Is there a future for boutique hedge fund administrators in a market dominated by regulation? Nicholas Pratt investigates.
GREATER DISCLOSURE requirements have seen hedge funds spend between 5% and 10% of their operating costs on compliance, according to a survey by KPMG, the Managed Funds Association and the Alternative Investment Management Association.
The Alternative Investment Fund Managers Directive (AIFMD) in Europe and Form PF in the US both require hedge funds to provide more regular reports to regulators on their counterparties, their exposure to derivatives and the level of liquidity in their portfolios.
Fortunately, a number of hedge fund administrators (HFAs) are only too happy to help, provided they are willing to invest in systems and technology, especially around the area of data management.
“The AIFMD requirements mean that the management of data used from the many sources takes on an even higher level of importance,” says Roger Woolman, senior solutions consultant, Advent Software.
“It will be those administrators that streamline and consolidate their data flows that will be able to facilitate hedge funds of varying asset sizes as well as compete more effectively in the new regulatory environment.”
Not every HFA has been willing to make the necessary investment. The most notable is Goldman Sachs Administration Services, which was acquired by State Street in October 2012. With further acquisitions and exits likely, a potential concern is that if administration becomes solely a scale business, the big HFAs will get bigger and the mid-sized firms and boutiques will find it hard to continue.
“If you are a single location, small HFA, then it will be a challenge,” says Stephen Castree, chief executive of Equinoxe, an administrator with nearly $15 billion of assets under administration (AuA). “The administrator needs to do all the reporting and slice and dice the numbers, and you need the technology to do that. You also need enough of a capital base to meet the greater due diligence. So there is not just a high cost of entry for boutique HFAs but also a high cost to stay in the market.”
However, he says, there needs to be a difference between the large scale, bank-based administrators and independent administrators able to offer a bespoke service. “If you are running a massive administration business within an institution and maximising the use of all business in different time zones, you have to commoditise to a certain level because you are moving to a centralised pricing and client relationship.
“That is why there will continue to be a strong place for the boutiques. While there are not many large boutiques, they are capable of being agile and coming up with new service offerings and upscaling or downscaling as required.”
Bank-based HFAs understandably have a different perspective. According to Mike Hughes, global head of fund services, Deutsche Bank Global Transaction Banking, there is a growing opportunity for HFAs to take a more meaningful share of the market, but scale will be important especially for the bank-based providers that are perhaps better able to absorb some of the regulatory costs than some of the independents and the boutiques.
“An HFA with sub £10 billion in AuA will struggle to deliver a profitable business. Also, a single-product HFA is no longer a saleable offering. Hedge funds need multiple services (such as depositary services, investor reporting, custody and collateral management) and it is not financially viable to buy these services from multiple, single-product providers.”
There is a place for boutiques, says Hughes, maybe in servicing some of the smaller hedge funds, but this could prove to be a false economy for the hedge funds if they have to hire more internal staff because they are working with a boutique that does not offer a full service.
“It is difficult for a hedge fund to launch with less than $75 million of capital because the investor base has changed. It is more institutional than high-net-worth and they are looking for more transparency and a robust infrastructure. Furthermore, these changes are here to stay, and not cyclical, because they are coming mainly from the investors.”
Another concern is that HFAs are increasing the threshold in terms of the size of clients they are willing to service and this may leave smaller hedge funds with a shortage of HFAs willing to service them. For example, HSBC contacted a number of its smaller Asian clients at the end of 2012 to inform them that it was terminating its agreements.
Other HFAs, though, say they have not made any dramatic changes to their threshold for clients. “We have always sought firms with a good reputation and a high probability of raising funds. The barriers to entry have meant fewer launches but we are talking to some premier start-ups,” says Philip Masterson, senior vice president, SEI Investment Manager Services.
“The big are getting bigger,” says Bill Stone, chief executive of SS&C Technologies, which acquired independent administrator GlobeOp in May 2012. There will still, however, be a place for boutique administrators focused on a specific locale or asset class, he says. The struggle will be for those in the middle that may not have the focused skill sets of the boutiques but will be challenged to meet the global ambitions of the larger clients they have. “Investors are demanding that hedge fund managers appoint a recognised administrator, so the administrators have to be prepared to spend money on the right IT infrastructure.”
The regulatory challenges are essentially technology challenges, says Stone. “Technology is a key component and being able to manage your own technology is the key to managing your costs.”
According to Dave Shastri, founder of software developer Comada, there is a fragmentation in the use of technology between the large administrators and the boutiques.
“The larger players tend to have a lot of big systems that are not very flexible. Furthermore, many are keeping their systems for longer so there are more add-ons used which makes it harder to be nimble.”
But while the bigger hedge funds tend be serviced by the bigger administrators, the boutiques have traditionally relied on servicing start-ups in the hope that some of them will grow to become large and successful and take their HFA with them. Unfortunately, there are fewer and fewer start-ups in today’s market.
This fragmentation in the use of technology is exacerbated by the market structure in the hedge fund world, says Shastri.
“Connecting information flows and more cost-effective data capture is what will save the hedge fund industry. But this is not a connected industry like the mutual funds market where you can create operational efficiencies within a structured market. Until the hedge fund market becomes more like that, it will be difficult to get the same kind of operational efficiencies.”
Acquisitions will also be key for the continued prosperity of many administrators, especially within the boutique sector. Japan-based Mitsubishi UFJ acquired boutique administrator Butterfield Fulcrum in June 2013. This was followed by the announcement from Bloomberg in June 2013 that it is considering acquiring an HFA. And there is a growing interest in the boutique HFA space from private equity firms, says Masterson.
“They see it as an attractive industry with a recurring revenue model and attractive margins.”
And despite the dominance of the top ten HFAs, it is still a crowded marketplace with other 300 administrators and not many of them are likely to run away from customers. But the message to the HFAs is clear – get scale or get skill or, ideally, get both.
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