Hedge Fund Administration: Creating agility in the hunt for Alpha
Ian Lynch and Pete Townsend of BNP Paribas Securities Services reflect on the dynamics at play in hedge fund management, and how service providers can offer managers the agility they need in the hunt for alpha.
Ian Lynch (IL): We are continuing to see a growing convergence between traditional and alternative asset managers. This is pushing hedge funds more into the mainstream as a growing number of alternative UCITS and liquid alternative mutual funds come to market. Hedge funds continue to grow their AuM, driven by the increasing amount of institutional investor allocations. This requires managers to be flexible and identify niche and exciting investment opportunities in the quest for alpha.
Clients continue to deal with the growing plethora of regulations that are impacting their businesses. These include MiFID II, the AIFMD, Solvency II, EMIR and Basel III to name but a few. Basel III will have a profound impact on the hedge fund industry as it will introduce Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) requirements onto banks, which may force some to strengthen their balance sheet if they want to continue participating in the industry at the same level. This has the potential to restrict prime brokers in their ability to hold cash or provide financing for certain strategies. We are already seeing prime brokers reprice their fees for certain clients to offset their higher cost of capital.
Clients and their boards are increasingly looking to strengthen their cyber security policies. We have spent an increasing amount of time and budget on this topic, working closely with technology providers and the industry to share knowledge. This will continue to be a core issue for the industry going forward.
Pete Townsend (PT): The impact of regulations on the hedge fund industry should not be underestimated.
There are huge volumes of regulatory reporting to begin with. MiFID II requires firms to undertake transaction reporting with numerous data fields needing to be filled in. Solvency II obliges firms managing capital on behalf of insurance companies to supply timely position level data to the insurers and this is a huge operational challenge.
Regulatory reports, such as the AIFMD’s Annex IV and Dodd Frank’s Form PF, have a significant number of data points. Finally, EMIR requires firms to report information about derivatives transactions to trade repositories. Attaining this information to comply with these diverse, and at times divergent, regulations is a huge exercise.
Most importantly, the data has to be accurate otherwise firms could face additional regulatory scrutiny. This is all very resource and cost intensive at a time when there are mounting pressures on the hedge fund fee model by institutional allocators. Hedge funds need to think about scalability and efficiencies when dealing with regulation. A growing number of firms are looking to external vendors to assist them with these operational and regulatory challenges. Demonstrating flexibility is also crucial. Firms need to react quickly to market developments and it is essential they have alignment across their front, middle and back office as well as service providers that can fulfil their needs.
PT: In terms of regulatory reporting, an outsourced provider can ensure the data is high quality and represented correctly. BNP Paribas Securities Services has always been forward-thinking when it comes to helping clients find regulatory solutions. Historically, our outsourcing solutions have focused on the middle office requirements of asset managers, but we have grown our hedge fund manager franchise significantly.
IL: A lot of hedge fund managers like to retain control over their middle office so we simply complement their existing systems. This could entail finessing investor risk reporting data within the UCITS Key Investor Information Document (KIID), or helping firms manage their collateral more efficiently. One of our key selling points is the strength of our technology. Outsourcing to a vendor with strong technology ultimately saves managers from continually having to develop and upgrade their technology platforms. This is particularly attractive for managers given the pace of evolution for technology.
Outsourcing certain operational functions enables enormous cost savings. A typical hedge fund will charge between 1.5-2% in management fees. Approximately 60 to 70 basis points of that management fee will be consumed on internal operations, such as regulatory and investor reporting or internal operational infrastructure. This will have a significant impact on overall returns for end clients. Outsourcing can help relieve some of those cost pressures, and simultaneously bring improvements to the business. Outsourcing to a highly capable external provider will also give institutional investors reassurance about the operations at that manager. It will enable managers to focus on what they do best and deliver solid returns to investors.
This also gives managers the ability to streamline their business, enabling better coordination to be undertaken between the front-, middle- and back office. Again, given the innovation in the hedge fund industry in terms of its investing, it is critical their operations keep up to pace and outsourcing to a high quality service provider is one mechanism by which this can be achieved.