By Simon Gray – Last year may have been a relatively quiet year for Ireland’s alternative fund services sector, and 2012 appears to promise more of the same, but “reports of the death of the administration industry are exaggerated”, says Dermot Butler, chairman of Custom House Global Fund Services. And Butler ought to know, as the founder of the Custom House group in 1989, right at the start of the country’s dizzying ascent to become a financial centre of international stature and a hub in particular of the global hedge fund industry.
A little over two decades later, Irish-based administration operations – not just in Dublin but scattered around the country, following a wave of expansion into satellite offices over the past decade – service around 43 per cent of global hedge fund assets, not only in locally-domiciled funds but a large slice of the offshore fund sector too. And that’s not counting Ireland’s sizeable share of the market for Ucits funds set up under the European Union regime for retail funds.
And while overall hedge funds are making heavy weather of the current economic climate and market conditions, curbing the industry’s growth in 2011, there are plenty of reasons to believe that Ireland is capable of expanding its market share and its overall volume of assets under administration in the coming years, despite the crisis – and in certain respects perhaps even because of it.
The involvement of a regulated Irish service provider (plus in many cases a listing on the Irish Stock Exchange) has long been a comfort to investors in offshore funds, but today there is increasing pressure from certain institutional investors for access to regulated onshore-domiciled vehicles too. The jurisdiction’s preponderant role in the servicing of alternative funds has undoubtedly been a factor in the increased use of Irish Qualifying Investor Funds over the past couple of years.
Meanwhile, the economic shocks that have hammered the Irish economy over the past four or five years, mostly stemming from the collapse of a real estate bubble, have at least had the effect of easing the cost pressures on financial services business. The crisis has pushed down commercial property rents and curbed what was at one time rampant salary inflation in the booming fund administration sector. In addition, lower staff turnover – job stability is much more prized than it was at the height of the boom – has helped administrators to offer improved continuity in client relationships, an important consideration for a service business.
A survey carried out around the beginning of this year by Deloitte, among fund administrators accounting for around 80 per cent of the assets serviced in Ireland, indicates that the industry feels under pressure from increasing client demands, notably concerning service levels, as well as continuing cost concerns. In addition, fee income has come under pressure as a result of volatility in asset levels and the fact fund launches have been smaller over the past year.
However, administrators also say they are benefiting from new business and additional asset volumes on the part of some existing clients, as well a shift in business onshore, and that they are improving productivity through the use of technology and lower staff turnover (down to an all-time low of 6 per cent, according to the report). Overall 40 per cent of survey respondents expected revenue growth of more than 20 per cent for the 2011 financial year.
Deloitte investment management advisory partner Brian Forrester says: “The fund industry employs over 11,000 people in Ireland in the administration of EUR1.8trn of assets, with assets exceeding EUR1trn in Irish-domiciled funds plus a further EUR820bn of non-Irish domiciled assets. The survey reveals excellent growth prospects for the industry. Demand for fund administration and associated custodial services has benefitted from the trend toward regulated fund offerings, as investors and supervisors demand greater oversight and transparency from hedge funds.”
Chris DiNigris of software firm Koger echoes Deloitte’s finding about the role of technology. “Our clients, which include fund and pension scheme administrators but also hedge fund managers, are trying to differentiate themselves in an increasingly competitive market by using best-in-class software. Each fiduciary is required to have proper systems in place, which might mean managers outsourcing to administrators that use such systems, and/or using them to monitor the work of external service providers.”
The Deloitte survey says that the provision of a broader range of services to hedge fund managers is helping to mitigate lower income from fees for basic administration, a conclusion endorsed by State Street’s Pat Hayes (pictured). “We have seen an increasing number of clients looking to outsource more of their middle office functions,” he says. “Regulatory requirements are one of the catalysts.
“In addition, organisations are examining their footprint and cost base and seeking to focus more on asset management, benefiting from the fact that organisations like ourselves have the expertise to manage their middle and back office requirements. Whereas once we just did the accounting and back office for most clients, today we're now seeing increasing demand for middle office functions to help our clients manage their cost base more effectively.”
Mark Mannion of BNY Mellon says that changes in the labour market in Ireland, and particularly in Dublin, have been central to the sector’s improved competitiveness. “There has been a remarkable reversal in the labour market between 2007 and this year,” he says. “Now administrators and custodians have access to graduates at a very competitive price, and turnover is at an all-time low because staff are conscious of the benefits of staying with one employer rather than trying to move around.
