Axa Investment Managers' fund of hedge funds platform
Sharmila Soosaipillai, head of operational due diligence
BNP Paribas Securities Services
Geoff Pullen, head of global sales hedge funds
Christopher Mulhern, chief operating officer and president
HSBC Securities Services
Paul Stillabower, global head of business development
UBS Global Asset Management
Thomas Wels, chief operating officer and head of fund services
HEDGE FUNDS REVIEW: As fund administrators move into the middle office, can you define ‘middle office’, and is it something administrators should be getting into?
Christopher Mulhern, Butterfield Fulcrum: At this point in time, what isn’t recognised is that a number of the larger administrators have been involved in middle office for almost a decade. Other administrators are moving into middle office based on the opportunity of incremental revenues for the firm. There are a few drivers behind it but, before you get to that point, you need to define what is ‘middle office’. There are a number of different definitions out there.
We, at Butterfield Fulcrum, define middle office as activities that we perform for our clients related to trade date, whether that be affirmations, confirmations work, cash, collateral management work, portfolio or profit and loss (P&L) reporting on trade date. That’s middle office to us. It’s not month-end tasks like reconciliations or net asset valuation (NAV) calculations done on a daily basis. That’s how we look at middle office.
Should we be involved in that? It’s hard as a fund administrator to turn away incremental revenue opportunities and requests for services, to be quite honest.
It was driven originally by fund managers being able to allocate work to the administrator that falls under the fund’s fees as opposed to the management fees.
Over time, people have started to suggest that independence is the driver behind putting middle office with the administrator. Right or wrong, we’re there. The majority of our competitors are there.
Paul Stillabower, HSBC Securities Services: I think the middle-office services are a natural extension of back-office services – fund administration – that we provide, and have done for a number of years. It has been a natural way of extending from the back office services as clients look to outsource non-core functions they are doing themselves and leveraging the scale that a fund administrator provides in those areas.
It is a complicated service that requires a good fit. We have all discussed the different definitions of middle office and if a client – and we all know a few that are – is trapped with a provider that is not providing a good middle-office service, it is unfortunately very sticky and difficult to unpick.
HEDGE FUNDS REVIEW: Do you think administrators should be offering these services as the skill set is very different from standard fund administration?
Geoff Pullen, BNP Paribas Securities Services: It is a natural extension, and actually could be interpreted as early fund administration, to a certain degree. Some fund administration staff will only cut NAVs but, as we extend into the middle office, there are definitely people that, naturally, can take on those processes and I think fund administrators do have those skills. Each client is different as is every fund administrator, but the skills are most certainly there.
Thomas Wels, UBS Global Asset Management: If I look into my role, I am confronted on a daily basis with two questions: to whom do I outsource and, on the fund services side, to whom do I offer services? If I outsource, I tend to go to best-in-class service providers. We regularly question whether the fund administrator is the better provider than a specialist, or if it is better to work with the risk management firm that is doing nothing else but risk management or whether we outsource or offshore parts to our own locations.
What we do is mix and match. The former pure-play fund administrators are pretty good at adding risk management services to their business, for example. Risk reporting just belongs in the package provided to their clients on a daily, monthly or quarterly basis. Web reporting belongs to this. Middle-office services always depend on how far we actually go down the value chain.
Geoff Pullen: It is important not to lose sight of what the core function of an administrator is, which is essentially to produce an accurate and timely NAV. Each client is different, however, and we do receive requests for middle-office services – and we’ve responded to that. Some managers don’t want to outsource middle office while others are principally interested in the NAV. Where the client demand exists, however, administrators will build the necessary infrastructure.
Christopher Mulhern: I think it is one of these issues where particularly big managers that have scale like the control. You cannot abdicate your responsibility as the manager, so there is the economic value you get by outsourcing. There is a move towards a variable-cost model so you can keep aligned with your trading activity. But it is different, depending on the ‘DNA’ of the manager.
Thomas Wels: If you look at the size of assets under management (AUM)specifically, smaller asset managers see the enormous back-office costs and they are prepared to outsource much more easily, while larger hedge fund or fund of hedge fund (FoHF) managers might say: ‘I am big enough to provide this service internally’.
