AIMA

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The Spectre Haunting the Hedge Fund Industry

Jose Santamaria

RBC Dexia Investor Services

Q4 2008

Absolute return has proved so effective at generating alpha that sustaining performance has become a larger problem for hedge fund managers than attracting investors. The continuing growth in assets, fuelled mainly by institutional investors, is imposing new risks and responsibilities on hedge fund managers. That they are largely operational in nature does not mean they matter less than investment strategies, asset class expansion or arbitrage opportunities. In fact, the lagging to keep apace operational performance of the hedge fund industry is fast emerging as the principal constraint on its growth. This article explains what hedge fund administrators must do to improve competence and add capacity.

The back-office is condemned always to remain behind developments in the front- office. The trading desk is a naturally dynamic environment, where investment bankers and fund managers are forever deploying new strategies, inventing new instruments, invading untapped markets or seizing unexploited opportunities. It is the task of operational experts to turn the ideas of investment bankers, traders and fund managers into the humble reality of assets kept safely, payments made and entitlements collected. If the gap between the level and complexity of front-office activity and the operational infrastructure becomes too wide, the potential operational risks and settlement losses to market participants and their clients can be worryingly large. The clearing and settlement backlogs that built up in the New York stock market in the 1970s and the European equity markets in the 1980s both imposed severe non-investment asset selection pressures on fund managers, their clients and the banks that serviced them. Signs of similar strains between the ingenuity of the front-office and the exotic instrument capabilities and capacity of the back-office are once more becoming plain today. One problem has already become serious enough to attract the attention of regulators and central bankers on both sides of the Atlantic: The confirmation backlog that accumulated in the OTC derivatives markets.

The largest buyers of OTC derivatives are, of course, hedge funds. The hedge fund industry has grown so rapidly in recent years and proved so adept at delivering alpha, that the operational strains imposed by that growth and success have not attracted the attention they warrant. Only now is the first evidence of addressing the industry on grounds of operational risk starting to emerge. There is a need for timely valuations of assets, naturally performed by prime brokers who may face complicated credit risks in lending to hedge funds, even on a collateralised basis. The suddenness of the change served also as a sharp reminder of the difficulty of valuing complex and illiquid instruments. Similar risks abound in the securities lending markets, where hedge funds are now the main drivers of activity. The scale of the indemnities given by agent banks to beneficial owners and their concomitant exposure to thinly capitalised conduits, are now measured in billions of dollars. The value of the collateral which underpins these exposures has yet to be tested in a declining market.

Similarly untested risks are now emerging in the hedge fund administration industry, whose accountants are responsible for the valuation of the assets and liabilities of hedge funds, fund of hedge funds and structured products. Not to mention the peripheral inclusion of venture capital, private equity and property investment classes. With most of the leading hedge fund administrators now owned by banks, which have shed smaller and less profitable clients, a new breed of non-bank administrator has emerged to service the hedge funds discarded by the major firms. As a recent law-suit attested, the ability of non-bank administrators to absorb the potentially ruinous losses that can follow valuation problems is not clear. What is clear is that the long revolution in the hedge fund administration industry, sparked by the repeal of the so-called Ten Commandments in January 1998, is unfinished. Until 1998, the hedge fund industry remained primarily offshore and Irish-centric. Administrators were appointed chiefly because they happened to be present in the domicile of fund jurisdiction. None was owned by a leading international bank. Only traditional mutual fund administrators operated wholly onshore and their equally traditional long-only clients had yet to develop an interest in hedge fund strategies. Domiciled and serviced in offshore locations, hedge fund managers sought knowledge from their administrators of partnership accounting and the ability to service master/feeder funds. Their investors, which were drawn mainly from the high-net-worth and family office sectors, sought only performance. Provided it was delivered, they were content with monthly or even quarterly NAV calculations by hard copy reporting.