“Meanwhile, Ireland has built up a specialist pool of labour because such a large proportion of global alternative investment assets are serviced here. This very talented pool of expertise is now available at a much more competitive rate than would have been the case five years ago. That could explain why some new players entered the market in 2011, for the first time in a while, and in Dublin as well. In addition, rents in Dublin are now very competitive again.”
Earlier this decade many of the largest service providers established satellite offices – in some cases two or three – in other parts of Ireland as a pressure valve to cope with increased costs resulting from intense competition for skilled staff and high levels of other overheads in Dublin. Today that trend has largely run its course, both because cost issues in Dublin are less pressing and because most of the service providers of a scale to set up satellite operations have already done so.
“The major players had already taken those initiatives,” says Tara Doyle at Matheson Ormsby Prentice. “There weren't really any employers of sufficient size or scale left to look outside Dublin. But it’s not a not a sign that people have lost faith in that model. Employment is continuing to grow among all the largest service providers, both in Dublin and outside, it’s just that it’s more low-key than in the Celtic Tiger days.”
UBS Fund Services’ Don McClean says quality of service is a paramount requirement for Ireland as a domicile and that satellite offices have enabled firms to maintain high standards without their costs escalating. “Providing high-quality service and controlling cost is an important balance to maintain. Operations located outside Dublin remain an important cost control mechanism for service providers. Some also outsource certain activities to low-cost jurisdictions, but that can be difficult to implement without impacting quality of service.”
Butler believes that a combination of factors is likely to lead to further consolidation in the hedge fund services industry – something that has in any case been underway for years as some of the biggest global financial institutions started to build a presence in the sector by buying up some of the mostly private standalone administrators that used to predominate a decade ago.
“I see continuing consolidation in the administration sector as the big get bigger,” he says. “Although another trillion dollars may flow into hedge funds, that may not mean a commensurate huge increase in the number of funds, simply that some existing funds have become very big. That is likely to mean that very big funds will have to go to very big administrators, like Northern Trust and Bank of New York Mellon.
“They may not even be looking at firms whose assets under administration are counted even in tens of billions rather than hundreds of billion, because of the perception that smaller firms pose a greater risk. Alternatively, managers may choose to spread the risk by having different funds with different administrators. Either way, we will probably see a continuation of the pattern of the past 10 years, where small administrators either get taken over or become medium-sized and start acquiring other small ones, and eventually they become attractive to somebody very big.”
The future environment, Butler acknowledges, will also favour to some extent administrators that are part of a group that also offers custody. “At Custom House we have always found it difficult to get a bank to act as custodian to a fund we administer, which means we have never serviced many Irish-domiciled hedge funds,” he says. But the question will become more acute when the AIFM Directive eventually requires all funds that seek distribution in Europe to appoint a depositary, as Irish funds already do.
As it stands, the directive will leave depositaries liable for any loss of assets in their custody or that of a sub-custodian, unless they can demonstrate that the loss “was a result of an external event beyond reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary”.
This provision comes close to requiring depositaries to act as insurers of assets in their custody, and is expected to push up the cost of custody, perhaps considerably. But the risk will be less for groups, including many of the big players in the Irish market, that have their own global sub-custodian networks rather than relying on unaffiliated providers, and the cost implications may be mitigated where the same group provides both administration and custody services. Conversely, the environment could prove more difficult for administrators that are not affiliated with a custodian.
McClean believes it is difficult to predict the full effect on this industry until all the directive’s implementing measures are finalised, but says: “There will be a direct relationship between depository costs and the liability of the depository – the higher the level of liability, the higher the levy depositories will apply. As a result of that increase in liability, you can expect to see further consolidation in the industry. At the same time, some fund managers will seek to avoid the impact of the directive and thereby higher cost structures for their vehicles.”
Mark White of McCann FitzGerald agrees: “Either depositaries’ costs will go up because they are insuring against the risk of something going wrong at the non-affiliated sub-custodian level, or they will be out of the market. The big firms will only get bigger, while the smaller firms will get squeezed. That was an argument made at the outset of discussions on the directive, that it would reduce the choice for managers, who would be forced to go with larger players.
“Obviously the bigger firms will be able to gear up better for the directive and other changes in the European legislative landscape, although smaller players can be more flexible when it comes to costs. I suspect it's getting tougher all the time for smaller and niche administrators specialising in the alternative space to continue to grow their business.”
Maples and Calder’s Stephen Carty adds: “While depositaries still have very strong views on the liability provisions, some have gotten more comfortable on risk, or at least taken a view on what they can accept, following Esma’s level 2 recommendations, if they are accepted, and a clearer categorisation of the affected asset categories. It also appears that the application of comparable depositary requirements for non-EU funds could result in a more level playing field between those funds and their EU counterparts than at first anticipated.”
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