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Large funds continue to rely on bank-owned administrators

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In a report published by eVestment last March (Alternative Fund Administrator Survey 2014), 95 per cent of respondents answered `yes' when asked if mergers and acquisitions were expected to play a role in the hedge fund administration over the next few years, citing the desire for economies of scale as the most likely driver of future deals.

"We agree with the eVestment findings. This is absolutely a scale game. Think how much regulation is being thrown at the funds themselves, the governance structure around those funds, the reporting requirements, compliance overlay. This is an expensive business to be in, and is becoming increasingly so. 
"It's all about scale and if you are a universal bank, where fund administration isn't core to your business, you might think about whether this is an important enough piece of your broader franchise to continue investing in," says Frank La Salla, Chief Executive Officer, BNY Mellon Alternative Investment Services.

"There's a bit of an arm's race to add functionality, add capability, stay compliant; you can't afford to do that unless it is absolutely core to your enterprise, as it is at BNY Mellon, or you've got an existing book of business with good margins to keep funding you."

Although the pace of acquisitions at the top of the food chain has slowed, the types of institution engaging in those acquisitions has become dominated by large transaction-based banks that are able to offer a slew of complementary services that large alternative fund managers come to expect today.

"We continue to look at acquisition opportunities in the market as and when they arise," comments Chris Kundro, head of Wells Fargo Global Fund Services. 
In the last couple of years, US Bancorp Fund Services, which sits within one of the best capitalised US banking groups, has acquired AIS Fund Administration and Quintillion Ltd. According to Joe Redwine, President, US Bancorp Fund Services LLC, any future acquisitions would likely be to extend the group's footprint in Europe as well as in Asia. 
"With respect to Asia, this will require lengthy deliberation and analysis. That said, we need to be where the growth is and Asia is clearly in our sights. This will bring to the forefront the "build or buy" question with the latter the likely direction in Asia. I see further expansion in Europe, Luxembourg for example, which will include both build and buy," says Redwine. 
Speaking of Asia, one bank that has been particularly active in broadening out its hedge fund administration business is Mitsubishi UFJ Fund Services, part of the Japanese Mitsubishi UFJ Financial Group. In a bid to widen out its expertise beyond long-only funds and pension plans, the firm has acquired the like of Meridian Fund Services and Butterfield Fulcrum, which, according to spokesperson Blair Henderson, are part of a wider growth strategy to become a leader in the global investment services industry. 
"This will happen both organically, as we invest in our team, technology and product offering, and inorganically, as the right opportunities emerge. We have very longstanding relationships with our clients, who have responded to the quality of our service and the solutions we offer. We are now focused on taking this success and growing our presence across Europe, the United States and Asia with the aim of becoming a top-three fund administrator," says Henderson.

Henderson says that any acquisition target must add value in terms of shared industry relationships and expertise: "As part of the Mitsubishi UFJ Financial Group we are fortunate to be in the position of being able to consider administrators of all sizes, but must be confident that any acquisition proves a valuable addition to our business."

The hedge fund industry, in all facets, is a highly cutthroat industry in which to survive and thrive. Small hedge fund managers are struggling to stay in business, the added costs of regulation and operations forcing many to exhaust their burn-through capital and go under before they've even had time to get going. 
The same pressures are being felt within the hedge fund administration space. Smaller administrators who can't invest in technology, provide an array of customised solutions, respond to regulatory developments, support multiple fund structures (both regulated and unregulated), etc, face an uphill task remaining in business. 
In the last five years, this has caused a great deal of consolidation at the lower end of the market, as well as at the top end where some investment banks have made a tactical withdrawal.

"While the cost of doing business has led to some larger competitors bowing out of the sector, the impact has been most keenly felt at the opposite end of the spectrum. With compliance and operational costs rising, it is often no longer viable for a fund with less than USD100 million of assets to stay in business. 
"This has caused a concentration of larger funds, which only want to be serviced by the largest fund administrators, fuelling consolidation in the fund administration industry. As a top-ten administrator owned by a global bank, we can continue to provide services for a range of fund managers," says Henderson.

The dynamics at work are no surprise to BNY Mellon's La Salla. As he points out, banks today have to pass liquidity stress tests to avoid another Lehman's situation from occurring. This is causing them to look forensically at their business mix to ensure that sufficient capital is set aside to protect against risks that are built into different business lines. 
"For some universal banks, I think fund administration businesses are just tangential to their core business. At the bottom end, small administrators don't have the capital adequacy challenge they just have a basic investment rate challenge and they need to get a return on their technology and compliance investment.

"The drivers at each end of the barbell are different but the net result is the same: namely, consolidation around a core set of players, both bank-owned and independent," says La Salla.

Kundro is in no doubt that the demands from larger managers, in particular, mean that it is a logical place for fund administration to sit within bank organisation who want a variety of other services and products; whether it is a complementary service such as custody and trust services, or financing arrangements and capital introduction services via the prime brokerage.

