In the Wake of the Crisis

Does the outsourcing ofhedge fund administration signal new growth?

Originally published in the September 2009 issue

Following the financial crisis, the hedge fund industry is reinventing itself. Market reversals and substantial reductions in assets under management have forced fully 12% of funds to close their doors (Hedge Fund Research). High-profile scandals and accusations of impropriety have driven hedge funds to offer transparency as a competitive advantage. And the prospect of new regulations in multiple jurisdictions around the globe means that hedge funds are bracing themselves for substantially increased requirements for compliance and reporting.
Hedge funds must maintain their focus on navigating the new financial terrain and rebuild their clients’ portfolios without letting these new demands distract them. For some years, hedge funds have concluded that the most efficient course of action is to proactively outsource the operational risks associated with these challenges to third-party administrators and custodians, leaving them to concentrate on protecting beta and acquiring alpha.

A recent paper, New Views of the Hedge Fund Industry, developed by State Street as part of its Vision series of thought-leadership reports, cites two major trends affecting the industry: a migration to third-party administration and custody services and increased regulatory oversight. The paper makes clear that these phenomena are interrelated and mutually supportive. But it does not foretell doom for an industry that has performed well on both an absolute and comparative basis for many years and throughout the financial crisis. In fact, the report concludes that the hedge fund industry faces positive long-term prospects and an increased share of institutional investor allocations. By systematically re-engineering the way that it does business, the report concludes, the hedge fund industry will likely emerge smaller, in terms of the number of funds, but eventually larger in terms of assets under management.

The move to outsource administration and custody appears to be driven by three factors: a need to increase efficiency and reduce operational risk, new demands for transparency, and regulatory initiatives that may effectively force large firms to outsource these functions. With assets under management collapsing from $1.9 trillion to $1.4 trillion in 2008, according to Hedge Fund Research, the hedge fund industry clearly faces a Darwinian environment in which only the best performing and best managed funds will survive and thrive. This means taking a long hard look at the substantial costs associated with self-administration and deciding whether that expense delivers sufficient return on investments.

A migration to third party administration
The complex systems and technologies required to keep track of numerous strategies in multiple world markets are expensive to create and daunting to keep current. Many hedge funds that were content to let their prime brokers perform these functions when they were in a growth phase have found those arrangements untenable as they acquired scale. As funds expand their assets under management, the complexity of their administrative requirements grows exponentially. Managing relationships (and counterparty risk) with multiple prime brokers at some point creates diminishing returns. This complexity expands by an order of magnitude as hedge funds enhance their offerings. As a means of insulating themselves from inevitable market cycles, many hedge funds are diversifying, offering different kinds of strategies that can be applied at different points of the financial cycle. In the same way that institutional investors distribute their risk exposure across different strategies to mitigate correlation, hedge funds are likewise seeking to diversify their risks through the use of more varied investment strategies. At the end of the day, institutional investors and the hedge funds that serve them are both pursuing the holy grail of uncorrelated alpha.

Many funds are finding that independent custodians and administrators can assist with this challenge in two ways. First, they are experienced with all the various hedge fund strategies and their application in multiple markets around the world. Third-party administrators experienced with the fund accounting, administration, tax and risk services required by sophisticated funds can greatly accelerate and simplify the migration of hedge funds through various strategies. A hedge fund manager shifting from merger arbitrage toward global macro (or the reverse) may find that their third-party service provider can provide a distinct added value by virtue of its experience with all these varied strategies. Secondly, leading third-party administrators can offer individual, specialised solutions to meet virtually any level of asset servicing that hedge funds might require. Inevitably, this implies the deployment of leading edge technologies that are constantly evolving. Hedge funds want to manage assets, not shoulder the complex burden of maintaining global platforms for technology, tax, regulatory compliance, and operational risk management in the sophisticated digital formats that institutional investors have come to demand.

Increasing need for transparency
Moreover, funds are addressing this newly complex environment under the glare of unprecedented scrutiny. Given the information opacity, illiquidity and incidents of malfeasance that were revealed over the course of the financial crisis, hedge funds need to offer broader, deeper and more timely information to institutional clients. Many hedge fund strategies require stealth. And no one is proposing that hedge funds erode their generation of alpha by exposing their strategies to the market-at-large. But investors are clearly demanding more information on a more constant basis. Leading hedge funds understand these new requirements for transparency. They further understand that investment boards view this transparency as a competitive advantage of the best hedge funds. And these funds, in turn, recognize that third-party custodians and administrators have the systems in place to deliver this information.

New regulatory requirements
Hedge funds are facing new regulatory demands all over the world. In the US, for example, the government’s plan for the overhaul of financial regulation at first glance appears to leave many hedge fund strategies unscathed. But in point of fact, it may permanently change the way that most US hedge fund assets are managed. In Europe, hedge fund managers are concerned over the prospect of over-regulation, in the wake of the recent EU Directive. While funds expect increased disclosure requirements, the concern is that new regulations may extend to include caps on leverage, requirements that hedge funds appoint an EU credit institution as a depository, restrictions on non-EU managers selling their products for three years, and questions over valuation responsibilities, which presently lie with fund managers or their boards.

Moving forward
Notwithstanding the bad news in markets and the short-term setbacks facing of much of the industry, the future looks bright. Hedge funds substantially outperformed long only investment funds through the course of the financial crisis. And the long only strategies of conventional asset management are being fundamentally re-examined. In some ways, the current hedge fund industry resembles the mutual fund industry of 25 years ago just prior to its most explosive era of growth.

Mutual funds largely abandoned self-administration when that industry’s assets under management took off in earnest. If the lessons of the financial crisis are extrapolated into the future, we may witness a fundamental shift of assets from the long only asset management trade to hedge funds. And we may find that for the hedge fund industry to re-ignite the growth that it has experienced in recent decades, the outsourcing of operational risk management to independent third-party professionals is an essential step.

Jack Klinck is Executive Vice President and Global Head of State Street’s Alternative Investment Solutions business.