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Migrating to Safer Shores in the Current Hedge Fund Environment

Date: Friday, January 16, 2009
Author: Marshall Saffer, Viteos Fund Services

Migrating to Safer Shores in the Current Hedge Fund Environment—the Answer Depends on the Questions.

If You Don't Know Where You're Going, Any Road Will Get You There

Over the course of the last several months, what was once the assumed wisdom and practice in the financial services industry is now longer a reliable guide for decision- making. It was not so long ago that the idea of a single prime broker was the accepted wisdom. Typically, hedge funds tied their brokerage relationships to a large, global bulge bracket broker as part of a package of services rendered by that firm (including technology, brokerage capability, back office support, etc.). Now, the large global brokers have either ceased to exist or are now doing so as commercial banks—and they remain under stress.

Part of the rationale behind reliance on a these global entities was the presumed security such a relationship entailed, particularly with regard to risk. As it turns out, that was a false assumption, as the risk profiles of the brokerages themselves were tenuous.

There was another assumption that trading practices such as short selling, on which hedge funds relied, would in fact continue to operate. This is likely to be the case, but in a modified way. Historically, shorting provided market liquidity, true valuation of companies, price discovery, and held managements accountable. What form shorting will take is an ongoing debate.

There was the assumption that only big hedge funds will survive and that smaller firms will have neither the capital nor the appetite for risk that has been seen in hedging up to now. That may be true in a macro sense, but targeted, focused and nimble players with a disciplined strategy and style will continue to survive.

The recent cataclysmic events in the market have not redefined the landscape. The landscape has altered in such a fundamental way that a new set of assumptions, based on but not limited to prior behaviors and practices, is in order. In this period, adaptability, both strategically and operationally, is mandated.

Such adaptability is rooted in two fundamental approaches to the future. The first is that firms that are looking for the right answers will be less effective then firms asking the right set of questions. Because in the end, fundamental change assumes that old answers won't work, but new questions will. The firms focused on the right questions will have a mechanism that will lead to the answers that will result in survival.

The second principal is that of paradoxical effect. Simply put: this is the idea that even in times of cataclysmic change, there are survivors. The "gene pool" always has some mechanism to evolve and eventually achieves stasis in the new environment.

So, if the right questions apply, there will be a roadmap that will help determine the outcome. If you do know where you're going, you'll know the road that will get you there.

Some Questions Funds Need to Think Through

Given the background detailed above, the most immediate question is what does all this theory mean in practical terms?

Practically … everything.

Over the course of the last decade all market players were operating under a set of assumptions that proved, if not false, at least flawed. Moving forward, awareness of underlying assumptions will influence operational choice and trading behavior.

Securing alpha will be more difficult than ever, though not impossible. Which leads to the next question: will the single prime broker model ever work again?

Most market players know that the single prime model was under threat before the crisis, and a movement to multiple primes was increasingly seen as a fiduciary responsibility. The crisis has put the nail in the coffin of single primes. Firms recognize the need to spread their operational and risk profiles. Some firms that relied solely on one prime broker for custody have seen their assets frozen in organizations that behave failed. Some even have unclear accounting. Firms that relied solely on brokers, as opposed to a combination of brokers and banks, now find that there are costs and benefits to each—and that they need access to both.

Such operational diversity will be one of the new assumptions.

Critical to operational diversity are three categories against which such operational diversity needs to be deployed, also based in three questions:

The first is: how can a firm be assured of an operating platform for expertise and sustainable growth in the current environment? The operational expertise and process for survival and potential growth is relatively difficult or easy depending upon the choices firms make: build or buy operational capability? Insource or outsource? Secure outside expertise or take on internal expense?

