Technology spend, historically speaking, has never been top of a hedge fund manager’s wish list. There has been a touch of haughtiness, a feeling that technology providers are useful but not vital. But it’s fair to say that regulation is creating a shake-up among managers.
Whether its AIFMD or EMIR trade reporting in Europe, CPO-PQR and Form PF in the US, FATCA, today’s reality is that managers have to be more operationally robust and compliant than ever before. This has led to a big push in outsourcing middle and back office functionality to service providers as managers seek to reduce internal costs.
As Martin Engdal, Market Strategist and Director of Solution Marketing at Advent comments, there is still a view among some managers “that outsourcing functions to service providers also means outsourcing responsibility. The FCA’s ‘Dear CEO’ letter and last November’s thematic review is a wake-up call. We are seeing closer collaboration between managers and large institutional investors. However, these investors are looking for the same security as they are with their traditional long-only investments.”
The FCA’s thematic review was called Outsourcing in the Asset Management Industry: Thematic Project Findings Report. The review looked to assess two areas of risk to determine whether or not investor protection was being compromised as a result of outsourcing.
These two risks were:
- Resilience Risk – Inadequate contingency plans in place to deal with the failure of a service provider
- Oversight Risk – Applying inadequate oversight of a chosen service provider
Whilst regulation has pushed outsourcing, the feedback from hedge fund managers to the FCA’s Dear CEO letter, and subsequent thematic review, has been encouraging. Managers are improving their plans to deal with service provider failure, and, importantly, potential errors. The FCA’s aim is to insulate best practices by managers to keep on top of the risks referred to above, and in Engdal’s opinion this will push forward technology and improve managers’ abilities to attract investor assets.
In short, managers will increasingly need technology solutions to mitigate the risks of outsourcing.
“There’s a theme emerging in the asset management industry,” says Paul Bebber, Regional Sales Manager for Advent. “That theme is to ensure that whoever is managing investors’ money, if they are outsourcing they need to have oversight in place to help verify the data and manage the risk associated with inaccuracies. The whole industry is looking at data consolidation. That ranges from accounting and IBOR (Investment Book of Records) to collateral management. There’s a big push on all three fronts.”
For regulators, this is a risk mitigation exercise. For managers, especially those who are running multiple legacy systems, this is both a cost and risk mitigation exercise. The cost of running legacy systems can be 10 to 25 per cent higher than today’s more integrated solutions, making for a significant challenge to get effective oversight in place. Having to use three or more systems to check that valuations and reconciliations against the administrator tally up is a time and a labour intensive exercise.
“Some large asset managers still use myriad systems for each asset class that were designed 20 or more years ago to support back-office activities only. When you outsource to different fund administrators then you have no internal oversight and that can create potentially severe problems; you don’t have control of the data to give you a holistic view of your business.
“That’s one of the key reasons why the FCA is pushing the agenda on managers addressing resilience risk and oversight risk,” says Engdal.
Approximately 80 per cent of net inflows to hedge funds originate from institutional investors. And even though there are some 14,000 hedge funds for investors to choose from, the bulk of that institutional money goes to bulge bracket managers operating at the top of the AuM pyramid.
These managers have the resources to bolster technology and deliver the kind of institutional-quality infrastructure that pension funds, endowments, SWFs etc come to expect. But they can’t afford to rest on their laurels.
“There have been examples of pension funds withdrawing assets based on their due diligence because they feel managers don’t have the right internal processes in place (to cope with today’s new regulatory environment). Ultimately, pension fund money is retail money. That’s why the FCA is looking at this closely. They are going to look for improvements over the coming period. Are managers making those necessary improvements?” questions Engdal.
A light touch solution
What, then, is the solution? What choices do managers have to address resilience risk and oversight risk? It largely depends on the type of manager.
As Bebber explains: “I’ve spoken to some managers who have looked at the FCA’s paper and put together a diary of events that they will follow each month: for example, they will visit their long-only administrator once a month and their alternative funds administrator every two weeks to carry out a series of spot checks.
“But I’ve also spoken to other institutions who are looking to shadow the book to make sure there are no discrepancies at all. However, what they want is a lighter touch solution. They don’t want to have to put another accounting layer on top of the investment fund accounting layer they’ve just outsourced.
“These managers want something that offers similar functionality but effectively assists with error tracking. They want a solution with the business logic in place so that they can quickly derive the fund’s positions and check against the administrator.”
Technology & attracting sticky assets
Too often, hedge fund managers – especially start-ups – focus on the here and now. They look at the costs of doing business without stepping back to look at the bigger picture. To a degree this is understandable but with the FCA’s mandate on outsourcing risk, investing in technology in the short-term could help them grow their AuM over the long-term.
Firms that have a light touch solution that allows them to monitor their service providers are more likely to resonate with institutional investors and attract sticky capital. They have the capacity to show that the fund can still operate as normal in the event that one of their service providers fails.
