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Three-stage evolution of the hedge fund operating model

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Over the last decade the approach to running a hedge fund’s operations has changed markedly, thanks largely to improvements in technology.

Ten or fifteen years ago, the perception among hedge fund managers – when launching their hedge fund – was that they needed a large IT infrastructure in place, which typically involved buying a substantial portfolio accounting system. In their eyes, this was the infrastructure that institutional investors expected to see as it served as a signal of the manager’s intent and reflected their commitment to growing and supporting the business. Since then, the vast majority of funds have also moved their general ledger and books and records to their Administrator. 

This transition, perhaps inadvertently, put growing managers on a long and winding path in which they would buy additional best-of-breed systems to support specific functions. Before they knew it, the managers’ IT infrastructure had grown to upwards of 10 different systems, requiring numerous IT staff. Synchronizing those systems was such a complex process that some hedge funds started to resemble system integration firms rather than firms that were focused on alpha generation.

“If hedge fund managers decided to begin trading a new product, they first had to make sure that each system would support the product. Then, if the connectivity between those systems supported that product, they had to ensure that there was communication between those systems. This required a very knowledgeable IT staff; not just in technology, but in the specific infrastructure and products that the hedge fund manager chose to implement.

“These developments, in turn, created key man risk around the technology infrastructure and meant that hedge funds needed to promote and appoint senior IT people as partners in the fund. When you look at the staffing of large hedge funds, nearly 60-70% of the total headcount comprises technology and operations staff,” observes Bennett Egeth (pictured), President of Broadridge Investment Management Solutions. 

Much, however, has changed in the last decade. The approach to building complex, multifaceted IT infrastructures and operations models internally is no longer viewed as the best model for managers to support their businesses. New options and models have challenged the definition of what is “Best of Breed.” Now firms are seeking integrated solutions provided and managed by well capitalized partners. 

“The decision to start with a portfolio accounting system was believed to signify a strong internal infrastructure, but in actuality what it meant was that managers were introducing a significant amount of operational risk by integrating multiple systems: managing vendors, managing platforms and how they host the vendors, updating licenses and so on. This process started to take on a life of its own,” says Egeth.

There are, in his view, three trends or factors that have pushed managers to revisit the way in which they view their operating models. 

Vendor risk

There is a heightened sensitivity concerning vendor risk. So much so that the SEC has highlighted vendor management as one of their six areas of focus for 2016.  

Hedge funds and large asset managers are becoming more aware of the risks of a small balance sheet and whether or not too much of a vendor’s revenue is concentrated in one particular client. These are developments that that these firms are paying closer attention to as they try to minimize the number of vendors from a cost perspective, in an effort to manage those vendors. 

Another element to vendor risk is that 2016 has seen an unprecedented change of control in companies that provide a large number of solutions to hedge funds. Between the acquisition of Advent, the acquisition of SunGard and the acquisition of Markit, a large number of solutions provided to the hedge fund community have changed ownership, seemingly overnight. 

When such dramatic change occurs, says Egeth, the first thing that one tends to see is knowledgeable staff within the acquired entities evaluating other opportunities in the marketplace. This can result in a brain drain of the most talented professionals from these firms. 

“The second thing you start to see is the acquirer looks for greater synergies across their product suite. They evaluate which products will be deprecated, consolidated, maintenance gated and which they will invest in. This process may take a while to figure out. Clients are all waiting for these answers and have become much more demanding when told “nothing is going to change” or “this is good for you”. They want concrete plans and commitments, not just today but for the future.

“When you build an IT platform that is dependent on multiple vendors and products, you leave yourself exposed to greater acquisition risk,” comments Egeth. 

Competitive differentiation

There is a growing acceptance among hedge fund managers that operational technology is not a competitive differentiator, it has become commoditized. 

If one boils down the core activities that define a hedge fund’s ability to differentiate itself in the marketplace, there are really only three tasks: generating alpha, raising capital and servicing investors in a way that makes them feel comfortable and reassured.

Hedge fund managers today are seeking more of a one-stop-shop solution and are ruling out solutions from smaller providers because, as referred to above, they can’t be confident that they will remain in business, or will be running the business as they do today, in years to come. They want to work with someone that can provide integrated solutions rather than maintain the status quo of maintaining multiple systems for particular parts of their business. 

“With that in mind, managers are also looking at their operating model in terms of staff. THEY are asking questions such as: How much staff are being used to support disparate systems and what’s the real cost of the organization in doing so? Moreover, what is the total cost of staff running operations? Is it the most optimal use of resources? 

“When a firm trades a new asset class or market, not only do they need the operational expertise in that market, they also need back-up for that expertise if the key person is out of office. A lot of large funds have built significant operational infrastructure and I think everyone acknowledges that operations can become a more ‘mutualised’ and shared solution,” says Egeth.

The first trend, therefore, has been a move towards reducing the number of systems, reducing the number of vendors (and associated risks) and moving to solutions rather than products. The second trend has been to acknowledge that operationally, there is no strategic advantage to bear the full brunt of operational costs when evolving into new markets and asset classes.

The decision to outsource operations should strengthen, not weaken, a hedge fund. That is because often, the appointed service provider is required to work under a strict service-level agreement (SLA) that simply doesn’t exist internally. If one was to walk into an average mid-sized hedge fund and ask ‘what service-level agreement is in place with the operations team,’ senior partners would likely be lost for words. 

“When you rely on an external vendor,” says Egeth, “there are contractual obligations on how quickly trade breaks get resolved and penalties when those obligations are not met. There’s also an ability to pool the knowledge and expertise of operations staff that support multiple funds, rather than having to retain that expertise in-house for every different fund. There’s at least a 30 to 40% cost savings – if not greater – to using an outsourced managed services provider. 

“When you make a commitment to give up a portion of your operations – if you move it to your administrator, for example – it becomes a lot harder to change that administrator at some point in the future. Managers are now seeking third-party service providers as a result.”

A question of costs

The third trend that has led to a change in the operating model is the increasing cost of doing business, driven in large part by the complexity of the products and additional layers of regulation and compliance that hedge fund managers face. 

Regardless of how many systems a manager might use, maintaining the proper controls to meet security requirements and regulatory requirements is growing significantly every day. 

“You can’t just be experts in running security or in running a data center; you now need to be experts in managing the audit and compliance requirements of your infrastructure and the information security of your infrastructure. It adds an entirely new level of operational overhead. This is becoming a crucial aspect of investor due diligence as well.

“We are seeing more managers looking closely at hosted solutions specifically to avoid this issue. They want to push that burden onto people who have the expertise to do that 24/7,” states Egeth.  

It is becoming impractical for managers to keep throwing money at the problem. Egeth estimates that anywhere between USD5mn and USD25mn a year is being spent maintaining existing internal operating models. That is a meaningful expense. Any savings that a manager can make by using managed services can be directed to generating alpha for the fund and /or passed on the investors. 

Clean slate

All of this is great news for today’s hedge fund community. They are able to leverage the power of new technology being offered via managed services and have no legacy system issues to overcome. The slate is clean. This is allowing start-ups to be operationally nimble from day one. 

These funds are able to buy much more complete solutions off the shelf that meet their needs, rather than having to build their infrastructure system by system. The options that combine technology and operations are far greater today via managed services. 

“The clients we are signing up are all seeking more complete solutions. They want the stability that Broadridge represents in the market, they are conscious of our commitment across all of our businesses and our focus on cybersecurity to ensure their data is as secure as possible. And of course, they are looking for long-term partners with technology and managed services’ expertise to support their business for years to come,” concludes Egeth.

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