By Simon Gray – The financial crisis and economic downturn of the past three years have brought fundamental changes for managers of hedge funds and other alternative investments, but also for their service providers such as administrators and custodians. A mix of changing demands from investors and increased regulatory oversight of the industry is putting pressure on providers, not least to product more detailed, frequent and up-to-date information and to demonstrate their capability to act as a backstop against mismanagement or outright fraud.
In Luxembourg these developments are taking place against a backdrop of pressure on the industry to keep costs down – an issue for most fund services jurisdictions, but one that has been sharpened by the adverse economic conditions and the less than stellar returns achieved by many hedge funds – and other alternative asset classes – since the onset of the crisis.
And perversely there is also pressure from some fund promoters for greater speed in the regulatory approval process, an understandable priority for managers with opportunistic investment ideas but one that appears to run counter to the general trend in favour of more rigorous scrutiny and oversight of investment vehicles and the firms that provides services to them.
In some respects the crisis has brought the industry back to basics, according to Keith Hale, global head of transfer agency at software provider Multifonds. “It’s focused a lot more attention on the fundamentals of the fund industry, things like regulation and risk management, which were less prominent concerns three years ago,” he says. “Then the attitude seemed to be ‘the more exotic the fund, the better’, without levels of risk and operational control to match. Fast-forward three years, and investors are far more concerned about the risk profile of the fund, the identity of the administrator processing it, and what their balance sheet and technology infrastructure look like.
“Whereas in the past asset managers were mainly concerned about being exotic and creative, today they realise the need to offer funds, whether mutual or hedge, in a controlled way and with an appropriate level of risk. Administrators are keen to offer their fund manager clients more middle office outsourcing services because investors want to see third-party oversight over what the managers are doing, in the wake of scandals such as Madoff.”
That is pushing fund administrators to impose their own demands, Hale argues. “Administrators need more operationally efficient platforms to cater for the widest possible range of jurisdictions and funds at the lowest possible cost,” he says. “Whereas before the crisis they were more focused on getting new mandates up and running quickly, now attitudes are much more pragmatic and sophisticated about operational cost and risk. This is reflected in the need for software that caters to the need for control within the industry but that enables managers, especially in the alternative space, to react quickly to change.”
But the background of managers may still result in different priorities. “New hedge fund managers might have started life as a group of prop traders who came up with a hedge fund strategy to offer to ultra high net worth investors,” Hale says. “They might not be used to the level of infrastructure of a traditional institutional buy-side asset manager, preferring fairly light, fast-moving, easier-to-change infrastructure that enables them to be highly reactive. Traditional asset managers and administrators may be more risk-averse in terms of their technology platform.”
For a provider like Multifonds, “you have to be proactive rather than reactive and speed to market is key. The challenge in serving administrators and their own alternative manager clients is making sure the systems can respond fast. We aim to react quickly to our customers’ needs. For example, there are a number of areas that are not necessarily core to our traditional processing systems, such as customised reporting. We have to enable our customers to support these needs quickly by providing flexible tools as part of our architecture.”
Another important development Hale sees is the blending of institutional and alternative fund services into a single offering. “Now it’s all just fund services,” he says. “That indicates that the alternative and institutional industries are coming together and the institutionalisation of systems and processes reflects that. Customers are expecting more robustness in the development, testing and roll-out of the functionality, although there will always be pressure to do things quickly and respond, for instance, to the latest performance fee and equalisation methodologies.”
Bradford Rowley, a senior business analyst at Pacific Fund Systems, provider of the PFS-Paxus fund accounting system, notes that in today’s market many service providers are carrying out operations across an extensive global network covering multiple time zones, and that they need technology to match. “They require the ability to work from a central database across multiple global locations,” he says. “Rather than having a different infrastructure for each office, they want an infrastructure shared globally, using a common set of standards, database and approach across all their offices.”
One of those providers to adopt a global operating model is Citi. “One reason we built and deployed a global operating model last year was that, especially with all the uncertainty in the marketplace, fund managers may take a wait-and-see approach, but administrators can’t afford to do that,” says Marion Mulvey,head of alternative investment administration services for Europe, the Middle Eastand Africa at Citi Global Transaction Services.
