No hedging the subject – discussing hedge funds and transfer agency
Tricia Riddell, Bravura Solutions’ Global Head of Product – Transfer Agency discusses the hedge fund market, what fund managers are looking for in transfer agency systems, as well as providing a comparison between hedge fund and long fund transfer agency.
Can you please provide us with some background information on hedge funds, what are the facts at a glance?
Hedge funds are collective investment vehicles that use specific investment techniques such as derivatives and/or leveraging in order to provide enhanced returns. They are characterised by having relatively low numbers of investors but with high minimum investment values (US$250k not being an unusual minimum) and very high average holding values. Hedge funds also often invest in assets that are difficult to sell quickly or easily, leading to the fund having poor liquidity. In order to deal with this they often have quite lengthy notice periods for investors wishing to redeem.
Recent estimations of the industry size quote assets under management in excess of US$1 trillion.
What are the trends in growth across jurisdictions such as Luxembourg and Dublin? What has the trend been in the Asia-Pacific region and what can we expect in the future?
The trend for hedge funds in Luxembourg has been growth, apart from a downturn in 2008 when the credit crunch hit.
A recent article in the Financial Times (published in December 2009) stated that “Ireland is already the leading EU location for the administration of hedge funds, accounting for 45% of global hedge funds. Until now, most have been domiciled in low-tax offshore jurisdictions….”
The Irish government is in the process of amending its regulations in order to make it easier for hedge funds based in the Cayman Islands and other tax havens to move to Dublin.
It is possible that as a result of the economic downturn, investors may switch to more regulated jurisdictions and it appears that Ireland wishes to be in a position to entice funds that are domiciled offshore to relocate there.
Ireland is placing itself to ensure that it is in a position to support new sources of revenue. There does not seem to have been a large re-domiciliation of hedge funds to date, but there is far more visibility and discussion of this topic, with the offshore fund domiciles more on the defensive than previously.
A recent article published by Hedge Fund Research (August 2009) stated that the percentage of Asia-focused hedge funds located in China increased to 23.6%, an increase of over 5% from one year ago. The article also said that the number of Asia-focused funds based in China has surpassed the number headquartered in the UK, and is approaching the number of similar funds located in the US. Clearly this reflects the growth of the hedge fund industry in this region.
In terms of transfer agency (TA) systems, what are fund managers looking for? How are market trends and the nature of hedge funds driving systems development?
Traditionally most hedge fund managers have had small fund ranges, with each fund having a relatively low number of investors, ranging from the high dozens to the low hundreds. Scale has therefore never been an issue for hedge fund systems.
On the other hand, the lack of standardisation with regard to performance fee and equalisation methodologies, and also the frequent introductions of new innovations – such as side-pockets, early settlement and forecast pricing – have meant that hedge fund systems have had to focus on being flexible and able to deliver change quickly.
As a result, most hedge fund systems can be characterised as ‘light’, with an emphasis on rapid change, rather than on robustness, scalability and auditability.
Hedge fund TA software has also tended not to provide or integrate with some surround technology frequently found in the larger long fund systems, such as electronic messaging for straight through processing (STP) trading, links to electronic payment systems (such as SWIFT and BACS), image and workflow systems, and links into automated composition and fulfilment systems for client and agent reporting. This is typically because the scale of operations being run could not justify the expenditure required to provide some of these heavy duty modules.
Long fund TA systems, on the other hand, have been aimed at retail books running to hundreds of thousands (sometimes millions) of investor accounts. The high volume/low value business has made it worthwhile to invest heavily in automation and STP. As a more mature, standardised and (relatively) simple business, the need for rapid change has been less marked than with hedge funds.
What is the difference between hedge and long fund transfer agency?
If you were to list the basic administration tasks for long and hedge fund administration, the lists produced would have a large degree of commonality. They would include anti-money laundering checking, trade placement, confirmation, pricing, settlement, investor servicing and investor reporting.
While there are nuances and different flavours within these tasks, they are essentially operating in a similar fashion. Hedge funds have a number of bespoke features that are synonymous with these asset types, such as performance fees, investor level equalisation, redemption notice periods and side-pockets.
We shouldn’t underestimate the complexity or the variety of methodologies that exist. Historically there have been no standards and each provider has invested its own solution for solving the same issues, hence there is a plethora of methods that exist. While we have seen some convergence of these methodologies, it is unlikely that this will converge to a single standard.
