There is plenty of scope for further consolidation in the hedge fund administration space, but only those with a clear strategic vision and a willingness to reinvest in their businesses will likely emerge as tomorrow’s winners.
Consolidation in the hedge fund administration space remains a prominent trend and as investment banks re-assess the profitability of non-core business divisions and small administrators sink or merge in response to market complexity, it is one that is unlikely to end anytime soon.
In the last few years Goldman Sachs has sold its fund administration business, BNP Paribas acquired Credit Suisse's fund administration division, US Bancorp Fund Services acquired Dublin-based Quintillion, Mitsubishi UFJ Financial Group has acquired Butterfield Fulcrum and UBS, SS&C Technologies acquired Citigroup's Alternative Investor Services division.
In particular, MUFG and SS&C Technologies – the former as part of one of the world's largest banks with USD2.4 trillion in assets, the latter a leading technology company – have both been active this year. This month, MUFG Investor Services, (the global asset servicing group of MUFG), announced it had completed the acquisition of Rydex Fund Services, a 1940-Act mutual fund administration business, from Guggenheim Investments, adding USD52 billion in AuA to bring the total AuA for MUFG Investor Services to USD422 billion.
Back in May, the group also acquired Capital Analytics, the private equity administration business of Neuberger Berman Group to brings its private equity and real estate AuA to USD145 billion.
Likewise, SS&C Technologies acquired Wells Fargo Global Fund Services in September 2016 adding an estimated USD42 billion in AuA and the capability to support a wide range of complex strategies traded by global portfolio managers including credit, structured credit, private equity, private debt, real estate and hybrid structures.
What these acquisitions would seem to illustrate is that tomorrow's successful fund administrator will be one that can support fund managers across the entire product and liquidity spectrum, from daily liquidity '40 Act funds through to the most illiquid real estate funds.
"I wasn't surprised by the Wells Fargo decision as it didn't appear to be a strategic priority of theirs," says Jack McDonald, President and CEO of Conifer Financial Services. "We rarely saw them in the marketplace."
In his view, SS&C is seeking to build scale in fund administration by leveraging their software business, particularly after their acquisition of Advent Software. "Mitsubishi appears to want to be one of the largest fund administrators by diversifying their product mix via acquisitions, having invested in fund-of-funds, hedge funds, private equity, ETFs and '40 Act funds administrators," adds McDonald.
Technology driving change
Dermot Butler is the former Chairman of Custom House Group. Commenting on SS&C's approach to making acquisitions, he suggests that by not integrating each acquisition it must make it difficult to reduce costs that arise from synergies, unless of course they end up using the same technology and systems.
"I think what will soon become the by-word is `independence'. Managers and Investors are going to become more concerned, not necessarily with the size of the administrator but that they are fully independent. Whatever they say or do, they are doing it without any potential conflict.
"Custom House Group have picked up business and had some nice due diligence results from serious institutional investors and it was largely because of our independence, combined with our first-class processes and people," says Butler.
Back in March 2015, Custom House announced that it had agreed with TMF Group – a global provider of business services that merged with Equity Trust in 2011 – to go back to being a fully independent administrator: Custom House Fund Services. The deal is, in a way, a reverse M&A, giving Custom House the ability to operate unconstrained as a fully independent administrator with no ties to a parent company.
"The fund administration model has changed. Your system still has to be able to produce all the accounts plus various management and compliance reports and it's all much more automated. I used to refer to Custom House as a specialist accounting service. Today, it is a specialist data collector, manipulator and producer. Managers need data to file this report to one regulator, that report to another regulator and yet another report to investors, and make sure they've got everything on file for the auditors. Managers expect all these commercial and compliance reports to be provided by the administrator," says Butler.
Which is perhaps why a company with the technology heritage of SS&C Technologies is leveraging the chance to acquire different administrators, using technology as the backbone for building a successful administration group that spans multiple asset classes, product groups and geographies.
This `Fintech' approach, as it were, is something that very few others in the market can compete with.