With Advent Geneva, which has become one of the hedge fund industry’s leading fund accounting and position management solutions, data is not stored but derived using knowledge-based principals. What this means is that Geneva can be used to turn off the investment fund accounting layer and provide position-level data which the manager can utilise and say to their administrator: “These are our calculations, show us yours.”
Rather than blindly trusting what the administrator is doing, it ensures best practices are being adopted to protect investors.
“Such a solution gives the manager a snapshot of the fund. The reason for outsourcing is precisely because the manager doesn’t want to be replicating everything the administrator does internally. By getting the administrator to provide a snapshot of the book for a manager to check against it helps them minimise ‘oversight risk’,” says Engdal.
As Bebber rightly points out, operational due diligence is not just about fund accounting and IBOR. It extends to cash/collateral management: “Currently, managers tend to use spreadsheets or simply trust their prime broker(s) when it comes to making margin calls. If they can replicate that margin call internally (like IBOR) with technology it will protect both themselves and their end investors to guard against margin call inaccuracies.”
This is set to become a key challenge for managers as the industry moves into a new paradigm of OTC clearing through centralised clearing parties (CCPs). Again, transparency and investor protection lie at the heart of this. Having to manage multiple margin calls and keep on top of collateral is only going to get harder, in terms of data consolidation.
Asked whether the penny has dropped among the wider hedge fund community in respect to the importance of technology, Engdal comments: “There’s no question that the thematic review has acted as a trigger for technology investment. We have to be realistic though. The vast majority will try and put it off for as long as possible but over the next five years (this need for technology to manage outsource risk) will become a bigger trend in my opinion.”
Engdal points out that recent discussions with a couple of prominent pension plans reveal that they intend to allocate a larger portion of their assets to alternatives. “However, they are mindful of remaining regulatory compliant. Unless they have full trust and confidence in a hedge fund manager they’re not going to invest. One pension fund I spoke with is looking to increase its allocation to alternatives from around 8% to 20% over the next five years. They said that investment performance is important but operational due diligence is equally as important.”
Having a strategy in place (in terms of shadowing service providers, business continuity) can make a huge difference to capital raising. If there’s a beauty parade of 10 managers the best manager might not necessarily be the one with the best track record “but maybe the second best track record who can also demonstrate that they have a strong technology set-up”, adds Engdal.
Strong operational due diligence is independent of the strategy being run.
A low risk mandate doesn’t necessarily mean the manager has greater operational due diligence, it just means they are investing in less risky instruments. “That’s how the market is now starting to look at things,” says Bebber. “If managers are going to attract money from the big pension funds they are going to want to see operational due diligence in action (regardless of the strategy).”
The mirror effect
The FCA’s assessment of outsourcing risk is the latest in a long line of developments/initiatives to introduce best practices to the hedge fund industry. Over the last five years the type of investor has changed significantly. Institutions are the main players now, not family offices or HNW individuals. This shift from private wealth money to institutional money was the first wave of change.
Now, with regulatory compliance and operational due diligence coming to the fore, the industry could be on the cusp of a second wave of change. One where managers embrace technology more fully to make their operational infrastructure resilient and they become more mature institutions, akin to more traditional asset managers.
As hedge funds attract more institutional assets they will start to more closely resemble the very institutions allocating to them.
“There are two reasons for this: one is because the regulators are pushing for it. Ultimately it is retail money going into hedge funds. Second, because managers are being subject to more detailed due diligence at the pre-allocation stage.
“It’s imperative that technology sits at the heart of this. It’s about having the right technology to minimise manual intervention and at the same time process as much data as possible,” opines Engdal.
An exceptions-based approach
Going forward, as managers begin to address the outsourcing risk concerns raised by the FCA they will need to have a full STP solution in place – if they decide to shadow the book – that shows only exceptions and alerts.
“Managers don’t want to have to recreate the fund accounting function, the collateral management function. They just want to the capability to check it. Advent can do that,” says Bebber, who continues:
“What we’re saying to the market is, ‘Look, Geneva does fund accounting and position management but what we can now offer is a solution where we can turn off fund accounting. Alternatively, you can create your own enterprise service layer. Either way, you need to do it’.
An exceptions-based solution will help managers to address the resilience risk and oversight risk highlighted by the FCA without becoming counter-productive; that is, it will give them a quick snapshot of the fund to can give them peace of mind and demonstrate to investors that they are on top of things, operationally speaking. Like the FCA (and other regulator) investors perfectly understand the need for managers to outsource. Indeed, the level of independence this brings is considered vital. At the same time, though, they want reassurance that a manager is not obfuscating their responsibilities to the fund.
Nobody can predict how far technology will be embraced to deal with such issues, suffice to say that the trend of institutionalisation within the alternatives space shows no signs of abating.
“The beauty of having a light touch solution (using Geneva) is that if a large manager decides to create their own enterprise service layer they are going to have to build their own business logic from scratch to deal with alternative investment funds. With Geneva, the business logic is already there. We’ve spent 20 years developing it.”