Sharmila Soosaipillai, Axa Investment Managers’ FoHF platform: I’ve seen a combination of both, whereby the larger manager wants that additional check and balance where they will extend the services their administrator provides. But the responsibility should ultimately lie with the manager when it comes to the daily trading process, the matching of those trades and reconciliation. It would be useful to get the assistance on the outsourcing front, especially if you are a manager who is starting up and you don’t have the infrastructure. Ultimately, the managers will need to make sure they keep on top of what is going on.
Christopher Mulhern: We could speak at length about whether we should be in this space and maybe agree or disagree. But, in a lot of cases, the client is defining that for us. By participating in the business development side of Butterfield Fulcrum, we are at the table with some clients and being considered for opportunities only because we have the middle-office servicing as part of our core service offering. To an extent – whether or not I want to be there – the client drives a lot of that.
Thomas Wels: It is driven by the request for proposal (RFP) and we just say, okay, either we want to be in or we want to be out.
Geoff Pullen: As mentioned, each client’s requirements are different and their interpretation of middle office might also differ. The challenge for an administrator is in being as flexible as possible, while remaining within the confines and boundaries of a global operating model. That means you can benefit from economies of scale. You have to take each manager on their own merit when you are working with them.
Christopher Mulhern: When you get back to the client side and the client demands, it helps to respect that, in the 1980s and 1990s, many of the strategies were a lot more simplistic, more seamless, more long/short equity with more difficult trading strategies and instruments being used as support instruments in hedging. Today – and in the last decade or so – these difficult instruments have become the strategies themselves. That has forced an increase in infrastructure and operational personnel at the hedge fund manager level. A lot of these hedge fund managers are located in high-cost centres such as New York or London, and it really takes a large bite out of their management fee to support this stuff. Again, this makes them look at the outsourcing model.
Sharmila Soosaipillai: Bringing about the question of expertise within the administrator to be able to deal with the complex instruments that are being traded by the manager.
Christopher Mulhern: In the 1990s, 80%–90% of staff being hired had designated accountant-type backgrounds. Today, a significant proportion of our staff comes from finance backgrounds, applied mathematics, financial engineering, chartered financial analysts, etc., that need to be there in order for us, as an administrator, to be properly equipped.
Geoff Pullen: We’ve talked to managers whose entire middle office is outsourced, but they also have an entire additional shadow function running in parallel. In that case, why outsource in the first place? If they don’t have confidence in their middle-office provider and they don’t feel that the technology and processes are there, why outsource? I think some managers may have lost some trust with lesser providers and ended up just replicating what they had aimed to outsource.
Sharmila Soosaipillai: It comes down to the ultimate responsibility lying with the manager. By outsourcing either to the administrator or some other provider of middle-office services, the managers are giving comfort to investors that there is independent oversight on the day-to-day activity, not just from a reconciliation perspective but also from the trade activity perspective.
Paul Stillabower: In the middle office space we have customers telling us that one of the things they like about HSBC – and obviously there has to be a Chinese wall – is that our global banking and markets business has a product control function that we can leverage. The function has 500 people that are intraday valuing the P&L of the instruments that HSBC trades. It’s more powerful than hiring a bunch of administrators to cross-check price sources. They are interested in HSBC putting together a package of services where we can use the intellectual capital of our product control function – for example, when there is a stale price or when we have to build a price from the bottom up. This is where we have deeper skills and that is one of the things that has trended out of the evolution of middle-office services.
Thomas Wels: Securities pricing is an interesting aspect because size and diversification of the asset manager or the group actually play a role. The bigger you are, the more data points you probably have access to for running your day-to-day business internally. Then offering these services to third parties just gives you additional leverage.
Sharmila Soosaipillai: From an investor perspective, the concern would be if you have the same group of entities that is providing prime brokerage services as well as valuation services and administration services because, ultimately, it’s all coming out of the same group, probably the same data source. The independence comes into question. Ideally, what we want is as little affiliation as possible between the various service providers to the fund.