"At a high level, what you see is a tremendous need for expertise. As alternative fund managers expand into different asset classes, they're encountering new structures with sophisticated waterfall calculations and regulations. Each domicile they operate in has requirements both for the fund and the vehicle they use. All of this change raises the question, `Can you gather enough expertise to be able to meet the needs of increasingly sophisticated clients?'
"This need for expanded expertise is driving a lot of acquisitions," comments Bill Stone, CEO of SS&C Technologies.
He says that just as technology companies like Uber and Amazon are changing the way we live our lives, the same is true for those who are can provide technology expertise to fund managers to support them in areas such as financial record keeping, position reporting, performance attribution, etc. "There is masses of financial data administrators have to slice and dice for managers to help them report to different regulators and investors.
"Fund managers are structuring themselves to be in the best possible position to chase alpha anywhere. SS&C's ability to integrate the Singapore, Hong Kong, Sydney and Melbourne offices of Citi with Wells Fargo gives us an increased level of expertise. This is very important to a variety of fund management groups that are trying to find alpha and outperform in a competitive environment," remarks Stone.
Peter Sanchez is CEO of Northern Trust Hedge Fund Services, one of the more prominent custodian bank-owned fund administrators. Speaking about technology, Sanchez says that "we have a technology framework that allows us to handle all types of investment strategies and portfolio complexities. Our technology utilises one data set throughout the trade and NAV lifecycles. Trade capture, fund accounting, performance attribution and P&L, investor accounting and investor reporting are all done on the same platform."
This is helping Northern Trust to respond to convergence in the alternative funds space as hedge fund managers develop more private equity-like structures and PERE managers add hedge fund-like satellite strategies to their core offerings.
"We have been investing into the back end of our system, focusing on sophisticated investor servicing tools as well as leveraging our existing tools to track performance and cash flows at the investment level. For example, private equity firms today ask for the return not only on a Limited Partner, but the return on a specific asset including all the cash flows and expenses and the return on a legal entity that holds that investment or portfolio," adds Sanchez.
More and more capabilities that leverage powerful data tools, such as tagging attribution tools, are becoming an important part of the solution set as fund administrators evolve their product offering in line with the changing needs of alternative fund managers.
Playing to custodian banks’ strengths
All of which involves capital expenditure; something that the investment bank-owned fund administrators have not necessarily had the luxury of pursuing.
Fund administration is not necessarily a core banking service. As the regulators put more capital requirement pressures on the banks – principally under Basel III – it is forcing them to look hard at whether this is a profitable area in which to continue investing.
"The complexity of the assets and fund structures alternative fund managers are putting together requires a tremendous investment in technology and I'm not sure banks want to make the financial commitment," suggests Stone.
By contrast, the core business of trust banks is asset servicing. They can compliment asset servicing with asset management services, wealth management and advisory services and as Sanchez is keen to emphasise: "Their whole bottom line – be it profitability or be it return on equity – is based on that business.
"When trying to solve problems, investment banks think about how to give investment solutions; how to earn fees and raise capital for their clients. In that context, they tend not to think about how to become a solutions provider to a client on custody, on corporate actions and complicated NAV structures.
"As a core competency of an asset servicing business, a trust bank is going to continually invest in that business because it is their core business. I think the investment banks looked at the administration business as a back-office business that they could make annuity fees on, but once they began facing balance sheet restrictions, they decided to look at what their actual core competency was, and it became quickly apparent that asset servicing was not part of it."
Hence why so many investment banks have followed suit once Goldman Sachs took the decision to vacate the space a number of years ago.
Although a more natural fit for the custodians, Stone actually regards MUFG as a bit of an outlier in terms of M&A activity.
"You don't see J.P. Morgan, or HSBC for example, anywhere near as active in acquiring fund administrators as they might have been five or 10 years ago. I think there is a pause with the major banks, with MUFG the exception to the rule. This might partly be down to the convergence point made above, as more illiquid assets and products come to market.