All of this has now changed. The number of funds and the value of assets under administration have both expanded rapidly. Though equity long/short remains easily the most popular hedge fund strategy, the investment possibilities have multiplied in both number and complexity. The multi-strategy hedge fund complex is now commonplace. One recent study identified $2.4 trillion invested through 12,474 funds, and $1.1 trillion invested via 7,584 funds of hedge funds. Fee structures are varied and the range of share classes has broadened. Even if they remain domiciled offshore, the vast majority of hedge funds are more often being administered onshore. Dublin has emerged as a specialist hedge fund administration centre but most of the major hedge fund administrators now effectively administer funds from nowhere in particular, dividing functions between multiple locations, leveraging a “follow the sun” doctrine in support of their fund clients across multiple global regions and time zones. Institutional investors have diverted significant assets into hedge fund strategies and long-only fund managers are developing equivalent strategies of their own. Even the most conservative institutional and retail clients are now being exposed to hedge fund strategies and techniques, through 130/30 and UCITS III funds. They have higher expectations than traditional hedge fund investors. Daily reconciliations and pricing; daily profit and loss accounting; supported by weekly NAV estimates and monthly NAVs; electronic or web-based reporting; real-time access to data; performance measurement and complex risk management services are all now routine aspects of the administration services provided in support of institutional investors.

These demands are symptomatic of the fundamental operational adjustment institutionalisation has imposed on the hedge fund industry: A business driven by fund managers is now a business driven by investors. The pressure from those investors for institutional quality administrative services has drawn attention to a degree of operational risk at least as worrying as that which confronted the American securities industry in the 1970s and its European equivalent in the 1980s. Hedge funds are invested in and financed by a series of instruments - OTC derivatives, structured products, short positions, loans, emerging market equities and bonds and other illiquid instruments – which are intrinsically complex to document, process and value. Many hedge funds also have multiple prime brokerage relationships, making it hard for any one service provider to understand the overall levels of exposure and risk lenders and investors have assumed. The degree of automation in the exchange of trade details, trade confirmations and valuations between hedge fund managers, prime brokers and fund administrators varies widely by the complexity of the strategy but it is undoubtedly low versus the traditional long only world.

In the fund of hedge funds industry, the trade execution, settlement and valuation processes all remain both labour and paper-intensive. There is no prospect of electronic trading or a settlement utility, akin to a centralised securities depository, being established in either the hedge fund or fund of funds sectors in the very near future. Though industry participants openly acknowledge the benefits of what this would mean to mitigate settlement and corporate event risks.

The influx of new money into the hedge fund industry is placing ever heavier demands on, already capacity-constrained, infrastructure. Hedge fund managers understand this well. It is why they are tempted increasingly to outsource their middle as well as their back-office operations. The hedge fund industry has predominantly outsourced all of its back-office needs from the outset but today only a tenth of middle-office functions, such as trade management, investment ledger/asset servicing, cash and collateral management, are being managed by third parties. That proportion is set to accelerate rapidly, imposing greater service demands on many hedge fund administrators. To meet the demand from investors for daily valuations of illiquid or exotic instruments, fund accountants are increasingly reliant on counterparty quotations, valuation models and prices supplied by prime brokers or hedge fund managers themselves. The shortage of the skills necessary to achieve even this level of competence has bid the price of talent up to levels that pose new economic realities for fund administrators, which must compete for them against the more glamorous opportunities offered by hedge fund managers and prime brokers. Even if they do not result in expensive operational failures, shortages of knowledge and experience of this kind are likely to constrain the growth of the back office hedge fund industry. This means the fund administration industry must invest now in the people and technology to increase capacity, reduce risk, cut cost and raise the level of automation. After all, if operational strains are apparent in an industry managing $3.5 trillion (combined hedge fund and fund of hedge fund), they are likely to prove unbearable in an industry which expects to be managing circa $5 to $7 trillion by 2010. The traditional answer to capacity constraints – hiring more people – simply does not measure up to the scale and nature of this challenge. The hedge fund industry must one day return to equilibrium. The unanswered question is where that equilibrium will be.
 

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