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.
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
Operations
Data Capture
Conclusion
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.
If You Don't Know Where You're Going, Any Road Will Get You There
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