"While custodians have control of the assets, primarily the custody is on tradable assets; stocks and bonds. Level 3 assets tend not be held custody by banks. They might have information on Level 3 assets but they are essentially a private contract between the fund and whomever they purchased the asset from.
"The requirements are extremely intricate. The accounting and reporting on performance, tax and valuations becomes a big drain on IT resources because one has to build algorithms and information delivery devices to satisfy clients' needs across those non-tradable asset classes," explains Stone.
When considering M&A opportunities, McDonald sees two lenses through which Conifer would look at an acquisition. "Firstly, if it is strategically important from a product extension standpoint," says McDonald. "And secondly, if it is strategically important from a geographic expansion standpoint."
Alex Mascioli is CEO of North Street Global Fund Services. Mascioli brings a deep well of M&A expertise to the table having initially set up as an investment bank, North Street Global Markets, before establishing the fund administration business within the group two years later, in 2013.
This was achieved by acquiring a small New York-based hedge fund administrator, called Hedge Fund Solutions, to diversify into the fund services space.
"Then, in 2014, we acquired Hedge Solutions based out of LA to give us a West Coast presence. We are currently working on our latest acquisition, which we hope to close by the end of the year," confirms Mascioli. He says the plan is to continue the focus of building out their administration arm in hedge funds and private equity funds.
"Each month, our Global Head of Sales, Dean Betzios, holds a competitor analysis meeting with the sales team to gauge where the firm stand among industry peers and identify any gaps they can fill in regarding services offering.
"We have data files on many of the other administrators, revenue-wise, size-wise, key people, etc. We identify potential targets and connect with the relevant people. Those introductions are either via a mutual attorney or through a small- and middle-market investment bank, or it could even be a personal introduction. We are only looking at private equity and hedge fund business. The administration platform, currently, is 45 per cent PE and 55 per cent hedge so we are pretty well diversified.
"Outside of the US, one market we've been exploring for the last eight to nine months is the BVI. We would like to open up a London office at some point as well if it makes sense within our business plan," confirms Mascioli.
At SS&C Technologies, they refer to their acquisition strategy as `methodically opportunistic', meaning they look at everything and move quickly if something fits the growth plan.
"If we say we will buy something, we will. We have the financial resources to do it," asserts Stone.
"The two key things we look for in a potential acquisition are: firstly, that pricing is consistent with our pricing and secondly, staff pay packages are consistent with ours. Those are the two biggest drivers that determine whether or not we are going to have a profitable business.
"As long as the pricing and salary models are right then we can bring all our capabilities to bear in terms of systems, processes, reporting, and to manage the business in a way margins move to our margins, which in my opinion are industry‑leading."
Christine Waldron is global head of the Alternative Investment Solutions team at U.S. Bancorp Fund Services. Discussing the acquisition process, she says that the key is to focus on the firm's core expertise and to only make strategic acquisitions when the right opportunities arise.
"If you look at our history, it has been a combination of the two. We have identified strategic targets where we've integrated them into the wider USBFS offering that provide us with access to new markets and increase our scale.
"Also, from a strategic perspective, it's important for us to maintain the culture of our acquisition targets; this is a people and a relationships business. It is critical that there is not a significant overlap with our existing offering, creating unnecessary complexity. I also think it is important to have product evolution and product development. As a fund administrator, you are going to have to also evolve your product offering, your processes and systems, and your people, to support changes that are happening in the marketplace," explains Waldron.
Mascioli likes the M&A market right now because as more of the small independent administrators get bought or merge with each other, it is creating a vacuum in the middle market: "Our average hedge funds are between USD125 million and USD140 million. We have some smaller funds, we have a few larger funds, but we like the middle market because we are making a name for ourselves through the expanded opportunities that the consolidation process has provided.
"I think it's going to become very difficult for small administrators going forward. The rising cost of compliance and adherence to certain standards is going to outpace their bank accounts (and balance sheets) in my opinion."
Impact on smaller managers
One of the inevitable consequences of continued consolidation is that smaller fund managers face the risks of having to find a new administrator. People will initially be concerned as to whether the client service team will change, whether the rates will go up and whether the client service experience will change?
