The Hosting Boom: Hedge Funds Share the Operations Burden

Date: Wednesday, February 13, 2013
Author: Ahila Karan, ProHedge.co.uk

The financial crisis and the oncoming weight of regulation was a treat for many service providers able to cater for the evolving needs of players in the hedge fund industry. The rise in operating costs in 2007 ignited specific interest in ‘hosting’ companies; an incubator for hedge funds to start up and share operating costs. There is a positive change in attitude towards ‘hosting’; the investor community has also recognised these particular platforms provide a credible source for investment opportunities. From both a manager and investor perspective it is an attractive scheme; it provides independent monitoring, which is highly sought-after in today’s environment, and it cuts on costs but not quality. Having introduced ‘Regulatory Hosting’ services provided at Mirabella Financial Services (of IMS Group) in HFMweek last year, Founder Joe Vittoria returns to speak to PROHEDGE about its merits. And, as a prospective hedge fund manager, Dominik von Eynern gives his stance on entering the realm of hosting.

To clarify terminology, if a company is ‘hosting’, it operates as a platform which holds hedge fund managers; most importantly, this is not where the money or the account sits. Whilst Mirabella is yet to offer clients (i.e. managers) the physical office space, their main purpose as a regulatory hosting company involves ensuring the manager is compliant with regulation, and that appropriate and independent risk management is in place.

“In 2007, people started to recognise it was expensive [to operate a hedge fund], and began to look at hosting,” and Vittoria has seen this trend gather momentum especially with recent regulations. On the demand side, von Eynern corroborated this sentiment, “what we bring to table is strategy so we’re looking for a [host] which is regulated, and will implement the operational procedures, risk management and will enable cross-checking”.

the pull factor

The framework allows unauthorised managers to join as ‘appointed representatives’, who are exempt from authorisation; using the host’s authorisation, these appointed representatives are able to legally operate. Delays to the FSA authorisation process has encouraged managers to approach hosting companies to circumvent the prolonged authorisation process. In fact, managers tend to postpone their own FSA authorisation applications, content with the authorisation coverage as an appointed representative. “Although it’s cheaper to get their own FSA authorisation than hosting, [managers] have to wait 6 months” until they can kick-start their business, Vittoria explained, so the hosting option allows managers to “focus on making money rather than running the business and all the numerous compliance procedures that are now an integral part of that”.

Von Eynern shares the opinion that managers are better focused on their core investment functions; “we add value in management instead, not necessarily in infrastructure… coming out of investment banks and hedge funds, more familiar with trading than operational aspects of hedge fund managing, it can lead to inefficiencies. So this is where this model really works”. Outsourcing these responsibilities allows managers to capture the value of the host’s regulatory and risk specialists, and as a manager “will you be any good an inventing the wheel from scratch?”

But he followed with caution, “you can outsource many things, but you can’t outsource responsibility” suggesting Due Diligence on the host is also essential. Can the host “up their game?… [especially with AIFMD] you don’t want to be left on a platform that’s out of date.” Also will the host be able to handle niche and highly specialist strategies? “And when it comes down to risk management, they should fully understand the strategy otherwise it’s pointless having a risk manager”.

on the investors’ radar

The biggest challenge for start-up managers is attracting investors, so good infrastructure works as a selling point; von Eynern told PROHEDGE investors are especially critical of managers when they start, “if you are providing below $300-$500mn, people do not trust you can sustain operations…with the appropriate infrastructure you take away some of the concerns of investors.” In addition to infrastructure, Vittoria believes Mirabella, a subsidiary of IMS Group, provides hosted managers with an affiliation to an established brand name, which further draws in investors; “we’ve got people that may be only managing $5-10mn but they want to reassure investors they have the infrastructure and knowledge of a $200mn manager. We can offer that through our infrastructure and what we are providing them.”

Back when Mirabella launched in 2004, speed and price were key concerns for managers looking to start up. This has changed, according to Vittoria, and now include a third element: quality. “Managers want to demonstrate independence, and they want to be seen by the bigger players that they are already at a certain level.” Mirabella ensures independence within the service they provide; they charge a flat fee, remain unlinked to service providers, do not resell products, and don’t offer capital to managers. In doing so, conflicts of interest issues are avoided; “all our activity is on the basis of helping clients to operate in a regulatory environment”.

a closed shop

The struggle for managers is joining the platform to start with, and from von Eynern’s experience the success of a manager is based on their pedigree; “larger firms like to pick and choose their managers, who are expected to have a good track record over the last few years, and a good reputation as a trader in a bank. When you’re less known it’s a little more difficult.” Mirabella also demand higher set-up fees for managers who have a less experienced background in running a regulated business . Vittoria however defends that it is not a closed shop since those “at the top of the game can generally find enough funding to kick themselves off [without a host]“, and he added, “it is not really clear who’s going to be the next Alan Howard.” Instead, Vittoria’s pre-requisites for new managers are centred around risk: “how do they handle risk? How do they explain risks to clients?”

Risk is a main focus point industry-wide too, “this is a new world, where the Risk Manager has to be taken seriously… [otherwise managers] shouldn’t be contemplating working in this industry” stated Vittoria. The industry has acclimatised to the transferral of power to risk managers, allowing them to veto decisions by investment managers. Von Eynern reiterated this importance, “if I employed a risk manager [as the investment manager], in theory he has an incentive to do what I say. With this platform, the host implements independent risk management, effectively regulating an investment manager’s power.”

Hosting companies vary in size and specialities, however collectively they have all flourished from a post-crisis demand and the regulatory downpour.  As the merits of such a system become evident, start ups increasingly vie for a spot on this well-coveted platform.