Redrawing the Lines

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The hedge fund sector is edging back towards historic highs, according to HFMWeek’s latest Assets under Administration (AuA) Survey. The industry has climbed a massive 21% over the last 12 months to post a total AuA of nearly $2.7trn in April 2010. Fund administrators working in the alternative space obviously welcome the uptick. Even so, the welter of regulation running through the US and Europe could force a restructuring of the alternative fund administration segment. It is unlikely that all the current set of providers will be able or even want to shoulder the burden of a heavier workload. What might the post regulation fund administration industry look like? Lynn Strongin Dodds reports.

With a total of single manager assets worth $2.657trn; the hedge fund segments appeal is back on track; good news then not only for prime brokers, but also fund administration specialists. According to an HFM Week survey the industry has now enjoyed a full year of growth, up 9% in the last six months, from $2.44trn in October 2009, and 21% in the last 12 months, from a record low for recent times of $2.2trn.

The revival of the hedge fund segment comes in two parts: the first is solid performance; the second is an inflow of fresh assets. US mutual fund allocations to hedge fund strategies in particular look to be on the increase. That is because managed accounts open up a way for mutual funds to tap non-correlated returns offered by many hedge funds which are now adhering to much improved levels of transparency and which can boast access to liquidity. It is a signal trend, particularly as the industry remains nervous about income streams in a still tight capital raising climate.

The results are balm to a sometime parched alternative fund administration industry. Not all of the current cautious goodwill is entirely the result of improving hedge fund fortunes. The fund administration industry has been able to win a host of institutional mandates through better due diligence, increased transparency and a wider move into new products, such as managed accounts and UCITS. The managed accounts space has seen a number of new additions in recent months, including Butterfield Fulcrums new $1bn platform Altinus, the first from a hedge fund administrator. In terms of UCITs, recent growth has been sparked largely by European managers; though there are signs of nascent interest emanating from the US. Mergers and acquisitions involving administrators continue to be a feature of the segment, with the acquisition of PNC by BNY Mellon acquired PNC in February for $2.31bn. Further along the food chain Credit Suisse remains poised to buy Fortis Bank Nederlands hedge fund services unit, Prime Fund Solutions. A number of private equity firms have also shown interest in the space.

Despite calmer sailing the industry remains cautious. Natural concerns over European sovereign debt exposure and a slower than expected return of consumer demand is beginning to unnerve markets. Another great unknown of course is how the regulation will pan out.

Ever since the worst days of the financial crisis and, particularly in the wake of the Madoff scandal, fund administrators have been laying the groundwork for higher quality and more granular reporting, robust risk management systems, independent valuation (particularly around OTC derivatives), tighter operational procedures and new products. There has also been further development of prime custody services as hedge funds looked to diversify their counterparty risk.

A recent report from Boston-based TABB Group showed that many hedge funds did move much of their unencumbered securities and cash out of prime brokerages to global custodians for safekeeping. As William Keunen, director of Citco Groups fund services division, says, There will undoubtedly be changes in the nature of the industry. Given that there will most likely be greater reliance on independent functions; we anticipate that there will be opportunities for administrators in areas such as valuations, disclosure and reporting to investors and regulatory compliance.

Susan Ebenston, managing director, product executive at JP Morgan Worldwide Securities Services, adds, Regulation will underscore what the future trends will be, but after Madoff there was already a move towards transparency and outsourcing of services to third party administrations instead of hedge funds doing things in-house. Regulation will only accelerate this and I expect to see hedge funds moving deeper into the value chain of services. It is early days though and until the legislation settles, it is difficult to know the exact details. However, it will be a gradual process and we are currently reviewing all the options in conjunction with our clients.

Dermot Butler, chairman at Custom House Global Fund Services, agrees that the main challenges are unlikely to change dramatically from those that administrators have faced over the past 1218 months. There has been a greater acceptance after Madoff that there needs to independent verification of valuations of assets that comprise the net asset value. One of the differences I think we will see in the future is that there will be much more pressure on the verification of the actual existence of some assets of the fund. This had not been one of the main requirements of hedge fund administrators in the past. One of the challenges will be to make sure that systems are up to date and to automate as much as the process as possible.

Darren Stainrod, head of alternative fund services at UBS Global Asset Management also believes there will be more consolidation in the hedge fund space. The barriers to entry will be greater and they will need to strengthen their infrastructure, technology and systems to deal with the regulation. I think we will see consolidation at the smaller end of the scale. At the larger and medium sized end, we are already seeing an increase in request for proposals for outsourcing, especially middle office services. They want to show investors that they have that independent stamp.

