Although the hedge fund industry has matured over the years, experts say it is still in its infancy, and it is currently seeing a significant shift in momentum in outsourcing middle and back-office services
Initially starting in the Middle Ages in Italy, banking used to be carried out by Italians who would conduct commercial trading and transactions sitting on a bench. ‘Banco’ means ‘bench’ in Italy, hence the word ‘bank’ that we use today.
Banking has been around for thousands of years, and hedge funds since 1949, which is long before legends like George Soros, Michael Steinhart, or Julian Robertson.
Eamonn Greaves, worldwide head of sales at SS&C Technologies, affirms: “The hedge fund industry is in its infancy, and independent fund administrators are even younger.”
Although in its infancy, the hedge fund industry has matured over the last 15 to 20 years. According to experts, mutual funds are the most mature, while private capital and private equity are the least mature, and the hedge fund administration industry sits in the middle.
Hedge fund administration involves the accounting, consulting and management of an investment firm’s key funds. A third-party, hedge fund administrator’s primary duties are to protect investors’ interests and to ensure that a firm’s funds are operating efficiently.
Over the past 20 years, there has been an expectation that all hedge funds will and should utilise a fund administrator. Experts say that one result of this shift has been more vendors offering fund administration services, creating more options for hedge fund managers.
“Most managers use an independent hedge fund administration provider, however, there are varying levels of expertise and technology across the industry. Smaller or less sophisticated providers may still be heavily reliant on excel spreadsheets whereas larger providers or market leaders have automated technology solutions that can support all instrument types,” says Iain Carey, head of hedge fund services for Asia Pacific, Northern Trust.
While managers used to seek hedge fund administration providers for fund administration services only, Carey says that now significantly more managers are outsourcing further up the value chain and are reliant on hedge fund administration providers for middle-office functions, management, risk and portfolio analytics, cash optimisation and treasury functions.
In order to reach a maturing state, the industry must consolidate. Richard Murray, global head of hedge at Sanne, believes consolidation has been a recurring theme for a number of years and will most probably continue in the near future.
“The industry is trending toward a final set of regional and global firms, but at present, a wide variety of local and global operators still remain active,” he says.
Mergers and acquisitions
In line with working towards greater maturity, there has been much movement in mergers and acquisitions (M&A) in the hedge fund industry over the last few years, partly due to the fact that hedge fund administrators, in general, do not make attractive margins.
The exit by global banks for whom hedge fund administration was not a core activity and consolidation have also been drivers of this trend.
Throw into the mix regulatory burdens, poor performance from the manager, plus the expensive cost of technology and human capital and it is perhaps not hard to see why. As well as this, Andre Le Roux, head of business development and client management (Africa) at Maitland says the size required for critical mass is getting ever larger and probably a bit elusive.
“It is probably equally true that the inability to get real automation has meant that only the big survive. Whether the big are thriving remains to be seen. Ultimately it becomes a ‘race to the bottom’ and increased pressure for more M&A,” he comments.
Northern Trust’s Carey noticed the exit of several global and investment banks from hedge fund administration as they exited non-core businesses.
Hedge fund administration is people and process focused and requires a commitment to asset servicing. Carey notes that for a company to provide the necessary long-term investment in the technology and operating model which successfully supports it, hedge fund administration needs to be a core business for the company.
Carey says he has also observed a degree of consolidation across the hedge fund administration industry reducing the number of global providers and managers who pivoted were successful.
Shift in demand?
Demand in hedge fund services is firmly robust, experts say, but there were some negative impacts brought about by the pandemic. The pandemic particularly took its toll on halts to intended fund launches as well as delays in investment allocations.
The pandemic did however bring to light the inefficiencies of legacy systems and processes in an accelerated manner.
Greaves explains that firms were thinking about making a change or doing an upgrade pre-pandemic, the recent events have only increased their focus and desire to make those changes.
According to Greaves, fund managers took an initial ‘wait and see’ approach to transformation projects through the summer months. Since then, firms have been accelerating their operational transformation plans.
The disruption of the pandemic also made it difficult for asset allocators to complete in-person due diligence, which created asset fundraising challenges for new managers. In turn, this meant there were lower launch sizes or launches deferred to 2021.
Carey says: “The pandemic highlighted the benefits of outsourcing middle office functions such as post-trade execution to a hedge fund administration provider. Managers benefit from a more streamlined workflow and gain a provider who can operate a global follow-the-sun operating model.”
Maitland’s Africa-based Roux observes that the pandemic has resulted in an element of ‘COVID Inertia’. So generally, he says, there has been little movement between administrators and little appetite for new services.
“Whether the hedge fund industry remains a standalone entity or simply another tool for managers within the asset allocation spectrum will determine whether hedge fund administration services will develop. It is likely that demand will remain mooted and again become the domain on boutique outfits servicing a small niche,” adds Roux.
Trends to drive growth
Despite the challenges of the pandemic, experts say managers are adapting their strategies to shifting market conditions, which has been most prevalent in the move from pure-play hedge funds expanding into closed-end private structures. Private equity is the most predominant, alongside private debt, real estate and infrastructure.
Northern Trust’s Carey affirms that there are also instances of private equity shops exploring open-ended fund structures, but the inherent imbalance of portfolio versus investor liquidity is a persistent challenge.
The emergence of these traditional hedge funds into ‘hybrid’ structures has strong implications for their own operating models, as well as for service providers and other stakeholders.
Ultimately, managers must consider their core strategy in the context of alpha versus liquidity, the shifting investor landscape, and the practical realities of executing their business strategy, according to Carey.
He says: “With asset allocators increasing their allocation to private equity, hedge fund administration managers will follow investors’ money and establish their own closed-ended private equity funds. And by expanding their offering, from hedge to hybrid private equity, they open up the universe of interested investors.”
Other trends set to drive growth in the funds industry include larger firms wanting a more holistic and comprehensive service provider relationship. Experts identify that there is a demand for value-added services as opposed to a pure focus on price management.
For example, SS&C is seeing a significant shift in momentum in outsourcing middle- and back-office services, in addition to firms seeking a full front-to-back offering.
SS&C’s Greaves suggests that a complete digital experience for customers and the convergence of hedge, closed-end funds and registered funds is emerging as large asset managers seek to attract and retain customers.
“Some hedge fund administrators are scrambling to react, ensuring they are set up correctly to succeed in the new environment,” comments Greaves.
Meanwhile, Murray muses that although there were winners and losers, overall during the pandemic, the hedge fund industry reminded investors of the value they bring as risk managers, during market shocks and times of increased volatility.
Murray concludes: “All indicators point to investors having recognised this and that they intend to increase their hedge fund allocation.”
“Regulatory reporting continues to evolve as the demand for environmental, social and governance reporting increases.”
“Hybrid fund strategies are a growing trend providing an opportunity for hedge fund administrators with diverse skills and consolidated technology to capture opportunities.”