Thomas Wels: I would look at it slightly differently. If you do the due diligence on our organisation, you would certainly figure out that we have multiple price sources. In fact, they are different price sources. We have independent valuation committees in different business divisions. It’s the same organisation but there are oversight functions and we can actually give our clients the choice of which price they pick, based on the independent advice.
HEDGE FUNDS REVIEW: Is ‘too big to fail’ a problem for administrators? What impact would failure of the related investment bank have on the investor, the management company?
Sharmila Soosaipillai: Certainly we would have concerns. While it may be a scenario where all entities in the group may not be affected, if something is happening within a group, there is going to be an element of uncertainty. People are going to be unfocused in terms of trying to get day-to-day work done because they are unsure as to whether their own business is going to survive. That could potentially lead to delays from the administrator’s side, for example, in the NAV being disseminated, or there could be mistakes made because people are not focused on what they are doing.
When we are looking at administrative functions, it’s not as easy to switch from one administrator to another compared to prime brokers. You can have back-up prime brokers in place in the event something goes wrong from a counterparty risk perspective. As for the administrator, you either have the existing administrator or if a change is required you have to go through a process of running parallel to make sure all historical and current information have a smooth transition to the new administrator.
Christopher Mulhern: At Butterfield Fulcrum Fund Services, we are truly independent. The only service we provide is fund administration. I think the argument about counterparty risk and Chinese walls is valid, but I also believe the focus of an independent administrator is to be good at that. There is something to be said for that as, in a big bank environment, for example, where it is just part of the overall offering and it’s not core from the P&L point of view. How much of tangible reinvestment does it get?
Paul Stillabower: Unquestionably, when we talk to the chief executive officers of our customers, they would much rather not talk about securities services because that means there’s a problem, such as what happened after Lehman. When it’s all working perfectly, they never have to worry about the back office. In that respect, we are quite confident in the universal bank model. We can, for example, do more trading and more financing with our customers’ assets self-collateralising, therefore helping to lower risk, both for them and for HSBC. And this is attractive to customers given our balance sheet and our standing in the market as a counterparty. There will probably always be space for someone who is an independent specialist who focuses 100% on this business, but the value proposition is different in a universal bank.
Geoff Pullen: From an administration perspective, managers are looking across their counterparts. Some managers consider their fund administrator to be another counterpart and prefer to work with a large banking group. In terms of asset protection, custody versus prime brokerage, managers are taking the view that they are willing to work with a large universal bank. They think there may be less risk, but they are moving assets into a custody account, not because of counterparty security, but the speed with which they can retrieve their assets should anything happen. They are moving out of a prime brokerage world into a global custody world where it is very vanilla, very clear about where those assets sit and who they belong to. I think there are a number of dynamics here. Some managers take the view they would rather be working with a global banking group and feel they get more security from that, while others may prefer to work with an independent group.
Thomas Wels: We should also talk about what type of risks the administrator takes on board. Independence and financial viability in the long run might sometimes not fit. So the advantage of being part of a large group and the size of the balance sheet are very important because, if you strike an NAV wrongly, who will pay for this?
HEDGE FUNDS REVIEW: Are any of you worried about regulation of administrators or the custodian? Is that a risk you are pricing in or concerned about?
Paul Stillabower: Not yet. I think it has to be clear what the rules are. That is still to be determined. It’s not just the Alternative Investment Fund Managers (AIFM) directive. It’s Solvency II, Basel III, Ucits IV and V, the US Foreign Account Tax Compliance Act (Fatca), it’s all of these things. So how they will impact is still unclear. In theory, this is all going to end up on the investor because, if you are changing the capital structure of the securities services business, then some providers won’t be able to stay in the business, because they don’t have capital. And some firms might choose to get out of the business because they decide to allocate capital to more efficient businesses using that capital. None of the regulations are meant to stop people from investing in the markets, but that could be an unintended consequence. If you are used to putting $1 in the market and getting $1.50 out – as was the case in the bull market –and now you’re putting in $1 and there is a 10-cent charge on top of that, it becomes a really unattractive model.
