In an industry environment where even the smallest start-up managers are being called upon by potential investors to demonstrate their commitment to effective risk monitoring and management, service providers are seeing opportunities to extend their market by targeting firms that in the past might well have handled risk through an improvised spreadsheet solution, if at all.
The development of products and service delivery mechanisms more attuned to the needs and budgets of smaller industry players is one aspect of the sea-change across the industry in the wake of the crisis of the past couple of years. It has opened up a broad range of new opportunities for providers of risk management and reporting software, but is also presenting challenges to these firms as managers and investors put their existing arrangements under critical examination in the light of the risk management failings the crisis exposed.
One important development is that service providers such as administrators are increasingly recognising their need to offer risk services alongside the other reporting functions used by their hedge fund manager clients – whether this involves building their own risk measurement capabilities or teaming up with specialist providers that can integrate their software within the administrators’ existing systems.
Butterfield Fulcrum, the international hedge fund administration group formed a couple of years ago by the merger of Fulcrum, owned by private equity firm 3i, with the administration business of Bermuda’s Bank of N.T. Butterfield, is one industry player that has embraced the new industry requirements, having recently launched an integrated operations and risk reporting service.
Says chief executive Akshaya Bhargava: “The reporting service takes the positions from our accounting system and generates a whole set of risk information, including all the ratios and reports on liquidity, on leverage, and on concentration by industry, geography and strategy. It includes some P&L analysis and elements of stress-testing within a very holistic package. Broadly speaking, we provide two sets of reports, one for the investment manager, which has position-level detail, and the other aimed at the investor, which does not.”
Bhargava says the initiative meets growing demand from clients for risk services as an integral part of a fund administration offering. “It is the logical place to do it, because an administrator is the only place where you get independent reconciled data on the fund,” he says. “The fund manager itself can do it, but it’s not independent, and prime brokers can do it, but their data isn’t reconciled. That’s why risk reporting integrates best with an administration service, and our clients are reporting that we offer quite a powerful package.”
This logic has informed the market approach adopted by New York-based risk software provider Portfolio Science. The firm’s product range includes RiskAPI, which involves integration of risk reporting into the systems of administrators and prime brokers through an application programming interface, bringing risk services to a much broader range of managers.
Portfolio Science president Ittai Korin notes that the experience of the past couple of years has brought home to service providers that risk reporting has become a much more important service for their clients, and that they need to be able to respond. At the same time, he says, this approach necessitates the willingness of his firm to eschew promoting its brand and controlling the application’s look and feel in favour of allowing the administrator or prime broker to deliver the service on a white-label basis.
“You have to change your priorities as a vendor,” he says. “You have to not care about having your logo out there, about the traditional concepts of the brand or the look and feel of the front end. What matters is being the back-end infrastructural DNA behind the services that they’ve realised they need to provide.”
Korin says the API approach avoids the need for a front-end interface. “The API allows users to access risk exposure calculations through standard operating environments. APIs normally allow users to customise software by developing code that can access and manipulate the software’s features, but RiskAPI takes the concept further by using a standardised interface to connect securely over the internet to a risk engine running on our servers. The API communicates user-defined parameters securely over the network to our engine, which runs them through all its resources and delivers the result.”
He argues that the model saves the service provider a great deal of time and effort. “Even for the simplest asset class, for instance domestic equities, they would otherwise have to build and manage a database of historical data and deal with splits, capital adjustments and all kinds of corporate actions,” he says. “Just maintaining that database of historical pricing would be a significant challenge for a fund administrator.
“In addition they would need a full understanding of the mathematics that goes into the risk engine. You’re talking about a massive divergence from their core business. Instead, RiskAPI enables them to deliver a whole structure of results with just a small amount of initial input. All they have to decide is what calculations they want and how they want to present them. We make it very affordable and speedy to go from the position data to the risk calculations they want.”
Portfolio Science has now moved a step further through an agreement with PortfolioShop, a software vendor that provides reporting infrastructure to administrators and prime brokers, to integrate RiskAPI into the enterprise investment management system FixQ. “Today in the fund administration and prime brokerage market there are different types of player,” Korin says. “Some offer reporting capabilities by purchasing systems or building them in-house, while others buy it in as a product or service.