The second question relates to conversion: How can a firm transition and convert from a single to a multi-prime knowing that true conversion affects all aspects of an organization? As with most conversions, converting to a multi-prime is not simply taking on a new broker, or simply a matter of changing the switch settings or preferences on computers. Though systems based, moving to a multi-prime is a business decision which affects all aspects of front, middle and back office operations, and even impacts a firm's operating culture. The decisions impact the relationship between technology, productivity, and costs—ultimately either enhancing or diminishing performance.

Taking a Holistic Approach

A holistic approach to the question sees the implementation of a multi-prime paradigm is not simply as an operating question, but as a strategic and tactical business decision, which a firm will live with for a considerable amount of time. It is so critical that it may affect the vitality of funds and the survival of the firm.

Taking a holistic approach, decision-makers will be advantaged by addressing larger questions of costs, the impact on every stage in the operating cycle, and whether there are efficiencies to be gained by looking to a variety of alternative approaches for implementation and the overall support of the new operational paradigm. Specifically, fund firms need to ask: does one build out the new internal operational infrastructure internally and deploy and expense all the required systems and staff, or should a firm consider the possibility of outsourcing as a more cost-effective and time-saving strategy (especially as time is of the essence)?

If outsourcing is considered, how the new accounting engine is structured and internalized within the culture might mean that a firm would develop a relationship with a strategic partner, one with domain expertise, and who understands the investment outcomes the fund seeks to achieve. It is only then that the more granular questions such as what the accounting engine will do can be addressed. This is because the accounting question is tied to the investment question. Expertise both in the business and in fund administration will be required.

The third question, again in line with the holistic approach, is: is there sufficient internal or external resource to support the multi-prime broker environment? Assuming the environment will be subject to constant change in the foreseeable future, firms will have a clear choice: either take in the cost of constant internal updating and education, or pay less for outsourcing that function, keeping in mind the necessity for a strategic vendor. Running internal operations requires expertise in operations and technology. Outsourcing arrangements (if structured properly) allows a firm to focus on its core competencies.

The Angel is in the Details

To be very specific there are a number of very detailed aspects of operations, affected by the movement to multi-prime brokerage. A checklist is detailed below:

General Considerations

A Firm's Operating Model
Operational Scalability
Business Organization
Organizational Structure
Leadership Team
Client Coverage Model
Shared Services—Operations
Shared Services—Financial Control & Business Unit Control
Overall Front to Back Process
Technology Architecture


Data Capture
Corporate Actions
OTC processing


In tough times, it is imperative that firms be more aware and conscious of the possible assumptions and implications of their decision-making: in fact, their survival depends upon it.

Movement to multiple prime brokerages is no longer a choice, but a necessity. In the context of that necessity, there are a number of decisions a firm needs to wrestle with. Most importantly, firms need to see that this is both a strategic and tactical process, impacting all the operations in which an organization engages. It is dangerous to assume that it is merely a matter of filling out a new brokerage request form.

A holistic approach sees conversion to multi-prime as an opportunity to, at a minimum, lower costs and improve productivity—thereby creating the possibility of enhancing alpha, and establishing a platform for possible future growth.

Firms need to consider insourcing vs. outsourcing as part of their time, productivity, and cost equations. The success of outsourcing is directly related to the selection of a strategic, bespoke vendor, rather than a "cookie-cutter" utility. There are several criteria for evaluating and choosing the appropriate vendor. Such a strategic vendor will have domain expertise on an ongoing basis, with an awareness of what investment outcomes the firm seeks to achieve. The vendor will need systems expertise that is tied to the business understanding, so that the business drives the systems rather than the reverse. There will need to be a breadth and depth of understanding of operating processes from order execution through clearing and settlement. Finally, the bespoke vendor will assign personnel who are dedicated to supporting the fund's success.

This roadmap allows firms to think through the issues large and small as they approach the difficult environment ahead. It does not guarantee success but it does set a larger rulebook against which firms can play.

Marshall Saffer is vice president for business development at Viteos Fund Services, a fund administration and middle- and back-office outsourcing firm. He can be reached at msaffer@viteos.com.