The onset of the Covid-19 pandemic upended the investment management, hedge fund, and financial services sectors, with firms quickly pivoting towards remote working and trading, investor and operational due diligence processes migrating to virtual settings, and industry participants describing the crisis as the ‘largest continuity test ever’ for business operations.
More than two years on, as forms of hybrid working remain in place, the experience appears to have shifted the needle, bringing about the increased potential for a range of back-, middle-, and even front-office functions traditionally performed on-site to be made permanently remote.
Appetite for outsourcing remains high, according to Hedgeweek’s survey findings. More than two-thirds (67%) of emerging managers globally are happy with their current balance of outsourcing, while 29% are preparing to outsource more functions (see Fig. 4.1). In addition, 55% have increased their outsourcing of compliance functions due to regulatory trends over the past year (see Fig. 4.2).
David “Tiger” Williams, founder of the equity execution service provider Williams Trading, observes how outsourced trading has provided emerging managers with added scalability. “Things on the outsourced side are not always necessarily regulatory driven – it can be cost-effective as it’s more of a variable cost than a fixed cost and the pandemic has certainly opened people’s eyes to the possibility of a more scalable workflow going forward.”
Culture
With a rapidly expanding landscape of third party service providers offering an ever-broader assortment of operational, tech, regulatory and trading products, the choice for cost- and time-constrained start-ups has never been greater.
But while the pandemic has helped accelerate the process of outsourcing, and demonstrated that many parts of the business do not need to be maintained all under one roof, managers say certain functions – those specifically relating to the ‘alpha-generative process’ – are best kept on-premise. In turn, newer managers’ selection of service providers – be they prime brokers, administrators, or software systems – is more important than ever.
“I think everyone agrees that Covid has accelerated a normal trend – we had 10 years of digitalisation within one year,” says Alyx Wood, chief investment officer at Kernow Asset Management.
For emerging managers, functions that form a core part of their competitive advantage, as well as functions that require full trust and oversight, should remain in-house or come under the scope of advisors, Wood says. In contrast, anything that is not a good use of managers’ time, and which can be executed better elsewhere, should be outsourced, he says.
“What’s our core competitive advantage? It’s research – so all our research happens in-house, we would never outsource that,” Wood says. “Everything else is about cost, speed and efficiency of service, whether it’s done internally with great advisors, or outsourced.”
The question of how fledgling hedge fund firms can maintain the balance between the increasingly loose constellation of networks brought about by remote operations while also fostering the creative “ideas factories” of physical trading floors critical to success also looms large over the outsourcing concerns.
“In terms of culture, having people in the room is really important. Being totally virtual would be wrong, so I think it’s a hybrid, progressive model,” Wood adds. “I think anyone who had legacy systems and were set up for the dark days before Covid, and then didn’t have a technology-led mindset, has been through a rude awakening and will probably struggle to fully catch up.”
Regulation
Reflecting on the extent to which start-ups should rely on compliance consultancy firms, Ant Bennett, head of sales and client development, ACA Mirabella, explains how access to expertise, cost and time to market are the three main drivers.
“With time to market, if you’re going through your own FCA application, there is a lot more that managers are now required to do upfront before even putting that application in place, though the timeframe is roughly the same,” he says of the UK market. “With a regulatory host solution, managers do not need a full compliance manual upfront because that is provided for by the regulatory host; you’re leveraging the permissions of the regulatory host firm. The complexity is still there, but you have the opportunity to familiarise yourself with the framework.”
He adds: “We have seen some initial investors, some of the managed account platforms, are unwilling to allocate directly to a brand new manager unless that manager can demonstrate sufficient expertise to be able to handle and manage that regulatory framework.
“It’s more accepted that you can leverage an outsourced middle and back office. We are increasingly seeing fund launches use a specialist launch COO to get up and running, what decisions need to be made in terms of the right growth trajectory, the initial costs, the main areas of focus.
“The willingness to stay with an outsourced compliance firm once a manager has gone live under its own FCA is growing more and more, and part of that is driven by some of the regulatory complexity.”
Prime brokerage
Meanwhile, selection of prime brokers – often considered the most important service provider – also remains critical to the start-up process. As the PB space has rapidly reshaped around consolidation trends among larger players and the continued emergence of smaller, boutique names catering to smaller hedge funds’ needs, key prime brokerage functions continue to evolve.
“The nature of capital introduction has changed a lot,” says Trium Capital’s Donald Pepper. “Going back to the early 2000s, the capital introduction teams were the nexuses of knowledge. Now, though, there is a lot more knowledge in hedge funds’ investor relations and sales teams whereby they don’t need the same level of introductory services that they used to have in the past. A lot of the capital introduction people now call themselves capital intelligence – it’s moved away from going to conferences and roadshows and introduction services.
He adds: “Hedge fund investors had to talk to the cap intro teams to understand who was the next big launch coming out. Now there is a lot more information about investors out there, and the value of having to speak to cap intro is more about hearing which investors are looking for strategies, rather than getting an initial introduction to these investors.”
Cybersecurity
The fallout from the pandemic has also brought greater scrutiny of how hedge funds and other asset managers handle cybersecurity. As businesses continue to operate with forms of hybrid working, investors are said to be looking more closely at the ways in which emerging managers and start-up funds manage cloud services, particularly as malicious actors look to take advantage in gaps in infrastructure.
“In the early 2010s, the idea that anyone that had information technology infrastructure would not have it on-premise, specifically when you’re dealing with highly sensitive information such as algorithmic trading patterns or even just data – whether it’s front of house or back of the house – was verboten,” says Faryan Amir-Ghassemi, co-founder, Epsilon Asset Management.
Observing the sea-change in recent years, Amir-Ghassemi believes newer start-ups are well-placed to capitalise on the availability of outsourced cybersecurity and cloud options on offer.
“In the last couple years, it’s become the de facto play, partly because of Covid, partly because of the changing landscape, partly because of the importance of cybersecurity and just the importance of information technology in running a modern business.
“Some of the very well-established, multi-decade hedge fund firms that have been building out processes and infrastructure in a methodical way are now the ones that are dealing with legacy technology and tackling the question of moving towards the best opportunities in the marketplace versus what they’ve inherited.
“But for the start-ups, they can almost leap-frog into the best-in-class options, and leverage that flexibility that the cloud offers, as opposed to building things on-prem.”
Key Takeaway
- The drive towards outsourcing over the past decade, which has gradually gained manager and allocator acceptance, was further accelerated by the Covid-19 pandemic. Hedge funds are satisfied with the amount of functions outsourced, though a number remain keen to increase this level further. Start-ups and emerging hedge funds are well-placed to leverage the expanding range of products and services on offer from third parties without having to deal with legacy infrastructure
