The Hedge Fund Custody Landscape in 2015

What are the game changers facing illiquid assets custody?

Originally published in the April 2015 issue

The world of hedge fund custody has changed dramatically since 2008. Many of the prime brokers who traditionally acted as the custodians of hedge funds have been scaling down or exiting the custody business altogether. The dramatic decision by Goldman Sachs to sell its hedge fund administration operation to State Street in 2012 was symptomatic of a broader trend, as shrinking revenues and thinner margins have meant that a smaller number of banks have chosen to remain in the market and continue to commit the investment dollars it demands.

HSBC closed its New York fund administration operation in 2012, while Citi announced in January of this year that it was exiting hedge fund administration due to declining revenues. Clearstream acquired the specialist hedge fund custody services operation from Citco in 2014. This all leaves the playing field to a mixture of large, specialist custody names, like the aforementioned State Street or Northern Trust, and a fragmented bevy of smaller, niche operators.

Look closely at the larger hedge fund custodians today and you will see banks that have evolved to meet the demands of illiquid or harder to manage assets, as firms that similarly addressed emerging markets securities. To remain in this business, they are having to innovate and to invest, which can be a tall order when regulatory demands mean capital is scarcer than it used to be.

Yet custody can be a source of regular fee income for banks while requiring less liquid capital. It provides banks with exposure to an asset management industry which is growing at 7% per annum. On the downside, there is enhanced regulation and the prospect of yet more aggressive behaviour from securities regulators in the future.

Custody is now regularly being leveraged using other services provided by the bank – for example, by sharing the same data. If an offering encompasses administration and investor services, savings can be made. Further integration is bound to occur as banks seek to capitalise on their internal hedge fund skill sets.

On the other side of the fence, investment managers are seeking to outsource more than ever before. Pressure on fees means many COOs are revisiting internal costs on a regular basis, even in the larger hedge funds.

Welcome to hybrids
The emergence of hybrid portfolios at an institutional investor level also means that custodians and administrators are having to leverage their operational expertise to cover both liquid and illiquid assets. Historically, family offices and private banks might make such demands of their custodians, but today it is pension funds and insurance companies. Many major pension schemes have exposures to illiquids like hedge funds and private equity well into double figures (averaging over 15% in Europe at the moment). While many institutional portfolios are now starting to look like old family office portfolios, there is a level of scale involved here which dwarfs what was previously asked of custodians. To be a custodian in the institutional space today requires the ability to take advantage of scale efficiencies in the processing of illiquid assets, and this in turn demands further investment in technology, while at the same time keeping head count at manageable levels.

The hedge fund custody industry is also in the middle of a major migration from highly manual processes to more automated ones that are less dependent on employee arbitrage, while at the same time delivering the cost savings that come with scale. Efforts have been made to build internal solutions, but these have frequently been costly failures, and we have yet to see the emergence amongst these of dependable alternative investment custody solutions that deliver the same efficiencies as the long-only funds sector.

Technology remains a key competitive edge, but in today’s world the proprietary platform is no longer the unique product it once was: most software applications run on pre-existing modules and applications, building on already established foundations. Hence, we see custodians and administrators going on the acquisition trail to provide a competitive edge. This not only provides solutions that have been tried and tested externally, but in an environment where operational security is paramount, technology with established protocols and regular updates is essential. Too frequently, firms rely on systems that are ageing fast and unable to keep up with the latest due diligence demands of investors and fund managers.

External vendor solutions are now sufficiently diverse and flexible that custodians can pick the systems they need and tailor them to their requirements. For smaller firms that will still need to compete on cost, and where the internal build option is simply not within budget, the prospect of letting a vendor worry about the investment in security updates is an attractive one.

Custodian or technology firm?
Like it or not, hedge fund – and hybrid portfolio – custody is becoming a technology-driven game. Participants in this market are increasingly looking like technology companies: SS&C GlobeOp is a good example, with its emphasis on investing in and delivering technology-focused solutions to the market. Not only did its parent, SS&C Technologies, acquire Advent in February, but in March SS&C GlobeOp announced the launch of a new group to service hybrid fund structures, recognising the demand within the industry for automated workflows and reporting for such complex vehicles. These strategic moves are indicators of the new landscape for hedge fund custody: no longer will market participants need to outsource to a galaxy of different service providers. Increasingly, technology-driven institutions will be able to offer their customers a single point of access to a wide range of services, handling the bulk of an investor or fund manager’s processing, data and reporting needs, regardless of asset class or fund structure. This will also continue to deliver economies of scale to those banks that seek to continue to compete in this space.

We are not there yet. This industry is still heavily employee-driven when it needs to be technology-driven. The levels of automation achieved in the UCITS or ‘40 Act fund universes clearing demonstrate what could be possible, but for many service providers that breakthrough remains elusive, causing them to shoulder expensive manual inefficiencies. Where is the scalability in that? In addition, not every fund is going to slot into a UCITS template: technology must be available to deliver effective servicing for some of the highly complex and illiquid structures which we see in the private equity and infrastructure worlds. Yet these are the strategies into which pension funds will expand their allocations in the next decade.

Custodians need to take a hard look at where they can compete, at how they can improve their service offerings. We are now at a juncture in technology development where the internet can deliver the secure connectivity that can allow the creation of the efficient networks that hedge fund custody requires; massive investment in expensive proprietary data networks are a thing of the past.

We are now seeing a hedge fund industry where larger managers are deploying money into more illiquid and specialised markets, like infrastructure deals and loans, and where some are looking at structures that would be appropriate for retail distribution. We look out now on a landscape that is very different from 10 years ago, and one that is being shaped to a large degree, like it or not, by technology. For custodians that want to continue to compete in such a market, cutting-edge processing and data systems are no longer simply nice to have.

Dave Shastri is president of Comada (bda) Limited, a specialist provider of alternative investment technology solutions to custody banks, fund administrators and transfer agents.