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Hedge funds move to outsource processing

Date: Monday, April 27, 2009
Author: Sophia Grene, FT.com

A lot has changed for hedge funds in the past year. The collapse of Bear Stearns and Lehman Brothers alerted investors to the importance of counterparty risk, while the revelation that Bernard Madoff had made away with up to $50bn (£35bn, €38bn) in a giant Ponzi scheme thrust the importance of administrators and custodians into the spotlight as guardians of investors’ interest.

In the US in particular, where many hedge funds have been self-administered without question, the effect has been striking for hedge fund administrators and custodians.

“The old system seemed to work pretty well as long as assets grew,” says Jack Klinck, head of global investment product services at State Street. “But now investors are really nervous. There’s a tremendous focus on ‘who’s your counterparty?’”

Mr Klinck expects to see a number of large US hedge funds, which have until now done all their administration in-house, outsource this function in order to reassure their clients. “Self-administered hedge funds are looking like outliers now. They’re having to break their operating model.”

The pressure for this change is coming from investors, according to David Aldrich, head of global investment services at Bank of New York Mellon. “They have institutional investors coming in saying ‘We want a known, credible fund administrator so if something goes wrong, we can sue them – and there’s some balance sheet behind that name’.”

Mr Klinck concurs: “We’re getting questionnaires from the hedge funds’ clients. They’re doing site visits and due diligence – they want to come in and kick the tyres.”

But giving away control of an internal process does not come easy to some hedge funds, used to playing everything close to their chests. Mr Aldrich says although investors are demanding some involvement of an independent administrator, the larger hedge funds are still not giving everything away.

“Some want a parallel process,” he says. In effect, they allow an independent administrator to run the numbers in order to satisfy client demand, but keep on doing the work in-house as well.

“They believe they understand the assets better than anyone else,” says Mr Aldrich. “The cost of doing this, while it is in the millions of dollars, is not material to their business.” He adds that even if a hedge fund were happy to outsource entirely “it’s not that easy to switch off all the accounting for $1bn”.

However reluctant the hedge fund, however complicated the outsourcing operation, it seems a foregone conclusion that the vast majority of US hedge funds will move to some form of independent administration.

“It’s not easy, but the alternative is a bleak one,” says Chris Adams, global product head for alternative funds at BNP Paribas Securities Services. “I wouldn’t want to be the person facing the trustees saying ‘it’s too difficult’.”

Although European hedge funds have never had a tradition of self-administration, this does not mean they are unaffected by the events of the past year. They are also being scrutinised over the creditworthiness of their custodian, with implications for those custodians.

“We have a service model that’s now very much in demand,” says Mr Klinck. “We’ve gathered a lot of assets, although that’s against a lot of redemptions.

“We see this as an opportunity to increase our market share. It’s about flexing our muscles a bit and taking market share from some of our weaker competitors.”

Bank of New York Mellon is also licking its lips at the prospect of picking off some of the less solid competition. Mr Aldrich predicts the industry will see consolidation in the next few years, having grown at unsustainable rates for a while. “In the past, everything only went up. Profitability was there, assets were there, revenues were there. But when the value of assets falls by 40 per cent, what happens to the hedge fund administrators?

“They’re struggling with the reality and perhaps looking for a white knight.” Mr Aldrich would like to see BNY Mellon in that role, but “it’s a question of timing”.

He makes it clear the object of consolidation is likely to be the middle rank of administrators. Boutique HFAs, if they survive, will continue to serve a useful function for the smaller hedge funds whose business would be unprofitable for the larger companies.

The industry may shift in other areas as well – there have been developments in the relationship between prime brokers and custodians, says Mr Aldrich.