...have always been very responsive to our requests and provided solid supporting data...

Susan M. Stein
Affirmative Insurance Holdings (NDQ: AFFM)

Right-size me: In or out? David Walker discovers which functions hedge funds think should be kept in-house and which outsourced.


By: David Walker | December 31, 2010

The practice of hedge funds outsourcing functions now stands at a crossroads, as managers begin selectively to draw back in-house some activities they earlier farmed out.

Functions such as those performed in the middle office are among those being retrieved. Service providers increasingly agree that insourcing, even in some cases of fund valuations, can make sense.

Insourcing is occurring slowly, and it must be said it runs against the prevailing trend of outsourcing, which is being driven by requirements of regulated products, by efforts to reduce costs, and by investors – “guarded if not suspicious”, according to one administrator – stipulating it.

George Sullivan, executive vice president and global head at State Street’s alternative investment solutions unit, says: “We have won 10 new clients in 2010 outsourcing their operations for the first time, and I would expect that trend to accelerate.”

However, David Aldrich, managing director at BNY Mellon, says some managers are now conducting what he terms ‘right-sizing’ reviews, assessing where some in-house activities might be acceptable to investors and preferable for their own business.

“Last year managers were too shell-shocked by the credit crisis to conduct reviews on what was outsourced and what needed to be. Before that they were growing too fast to stop and review it,” says Aldrich.

“Now we are seeing some insourcing of functions which best fit within the fund itself, but it is a gradual process. ‘Middle office dichotomy’ is the result and this delivers better control and value to the manager. Every manager can divide their operations appropriately between external and internal components,” he explains.

Other manifestations of the right-sizing Aldrich mentions are reductions in the number of administrators while hedge funds that have grown appreciably engaging larger administrators.

Aldrich says BNY Mellon’s approach is to “assist funds in their right-sizing approach on an à la carte basis with the multitude of operational outsourcing solutions to utilise, including custodial accounts, fund administration, middle office outsourcing, share class hedging, foreign exchange and cash and collateral management services.”

He points out that funds may previously have outsourced everything but gradually built up operational capabilities only to find themselves duplicating what they pay service providers to do.

Middle office and trade reconciliations are being kept or brought in-house, especially where portfolio complexity can mean time delays are dangerous and costly, Aldrich notes.

“If you are a smaller manager doing 10 equity trades a day, you might be more relaxed about service providers being involved but if you are a more complex fund with several billion dollars under management you need to have a full reconciliation function yourself,” he admits.

State Street’s Sullivan says: “There will be people who hold out [outsourcing middle office functions] in the longer term because they feel they add value and are willing to meet the expense.”

Managers who decide to outsource a middle office cannot simply shut their own one completely, cautions Dermot Butler, chairman of administrator Custom House Fund Services. “It behoves a manager to know exactly where he is at, at all times, both for trading reasons and risk management,” he says.

Sullivan says managers often farm out middle office activities to avoid the costs of increasingly complex technology and burdensome regulation.

“As managers mature and develop their businesses, and as regulatory requirements continue to change, they are evaluating the cost of upgrading legacy systems and analysing the expenses,” Sullivan notes.

Aldrich estimates savings of 20% per function farmed out while Mike Clark, chief executive officer at Butterfield Fulcrum Group, says managers could pay the equivalent of around 12 salaries to replace a 30-member back office team with three to four people overseeing the farmed-out function.

However, Vernon Barback, president and chief operating officer at GlobeOp, says managers typically rank saving money almost last among reasons to externalise administration activities.

“If, as the Capco study [in 2003] indicates, 50% of hedge fund collapses are due to operational issues, paying an independent administrator is a small price. For most functions the impact on the management fee can be measured in single figure basis points – inconsequential compared to a failure in in-house operations,” explains Barback.

“That said, without question, meeting business costs can be easy when you are growing, such as before the crisis, but can be more difficult when you are shrinking, as many funds did in 2008/2009,” he adds.

Managers with 10 or more International Swaps and Derivatives Association (ISDA) agreements increasingly outsource managing credit support annexes for over the counter (OTC) derivatives to avoid making errors themselves, says BNY Mellon’s Aldrich.

Managing margining for derivatives trading can also be farmed out, he says, “unburdening the manager and potentially also making the process safer for their counterparty.”

