Using Operations As a Tool For Success

Even operations are receiving the alpha treatment

Originally published in the July 2007 issue

The arrival of anti-smoking legislation may be the beginning of the end for smoking in public, but the days have long since gone when hedge funds ran their operations on the back of a fag packet. Now with the asset flow into hedge funds almost reaching the $1.5trillion mark, the prospect of an industry maturing and the continuing debate on transparency, hedge funds cannot rely solely on returns for their success. It has become an increasingly complex area and one in which the question of operational excellence is gaining momentum. Prime brokers and administrators are now seen by many as the backbone of a hedge fund's success or failure.

While all administrators and prime brokers will attest to this, there is evidence that they are right. Many managers have gone far beyond the original boutique structure and the influx of investment (primarily from institutional investors), is tending towards the big names which follow standard international practices. According to a report published in July by KPMG on 'The State of the Investment Management Industry in Europe', the top 100 funds currently hold 65% of the assets. The emphasis now is on building a business, offering an infrastructure that works and attracting the so-called sticky money. The methods used to attract that investment mean that many managers have had to sharpen up their act.

Administrators and prime brokers are finding that they are the cornerstone of hedge fund business rather than mere 'service providers'. Regulators and investors are calling for more extensive reporting and those that can service the ever-increasing trade volumes are finding that their own assets under administration are also growing at a rapid pace.

What investors want

The new breed of investor is less focused on culture and personality and with the multi-million dollar investments come stringent conditions. There is also a growing feeling among the investor community that transparency from hedge fund managers should not be regarded as just a bonus.

Managers must be prepared to open their doors wide to investors for full due diligence and be prepared to include the third party service providers too. Of course, there is the inevitable form-filling but many investors combine this with on-site visits. "Investors are definitely becoming more demanding on the operational side," says Nick Tyler, COO, Adelphi & Co "and hedge fund managers are now embracing the standards of credibility and permanence similar to those in public companies."

The golden triangle

The collaboration between fund managers, administrators and prime brokers is fast becoming a crucial talking point as the Amaranth and LTCM testimony bears out. This heady cocktail can and will affect the success of a hedge fund.

From the hedge fund manager's perspective, success is all about profit and loss. However, growth will only be achieved if the infrastructure is right and affordable, scaleable technology is in place. It will be those hedge funds that regard operational efficiencyto be key that will be the winners in the long-term. Hedge funds rely on their prime brokers to facilitate settlements and process corporate actions, both of which carry high levels of operational risk. Although many managers maintain multiple relationships, prime brokers act as a centralised source of information and leverage to managers. In all cases, risk management is an integral part and they need to have a robust monitoring system in place.

From the administrator's perspective, it's more than just producing a balance sheet. It's about relationships and the key to success is to use the administrator properly. Hedge funds must use the expertise that will mitigate operational risk: pricing policies must be outlined and all interaction between the prime broker and hedge fund must be checked; daily reconciliations should be done where possible and all processing controls should be the responsibility of the administrator. The KPMG report finds that administrators are frequently moving up the value chain into the middle office of their hedge fund clients, and even providing additional services such as financing. However, the basis of this relationship is not just about procedures, it is longevity thinks Joan Kehoe, CEO of Quintillion. "The people must stay with the business; to be there when it grows and the administration must grow with the business. The level of expertise is such that we need to have people to understand the products."

Operational staff have to be of a high calibre, concurs Tyler: "If you are not using your third party service provider properly, then you are missing a trick. In fact, the benefits of a good prime broker and administrator relationship cannot be underestimated. It is a triangle which creates a synergy and there is no reason why it can't be well controlled."

Free flow of information

Controlled, yes, but there must be a free flow of information. The key to mitigating risk is to use technology that is compatible with all three parties. In a study of 96 (mainly) US hedge fund managers, carried out earlier this year Carbon360 predicted that total spending in risk and portfolio management systems will rise by 17.36%, to an estimated $5.25 billion in 2007. By 2011, it predicts spending will be almost $10 billion: technology will become one of the differentiating factors for a successful hedge fund operation. "Investing up front will create an exception-based processing environment" says Kehoe. There are many technology providers to choose from: Paladyne, Beauchamp, Fidessa, Sophis, although the most popular technology to date for the hedge fund community is Advent Software. A staggering 80% of global prime brokers and 80% of global fund administrators use Advent technology.

Quintillion has signed up to the Geneva Advent Revolutionary Global Portfolio Accounting Solution. Kehoe's main reason for choosing this was because reconciliations can be analysed in real-time which means that there are no batch cycle delays and an integrated general ledger. "It is streamlined and the results are clear," says Kehoe, "we have efficient operations, more accurate investment data and improved access to information. Advent has enabled Quintillion to deal effectively with data and develop a customised trade process with very little opportunity for manual errors." Less errors and a more efficient system mean a better relationship with managers.

So why now?

So why the rush to improve efficiency? In a recent White Paper, Advent Software recommended that it is better to adopt bear market practices for bull market growth. Improving efficiency and reducing costs can only be a good thing, while fees for standard services are dropping. As a result scale and investment in technology have become more important to achieve economies of scale. However, there are deeper reasons. The greater sums of money involved and the need for permanent capital has meant that hedge fund managers have had to lookat their own operations before courting investors. In an environment where an average fund of funds manager sees 170 funds, but will allocate to only 17 (10%), having a sound operational infrastructure is one of the keys to attracting investment. In short, operations could make that difference.

Besides the returns, investors are now focusing on the documentation processes: is documentation easily accessible, are the NAVs as cast iron as possible for example? They will analyse the relationships that managers have with third parties, and examine their cash management, foreign exchange and hedging processes, timings and error and valuation procedures. They will be looking for any 'red flags': an understaffed operations area or incomprehensible procedures. Any concerns in these areas will wipe out a hedge fund's chance of making it into that 10%.

There is no doubt that increased competition for assets has been a key driver in improving the efficiency of hedge fund processes. As a result, the industry is seeing a dynamic shift towards a sense of permanency and fair value. And Quintillion's Kehoe sums it up: "Operational excellence can only be achieved with strong people, strong processes and strong technology."