle office services, increase the role of the administrator and influence both the services they provide and the technology they choose in order to fulfil the needs of investors and managers” he says.
“A key regulatory development in the evolution of valuation practices is the FASB’s Statement of Accounting Standards No.157 (FAS 157), which will takes effect for financial statements of companies with fiscal years beginning after November 15, 2007. Introduced to meet demands for greater disclosure of valuation methodology in the face of increasingly esoteric investments and to improve consistency and comparability across a historic mismatch of financial statements, FAS 157 provides guidance for defining and measuring ‘fair value’ by establishing a three-tier classification system for securities and stipulating valuation procedures for each tier.
“While the manager is ultimately responsible for pricing methodology and valuation procedures, the administrator has a fiduciary responsibility to investors to provide independent portfolio pricing, and although it will be difficult to ascertain the exact effect of the new rule until after this year’s financial statements have been prepared and audited, the administrator will play a pivotal role in helping clients interpret the rule and ensuring that they are comfortable with the level of disclosure made in their financial statements.”