"It seems to me to be a natural place for the business. On the other hand, many of the banks are being run in different ways and for some they are taking the decision that it's no longer a business they want to be in; it's incidental whether it is a bank selling or a non-bank," says Kundro.

La Salla notes that the way the chips are falling as the HFA industry continues to consolidate is simply a repeat of a pattern that the custody business went through in the 1980s. Back then, there was a proliferation of custodians, but by the mid-90s consolidation had taken hold and the wheat had been separated from the chaff. 
"Then we saw it in the mutual fund administration space with around a 10-year lag, and now you are seeing it happen in the alternative fund administration space with a further 5-year lag. It always becomes a scale game and only a limited number of players have the capability, investment appetite, and the right credentials and experience to survive. 
"Who's in it for the long haul? Who has the right focus, experience? Are they willing to invest? To keep up with the regulatory spend needed?" questions La Salla. 
"I think some of the small niche administrators can continue to succeed and remain profitable," says Redwine. "When you are small, though, you always incur the risks associated with a limited balance sheet. It can have a major impact on client retention as well as gaining new clients. Larger AIFMs are hesitant to turn too large a "share of the wallet" over to smaller firms. We've benefitted from this phenomenon in both the AI and US registered space. Quintillion is a great example; a phenomenal firm in virtually every aspect but one prior to our acquiring them with limited balance sheet. That is no longer the case and many more opportunities have arisen, including increasing "share of wallet" with current clients."

The trick for independent administrators is not to allow concentration risk through a small number of managers dominating the firm's total AuA. This is a relationship business at the end of the day. If they've delivered exceptional service and supported the manager, they will likely maintain the partnership but it's a careful balancing act nonetheless.

"I suspect many hedge funds are going to non-financial institutions for administration and quickly realising that when they go to get other services from a bank they're going to struggle to get that balance sheet from the bank; they're not simply going to hand over balance sheet anymore without non-balance sheet products being part of the product mix such as administration," says Kundro.

"It's going to be a struggle to get banks to extend as much balance sheet if the manager isn't using them for admin services or other non-balance sheet intensive services.

"Many of our clients are not just using us solely for fund administration services, they are using multiple services at Wells Fargo; it could be financing from a variety of businesses, it could be custody, trust services, it could be subscription financing for PE funds etc. There are many things that a hedge fund or a PE manager can acquire from a banking organisation and I think that's what they're looking for now."

One criticism that has been levelled at more of the investment bank-owned HFAs is that over the years their strategy has been to cast their nets wide and bring on as many managers as possible. This has pushed costs down, without careful consideration of the returns on assets.

Redwine is quite clear when he states that at U.S. Bancorp Fund Services, regardless of whether they are servicing registered funds or hedge funds, every service is priced competitively and to make a profit.

"We don't give away one service and try to make up the margin somewhere else. That strategy will work up to a point, but when it stops working it can quickly become very painful. Because we are profitable, and have a high return on equity and on assets, we are able to add the resources we need, when we need them. Those resources fall primarily into three categories: 

• Risk management
• People, and 
• Technology

"Technology is obviously a given so when you are trying to differentiate yourself, it really comes down to your people – the quality and breadth of services they provide, and your ability to add people through the growth cycle.

"A key to any successful acquisition is acquiring talent. If you look at our fund services business across all business lines, we had approximately 600 employees in 2007. Now we have 1,300 employees. All but 250 of those people have joined the firm to support the significant organic growth we've experienced. That's important because investment management firms see our level of commitment and our capability to add the people we need to service them well," explains Redwine. 
Over at Wells Fargo Global Fund Services, care is taken not to get fixated on the AUM number alone. The depth and breadth of the client relationship is key.

"We run every potential client through a series of sophisticated models to determine what we need to bid on that relationship and what the minimums need to be to support the relationship, regardless of the size of the manager.

"Then, on a month-by-month basis we re-run the numbers through those models to see what, if anything, has changed. Is the nature of the fund different? Are they trading differently to what we thought? Are they not growing as much as we thought?" states Kundro.

La Salla believes that the bifurcation process in HFA industry – the barbell analogy made earlier – is well underway. Speculative niche players will continue to be successful by support small- and mid-sized managers, "while administrators like ourselves will continue to align with the largest fund managers running multi-asset class, multi-fund businesses that are more sensitive to the scale and stability of their service provider."

Mitsubushi UFJ Fund Services is emphasising the need for a data-driven approach to succeed under today's industry dynamics.

"The fund administration landscape is changing significantly under the pressure of increased demands on data quality and aggregation from regulators, managers and investors. We are investing in technology which will efficiently extract, organise, import, enhance, transform and load data from clients, third parties and in-house systems to provide a consolidated view of information for fund managers. 
"A successful fund administrator must constantly improve the technology it uses to ensure its offering is in line with managers' needs," concludes Henderson. 

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