Thomas Wels: And it is very likely to be more than 10 cents. If I look into the recent developments, just due to taxation changes in each and every European Union country, due to additional oversight – from Ucits, Fatca or whatever – the consequence is that this is not for free. This bites into the investment performance of the investors, who at the same time are confronted with lower returns. Sometimes, in the more commoditised type of businesses, the viability of the asset management part of the structure disappears.
Christopher Mulhern: We have enjoyed a 20-year run of very positive returns in the space. If you start taking that out, the risk of the alternative space itself and the instruments being dealt with become less attractive.
Paul Stillabower: I think what will happen over time – not tomorrow and not in six months – is that managers will be forced to take more risks to try and outperform to cover the costs of regulation. That actually defeats the purpose of the regulation in the first place.
Geoff Pullen: You may find that, because of the AIFM directive, fewer shops are willing to become a depositary. This could concentrate the market and you will have a counterparty exposure problem again. I think regulation can go too far. It can depress the market from an investment perspective and also for service providers that are willing to take on liabilities or that extra cost.
HEDGE FUNDS REVIEW: Are we also going to start to see a move away from a fee structure based on assets under administration to something different?
Christopher Mulhern: We all enjoyed the reward component of the risk-reward side of asset-based fees. Over 15 years of being up 15% a year, we always knew the fees were going up on our side. Then we see the financial crisis and what that could do. To a large extent, you need to consider de-risking at least part of your revenue side through fixed fees, time-based fees, things like that. It needs to be considered.
Thomas Wels: As long as the markets went up, we as fund administrators loved the model. Firms were actually adequately compensated for the work they did and adequately compensated for the risks they took. This clearly changed, and renegotiating today with the asset manager is hard because they are under pressure as well.
Sharmila Soosaipillai: Part of it could be that, because of the changing regulation, you have to introduce greater infrastructure that may be from the technology perspective or you need to take on more staff to deal with it. A lot of it could be initial costs incurred that, over time, you would be able to recoup. So when considering whether there is going to be a pass-on of costs to the fund, we need to take a step back. Over the years, administrators have had the benefit of AUM growth. Maybe now is the time to give some of that back to build the necessary infrastructure and, in the future, administrators can hopefully start benefiting again from AUM growth once the dust settles from regulation.
Thomas Wels: It’s just the cost of doing business. The fund service provider has to pick up the investments and hopefully, over time, we can price it in. The situation though is that the assets dropped in the hedge fund space by 15%, the equity market never really recovered and, at the same time, fund services providers are under permanent scrutiny by the asset managers.
Geoff Pullen: We are always discussing price with managers. A part of our function and responsibility is to continue to invest in our infrastructure to make it more scalable, industrialized and free of as many manual processes as possible to ensure full straight-through processing (STP) platform to drive down costs. I think managers appreciate that, and they don’t want us to under-price. I think they realise that we continue, as most administrators do, to drive the growth of the infrastructure and invest in it.
Paul Stillabower: This is a highly competitive industry. There are always providers willing to lead on price. As much as managers mention service, they will often take the lowest price. If you look at what has happened to securities services post the credit crisis, it has been a blood bath. It’s not just the sideways-moving stock market – securities lending, in particular cash collateral in the US model, was a disaster. Leverage has shrunk in the market. There is less foreign exchange activity even though the volatility is there. Interest rates are down at zero. This has been an assault on all fronts. I’m convinced that, as long as we are in sideways-moving or falling or very slow-growth stock markets, this is a business that is going to struggle, in particular with the cost of regulation, unless the pricing model starts to change.
HEDGE FUNDS REVIEW: What role can fund administrators take to help the smaller, new managers?
Paul Stillabower: We are seeing a polarisation where the large managers are brand-attractive so they do very well because investors like the big brands in a crisis, whereas the small ones are nimble and generate many new ideas. They have investors backing them, so they launch with funding and do OK. I think the middle ground is a trickier space where managers try to be all things to all people, but are not big enough or nimble enough. For us, there is a fixed cost for fund administration. So, if a small manager is launching with $10 million, it is very likely that our fixed cost will be prohibitive to that manager. That is, we will do it, but it may be cost prohibitive for the manager to cover our fixed costs.
