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The industrialisation of outsourced compliance

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There is a growing attraction among hedge funds of all shapes and sizes to outsource any non-core related functions to trusted third parties as the demands of running a hedge fund in today’s regulatory-heavy environment increase. This has led to an upsurge in demand from managers across the AUM spectrum for outsourcing and managed services, as they seek to ease the operational burden.

As Gerhard Grueter pictured), co-founder of Lawson Conner, a market leader in compliance solutions for the investment fund industry, observes, the pace of regulation has increased over the last five years and become much more complex: 

“Fund managers have two choices; to use in-house intelligence to build infrastructure around compliance and regulatory requirements. Or, to give that task to someone who is much better at dealing with these issues, and in a more cost-effective way.” 

Deloitte has recently launched a managed service called Prisma, to deliver reports for multiple regulatory and investor requirements whilst technology giants like FIS Systems Limited provide a comprehensive range of managed services on its Hedge360 cloud platform. On the sell side, Societe Generale Securities Services now provides an outsourcing platform that encompasses a fully integrated set of modular services from execution, liquidity support, middle and back office processes, to core securities processing and asset servicing. 

There are essentially two arguments to outsourcing:

 

  1. Can someone do it better?
  2. Can it be done more cost effectively?

Grueter would argue that it is better to leave non-core functions, to people who handle such tasks every day (at scale), have the systems in place, understand the nuances involved, and keep up-to-date with developments. 

“Leave it to the experts,” says Grueter. “Regulatory reporting on manager and fund level across multiple jurisdictions is quite an administrative process. Is that really the best use of a fund manager’s time? Getting their back-office team to do all the capital adequacy calculations, Annex IV reporting, reporting to US regulators, EMIR trade reporting to ESMA in Europe? Why don’t you leave that to someone who has the technology, the expertise and the background to cover all regulatory reporting functions. . 

“When it comes to dealing with the enhanced complexity of regulations and compliance, using a third party will reduce risk and cost.”

In many respects, the fund industry has been slow to adopt outsourcing. For many other industries it is a necessity. Take aviation by way of example. When Airbus builds the A320 family of aircraft they outsource across the supply chain; they use Pratt & Whitney engines. They don’t try and build them. 

Perhaps previously the reluctance among fund managers was that it would be viewed negatively by investors, but this perception is no longer of concern. 
 
“Investors are increasingly requesting managers to use outsourced compliance specialists because they don’t want the manager to get anything wrong on the compliance side. In their view, it is better to have an independent set of eyes that can identify if something goes wrong and report to the manager as opposed to relying on someone internally within the firm,” comments Grueter.

As such, outsourced compliance can reduce a manager’s overall operational risk. Imagine if someone spins out of a large asset manager or hedge fund, where they were able to rely on a whole host of functions. 

They might be a great trader, but when they spin off on their own they might not necessarily be the best business manager. 

An outsourced compliance partner can provide similar infrastructure to that used by the trader prior to going solo. There are six or so main areas of compliance that can be outsourced training and competence; regulatory reporting; trade surveillance and cross-trade survelliance; policies and procedures; governance; cyber security; and also risk management. 

What this means is that the start-up manager can pass on those compliance functions and get the outsourced provider to report to them when anything goes wrong. Immediately it takes the burden off their shoulders and allows them to focus on what their core strengths are: namely managing money and raising capital. 

Of course, another driver in the increased adoption of outsourced compliance is cost. Industry surveys estimate that the industry is spending on average 7% of operating costs on compliance, where smaller managers are spending around USD700K per year and a much higher percentage of operating costs. 

As an approximation, compliance costs can amount to anywhere between USD1mn and USD10mn per annum for small and mid-sized hedge funds. That’s not an insignificant figure when one considers the challenges that managers have raising new assets. 

“It is very rare today to see a new hedge fund launch with USD500mn or more of day one capital. Managers are facing much greater pressure on their management fee and are looking more closely at their cost structure. They are starting to think, ‘Do we really need five people in compliance? Can we reduce that to two people and use the other three people at an outsourced service provider?’ 

“This helps to improve efficiency because they don’t have to hire these people, they don’t have to train them. There are peaks and troughs in reporting deadlines that need to be dealt with; to cope with the complexity there has been a clear trend towards outsourcing over the last couple of years,” says Grueter. 
Grueter believes that compliance outsourcing can reduce costs by 30 to 50 per cent. 

“Just look at rent in Mayfair. Reducing desk space can have a real meaningful impact on monthly operating costs and go a long way to making the manager more competitive,” adds Grueter.

He points out that Lawson Conner has more than doubled the number of clients using its Outsourced Compliance & Regulatory Services.

“We’ve not only seen the number of managers increase but also the size of the mandate increase. We have a pipeline of meetings throughout the summer but we need to make sure we avoid bottlenecking. The biggest challenge, when you grow, is ensuring that you provide consistent quality of service, which relies on having trained, competent personnel in place.”

A few years back, institutional investors tended to seek reassurances in the institutional quality of a fund manager based on the depth and breadth of the team, front through back. Technology, and outsourced compliance, means that investors are no longer concerned if fund management teams become leaner and meaner. It is a model that is likely to continue building momentum over the coming years.

“My argument would be that it helps the manager look more professional and less risky because they are not just relying on one or two compliance experts in-house, they are also relying on a team of 40 or 50 compliance people at their outsourced partner. Managers might appear more streamlined, but they have this huge support network working in the background,” comments Grueter. 

Lower operating overheads might even allow the manager to offer more competitive fees by reducing the management fee – maybe a 1.5/20 or 1/20 arrangement – precisely because they are more streamlined. This could then result in attracting more institutional assets to build the firm’s AUM.  

Back in 2008, hedge funds hired scores of people because they were intent on getting their regulatory and compliance processes in proper order. But many of them are now revisiting the efficiency of this approach and realizing that if they have a technology platform or outsourced partner, it puts them in a stronger position to reduce risk.

“The responsibility still falls squarely on the shoulders of the fund manager; outsourcing compliance does not mean outsourcing responsibility. But what you are getting is a dashboard view that shows the main risks to the firm i.e. what are the top 10 things that need to be addressed in the next three weeks. For the compliance officer to have this dashboard summary of the business is hugely beneficial. 

“By using smart technology, you can deliver that to an entire organisation,” concludes Grueter.  

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