In the past two years, the hedge fund management business has been shaken up like never before, with redemptions on an unprecedented scale, fund closures, asset values dropping and demands for stricter regulation.
However, the fund administration business has experienced a positive effect, with hedge fund managers knocking at its door to learn about services that can lessen risk and provide greater transparency.
Naturally, the ‘M’ word is on the lips of every administrator: Madoff. The ubiquitous euphemism for ‘devil incarnate’ still haunts the hedge fund industry, and the spectre of the imprisoned investment adviser is quickly pushing the industry into the world of outsourcing.
Gary Enos, VP for relationship management for alternative investment services at State Street, says Madoff’s case brought opportunities to fund administrators. While many of the accounts and transfer agency operations had been commonly outsourced in the European hedge world, their demands for new services increased. Meanwhile, US players were shaken out of their practice of
near-exclusive self-administration for the first time.
As a perfect storm hit the investment markets, hedge funds began to gate redemptions. A third of funds curbed withdrawals in 2008, while the investments lost a fifth of their value, according to analysts Hedge Fund Research. As this gating snapped into place, the funds’ estimated highest redemption rates proved to be far too low, and the situation went from bad to worse.
The collapse of Lehman Brothers and Bear Stearns showed that hedge funds were not the weakest link in the counterparty chain, but there were still serious flaws in the process.
Hedge funds began turning away from the prime brokers and their valuation models. Prime brokers constituted counterparty risk. Many hedge funds, both in Europe and the US, turned to the largest trust banks and administrators for help, especially for the valuation of assets that were effectively illiquid.
“We certainly saw a flight to quality, with funds seeking security in our scale and expertise and moving business to us,” says David Aldrich, managing director, global client management financial institutions division at Bank of New York Mellon (BNY Mellon).
Blossoming administration
Indeed, while asset values shrank, BNY Mellon’s client list grew. It was the same story at State Street, as Mr Enos reports that 2009 was its best-ever year for new clients in the US.
In the midst of widespread financial chaos, many hedge fund managers realised the value of independent administration. “There is more demand for these services across the board,” notes John McCann, managing director at Trinity Fund Administration. “It certainly got up a head of steam after Madoff, as [the scandal] highlighted what fund administrators have been arguing for decades: handling operational risk is just as important as trading risk.”
But just at a time when certain funds were seeing the value of independence and administrative skill levels that many had never experienced, those gated investors had their own demands.
“After Madoff, the investors were asking questions such as, how do we know their valuations are correct, or who is providing them?,” Mr Aldrich observes.
Transparency, long talked of within the hedge fund world, moved from a debating point to a necessity.
A rising number of institutional investors had entered the hedge fund world. According to some sources, they had a greater interest in the underlying nuts and bolts of an operation, unlike high net worth private investors.
“Hedge funds came under pressure, especially from institutions, to increase transparency,” explains Hans Hufschmid, chief executive at GlobeOp.
“Institutions wanted to see independent valuations. They wanted to understand who undertook the work; they wanted to make sure the assets were actually there instead of making assumptions; they wanted to understand the risk of counter-party exposure; and they were more concerned about cost.”
This renewed interest in good due diligence might have come a little late, but institutional investors’ awareness of the need for good practice grew into a full-fledged obsession.
Mr McCann reported that on top of hedge funds seeking his firm’s services, their clients were directly asking the new administrators about pricing and everything else. “It wasn’t just questions like, where do prices come from?, but also do the managers try to interfere with pricing, and is there an audit trail?”
“Times certainly have changed when we’re getting questionnaires from our customer’s customer,” Mr Enos agrees. While he believes many of these queries are based on consultants’ advice, he
does warn that many investors may not always understand what the answers mean.
In Europe in particular, many hedge funds sought new services in the middle-office. This was partially to help with fresh demands for transparency, but was also aimed at making their operational risk more secure.
“Take reconciliation. This has become substantially more complex since the credit crisis. In the past, a fund might have had one or two prime brokers and derivative counterparties,” explains Mr Aldrich. Now, he says, there will be multiple counterparties as the funds try to mitigate this risk, creating a complex paper flow.
As the complexity of the operational process increases and the demands for clear client reporting grows, so too do the costs of administration.
While recent indices show some recovery in the hedge fund business, the HFN Hedge Fund Aggregate Index went up 19.4 per cent in 2009, compared with 2008’s 15.7 per cent fall, so cost has become a consideration. For companies in Europe that retained parts of the administrative process, these complexities are pushing the costs ever higher, even without such pressures as new products or more clients.
“We think in some cases, management fees have been cut,” Mr Hufschmid observes. “For the first time, hedge funds need to watch the bottom line more closely.” In contrast, Mr Enos thinks many
in the media have overplayed the falling fees story.
