Independence is driving force
When Long-Term Capital Management (LTCM) was on the brink of default in 1998, one area of its operations gave no cause for concern - its back office-processing infrastructure. This continued functioning smoothly, and ensured that no payments to creditors were missed and that it did not have to re-state its net asset value (NAV).
The lesson that, although LTCM’s investment strategy had gone awry, its fund administration operation had performed well was not lost on the hedge fund industry.
A year later some of the principals of LTCM offered their back office expertise to the hedge fund industry in a company called Globe Op. Today, Globe Op is a leading provider of outsourced back office support for hedge funds.
The number of hedge fund administrators has grown with the hedge fund industry. The bi-annual survey by AFSR/CorrectNet last year identified 39 hedge fund administrators (see table), administering assets totalling $1.1trn (e87bn).
The market is dominated by five providers – Citco, Fortis, Bank of Bermuda (now part of HSBC), IFS and BISYS – each with between $82bn and $160bn assets under administration.
Below these are a large number of providers, most of them the fund services of banks, administering assets of between $10bn to $55bn. And below them are a dozen or more niche players with less than $10bn assets under administration.
What distinguishes most hedge fund administrators from traditional fund administrators is their trading background. Hedge fund administrators have their origins in back office systems developed to support traders.
In contrast, mainstream fund administrators have their roots in the mutual fund industry and use systems developed for dealing with regulators rather than traders. Because of regulatory constraints on what mutual funds can and cannot invest in, they have little experience of complex securities, and none of hedge fund strategies.
This was seen as a disadvantage when institutional investors began to enter the hedge fund market and demand both transparency and timely reporting.
Today, the main task of hedge fund administrators is to ensure that the assets of hedge funds are correctly stated. In particular, this means calculating the NAV and the NAV per share or unit, either quarterly, monthly weekly or daily.
In the past, many hedge funds have done their own NAV calculations, with the fund manager doubling as the fund administrator. Institutional investors, however, now expect hedge funds to outsource this task to a third party to ensure that the NAV calculations are being carried out by a firm that is independent from the fund’s manager, using independent prices and transaction data sources.
In many jurisdictions, it is now a requirement that all but the largest fund managers, which may have their own separate administration company, appoint an independent administrator.
As the institutional demand for independent hedge fund administration has grown, so has the interest from the banks, which serve these institutions. In the past 18 months a number of independent hedge fund administrators have been snapped up by global investment banks.
In 2003 HSBC acquired Bank of Bermuda for $1.3bn and with its alternative fund services, which services 1,000 clients and around 2,000 funds.
At the end of last year, this business had $155bn in funds under administration, of which $10bn is in private equity, $90bn in single strategy hedge funds and $55bn in funds of hedge funds.
Last year, JP Morgan Chase acquired Tranaut Fund Administration, a privately owned hedge fund administration services company servicing 40 hedge funds and with $5bn in assets under administration.
This year Mellon acquired Derivatives Portfolio Management (DPM) a New Jersey-based independent fund administrator with 91 clients and assets of $30m.
Robert Aaron, chief executive officer of DPM Mellon says the acquisition was driven by investor demand; institutions wanted providers that were handling the administration of their traditional investments to handle the administration of their alternative investments as well.
“The change for independent shops has been client-driven and this is the response to it. The business was moving towards the integration of traditional and alternative at most of the client levels. When the large institutions that had long been used to custodians started to look at alternatives they wanted one provider.”
In their turn, hedge fund managers were looking for fund administrators with the backing and resources of large institutional banks, he says. “As hedge fund managers are becoming more institutionalised, they are turning to administrators that are part of large well-regarded financial institutions that can provide the transparency they require.”
The effect has been to encourage a convergence in the hedge fund administration business, he says. “Everyone started off as a niche player, but the growth of the market has forced everyone to become a generalist to some degree.”
This convergence is noticeable in the move by hedge fund administrators from monthly to daily pricing. “The industry grew up with offshore administrators doing things on a once a month basis. A lot of mutual funds administrators in the US were doing things on a daily basis, but they weren’t handling alternative assets.
“The group of hedge fund administrators with a trading background really did have the ability to do hard things on a daily basis. Now you’re seeing the traditional offshore fund administrators going from monthly to daily pricing, while the mutual funds group is moving from relatively long-only type instruments to more complicated types of instruments. So everybody really is moving in the same direction.”
The institutionalisation of hedge funds has brought a demand for greater transparency, Aarons says. “It used to be that hedge funds didn’t want to give transparency. Now they are much less averse. They might consider a managed account or they might provide detail to an independent third party who will provide summary detail back to the investors.”
Institutional interest in hedge funds has also put a premium on pricing.
Exchange traded instruments are relatively simple to price, and hedge fund administrators will price them each day from publicly available data feeds provided by Bloomberg and Reuters.
Off-exchange over-the-counter derivative contracts can pose problems, however. Some can be priced relatively easily off other things. For example, contracts for differences, synthetic futures, can be priced directly off the equities markets. For others, though, there may be no readily available price.
DPM Mellon uses at least three different sources for pricing: fund managers, prime brokers and the standard models of Bloomberg and Reuters. It also plans to develop its own in-house pricing model.
The off-exchange pricing situation has improved recently, says Aaron. “More model-driven pricing has become available over the last year or so. Outfits like Lombard Risk, for example, are starting to be utilised by administrators. There are economies of scale where everybody wants to be able to get an independent pricing source, and we’d all love to get it from Reuters and Bloomberg.
“Most firms don’t have all of these instruments right now, but there’s no reason to believe that there won’t be firms that will pop up that will make that kind of pricing available.”
There is an alternative scenario to convergence within the hedge fund administration industry. That is that the industry will polarise, with specialist, niche providers handling the complex transactions while entrants from traditional fund management will handle plain vanilla, long/short equity transactions.
Aaron suggests that niche players can retain their specialist edge within a large investment bank while benefiting from the bank’s resources. “There’s the added resource of systems, back up, talent and certainly sales. But at the same time it still remains a niche
“All the DMP Mellon principals who have a trader background are staying with the firm. It’s still the same leadership, and the same group that’s been together for a long period of time. So in that sense, the business has not changed.”
In the hedge fund administration industry, where independence is prized, that is what institutional investors want to hear.