“PortfolioShop’s decision to offer risk reporting to its service provider clients represents a new strategy that reflects how the industry has changed and what service providers now need and want. It can now offer a whole suite of risk reporting tools to administrators and prime brokers alongside the original features of its application. Through this single integration, all PortfolioShop’s clients can offer risk reporting to their own fund clients in turn.”
PortfolioShop president Harvey Sontag adds: “Using RiskAPI, we have been able to completely embed a full suite of risk analysis features into FixQ. Our clients’ fund customers now have instant access to dynamic exposure and risk analysis. The service has allowed us to quickly offer powerful multi-asset risk analysis including value at risk, correlations, betas, derivative sensitivities, stress-testing and much more. The result is a ground-breaking combination encompassing accounting, reporting, performance and now risk.”
Another provider that is examining different ways to meet the new needs in the market is PerTrac Financial Solutions, provider of the eponymous analytical platform used by managers and investors, and which is looking to reach players in the market that in the past have been deterred by cost factors from investing in advanced risk management tools. Says managing director and head of global marketing Meredith Jones: “In April, we are launching an advanced risk module for our platform called RiskPlus, which allows very sophisticated modelling of a variety of risk factors.
“The PerTrac platform has always had a strong risk evaluation component that enables clients to perform analysis such as Monte Carlo simulations and stress testing as well as statistical analysis to help determine the risk/reward profile of the fund. This new product takes the process a step further by bringing more sophisticated, academically-proven risk evaluation tools to a wider section of the market.”
Jones notes that historically risk evaluation tools have cost as much as USD100,000-plus, pricing them out of the range of smaller investors and managers. “Our new product will be priced between USD12,500 to roughly USD20,000 to offer smaller investors and those on tighter budgets access to some of the same sophisticated risk evaluation and management tools used by larger investors,” she says.
PerTrac is also responding to the new environment by actively promoting its P-Card system for the transmission of information by managers to investors in a way that enables the latter to integrate the data directly into their own systems rather than having to re-key it, with all the loss of time and potential for errors that entails.
“If you need to make adjustments to your portfolio or send in a redemption request, time is of the essence,” Jones says. “That’s a huge part of managing risk. Without transparency you cannot possibly manage the risk in your portfolio. And without efficient transparency, a lot of people end up receiving critical information but not necessarily being able to act on it, which is dangerous on a number of levels.
“First, if you have any type of fiduciary responsibility, it increases when you receive information from a manager. If you don’t do anything with the information you receive, due to lack of either time or expertise, you have effectively increased your liability toward your end-investors. Even investors that may not have fiduciary responsibility face increased headline risk – that if a fund blows up and they had information that might have mitigated that risk, had it been acted upon, it all ends up in the Wall Street Journal. It’s not just mitigating the risk within the portfolio but risk to the organisation as a whole.”
She likens the experience of the past two years to that of a car accident: “Before 2008 the perception of risk in the marketplace was like having an accident in a Hummer – risk was something that was really far away and didn’t necessarily touch you personally. Since 2008, the perception of risk is more like having an accident in a Smart car. Anything that hits is up close, personal, and it’s definitely going to affect you.
“Errors and fraud are no longer abstract things you read about in newspapers on occasion but things that happen to you or to other investors that you know. That has given everyone a much healthier appreciation of the true extent of risk and made people more willing to do the work necessary to mitigate it. Investing in anything, whether it’s a house, a mutual fund, a hedge fund or a private equity fund, cannot be easy if you do it right. You have to be vigilant and do the research. If you don’t, now we really know what can happen.”
This appreciation has also brought new business to specialist firms such as World-Check, which provides enhanced due diligence on individuals and companies. Doug Nairne, head of enhanced due diligence operations, says that scandals like the Madoff affair and others have brought home to investors, including institutions and fund of funds managers, the importance of conducting background checks.
“Conducting due diligence is like getting a medical check – it may not find everything, but it will find more than doing nothing,” he says. “Many of the people implicated in recent fraud cases had previously faced litigation, investigations by regulators or allegations of wrongdoing by former business partners. It’s a rare that the perpetrator of a major fraud hasn’t left a trail of less serious problems that could serve as a warning.”