In addition, hedge funds have a number of non-functional requirements, such as high levels of personal investor service, reflected by the more frequent investor reporting and the sophistication of the investor report customisation. Clearly these requirements are driven by the extremely large amounts invested by organisations and individuals into hedge funds. Although this is certainly a requirement in the long fund arena, particularly for institutional business, there has not been a demand to deliver it to such an exacting standard.
There is a call now to integrate hedge and long fund transfer agency, what are the drivers for this integration?
Let’s look at this first from the perspective of the long fund manager and then the hedge fund manager.
Long fund manager:
Historically long and hedge funds have operated as two separate divisions within an organisation – separate silos. We are starting to see companies pulling these two divisions together as they recognise that the basic operating and administration practices to support them are very similar. As they are doing this, they are starting to ask why they require multiple platforms to support them and why they cannot be supported by a single integrated solution. They can see the cost and process benefits of this consolidation.
Hedge fund manager:
We are all aware of the havoc wreaked on the hedge fund sector by the credit crunch. Now we are seeing the situation start to improve, and hedge fund managers are looking for ways to regain the trust of investors and to increase their assets.
One way they see of achieving this is via the launch of UCITS III hedge funds, or as they have been coined ‘Newcits’ – the new generation of UCITS. This will enable hedge fund managers to move into the top end of the retail space by leveraging the UCITS brand.
At the Future of Fund Management Conference in London in March this year, Mark Chambers, Head of Sales Management for Europe at Man Investments, stated “The battle is on for the hearts and wallets of investors….we have seen what hedge funds are doing, it will be interesting to see what traditional managers do in response.” He continued by referring to 130/30 funds; “Uptake was slow when these funds were first launched, but as we have travelled through the crisis there has been a greater uptake. I think we will see a proliferation of these products being launched by some traditional managers.” This provides further drivers for a combined long and hedge platform.
However, as hedge fund managers look to increase their investor base, and attempt to regain assets lost during the credit crunch, we are likely to see them expand their fund ranges, launch more retail orientated UCITS III style funds, and give themselves a degree of counter-cyclical protection by either merging with or acquiring long fund managers.
At the same time, either by regulation or by pre-emptive voluntary market action, we are likely to see greater standardisation and best practice standards emerge, which will require hedge fund TA systems to provide a greater degree of robustness, scalability and auditability.
Long fund managers may respond by continuing the trend of launching UCITS III funds, either as 130/30 funds or funds adopting other hedge fund-like features.
Both hedge and long fund managers are therefore likely to be looking for systems that combine the features and attributes of hedge and long fund systems. While it would theoretically be possible to take an existing long or hedge fund system and build out the missing features, it is likely to be much easier to add hedge fund features to a long fund system than it will be to try and engineer robustness and scalability into a hedge fund system after the event. We therefore believe that enhanced long fund systems are likely to form the basis of combined long/hedge fund platforms.
What are the potential benefits for this integration?
It will come as no surprise that supporting these asset types via a single TA platform, rather than multiple platforms, will lead to reduced system costs for the outsource provider or the fund manager – whether these are the day-to-day maintenance costs, or the ongoing development costs for regulatory and industry change. Importantly, a single software platform also provides a single supplier relationship which reduces the amount of time TA management spend interfacing with multiple vendors.
A single platform will also allow the provider to support a single operating model with a single set of procedures, administered by a single set of operational staff that (depending on the peaks and troughs in the business lines) can be redeployed as necessary across asset types. A valuable by-product of this is that investors also enjoy a common customer experience and process flow, regardless of the asset type being purchased. Of course, all the standard components built for the long fund world, such as integrated image and workflow, STP trading and composition fulfilment engines can be leveraged for hedge funds.
What are the challenges facing this single integrated platform?
One of the challenges facing software providers is finding resources with expertise in both long and hedge funds. Given that these have historically operated as separate silos, it is difficult to find individuals with a detailed knowledge of both. This applies to both business and software development knowledge.
One of the other challenges will be to ensure that the implementation of the hedge fund features, some of which are complex, does not impact the inherent scalability and processing times for the long funds. It will be essential to ensure that these are not eroded and that the levels of scale achieved for the long funds will be inherited for the hedge funds, particularly as the levels of UCITS III hedge trades increase.