Middle office outsourcing and the changing landscape of the hedge fund ecosystem

By Thomas Zdon – A year or two on from the financial crisis Hedge Fund firms were still reeling from the impact of the market on the absolute return model of the industry. Confronted with fears around risk and exposures founded by well publicized counterparty collapses, firms sought to regain investor confidence while shoring up best practices around risk management.

Core to the new paradigm was a multi-counterparty model designed to take advantage of the lower custodial trading fees and to reduce counterparty risk while expanding product offerings (SMA, UCITS) to bolster a somewhat eroding bottom line.

A direct impact of these changes, further mandated through increased regulation (AIMFD, Dodd Frank, UCITS IV, FATCA…), is the increased volume of counterparties, custodial relationships and investor tracking needed, placing strain on operational resources that were already spread thin. The changes in trading, custodial, and prime broker relationships also created a noticeable gap in the technology and solutions provided by exponentially increasing the efforts required to accurately ensure legitimacy of trades and information within core systems. Essentially, to mitigate risk firms expanded counterparties – and in so doing exponentially increased middle office, back office, and technology work required to track information in a timely fashion. Just as trade fees have decreased, the total cost of supporting trading and distribution have risen dramatically.

Approached by its hedge fund clients as a technology provider with a unique position within the hedge fund ecosystem, Advent began to develop a set of tools and services designed to reduce both the cost of increased counterparty management and the impact of rising technology requirements for its clients. Hedge funds were primarily looking for three types of toolsets:

  1. Trade lifecycle management solutions providing connectivity to clearing, confirm, and affirm providers in a cross asset class model allowing firms to begin to process trades T+0 regardless of their counterparty
  2. Reconciliation toolsets with the necessary linkages to custodians and prime brokers, to facilitate the rapid management of trade, position, and cash balance accuracy
  3. Dashboard creation tools allowing for exception based management and workflow design, to mitigate reliance on custom technology solutions.

Hedge funds were looking for systems to facilitate and reduce the cost of connectivity and increase timeliness of data while tracking additional information such as “cost of carry”, exposure reporting, and liquidity analysis. They were also looking for added functionality around risk and performance as those hedge funds in the retail space continued to seek benchmark tracking rather than the original pure absolute return model.

When those tools were added to the suite, because they were coupled with Advent’s long-standing investment keeping, cost basis tracking and P&L capabilities, they were immediately popular and spurred significant growth in software sales.

However, the relative ceiling for the ability of a firm to maintain profitability while adopting new technology, training and retaining staff, all while responding to the needs of enhanced investor due diligence, caused other firms to completely rethink the development of internal technology capacity and therefore revisit outsourcing options. Their chief challenge was a desire to outsource functionality and yet maintain oversight and control of the process.

In parallel, some of the largest fund administrators, asset managers and hedge funds started to think about developing their own investment keeping and middle office initiatives, and looked for adequate systems to support them. Advent Geneva’s unique scalability and asset class coverage meant that the system could overlap one or more back-end accounting systems while still providing a superset of data to each system, thereby eliminating many of the tasks associated with the fund accounting process and providing firms with a more timely way to reconcile valuations and NAVs from different sources. Essentially, firms were looking for a more scalable infrastructure which would enable them to meet the demands of front office users and rationalise efforts on the back office by separating T+0 activities and decision support reporting from T+X functionality. Additionally, the model employed needed to allow for a multi-tenant environment in which a firm could offer multiple delivery options of information to clients (Web, direct access, reports), cover the breadth of asset classes their clients might trade, provide highly scalable technology that could support a wide array of connectivity, client style, and collaborative toolsets, and service any number of clients.

Indeed, fund administrators were facing a complex set of key challenges, from the disparity of systems needed to offer middle office services, often requiring a best of breed approach at a “Rolls Royce price”, to massive integration and internal development efforts required to provide a cohesive solution to clients, gaps in terms of coverage across platforms depending on asset class silos and historical placement of the products in the market, and multiple product instances used to service various asset classes and geographical regions, due to either footprint gaps or scalability needs. The “sledgehammer to kill a fly” scenario often arose.

After a first analysis of these challenges, Advent conducted a comprehensive client interview process to gain a better understanding of the evolving landscape, and identified five key requirements for a technology solution enabling fund administrators to offer outsourced middle office services to their hedge fund clients – requirements that Advent’s Geneva solution and ancillary modules are now equipped to meet:

  1. Centralised, more efficient trade operations workflow
  2. Custodial / Prime independence
  3. Intraday views of data including real time information, made easily manageable with exception based reporting
  4. Operational transparency
  5. A simplified technology environment with less integration, a single support model and a trusted partner, but one that would be multi-firm and multi-tenant, and with multiple delivery models.

To meet today’s challenges, firms need a single hosting environment for portfolio management, fund accounting and/or NAV shadowing, and a system to manage cost controls within the firm as well as margin and financing. These challenges, combined with regulatory changes, mean firms are also faced with an increased cost of IT. They have to do more and more, costs are ever higher and the market changes faster and faster. In response to this Advent has developed its application footprint for hedge funds to the middle and front office and offers a rules-based workflow, with information delivered in a format that can be easily customised to fit the needs of each function. For fund administrators, Advent has been working on tools that will enable them to move to a T+0 model, to give their hedge fund clients the information they need in the format they want, and to bolster their middle office service offering.

Thomas Zdon (pictured) is Vice President of Solutions Consulting and Business Development, Advent Softwar

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