Celent reports formidable challenges for hedge fund administrators

Date: Thursday, September 4, 2008
Author: Hedgeweek.com

With the hedge fund industry undergoing seismic shifts, fund administrators are faced with a formidable set of business and operational challenges, according to a new report from Boston-based strategic consulting firm Celent.

In the new report, 'Trends in Hedge Fund Administration 2008', Celent offers a broad view of the trends and drivers in this space. The expansion of third party hedge fund administration continues at a remarkable pace, the hedge fund administrator's role is evolving, and the product "fund administration" is expanding.

Funds are looking to their administrators for expanded valuation and reporting capabilities as well as greater middle office functionality, collateral management, risk reporting, and compliance services. In addition, administrators are gearing up their offering to grab a share of the rapidly growing market for fund of fund administration

Continued growth of the hedge fund industry stands out as a capital driver of the hedge fund administration market. As competition heats up, the majority of hedge funds have opted to unload the burden of maintaining a back office in order to free up resources to allocate to their core activities--trading and generating alpha. Additionally, increased fund complexity and shifting sources of capital have created an incentive environment that is highly conducive to the outsourcing trend.

Alpha/beta bifurcation and greater levels of competition have made alpha generation an increasingly difficult proposition for hedge funds. Growing fund complexity has forced administrators to adopt a broader business model. Today, administrators are providing a host of added-value services in the middle office area.

More complex products and strategies have also had a direct effect on administrators' traditional suite of services, requiring them to develop a thorough understanding of new products and strategies and to enhance their valuation capabilities accordingly. What is more, pension fund money comes with demands for increased fund transparency, which raises reporting standards for administration firms.

For industry needs to be met, fund administrators are revisiting their operational infrastructures in terms of technology, organization, and staffing, as well as geographical footprint. As hedge funds have become more discriminating in their choice of service providers, the administrator's risk management and controls have been propelled into the spotlight. With fund managers' increased focus on the quality of services and operations, price sensitivity and pricing pressures have abated.

"We anticipate that, in an analogy to the hedge fund industry, the administration space will experience further 'barbelling,'" says Isabel Schauerte, an analyst with Celent's Securities & Investments Group and co-author of the report. "The ongoing institutionalisation of hedge funds will ultimately lead to a two-tiered market, with large multi-service administrators on the one hand and niche players left to service start-ups and independent boutiques on the other," she adds.

Key findings of the report include:

In 2007, hedge funds saw record capital inflows of USD 194.5 billion, according to data released by Hedge Fund Research (HFR). This represents a 54% increase from year to year (USD 126.5 billion in 2006) and leaves the industry managing USD 1.87 trillion as of year-end 2007. In Q1 2008, hedge fund inflows slowed to a trickle. Consistent with the theme of lower risk appetite due to credit and equity market weakness, investors allocated a mere USD 16.4 billion to hedge funds. The 0.38% increase in capital represents the smallest increase since the second quarter of 2004, and brings total industry assets to USD 1.875 trillion.
High net worth individuals still make up approximately 54% of the total hedge fund industry, but future flows are expected to be significantly institution-heavy. Celent estimates that endowments and foundations currently account for 40% of institutional hedge fund capital, while pension plans, which control significantly more in assets, account for 50%. Pension funds will account for 65% of cumulative hedge fund net inflow until 2010.
To date, approximately 65% of hedge fund industry assets are in funds of hedge funds. Whereas the trend of spreading risk across many managers is slightly regressive, funds of funds will still make up an estimated 60% of hedge fund AUM by 2012.
While AUA growth from November 2007 to April 2008 (9%) has slowed in comparison to growth over the same period in 2006/2007 (17%), the trajectory is nevertheless impressive given severe and ongoing financial market distress. The resoluteness of the administration market shows that the outsourcing trend in the hedge fund industry is driven by structural factors which defy cyclical weaknesses.
The continuing growth of the hedge fund industry stands out as the capital driver of the hedge fund administration market. As competition heats up, the majority of hedge funds have opted to unload the burden of maintaining a back office in order to free resources to allocate to their core activities-trading and generating alpha. Increasing fund complexity and shifting sources of capital have created an incentive environment that is highly conducive to outsourcing.
The fund administration space has become a battlefield for a wide range of players seeking to capitalize on the hedge fund outsourcing trend. As prime brokers and big banking institutions are aggressively expanding their offerings to include fund administration services, they have generally adopted a buy-and-grow strategy rather than retooling long-only fund administration systems or building from scratch.
Large-scale acquisition activity and institutional money's outspoken preference for blue chip administrators have led to an increased level of asset concentration in the marketplace for hedge fund administration. The big players' focus on large funds, however, leaves a void in the marketplace and creates opportunities for smaller and more flexible administrators willing to take on startups and independent boutiques.
As hedge fund investing has evolved to include ever more complex instruments and strategies, the 'fund administration' product is expanding outwards. Today, funds are looking to their administrators for expanded valuation and reporting capabilities and more middle office functionality-that is, inter alia, collateral management, risk reporting and compliance services. In addition, administrators are gearing up their offerings to grab a share of the rapidly growing market for fund of fund administration.
For industry needs to be met, fund administrators are revisiting their operational infrastructures in terms of technology, organization, staffing and geographical footprint. As hedge funds have become more discriminating in their choice of service providers, administrators' risk management and controls have been propelled into the spotlight. Here, SAS 70 has become a standard due diligence requirement. With hedge funds' growing focus on the quality of services and operations, price sensitivity and pricing pressures have abated.