Geoff Pullen: You judge every manager by his or her credentials. It is possible to be more creative on the pricing for a good manager but you have to take a bit of a leap of faith. We have a fixed cost. We have to overcome that and have the flexibility with our internal pricing structures to allow us to do business with the right managers.
I feel that is turning around a bit at the moment. Investors still want to invest with the large managers, but there are still some capacity constraints that are creeping into the industry. The larger managers are now trying to market their smaller products, the less well-known brand names. Some of the start-ups that are coming to market now are seeing more benefit from investors looking for quality.
Thomas Wels: We have seen lots of new players. We don’t know who is going to be the winner or the loser, so we are trying to on-board as many smaller funds in parallel and hopefully one of them is the next ‘big boy on the block’. The money flow is significantly lower because the due diligence is tougher. The new hedge funds have to develop a track record first.
Sharmila Soosaipillai: What we find challenging at the moment is when you are looking at managers that are trying to start up, they have a small AUM, and when they are looking to give the administration business to a larger, more well-recognised administrator, the cost benefit is not quite there from the administrator’s perspective. These managers struggle to take on a recognised name.
As an institutional investor, we want them to go with reputable, recognised service providers – be it prime brokers or custodians or administrators – but what ends up happening is the managers may need to start off with a lesser known administrator in order to match the fees to the AUM and grow with that administrator. As the AUM grows, they gather a critical mass that would attract the attention of the better-recognised administrators.
HEDGE FUNDS REVIEW: Is it easy for a fund that outgrows a fund administrator to move?
Christopher Mulhern: It’s never easy to change fund administrator, especially from the perspective of the investor: What does it mean to the investor when a fund switches administrator? Is there a problem with the current administrator? That’s the first problem.
From the technical side, the actual shifting of books and records, parallel runs in conversion of data, and becoming comfortable with new reporting systems and people are very difficult concepts.
Sharmila Soosaipillai: If it happens more than once, it would be of concern. From an investor perspective, what is key is communication between the manager and investors. If the manager comes to us and says, ‘look, we started off with this administrator but now we’ve grown in AUM and we would like to change to a larger administrator’, or perhaps they are more focused on a specific strategy where another administrator has greater expertise, then that open dialogue will give us comfort. We understand what is driving the change, we are comfortable with it and we will continue to be updated on the progress of parallel runs. We would also like to speak to the outgoing administrator to understand whether what we’ve been told is what is driving the change. That is quite important – that we can verify independently what we’re being told by the manager.
Geoff Pullen: Obviously any change of service provider can be tricky. We have a team of project managers that effectively take the whole project on because we enjoy taking on business from our competitors. I think we make it as easy as possible for the manager to do that. Clearly, investor communications is very important. If the manager is looking for a more institutional feel for its fund administrator, I think that is a valid reason to change.
Thomas Wels: I can imagine one other reason to change administrator: you change the strategy from multiple sourcing to dual sourcing. For example, do we really want to have five custodian banks and administrators in some countries, or do we want to come to work with one globally active and one or two strong local names? I think we initiate some of this consolidation in the traditional space. What we also see in the hedge fund of fund space is the larger FoHFs consolidating their providers. Because, historically, you built a portfolio of providers that is not sustainable, you end up with an oversight organisation, which is too expensive.
Sharmila Soosaipillai: I have seen larger managers that deliberately use more than one administrator – or at least two – so that, if there should be any issue with an administrator similar to counterparty risk, they know they’ve already got the process in place to be able to switch seamlessly to the other administrator.
HEDGE FUNDS REVIEW: How has the due-diligence process changed? How important is it for really deep due diligence on the fund administrator?
Geoff Pullen: As with most administrators, we are obliged to ensure that we have industrialised infrastructure – technology, process, SAS 70, the whole shooting match. It is a long process but we don’t have any problem bringing investors into our office because we’re more than happy to show the inner workings of our organisation.
Christopher Mulhern: It has a real positive effect, getting the investor and the manager in to take a look at what’s going on day to day with the individuals. It has opened up what we do because there was some kind of a shroud over what was going on at the fund administrator historically.