“A lot of this is technology-driven, and things like that don’t happen overnight. One of the benefits of a larger player, especially the handful of truly global players like Citi, is our ability to invest in the technology and prepare. And while certain new features and requirements are coming in with the latest fund regulations, in reality the need for transparency has been around for a long time.
“Once you build a global standardised platform and all your systems are in sync, across the world you utilise the same processes, and your team is organised around the same roles and operating models and principles. It allows for a more simplified and streamlined ability to address new regulatory requirements through a single change to a single application deployed literally worldwide.”
Another aspect of technology, data security – a hot topic throughout the global financial world – is especially important in Luxembourg because of the legal implications of the country’s confidentiality rules. “To obtain an administrator licence you need to be able to show the regulatory authority that the client data will remain confidential,” Rowley says. “We have an encryption process that encrypts all the underlying data and any correspondence to protect data against being stolen. Without a valid password or cipher key, the data is completely illegible.”
As Europe’s largest fund services centre, Luxembourg appears well placed to benefit from the evolution of the service provider industry as a result of changing regulation as well as the impact of technology costs. José-Benjamin Longrée, until recently managing director of Caceis Bank Luxembourg, notes that with a third of the EUR150bn in total assets under fund administration in the grand duchy consisting of alternative investments, the group has taken steps to organise its global fund business accordingly.
“A lot of players have strategies to offshore or ‘nearshore’ various operations, and are looking at what part of the value chain they put in Luxembourg and what part should be outside,” he says. “Caceis has centralised independent valuation of derivatives and departments for processing derivative instruments in Luxembourg on behalf of other branches or subsidiaries. It is a centre of excellence for the group. Other groups have also realised they need their centre of expertise close to the main centre of alternative investment funds.”
That’s not to say that smaller players are necessarily being squeezed out of the fund administration market. “We are seeing more and more new entrants, especially in the fund accounting sector,” says Deloitte & Touche audit partner Johnny Yip. “In addition, some Luxembourg-based institutions are opening up specialist hedge fund desks, and there is a lot of interest in Newcits business.”
Nina Kleinbongartz, product manager for alternative investments in Europe at Citi Global Transaction Services, adds: “There will always be niche or boutique fund administrators targeting particular strategies or small and start-up funds. Currently we don’t see a great trend toward consolidation among fund administrators. On the contrary, Luxembourg is a good place for niche providers.”
However, she cautions that the environment for such niche firms will become more complicated when the EU Directive on Alternative Investment Fund Managers comes into force in 2013, bringing with it increased liability on the part of the depositary bank for losses suffered by investors through a tightening of the obligation to make restitutions of fund assets to the manager or to investors.
“Niche providers will have to team up with a depositary bank when the directive comes into force because often they do not offer in-house custody services, whereas Citi is well placed to provide these services higher up the value chain,” Kleinbongartz says. “Fund managers are especially are looking for service providers with deep pockets, while investors prefer brand names to small boutiques. However, if the latter can partner on the custody and depositary bank side, that could be a good business model.”
That may not preclude consolidation on the depositary bank side, she adds, and Longrée agrees that further developments in the regulatory environment for custody providers, including the AIFM Directive, could offer a big advantage to global institutions. “If the depositary effectively becomes insurer of the fund, that will be a huge advantage for players – there are only a very few of them – that have a giant footprint all over the world,” he says. “It will be a big advantage to be able to offer their clients a guarantee because they have their own sub-custodian network.”
He warns that these provisions may make investment in emerging markets more difficult and expensive because of the potential liability incurred through outsourced sub-custody arrangements. “At the end of the day, as long as you use first-class counterparties in Europe and North America, the impact might not be that huge,” he says. “But you will have to find other arrangements that may be more costly when you invest in certain geographical regions or sectors. If responsibility for sub-custodians is really strict, it will be very expensive for funds investing in these areas.
