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Independents must guard against choking talented start-ups

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Focusing on bank-owned administrators, nobody knows the precise reasons as to why investment banks have been vacating the hedge fund administration space other than the banks themselves. One possible explanation is that the integrated model they have been running for years perhaps no longer aligns well enough with both clients and the ever-changing market regulations. 

At the start of the century, investment banks were ideally positioned to build out fund administration as part of a bundled service including prime brokerage, research, execution and clearing, custody services and so on. Since then the risks to running a fund administration business have become inexorably different and according to Michel van Zanten, a Switzerland-based director of Circle Partners, an independent fund administrator, the future of M&A in this space will be influenced by who is able to offer a better integrated fund model for fund managers. 
“What I mean is if you were a prime broker 10 years ago, the integrated business model was a great opportunity because even though you made not a huge profit on the fund administration, transfer agency or custody side, you always had financing, securities lending and trading from which you could earn enough margin over the whole relationship whilst leaving out the need for other 3rd parties and almost keeping the fund and the manager a private relationship.“

“Even though these functions and services may have been quite well separated from each other, the regulators are now making sure that the integrated business model should be funded, sourced and serviced alike. If you look at the capital requirements related to prime brokerage business in the UK and Europe, it doesn’t necessarily make it attractive for banks to be active in all spaces when they should be able to make enough in their (core) space. 
“Indeed, if you are able to make high margins on the financing side of prime brokerage, why add a lower margin business in the same environment and introduce a whole new additional set of risks in relation to regulations and rules?” comments Van Zanten.

The added liability of engaging in fund administration as well as depositary and custodial work, providing leverage, financing and securities lending is, as a result of Basel 3 and Mifid II, putting significant added pressure on banks’ balance sheets. The balance sheet of the bank is clearly still important for hedge funds but is also becoming a bigger burden for investment banks and losing relevance as a selling point for fund administration services. Today, every dollar counts, and has to be accounted for. 
Some of the beneficiaries of this de-risking exercise are the larger transaction-based banks: the Wells Fargo’s and State Street’s of this world. Fund administration seems to be a better fit for these institutions and provides greater economies of scale for them to leverage. Fact is that Mitsubishi UFJ Financial Group bought up Meridian and Butterfield Fulcrum and BNP Paribas Securities Services acquired Credit Suisse’s administration business and so on. “Some of the larger investment banks seem to have made the decision to move on,” says van Zanten, who continues: “I think that a lot of investment banks have operated in the past in such a way that high AuA was perceived to increase the prestige and valuation of their organisations. However, not much of that actually converted into value increase of their share price (much the same as the share prices of these banks did not suffer when fund administration businesses were sold) and under the new Basel 3 rules and Mifid II rules every USD1 billion needs to also be properly funded on the capital side in investment banks. 
If you then look at the return on investment of having USD1 billion AUA versus having all the inherent risks on the regulation, reporting, compliance and possibly the capital side, that AuA number might not be as attractive anymore."

Service businesses, like fund administration and transfer agency are in need of significant investment, adapting to the ever changing regulatory reporting and tax environment in global operating environments require significant investment with long term return horizons. Given the high pace of change and some of the local requirements, some require a change on change investments. 
Large global project teams, long time horizons and funding: these are not easy changes for an investment bank that also needs to make necessary investments in the front office to support higher margin business.

Transaction-based banks, on the other hand, look at this business somewhat differently. State Street has an asset management arm and a bit of investment banking but by-and-large its core focus is getting as many billions of assets under administration and under custody as possible. That approach no longer seems to hold water for the investment banks. In addition to the larger investment banks getting out of fund administration, private equity investors who have taken a position in the (mid sized) administration space have been looking for their exit.

Aside from the greater synergies for transaction-based banks in buying businesses that operate in a similar way to their existing core business, they also seem better able to capitalise on providing custodial and depositary services to the underlying managers they take on board. 
Whichever way you cut it, fund administration on its own has become a commoditised business. Margins have fallen and in that sense or otherwise better explained more services are expected for the same dollar, in that respect custodial bank owned fund administrators have a somewhat similar issue as investment banks. 
However, by making acquisitions in different time zones and reducing operating costs due to greater synergies, they are at the same time able to extend their custodial services and network and are in a better position to manage the level of returns they may or may not be making on fund administration services. Fund administration in that sense acts more as a protector towards the core custody business.

Thus comparing bank owned administrators, these transaction based banks are now better positioned to offer a more balanced integrated business model where costs can be more easily assimilated going from owning a super manco down to reconciling the transfer agency transactions and where headcount is not the main concern. That business model today makes for a better fit. 
"We are an innovating administrator that supports large and complex managers, but the fact is there are plenty of smaller fund managers sub USD100 million that need independent boutiques like Circle Partners to exist. Start up managers and (multi-)family offices need a great service at a good price," says van Zanten.
If these administrators get consumed into larger entities, even if it is for the right reasons, the risk is that smaller managers will get cut adrift. 
Back in the 1950s, the Dutch had waterlogged areas of land and they had two choices: either close them all off and build huge dykes or leave them open. They chose to leave them open because they acted as a chamber for fresh fish. 
It is no secret that Circle Partners found its origin in the Netherlands, but "I like to think about independent administrators delivering a boutique style service in a similar way; building bridges and implementing smart solutions, because without them, you run the risk of choking off that fresh influx of new talent; whose going to be there to support them?" concludes van Zanten. 

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