Crisis accelerates emergence of new industry models
Ireland’s alternative fund services industry is standing bloody but unbowed following the crisis of the past three years, which saw many fund administrators and other providers hit by falling asset-based revenues and clients running into difficulty. On the other hand, the turbulence also brought powerfully home the importance of administrators and custodians within the regulatory, governance and compliance structure of the industry as an important line of protection for investors’ interests.
Service providers are seeing increased opportunities not only from confirmation of the move in the US industry toward use of independent third-party administrators but the increased willingness of managers to turn to administrators for a wider-range of middle-offices services. But at the same time there are questions about the future structure of the industry as administrators face increasing financial demands to stay at the cutting edge of technological development that their clients require.
In some respects the crisis has eased exiting structural problems for the industry in Ireland.
A by-product of the country’s general economic difficulties has been to dampen a cost spiral that was starting to become a significant issue for the international financial services sector in general and fund services in particular. As the froth has come off Dublin’s once-overheated job market, the salary expectations of skilled employees have moderated and staff turnover, not so long ago a serious client service problem, has dipped dramatically as stable employment and long-term career development have become more important priorities.
Dermot Butler, chairman of Custom House Administration, notes that many administrators in Ireland resorted to cutbacks and salary freezes in response to the fall in revenues. “In times like these, in every industry people start focusing on costs, so that when the market comes back up they have a better-oiled, more efficient machine. Because Custom House has offices in Malta, Luxembourg, Chicago and Singapore as well as Dublin, we are able to direct business to where it can be done most efficiently and economically.”
David Whelan, managing director of Admiral Administration (Ireland), agrees that the global downturn has been a stabilising factor for the industry. “People are not jumping ship, and there’s a lot more commitment toward developing within the company. Staff recognise that their success can be driven as much by the success of our clients. Through providing a superior level of service by being responsive and attentive to the clients’ needs, a client may be more inclined to refer additional business to the company which will result in employment growth and promotions for existing staff. We’ve seen a lot more buy-in to that mentality over the past two years.”
Alan Raftery, managing director of the Dublin office of fund services software specialist Koger, provider of the NTAS transfer agency platform, says the fact that some firms have slimmed down will leave them better equipped to prosper in the future. “Industry-wide, we’ve had time to re-evaluate and readjust as a whole,” he says.
At the height of the boom, according to Raftery, it was extremely difficult to hire staff without falling into an inflationary spiral. “I was receiving CVs from people with limited experience looking for high salaries, and we were losing jobs to other offices that could hire staff with similar qualifications at a lower cost,” he says. “The readjustment did Ireland’s hedge fund services market good. The country is now more competitive due to a lower cost base.”
Gerry Brady, country head of Northern Trust Ireland, also sees benefits for the industry. “Ireland no longer enjoys full employment, and educated and industry-savvy recruits are more readily available,” he says. “In addition, existing employees are more focused on staying with their employers as they realise the importance of job security and working for a good company that is focused on their long-term career development.”
This trend has reinforced the efforts launched by many fund administrators in the past decade to relieve pressure on their central Dublin operations by establishing satellite businesses on the periphery of the city or other parts of the country. These moves have enabled service providers to tap into labour pools that they were previously unable to access, take advantage of lower costs and greater workforce stability away from the capital, and participate in the economic development of other parts of the country by creating skilled and well-paid jobs.
“In 2004 and 2005 Ireland struggled in terms of experienced staff,” says Simon Phillips, executive vice-president with the asset acquisition group at Daiwa Securities Global Asset Services in London. “It was difficult for the industry to keep a solid workforce because everyone was poaching staff from everywhere else.”
His colleague Karl McEneff, managing director of Daiwa Securities Trust Europe in Dublin, adds: “Staff turnover was an issue for the industry because it’s a very personal business. People build relationships with the asset manager client, then all of a sudden they’re no longer there. It was a period when there was a lot of frustration among clients who felt the high turnover of staff was unacceptable. However, the trend stabilised with the creation of satellite offices outside Dublin.”
Daiwa was one of the firms that joined the decentralisation trend at that time, establishing a servicing operation in Dundalk, close to the border with Northern Ireland; other administrators set up operations in regional centres such as Galway, Limerick, Waterford and Wexford. An important benefit says McEneff, was that Daiwa was able to attract seasoned industry professionals who longed to escape the pressures of the capital: “A lot of people contacted us who had experience in the industry and were interested in going home.”
Tony McDonnell, head of business development at HSBC Securities Services, believes that this and other developments have had a big impact on employment trends in the industry. “Around 2006 the hedge fund industry in Ireland was suffering from staff turnover averaging more than 30 per cent,” he says. “Our turnover rate in Ireland is now quite low at about 5 per cent a year. This probably reflects in part the economic situation – people don’t want to leave a secure job – but also the efforts we’ve made to engage with staff. I think that’s an important factor in our attrition rate falling so low.”
Barry O’Rourke, managing director of SEI’s global fund services business in Ireland, notes that the downturn has slowed the drive by administrators to expand operations outside Dublin, but believes it may revive before long. “The trend was very much driven by growth, which has been less strong in recent years,” he says. “However, it may pick up again as in general those moves outside Dublin have been extremely successful. Firm have been able to tap into a human resources market that wouldn’t have been available had their entire operations remained in the city.”
The experience of the past three years might also spark a more fundamental redesign of the economic model followed by the hedge fund services industry, according to some industry commentators, in response to a combination of circumstances that has seen the range and complexity of services required of administrators grow at a time when (temporarily) falling asset levels have reduced their income.
Some members of the industry are starting to think the unthinkable and wonder whether remuneration should remain largely dependent upon the volume and value of the assets that providers service. They note, for example, that while the existing pricing model suited all parties when asset levels were growing, it may not fully take into account the exposure that administrators take on and the liability they may face in the event of losses, whether they result from service providers’ errors or not.