Regulatory trends

Although there are various proposals on the table for over the counter derivatives and UCITS IV, the one that is generating the most headlines is the European Unions Alternative Investment Fund Management Directive (AIFM). One of the main sticking points in the current negotiations is over the third country provisions concerning funds and managers based outside the EU. The European Council, which consists of ministers from the blocs national governments, is proposing to allow non-EU funds to be marketed within the union using national private placement regimes. This position contrasts with that of the European Parliament, comprising directly elected representatives, which recommends that funds domiciled outside the EU should only gain a passport if the country of domicile meets certain equivalency criteria. A vote on the final draft of the directive is due in the parliament on July 6th; although market participants believe this timetable may slip.

One area that the Council and Parliament do largely agree upon is the proposal whereby every alternative investment fund manager must have a registered depositary or custodian to take charge of, and safeguard, its clients assets. The fund manager itself cannot act as a depositary. Depositaries can delegate tasks to other firms, but must maintain oversight of them. They are liable for all losses caused by its mistakes or mistakes of the firms it has delegated functions to. This would have a significant impact on administrators, particularly those tending to emerging markets funds, which often rely on sub-custodians or depositaries in those markets.

Sen Pircir, partner at Brown Brothers Harriman, says, The AIFM proposals over depositaries is an item of concern. It puts custodians in an inappropriate role because they are being asked to be responsible for risks they cannot control. Stainrod also believes that if custodians are being asked to be more accountable then they will have to be compensated.

One of the main issues is that the increased liability would prevent some companies from acting as a depositary in the EU, leading to a concentration of risk. Not surprisingly, it would be the larger asset servicers who would be better placed to deal with the more onerous requirements. As Ebenston puts it, Under the proposals, the custodian would have to return the assets to the holder and then pursue compensation through the courts. As a result, you need a strong balance sheet to be able to do this.

Keunen says, The issue of depositary responsibility and liability is a controversial measure which if adopted in its current form will restrict the choice of suitable service providers from a cost or risk perspective, which seems counter-intuitive to the objective of providing greater protection to investors. Views are mixed though as to whether the larger players will be the only ones to benefit from the shifting landscape. Ebenston believes: those in the middle ground will be hurt and that there will be a polarisation between a handful of niche firms and the bigger players who have the infrastructure and experience of applying the lessons they have learnt in the long only space to the alternative space.

Chris Adams, global head of product for alternative funds at BNP Paribas Securities Services, on the other hand, argues that small is not beautiful in this situation. Going forward, I think hedge funds will be partnering with a smaller number of asset service providers that can offer a bundled package which includes a wide range of services, such as custody, fund accounting, risk management as well as alternative fund administration products. The organisation also needs to have a strong enough balance sheet and scale to meet the clients growing and evolving needs.

George Sullivan, executive vice president of State Streets alternative investment solutions group adds, We have seen a flight to quality and I think that hedge funds will gravitate towards the larger providers who have a broad service offering. These larger firms have been able to demonstrate that they possess a well-established organisational structure that includes the intellectual capital, infrastructure and technology necessary to handle highly regulated products efficiently.

Independence Day

Ron Tannenbaum, managing director of GlobeOp Financial Services, an independent hedge fund administrator believes that there is an increasing demand for independent fund administrators wholly dedicated to investing in and providing administrative services, and who are not commercial counterparties to the fund for any trading or custody services. Investors want administrators to be free of conflict since they are the one party sitting in the middle of the funds and their counterparties — the custodians, prime brokers and broker/dealers. The administrators role is then to offer the independent reconciliations, reporting and oversight investors now demand.

Although views differ depending on their positions as to who will carve out a larger slice of the pie, all agree that the threat of onerous legislation is likely to push more hedge funds over to the UCITS camp. This is because the regulatory oversight embedded in the UCITS framework not only addresses the regulatory issues but also mitigates the cost that might arise of distributing non-European funds.

The same holds true for managed accounts. Butler says, We have definitely seen an increase in demand in the managed account space and I expect this to continue because investors feel more secure and safer with the transparency, flexibility and liquidity of these types of accounts. However it is important to have an understanding of what the investment manager is doing. If you dont understand the strategy, you wont know exactly why a particular instrument is in the portfolio, or how to value it.

David Aldrich, managing director, BNY Mellon, UK and Ireland, also believes there will be further development on the prime custody services front. We are definitely seeing more links between the prime broker, hedge fund and custodian to improve the model and to mitigate the risks. For example, Deutsche Bank s Global Prime Finance recently launched a hybrid custody version of prime brokerage, named DB Integrated Prime Custody. It enables funds to hold unencumbered assets that were typically held within their prime brokerage in a separate custody account held at BNY Mellon or within Deutsche Banks separate custody division. It also offers an open architecture approach should clients have a preference for a particular custodian.

Looking ahead, Aldrich believes that one of the biggest challenges will be to provide the quality and breadth of services for hedge funds of every size in a cost effective manner. Smaller funds and start-ups have more difficulty. One way we have addressed this is that we have support operating centres in Poland and India which handles components of the administration business such as fund accounting. This helps reduce the overall cost of the outsourcing.