23 Dec 2010, Brian Ruane, CEO of alternative investment services, BNY Mellon, Hedge Funds Review
Hedge funds have been one of the fastest-growing segments of the investment world, after growing at more than 20% a year between 2000 and mid-2008. A major contraction with record redemption levels since the onset of the financial crisis has resulted in a capital base that is skewed towards institutional and North American investors. The commitment of these investors to hedge funds is positive news. However, hedge funds now need to mature and make sure their operating models include robust systems, processes and controls as well as ensuring greater independence for key administrative and operational activities. The result should be the transformation of hedge funds from being seen as an asset class to an investment framework that is applicable across all traditional asset classes and investment programmes.
The wholesale re-examination of legacy operating models is partly down to the ‘cottage industry’ roots of hedge funds and the need to professionalise them. It is also due to structural changes brought about by the 2008 crash.
Prior to 2008 prime brokers effectively subsidised operational models by providing leverage and absorbing counterparty risk. As banks (in which prime brokers work) deal with their own recapitalisation and face higher capital requirements and tighter regulatory oversight, the rationalisation of the hedge fund client base may be needed. This could result in managers having to bear their own operational costs.
The above, combined with factors such as poor investment returns, unexpected illiquidity, rapid market de-leveraging, major counterparty failures and unprecedented fraud has caused investors (and regulators) to redefine standards for transparency and business risk, forcing hedge funds to restructure their operations.
In broad terms hedge funds will need to show a greater use of non-conflicted third parties for a growing range of operational and administrative functions. In-house operations and controls will need to be stronger to shadow and verify third parties and provide deeper and timelier reporting to investors and regulators, who for their part will demand more robust and segregated compliance and risk controls.
Using third parties, firming up internal operations and being more transparent will also carry a price tag. Managers will need to deal with that. Liquidity terms, fee structures and compensation of the investment team will all need to be looked at in the context of a consistent time period and this need not be a calendar year. This means terms, fees and compensation will vary across managers and strategies.
BNY Mellon research shows that successful companies will be characterised by excellence across four functional areas: business management, investments, distribution and operations. Each has their own set of best practices.
Hedge funds will need to install business leadership as a discrete and accountable function. This will mean defining a vision and long-term objectives that should be clearly communicated to everyone working within the company and are also consistent with the company’s strengths.
There also needs to be a client-centric culture where senior leadership embraces key clients as partners. Again, this needs to be a company-wide goal. A systematic product development process that incorporates input from investments, distribution and operations should also be part of this robust framework, aligned to the above compensation. This should be driven according to role-specific behaviours and linked to defined long-term success. The next target is distribution models. These need to become as important as the investment process itself. There is no point in having a decent product if you cannot sell it.All the functions around distribution, sales, marketing, relationship management and client service need to be enhanced and a client-centric culture embraced. In practice, this means a proactive relationship with clients that is open and forthcoming rather than secretive and exclusive. Behind this should stand a clear strategy for relationship development and management.
As part of the culture of openness, hedge funds also need to deploy an active and visible marketing strategy to engage creatively with the target audience and gain kudos through thought leadership.
Prime brokerage and custodial relationships, cash management, swap counterparties and other sources of financing all need to be of the highest institutional quality, diversified across multiple organisations and continuously monitored. There should also be third-party administration including the provision of fund accounting, reconciliation and pricing – all monitored in-house. If all of these things are done – coupled with effective and reliable systems and processes to give real-time tracking of data and assets from bridging operations – then clients, regulators and the investment team as well as the management company itself will operate with strong controls and compliance procedures. This will make for an operational structure that is transparent and robust.
The move to outsource administration in particular is key. In the past the same data and systems that powered the middle and back offices (for instance, to generate statements) also powered the investment team’s portfolio management tools (such as modelling trades or confirming margin levels). At the same time, some managers believed third parties lacked the appropriate capabilities or experience.
Maintaining the ability in-house to generate real-time information is a portfolio management requirement, not simply a question of overseeing third parties. Maintaining in-house operations for these dual purposes requires clear segregation of roles and strong compliance and controls.
Hedge funds able to adopt many or even all of these attributes should prosper. Having the funding to do all this, however, will raise the entry level for hedge funds. Nevertheless, the single-strategy boutique will continue to command a share of assets simply because of its ability to produce strong returns. These types of funds are more likely to have a concentrated focus not only for the strategy but other things such as distribution. They will also be a useful diversifier for many investors.
BNY Mellon forecasts the multi-capability platform model will experience the highest growth in the future. It offers unbundled strategies and teams, basing itself on a series of distinct investment capabilities and leverages a common business infrastructure, brand and distribution. It is also scalable. This will be attractive to operating and trading counterparties. Such structures will also maintain a diversified revenue stream, which is likely to attract the attention of sophisticated institutional investors.
The merchant bank model too will enjoy success as its capabilities range across many disciplines beyond asset management. This is a less common model but benefits from the perception of a unique investment ‘edge’ as well as highly diversified revenue streams. It can, however, be a complex model to manage. A more unusual model is the manager running a franchise that transcends the traditional/alternatives divide. This could be an interesting model to watch. It has the greatest scale potential and is likely to benefit from a legacy market presence, brand, infrastructure and diversified revenue streams. It is difficult to execute, however, particularly as effective investment integration is a major challenge.
Another model is the alternatives holding company. This can be in the form of either a seeder or something more like a platform built around investing in managers at scale and creating a diversified mix of affiliates without seeding or resembling venture capital investing. For many managers, especially single-strategy boutiques, selling a stake to an alternatives financial holding company can be an effective step towards ensuring long-term internal alignments are strong, while at the same time allowing an inter-generational transfer of ownership and management.
Finally, there is the fund of hedge fund (FoHF) model. There is no doubt the ones that survive will maintain their role as one of the primary hedge fund distribution models and are likely to oversee close to 5% of total hedge fund assets by 2013.
Clearly the industry’s recovery and future prosperity depend on companies undertaking a wholesale review of their operational models in order to provide a more balanced and transparent business model – one that is able to combine the provision of alpha to investors, reward performance and benefit the future development of the organisation.