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Debate rages over viability of outsourcing hedge fund COO function

Date: Wednesday, November 23, 2011
Author: Charles Gubert

Debate is raging as to whether hedge funds, particularly start-ups, should be outsourcing the chief operating officer (COO) role.

Outsourcing the middle and back office is not an uncommon trait and is definitely not unique to smaller managers. Bridgewater Associates, the $125 billion Connecticut-based hedge fund, recently announced it was outsourcing all of its middle and back office staff to BNY Mellon.

However, smaller hedge funds are increasingly outsourcing their COOs particularly in the face of investor pressure on management fees. While the majority of these COOs will not have a full-time office presence, they generally adopt a very “hands on” approach. Most will also have senior management experience in a hedge fund. Nevertheless, some believe there is a risk of disconnect and operational error if the COO does not have a full-time role at the company.

“Hedge Funds traditionally have been operated on the three pillars principal operationally - sound investment management operations, independent administration and an independent custodian or prime broker. Fundamental checks such as trade reconciliations rely on three way checks between the manager, administrator and prime broker to ensure accuracy and completeness of trade capture. Outsourcing the COO function is effectively removing one of the pillars and makes a hedge fund platform inherently unstable,” said Rajiv Jaitly, founder of independent consultancy firm Jaitly LLP and himself, a former COO at Axa Investment Managers, a fund of hedge funds (FoHF).

“An outsourced COO is not going to be connected to the hedge fund business in the way that an in-house COO would deal with issues. From an operational due diligence point of view, I would point to this as an inherent risk in the structure. Outsourcing this area is more about cost reduction but hedge funds need infrastructure and managers need to invest in infrastructure to give their fund management functions depth and stability - this needs in-house resources to be effectively managed on a full time, in-house basis,” added Jaitly.

A lot of start-ups or emerging firms are bearing the brunt financially of intrusive regulations stemming from both the US and European Union (EU) and increasingly stringent institutional investor demands. Managers are bracing themselves for an array of rules including Dodd Frank, over-the-counter derivatives reforms, the Alternative Investment Fund Managers Directive (AIFMD), the European Markets Infrastructure Regulation (EMIR) and the Foreign Account Tax Compliance Act (FATCA). This will not come cheap. “Sometimes, it makes sense for smaller shops to outsource the COO role. There still needs to be oversight and ongoing monitoring of operations,” said one hedge fund manager.

Some start-ups, on the other hand, might not have the experience or resources to hire a suitable COO. “For a start-up manager, it does make some sense to consider outsourcing the COO functions as these funds and their chief investment officers (CIOs) are often not experienced enough to appoint the right COO with the professional and reliable network of strategic partners and service providers. Therefore, it could be sensible for them to look at outsourcing options and hire an experienced individual to serve as COO,” said Pierre Emmanuel Crama, head of operational due diligence at Signet Group, a London-based FoHF.

There are also question marks as to whether there should be an asset threshold at which a hedge fund should appoint an internal COO. Most experts agree there should be no fixed AUM (assets under management) for this as factors are complicated by investment strategy, portfolio turnover and fees.

Crama highlighted outsourcing the COO role was sensitive. “It is better to hire someone who is capable of putting all the processes and infrastructure in place, negotiating all service providers’ agreements and hiring the right people. It is a better option for 12 to 18 months rather than a CIO hiring a head of operations who has never run a business before,” he acknowledged.

Given the market volatility and eurozone turmoil, it could be argued that it is absolutely essential to have a full-time COO. “The COO has to be internal and it is essential there is somebody there who understands the business properly, especially in these volatile markets. Outsourcing COOs and compliance will mean there will be just a bunch of traders making decisions without properly understanding the overall impact their decisions will have on the business. It is commercially very dangerous for the manager,” said Jaitly.