“To become the insurer of an economic structure is completely different from being a service provider essentially focusing on operational risk. You will have to calculate things in a different way, and there may be consequences for depositaries’ capital adequacy requirements. Even big providers with deep pockets will have to get insured in turn. With investment funds you are very quickly at a level of economic liability for the assets that is big for anyone in the world.”
The potential for increased costs of the new regulatory arrangements in Europe are an additional concern for a Luxembourg industry that has always needed to keep a close eye on its competitiveness in relation to rival centres. However, members of the industry point out that Luxembourg’s ability to attract to its workforce skilled individuals from neighbouring areas of Belgium, France and Germany has long been a brake on salary inflation. Beyond that, they say, you pay for what you get.
“Luxembourg is not cheap, but it depends whether you want to drive a Mercedes or an Opel Corsa,” says Mariusz Baranowski, the former managing director of Custom House Fund Services (Luxembourg). “You can’t buy a Mercedes for the price of a Corsa. Managers and investors continue to come to Luxembourg even if it’s a bit more expensive for many reasons, starting with the quality of service providers.
“In Luxembourg, you have numerous top-class lawyers, custodians, auditors and fund administrators within a couple of square kilometres. In half a day you can establish good relationships and be sure that your fund will be formed and administered to the highest possible standard. That’s not so easy elsewhere. In addition, Luxembourg is a jurisdiction with experience, which has been through many crises and other developments over the years. It is because of its experience and expertise that Luxembourg has the ability to reinvent itself.”
Baranowski adds that the crisis has made competition within the marketplace keener. “Once a manager might have gone to a lawyer to set up its fund and just paid whatever fee they quoted,” he says. “Now they would go to four or five different firms.” There is greater flexibility in other areas, too. “For example, office rental prices have not gone up at all, and it’s much easier to talk to property managers. When business was booming for years on end, people saw no reason to negotiate, whether on office space or salaries, but now that’s all changed.”
Longrée argues that cost levels are not dissimilar to those in Dublin, where many of Luxembourg’s fund service providers also have operations. “We are very much on the same path, with different advantages and disadvantages that at the end of the day lead to the same kind of cost structure,” he says.
“The fund industry is at maturity, and you have a certain number of people that may not necessarily be the cheapest on the market, but that’s in part because groups are putting more and more value-added services in Luxembourg. But ultimately a number of comparative surveys have made clear that Luxembourg is in a good position compared with many European countries.”
Quality and attention to detail may also have something to do with the complaints that can occasionally be heard from fund promoters that the process of gaining approval for new funds is not as fast as in rival centres. The industry regulator, the Financial Services Supervisory Authority (CSSF), has said it is looking at ways to reduce delays, but some analysts say there is still work to do. “We may never be as fast as the British Virgin Islands or Cayman, but we are working hard to improve our speed,” says Yip. “Our benchmark should be Ireland.”
Baranowski notes: “We are a victim of our own success. You can see it as a negative, but at the same time it shows that proper due diligence is being done at the set-up stage, and that once it’s up and running the structure works. You might be able to buy off-the-shelf holding companies, but in the fund industry you need to take time and ensure every aspect is properly thought through, to avoid having to rewrite all the offering documents a couple of months later.”
Longrée believes that the sheer variety of funds using the SIF regime is a factor. “The problem is that there are not just two or three categories of SIF – there are as many categories as there are SIFs,” he says. “That helps explain why in certain cases they go through very quickly and in others they go a little slower.
“Caceis’s recent experience with the CSSF has been very good, but it’s always the people who are not satisfied with a particular case that are vocal. But I wouldn’t say it is worse that in the past. The CSSF is doing pretty well and I’m convinced they will take the necessary steps in the future to ensure they have sufficient resources.”
Baranowski concurs: “Because Luxembourg is in fashion, the SIF law is extremely successful, there is some redomiciliation taking place, and the regulator is understaffed, they don’t have enough people. Now the CSSF has started to poach people from the industry, so people who used to work in fund administration are turning up working for the regulator.”
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