Thomas Wels: I think the whole industry is changing in this respect. Even in the institutional space we have to open up our traditional middle office because clients want to understand how, for example, investment guideline monitoring works. Does STP really exist or is it just a nice phrase? They sit in our offices for some time to figure out how the processes actually work.
Geoff Pullen: It’s not just investors – it’s also bringing managers in. Maybe a few years ago it would be an hour-long visit; now it’s half a day. To sit a fund accountant in front of a manager and have him explain his process and show him what we can do is a really positive experience. They also get to meet the guys with whom they will be working.
Sharmila Soosaipillai: I agree it is cascading down because, when we speak to managers, they are going in and kicking the tyres. Some of them are doing that on a quarterly basis, others on an annual basis. The larger funds actually have weekly dialogues with the administrators. They go through the agreed upon key performance indicators.
Being from a FoHF that invests in underlying funds, we also reach out to administrators. We will be looking at the whole range of administrators rather than specific ones because we could come across them at the next fund we’re looking at. It is helpful that the doors are opening and we can get in there and carry out due diligence because a better understanding of what the administrators do gives us, as investors, greater comfort over the processes. Ultimately, what is important to investors, especially from an operational due-diligence perspective, is the safeguarding of the assets and the value of the assets that are being safeguarded. These are two key elements that an administrator plays a fairly large role in.
Paul Stillabower: I would love to see more of an industry-like standardisation of this part of the process. The problem is: how long is a piece of string? Investors are worried about some things, for example, Greece is in the news so investors want to know everything about Greece; how the sub-custody works and what happens if this or that event occurs. It becomes very difficult if every investor comes from a different direction. If the administrators, the managers and the investors sat down and agreed on a process – “this” defines acceptable due diligence – I think that would make a huge amount of difference to the industry. It would also be less risky because the industry would be held to reasonable standards. One couldn’t say, in hindsight, to an investor or manager, ‘you should have been doing this’. Your accord would say this is a reasonable person’s standard.
Thomas Wels: Full standardisation of RFPs would mean there is no need for competition. So, I’m not so sure whether standardised RFPs really help us to tailor the solutions to the clients. From the regulatory perspective, I might agree.
Paul Stillabower: Let’s not even get started on RFPs – a 500-question RFP gets issued when, really, the manager has only three or four key questions they want to ask. I was with one of the other banks recently, discussing this issue and, to go through one of these RFPs and resulting process, you are burning three, four, five million dollars, and in the end the process ends up being a pricing exercise. Other than the consultants being happy, I’m not sure who ends up winning.
HEDGE FUNDS REVIEW: Would you be happy to see standardised due diligence?
Sharmila Soosaipillai: I would probably say an approach of best practices would be more workable. That way there is guidance, something everyone is aware of and there is an open forum in which issues important to the various participants in the industry can be discussed and accepted as best practices.
Paul Stillabower: What worries me on the current approach – and why I suggested the standardisation – is when the questions don’t stop and they venture into areas that we shouldn’t be disclosing, for example who are the three largest investors in that fund. What I worry about is that, in an industry where some providers have one client that represents 60% or more of their AUM, they might answer loads of questions that another organisation wouldn’t. I think it would suit everyone, and it would be less risky, if we had more of a best-practice model.
HEDGE FUNDS REVIEW: How has technology changed fund administration and the processing of information?
Thomas Wels: Technology allows daily NAVs. Perhaps the asset managers don’t require daily NAVs, but there is a clear trend towards this. If you talk about Brazilian hedge fund managers, they have been on daily NAVs for the last 10 years.
You may have highly automated interfaces between asset manager and administrators and then a new shop starts and the organisation sends around faxes. You have to start with that from scratch, integrating the information. I think, technology-wise, most players in the industry work with similar platforms, similar technologies and similar standards because this is expected. It is expected from the larger players and by the regulator. It is the permanent change and innovation of products that stretches us.
Christopher Mulhern: The industry has evolved, it is more and more complex and we are always chasing the technology.
Geoff Pullen: But nothing will ever replace the personal interaction between the administrator and manager.