Mention 130/30 or any short extension configuration and the fund administration and prime brokerage industries rub their hands in anticipation. Long-only fund managers are hoping to play the game, once the preserve of the hedge fund community, thanks to a more flexible regulatory environment in Europe and the never-ending quest for alpha.

At the moment, there is a lot of hype about these types of products. UCITS III, which came into full force last February, is expected to be a real boon for business (see page 17). Although the rules do not allow fund managers to short physically, they now have the power to use derivatives, which allows them in effect to create a synthetic short. Moreover, in the unregulated world, institutions have been eyeing a range of alpha-generating strategies for their segregated mandates and long/short funds are seen as an option.

The hitch, of course, is the current precarious state of the markets. After all, 130/30 or 140/40 funds are ideal in a state of low volatility but the scenario has changed in the past couple of months. While fund managers may delay their launches, industry participants do not believe they will shelve them altogether. James Palmer, director of prime services at Credit Suisse, says: “New products are always impacted by uncertainty and the market may be in a short-term defensive position. In the long term, though, investors are looking to achieve a better risk-adjusted return and 130/30 funds are one way of doing that.”

For now, both the prime brokerage and fund administration communities have laid the groundwork and are hoping to catch the 130/30 wave when it arrives. The larger players in both arenas have not had to make radical adjustments to their infrastructure. Instead, many have upgraded and enhanced their already integrated systems to cater to the particular needs of their European client base, many of whom are likely to launch funds under the safety of the regulated UCITS umbrella.

One main difference with the short extension products is that there are no off-the-shelf solutions, according to Jim Connor, partner and investment management and systems specialist at Morse, a UK-based consultancy. “I think in the first instance we will see many long-only fund mangers going to either their custodian or prime broker for help to develop these kinds of structures,” he comments.

The general consensus is that long-only fund managers may employ a prime broker for the synthetic swap component of the 130/30 strategy and continue using their custodian bank for the rest of their administration needs such as collateral management, fund accounting, transfer agency and performance measurement. This is especially true of the small to medium-sized funds that may be new to the derivatives world. As they become more sophisticated, it is likely that they will follow in the footsteps of their bigger and more advanced brethren, which have well-established relationships with both groups and follow a more component-based approach.

Prime brokers and fund administrators are well equipped to provide guidance and while they bring different capabilities to the table, the line of distinction between them has become less clear as both have targeted the hedge fund community. Much has been written about the prime brokers’ experience in the hedge fund sphere. Their main role in the unregulated, non-UCITS world is to act as a central facilitator for a manager’s short sales, clearing and settling them, keeping custody of and lending against assets, and maintaining records. The ability to source inventory is critical to its success.

However, over the past couple of years, many prime brokers have entered the fund administration business, while several large custodians have become providers of hedge fund services. Both have also been busy poring over the fine print of the UCITS rule book. As Sean Capstick, co-head of European prime brokerage sales at Deutsche Bank, notes: “We have had to become experts in the UCITs regime because we spend a lot of our time helping educate clients on how to construct a long/short portfolio, the risks involved and what rules they should be following in a UCITS framework.”

Ian Headon, product specialist, alternative fund administration at Northern Trust, says: “The introduction of fund products such as 130/30 vehicles continues the convergence between the hedge fund and long only world. As a result, it has posed questions for those of us in the asset servicing industry. The main difference between the two asset servicing models has been the organisational DNA of the servicing firm. Prime brokerage was born from the investment banking side and has typically focused on middle and front office services. Custodians have typically looked at the back office but going forward we expect to see continuing development of the service models and product ranges of all asset servicing firms with a view to servicing the needs of the fund manager, as opposed to focusing specifically on hedge funds or traditional managers.”

David Claus, managing director at The Bank of New York Mellon, agrees. “In some ways you can view the 130/30 product as a watered-down hedge fund,” he adds. “Many firms such as ourselves have leveraged our experience in the hedge fund administration industry to service UCITS clients. Aside from needing to have large-scale resources, the main challenges are the same - the volume of information and the ability to source pricing in OTC products. Our service includes the basic components of fund servicing such as fund accounting and risk management, transfer agency and custody as well as cash management and securities lending.”

Many believe that one of the keys to capturing a slice of this burgeoning business is to adopt a flexible approach. Susan Ebenston, head of international fund services products at JPMorgan Worldwide Securities Services, says: “We all play in different spaces. If a client wants, we can provide an end-to-end service and offer our MasterSwap product [a synthetic prime brokerage service] through our investment bank, along with our custody, fund accounting, administration and securities services. On the other hand, clients may want to continue using their own prime broker and just use a number of components of our services.”

Blair Pollock, director, equity finance at Citi, agrees. “We do not believe in being prescriptive,” he notes. “We can provide a full service offering but we do not expect people to change the way they conduct business or their custody relationships. Although we have not had to build new services, we have created a UCITS advisory group which is a small team of four that offers advice to about 70 clients in the long-only world, including 130/30 funds.”

According to Pollock, the main challenges fund managers will have to contend with range from risk management, valuation and the management of new derivative products to compliance and legal issues. Citi offers custodial arrangements to ensure compliance with UCITS counterparty exposure and it recently launched an enhanced swap platform that helps clients manage their positions and cash flows. It can also deliver different types of reports depending on the fund’s specific requirements.

Palmer of Credit Suisse also emphasises that experience should not be underestimated. Within its equity department, the firm offers equity swaps, prime brokerage, securities lending, and custody solutions on a single, integrated platform. However, he adds: “We have a strong partnership with our clients and it is important that they work closely with someone who understands the framework of the 130/30 strategies because they are more complex to administer and implement than long-only strategies.”

For example, if the administrative and operational requirements are not handled correctly, an element of operational risk may be introduced into the process, which would impact on the performance, according to Russ Kamp, chief executive officer of the global structured product group at Invesco, a US-based fund management company.

“It is also important that fund managers do their due diligence on their counterparties particularly in this current environment. These are sophisticated products and this may be the first time they are entering a prime brokerage relationship. An important aspect of the risk management process is to ensure that the prime broker is viable. I would not have said that until recently but in early August, there was a possibility that one of the major brokerage houses would go under,” Kamp notes.