Hans Hufschmid (pictured), formerly at doomed hedge fund LTCM and now CEO of GlobeOp, tells Nick Fitzpatrick (editor of Funds Europe) how LTCM has influenced fund administration ...
Ten years ago this month the hedge fund Long-Term Capital Management (LTCM) produced a very ominous piece of investment data: its monthly return was -6.42%. After several years of much better returns – sometimes as high as 40% – in May of 1998 LTCM was beginning its colossal nosedive that would result in the Federal Reserve organising a bail-out of the fund to prevent wider financial chaos.
Although it had not been possible to save the money of its investors from the wreckage, it was possible to salvage one aspect of LTCM’s business: its middle and back office operating model, or administration.
Hans Hufschmid was a principal and the co-head of London at LTCM at the time. “The thing that really worked at LTCM was the middle and back office,” he remembers. “People said that if we could package LTCM’s operations, it would sell.”
So Hufschmid and colleagues did just that and he is now CEO of GlobeOp Financial Services, a third-party fund administration business headquartered in London and the US.
It might seem strange that any fragment of the LTCM business model should still be employed in the fund industry today. For a long time after the LTCM blow up, the image of hedge funds would be seriously tarnished. But whereas LTCM’s trading strategies may not have been robust, the turmoil that its front office traders caused their colleagues in the operations department tested the administration model to the hilt and it did prove robust. Having withstood the demands placed on it, it could be argued that LTCM possessed a working blueprint for the future of institutionalised hedge fund admin.
Trial by derivatives
Certainly this is what Hufschmid appears to believe, as he describes GlobeOp as one of the top three third-party fund administrators in the business.
What particularly tested LTCM’s admin function were derivatives. Fairly unusual for hedge funds at the time, LTCM traded heavily in derivatives, meaning margins had to be met and collateral had to be managed.
“At the height of the crisis LTCM had a balance sheet of around $120bn, with little equity. Every day we had to mark the entire portfolio to market, but we never failed on a payment. People were nervous and tried to keep our collateral so we had to manage the collateral process very tightly. Some days we saw $2bn moving in or out,” Hufschmid recalls.
He adds: “In the fund administration industry then, there was no verification or reconciliation of trades. Reconciliation is a hell of a lot of work.” But he says that LTCM did its own portfolio valuations and the administrator verified them.
Although today valuations are increasingly carried out by independent fund administrators, Hufschmid claims that only GlobeOp and “two or three”other top administrators are really capable of valuing hedge fund portfolios.
“The complexity of portfolios has increased since LTCM. At the time of LTCM, hedge funds were mainly long-short equities, bonds and currencies. They were investing in observable instruments. Today, strategies include derivatives across the entire spectrum in addition to those traditional securities.”
He adds: “LTCM was probably the first hedge fund at the time to get into derivatives in a substantial manner. This meant LTCM negotiated bilateral collateral agreements with counterparties and marked the portfolio to market daily in order to calculate collateral.”
Hufschmid, along with Ira Rosenblum, also formerly at LTCM, and Ron Tannenbaum, formerly at Salomon Brothers, launched GlobeOp in 2000. As of 31 March 2008, GlobeOp had $100bn of assets under administration, up from $97bn in December. Its revenues, at $166m for its last reporting year, had grown 23%.
GlobeOp’s first client was Endeavour Capital Management – a spinout from Citi – and it is still a client today.
“Endeavour was quite complex because they had leverage and used derivatives. As I said, only two or three administrators can value these instruments today. We take every trade and position and price them daily. We also do collateral management and accounting.”
Demands of pension funds
Other administrators are not as rigorous, Hufschmid says. “Some administrators just take a file from the prime broker and put it in an accounting engine to produce reports.”
The importance to hedge funds of an independent third-party administrator has grown significantly in recent years, led by the exacting demands of pension funds.
“There is more independence in hedge fund administration now than in the past. Ten years ago, many US funds were self-administered,” Hufschmid says.
An area in which the need for an independent administrator is keenly demonstrated is in portfolio valuation, where, says Hufschmid, hedge funds will often attempt to override the administrator’s pricing. However, there can be good reasons for this, he says.
“Fund managers are always trying to maintain consistency in prices given by their third-party administrators... For example, a popular strategy is to be short a CDO and long a set of CDSs against it. All that the fund is doing is expressing a view on correlation.
“There could be disagreement about the spreads between the different instruments. Spreads used to price the CDO and the CDS must be consistent.
“For example, if the fund is long bonds and short futures, it looks at this as a basis trade which is quoted in the market as a spread. If the administrator values the futures and the bonds individually, depending on the timing the spread might be slightly different than that which was actually quoted in the market. Pricing is an art not a science.”
There is still much debate about exactly how hedge funds should run their operational processes in order to gain wider institutional acceptance. Hufschmid believes part of the answer lies in obtaining an SAS 70.
“Hedge funds are becoming more institutional because investors such as pension funds are requiring a more solid, independent and transparent infrastructure. That’s why external certification standards like SAS 70 are important – they confirm to investors that documented and regularly audited trade processing controls are in place.”
But pension funds must not expect third-party administrators to be able to prevent hedge fund blow-ups of the kind witnessed lately at Bear Sterns and elsewhere.
“That is not our job; administrators could not have done anything to prevent it. Many of the problems were owing to liquidity. To say that we could have prevented these closures would imply that we have control over the risk management of the fund, which we do not.
“Administrators might be able to calculate that a fund has x-times leverage, but it’s not for us to say that’s too much or too little.”
The fundamental role of the third-party administrator is to increase operational efficiency for the client. However, firms like GlobeOp also have their own operational efficiencies to worry about. To this extent, India plays a big role in its strategy.
India provides answers
“The driver for India was scale rather than cost. When we made the decision to go to India [in 2003], the hedge fund industry was booming. It was difficult to keep staff in London and New York because competitors and other financial institutions were hiring them away.
“India was a good solution. We had to train people. Ninety-eight per cent of our employees there have a degree and 40% have a second degree. They did not know much about derivatives though, and it took two years to train them in that expertise.”
Hufschmid admits that staff turnover has been a challenge. Although low at the senior level, it is higher at the 6-18 months tenure level. “We train people well and we see banks offering our people jobs without even looking at their CVs.”
Last year GlobeOp entered deeper into the Ucits III market by launching a product for fund managers that use derivatives that are allowed by the European Ucits Directive. He says that interest in this service comes from traditional long-short mutual fund managers and their custodian banks.
Pioneer Investments, part of the UniCredit Italian banking group, is one client.
“We provide derivatives processing for them and also work for Nordea and certain other Scandic funds.”
Hufschmid adds: “The issue is that many traditional fund managers do not have the systems to short equities or process derivatives and it could take them as long as two years to build their own capability, with no guarantee of success.”
Last year the company listed on the London Stock Exchange. It is a notable coincidence that in this anniversary month of LTCM’s demise, GlobeOp will pay its first dividend.
Visit GlobeOp at www.globeop.com
© 2008 funds europe