In addition, the knock-on effects of the decline in assets in late 2008 and the first half of 2009, through a combination of negative performance and net redemptions from funds, had the consequence of creating additional work for service providers, including handling the gating or suspension of redemptions and the creation of side-pockets for illiquid assets, on top of the increased difficulty of valuing complex financial instruments in often very thin markets.
In response, some administrators are considering moving away from being largely dependent upon the value of assets serviced to a more disaggregated model involving separate fees for individual services, which would reflect the increasing complexity of the assets serviced.
Says one analyst: “There is a strong case for rethinking the charging structure and perhaps build in more downside protection for service providers’ revenue streams where funds shrink in size but increase in complexity. There have already been moves toward disaggregation of fees, with every service being individually priced. It might be more complex, but it would ensure service providers are properly remunerated for what they do.”
In the meantime, service providers are exploring new ways to provide value to their clients. “Many custody houses and administration firms have started offering a wider range of services including cash management solutions and more middle-office services,” says Peter Stapleton, a partner in the investment funds group at the Dublin office of international law firm Maples and Calder.
“Some have also partnered with consulting firms to offer a wider range of services. While the business of some service providers may have been affected by a drop in their clients’ assets under management, they have reacted by moving into new areas, adding services that they didn’t previously offer, and many of them are undertaking new developments in IT systems.”
An example is the launch by Custom House in June of the Chariot Dealing Platform, a secure online dealing portal developed in partnership with Comada that enables existing shareholders in Custom House-administered funds – on whom the firm has already carried out due diligence – to carry out trades. According to Butler, a key benefit is to reduce the risk of errors resulting from the manual re-entry of trade details received by e-mail or sometimes fax.
“This helps to avoid the classic human errors, such as people entering a buy order instead of a sell order,” he says. The system can also offer substantial time savings: “On one occasion an investor who wanted to redeem out of one fund had to complete something like 104 pieces of paperwork. The net result was that the instructions were received late because it simply took too long.”
McDonnell says new opportunities have opened up from a shift by larger hedge fund managers to take back in-house middle-office functions that they had previously outsourced, with help from their service providers. “In particular managers of more complex strategies are re-evaluating their approach to middle-office capabilities,” he says. “Managers are starting to appreciate that outsourcing everything to one administrator may not necessarily be the best solution. Some are building out part of their middle office and looking for a provider able to validate all their numbers on a daily basis.”
Meanwhile, HSBC has built on its established administration and custody business in response to concerns in the aftermath of the Lehman Brothers bankruptcy about the counterparty risk involved in leaving assets in the hands of prime brokers. “We developed a quasi-prime brokerage financing platform called Custody Plus, which involved providing leverage and financing to hedge funds based on their assets in custody,” says Chris Barrow, global head of sales for the new prime services business at HSBC Bank. “Instead of the transfer of title and rehypothecation of assets in the traditional prime brokerage model, the client retains ownership of the assets.
HSBC saw a further opportunity to expand its offering to the hedge fund community. Says Barrow: “We had many of the elements required by the industry, such as a strong credit rating and balance sheet and segregation of assets, and much of what we needed to run a prime services business – futures, options, equity financing, foreign exchange, interest rates and a custody platform. Bringing these various elements together into a single offering was an obvious thing for HSBC to do.”
Northern Trust offers its fund of hedge funds clients Hedge Fund Monitor, an online tool that enables managers “to drill down and look at liquidity and exposures, to carry out what-if scenario-type planning and use a whole suite of attribution analysis,” Brady says. “This type of online tool and the suite of products and services we can provide helps managers meet the expectations and requirements they are now facing.”
O’Rourke says the use of technology beyond the basic areas of fund accounting and transfer agency is an increasingly important differentiating factor for service providers. “We operate in a market where costs have historically gone up while revenues have come down as a result of increasing competition,” he says. “As margins become ever tighter, technology is the solution to that and Irish fund administrators are continuing to invest in technology to ensure they keep ahead of the market.
“Our clients expect to receive basic services; what differentiates you is the add-ons. For example, SEI’s Manager Dashboard allows fund managers to query and access all the data that we maintain on their behalf. It’s very easy to use and offers the manager customised reports. We find it’s a big selling point at the moment. Fund administrators will need to offer a broad range of add-on services to stand out from the crowd.”
But the cost of keeping pace with technological development is one of the factors driving consolidation in the industry, as institutions look harder at the risk/reward trade-off within hedge fund administration. Says Brady: “A number of players are considering whether they want to remain in the business, given the likelihood that volatile market conditions will continue well into the future, with all the risks that entails, but also the capital expenditure required to keep up with innovation in the industry.
“Continuing restructuring and merger and acquisition activity seems likely. The outlook is for increasing polarisation between a handful of very large players that view fund services as fundamental to their future strategy, and which will continue to invest in the business, and niche players with a particular specialisation or close ties to a small circle of clients. Businesses in the middle may be squeezed out.”
McDonnell expects the number of smaller administrators in Ireland to shrink in the coming years. “There will always be a demand for smaller players that are willing to take-on start-up funds and managers, but I don’t know how they can continue to survive without a commitment to growth at some level,” he says. “Many smaller firms don’t have custodial companies attached to them and can’t offer a one-stop shop solution.
“Assuming a shift from the offshore model to a more regulated environment, operating at the same cost-income ratios as today may present a challenge if firms can’t offer more services that would bring in additional revenue. And managers of regulated onshore products may prefer better-capitalised companies and global brand names as an assurance in the event that something goes wrong. They want to know you can stand behind any errors and put the end-investor right. That’s a challenge that not all administrators will be able to meet.
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