"In a scenario where the client experience is stable and/or improves, I think it will lead to a high degree of retention. If the opposite is true, and the people the manager previously dealt with are no longer in the client service team, etc, clients can get anxious. Most people in that situation tend to adopt a `wait and see' approach," comments McDonald.
When making an acquisition, people want to retain clients and the easiest way to do that is not to mess with the model if it's working.
"Clients want consistency. At the end of the day, changing your fund administrator is not easy to do. If you can sustain or augment the level of service, of product, of pricing, or improve via an acquisition – i.e. better reporting or improved overnight reporting – then clients should remain happy," he adds. "At Conifer, we strive for continuous improvement of the client experience."
Lack of standardisation
Hedge fund administration remains a highly fragmented industry. The number of independent administrators is unnecessarily high – there are an estimated 78 fund administrators in Luxembourg alone – creating an unstructured miasma that lacks standards or uniformity. To take a very simple analogy, in the automotive industry, global car manufacturers use robust messaging and logistics standards. The number of airbag suppliers is in the tens, rather than the hundreds, as is still the case in hedge fund administration.
"The last number I heard is that there are approximately 300 fund administrators and I think that number needs to be cut down to 50 or 70 over the next couple of years, and even farther over the next five years."
"There are too many administrators. As a result there is no uniformity as there is in the prime brokerage business and there needs to be," proffers Mascioli.
Stop the race to zero
One of the biggest issues in the HFA space is not just the lack of standardisation and sheer diversity of players, it is the fact that over recent years administrators have engaged in a race to zero, constantly lowering their prices in a bid to win mandates. This has diluted the service offering and partly explains why, at the lower end of the scale, smaller administrators have either gone under or been forced to merge.
This act of self-cannibalisation is economically unsustainable.
"It is not beneficial at all to continue to drive down prices just to try to win new business," states Waldron. "What I have found is that our clients want assurance that we are profitable and that the partnership is profitable to us as a business because they understand the risk of that not being the case.
"Our clients expect us to have a mindset of continuous improvement; improving on our offering, on our efficiencies and that we then pass those efficiencies on to them. I definitely think the industry has to get more into that mindset of continuous improvement."
Butler agrees that the model is unsustainable.
"I've no idea how some administrators are able to stay in business, with their price models. I don't know if they will survive, although the old "suck-in" trick still seems to work, whereby a "loss leader" price is agreed in year one, only to be doubled, or more, in years' two or three," he says.
Set a clear strategy
To remain successful, Northern Trust's Sanchez believes it is necessary to solve clients' issues with a strategic operations partnership mentality. By default, this means continuously investing in the business to build functionality and capabilities that meet the needs of the largest fund managers.
"To be able to enhance your product in terms of administration, plus offer cash management, depositary, trade execution and wealth management advisory to name just a few, I believe that the largest fund manager clients will likely end up with trust banks that are able to invest in their business and, importantly, generate a high ROE on their business.
"Whilst there will likely be fewer independent administrators in future, they will still exist and play an important role (especially in terms of pricing) to smaller fund managers. I could see a situation where the biggest managers become so big that they start to move into multi-administrator relationships. Some of the largest traditional asset managers have multiple administrators and I could see that happening in the alternatives industry, perhaps based on strategy, or investors requirements," suggests Sanchez.
As a concluding observation, SS&C Technologies' Stone highlights the importance of setting a clear strategy and then leading the organisation to execute that strategy.
"I think that's something we do pretty well and something that I am very focused on. This allows the entire organisation to understand what our objectives are and share in the fruits of our labours if we achieve those objectives. We have an execution and reward system which leads to a great esprit de corps."
There will be plenty more consolidation over the coming years. The industry needs it. Whilst some large custodian banks and independent administrators will support the upper echelons of the industry with multi‑product, multi-geographic service models as the alternatives industry converges, further mergers among smaller administrators will help to create a more standardised model.