Evolution Not Revolution

Originally published in the July/August 2011 issue

All the signs point towards hedge fund assets reaching record levels by the end of 2011. At first glance this might signal ‘business as usual’ but comes at a time when investors and regulators are making increasing demands for greater operational efficiency, transparency and governance.Over the next 18 months hedge funds will be affected by a new regulatory environment with the likes of AIFMD, Dodd Frank, UCITS IV and FATCA. The potential effects are numerous: increased disclosure, compliance costs, depositary costs and regulatory oversight and tighter monitoring of risk.

With a revitalised start-up market and growing duediligence on existing funds it has never been more important for managers to ensure that they have the right people, infrastructure and technology in place for their business today and to consider what will be required tomorrow.

At the various phases of a hedge fund’s life-cycle requirements will change; managers should examine not only what may be needed in the future but what may also be left behind from previous stages. Decisions made on technology at any given point can obviously have an impact in the future if systems are no longer useful, robust or have evolved into something unmanageable. Hedge funds invest in technology at start-up and as they progress through the stages of small, medium, to large funds they must continually reconsider their needs. So, whether it is external regulatory factors or an internal factor such as growth, the message is be prepared for change.

From little acorns
The initial investment in systems is often made when investors are still few and the manager can handle the communication on strategies and performance and controls costs to maximize alpha. As the fund grows, a non-systemic approach is applied to the addition of new systems and resources are generally aligned with key pain areas. As much as possible is deferred to the fund administrator for regulatory reporting, valuations and NAV production. At this stage counterparty exposure reduction is directly contrary to cost reductions so often managers will maintain a single prime to maximize the value of their contracts. A ‘trust’ relationship exists across the board and reconciliation and data flows are simple enough to be managed manually.

New strategy launches then require new systems, whether EMS or OMS-focused, or the addition of spreadsheets to manage daily flows. Margin optimization, collateral management, and investor due diligence is managed tightly. System selection often focuses on middle/front office requirements rather than anticipating future success and its consequent operational needs – which in actuality defers conversion costs, making the entire platform more expensive when a start-up moves to its next phaseof development.

Portfolio management and accounting systems that may seem overkill at this time will not only provide longevity and ease of transition in the future but have immediate benefits: strong reporting capabilities, simplified integration with third-party data sources and efficient reconciliations with administrators and prime brokers. Having these tools in place early on will provide the basis for a robust and scalable infrastructure and in the case of start-ups should be very quick and inexpensive to implement.

Adding complexity
When a hedge fund hits the $500 million to $1 billion mark both the financial and operational support frameworks need to be re-balanced as complexities arise. Multiple counterparties and prime brokers need to be controlled to ensure an efficient and profitable middle office operation. Any foresight shown at the start-up stage now comes into play.

As operational staff is added, segregation of duties and workflow management controls should be enhanced to bolster the existing environment. The emerging fund is likely to want in-house trading, portfolio management, risk, reconciliation, and accounting systems for investment oversight and operational homogeneity. Shadowing of the administrators’ NAV should be a given.

Margin and collateral management will also become more important and managers may have to consider whether it can be easily integrated with their portfolio management system. Margin optimization will be of particular interest as the fund seeks to reduce counterparty risk through multiple relationships. As roles within the fund become more specialised a culture of ‘management by exception’ will develop.

The adequacy of the firm’s system with regards to its needs should be continually questioned. If the system is meeting basic needs then what other benefits might be derived? Increased investor confidence leading to increased funding? Reduction of compliance costs? Etc.

Investor due diligence will become more thorough and the fund will need a framework to control its own destiny. Ideally a single investment platform that supports the full range of asset types should now be employed, with the ability to manage large trading volumes with the requisite uptime, reliability and security ready for the next stage of growth.

Without a strong operational oversight the small firm that grows larger soon finds its data distributed across hundreds of spreadsheets managed by individuals who are key single points of failure. These staff then retain their processes as cultural imperatives and create work silos that do not look across the organization. In effect the firm creates a group of domain subject matter experts with little flexibility or understanding of industry and organizational impacts.

Building a brand
When a hedge fund evolves into a large-size undertaking its capital raising, retention and promotional differentiators will be foremost. Investor relations will require greater transparency and all data, including investor records, will be maintained internally. Specialised reports, dashboards and analytics by role will be employed to monitor investments and maximise alpha. Product controls will now umbrella multiple managers, strategies and locations and it is likely that all potential asset classes will be exploited.

The fund’s assets under management are likely to be well above $5 billion and its scale, stability and governance will underpin the marketing effort. Tools will be required to manage actual and projected investor cash-flows, to meet larger scale cash requirements and facilitate treasury operations.

As with every previous stage systems should be rationalized to ensure they are consistent with the growth of the firm and meet the needs of internal and external stakeholders. Potential benefits of a platform change should be assessed.

Corporate governance and transparency must be facilitated by a robust IT infrastructure and team. With careful planning in the earlier stages this goal may already have been achieved and a proven, scalable platform installed which is adaptable to emerging markets and instruments.

First we take Manhattan…
As funds move to global coverage, and potentially assets over $10 billion, they will seek local representation, local talent and support in a 24/7 environment. They may be required to replicate their operations into various geographies and ultimately will seek to attract a greater concentration of institutional investors.

Real-time, global portfolio views and client reporting will be essential. As the number and types of funds broadens, each regional team must have the capacity to handle increasingly sophisticated fund structures and shareholder accounting. These challenges might be mitigated by a flexible, service-oriented architecture as opposed to a comprehensive data warehouse solution but whatever choice is made then, prior operational and technological decisions made throughout each phase in the life-cycle of the firm will be seen to have an impact, and hopefully benefits, for the entire life of the fund.