A $10 billion syndicated loan manager could face quite literally millions of faxes annually, “and if 10% of the original faxes to reconcile their payments are wrong, that is a problem,” says Butterfield’s Clark.

“Outsourcing lets the hedge fund manger concentrate on his real job, which is to make money,” comments Butler at Custom House.

GlobeOp’s Barback concurs. “It is healthy for managers to focus in on what their true core competence is, which is generating alpha, managing risk and the relationships with their clients.”

While administrators extend these carrots, Jeremy Swindell, head of operational due diligence at Stenham Advisors, describes the stick his company wields. “We expect to see quality third parties providing services such as legal, administration, prime brokerage, custody and audit.”

GlobeOp’s Barback says: “With SAS 70 Type II certification and its successor ISA 3402/SSAE 16, moving from an in-house model to an outsourced one can give investors comfort through the due diligence process that technology platforms are strong and that processes and controls are in place and being run properly.”

Swindell’s team will also form a judgement on whether the service obtained is appropriate for the strategy, if fees are reasonable and only charged to the fund “where appropriate”.

 “The current attitude of investors is guarded if not suspicious, they ask a lot of questions, and want to see a lot of data,” says Butterfield’s Clark. “They do not want to take anyone’s word. They want third-party involvement to know figures have been vetted and if there is a question about a figure that it can be brought out as an exception.”

He says an administrator can rapidly inform managers if they overstep investment limits, or stray into asset classes not permitted by their fund’s prospectus.

Engaging parties to value portfolios costs a manager but BNY Mellon’s Aldrich says ultimately it can prevent losing investor confidence and assets.

EIM, Man and Union Bancaire Privee are among allocators that started pulling money from funds valuing in-house after Bernard Madoff’s $65 billion fraud was uncovered.

At the same time, notes Custom House’s Butler, investors are facing significant investor pressure. Administrators have become subject to “quite aggressive due diligence by major investors which, frankly, is a good thing”.

GlobeOp’s Barback estimates his company received 30% more due diligence meetings and twice the on-site visits from investors than it did before the financial crisis.

“After Madoff, the sub-prime market and the credit crunch, when it became apparent many derivatives were being mispriced, investors were pressing for independent valuation of assets, or at least independent verification of the valuations,” notes Butler.

A small number of funds felt in 2008-09 “they were comfortable with their set-up, and losing the odd investor was a lesser cost to the business than changing their entire operating model. They were generally large US funds with significant assets and successful over a long period,” continues Barback.

Some are now revisiting that decision if they want to launch new ventures and attract new investors “and they are finding the investors’ hurdle is set higher”.

Butterfield’s Clark concurs but says not every manager will end up outsourcing valuations. “Do I see Warren Buffett or George Soros calling us in tomorrow? Probably not.”

Some of their largest veteran investing peers already bowed to pressure to outsource valuations, including Bruce Kovner (Caxton Associates hired International Fund Services), Stephen Cohen (SAC Capital enlisted Citco) and Millennium Management (Israel Englander engaged GlobeOp).

Custom House’s Butler says he is aware of one case of a fund considering enlisting two administrators, one monitoring the work of the other. He adds some managers ‘shadow’ their administrator’s performance themselves.

Butler says: “It is always better if the valuation of assets in funds is outsourced by the manager to an appropriate third party, and this will continue to be the best in class standard.”

He does not, however, think outsourcing valuations is the best option in every case. When it is not, all involved must know net asset values (NAVs) are struck in-house.

For some strategies such as distressed assets, “the manager’s price could well be the best source (and) the person most capable of giving a fair value is probably the manager,” Butler says.

“Bearing in mind that it was the manager who set the price at which he was prepared to purchase or sell the original investment, then it seems reasonable that, providing there is full disclosure, managers’ prices could be used as long as shareholders know that is going on,” he adds.

Espen Robak, president of pricing agency Pluris Valuation Advisors, adds: “The fund manager is almost always better informed of all the facts and circumstances of assets in his portfolio than anyone outside the fund, and this applies doubly for illiquids. For a private equity investment, for example, fund analysts and managers will often be in constant contact with the investee entity’s management, have updated projections and have board materials. In fact this is why management is always the party that’s ultimately responsible for the valuations, regardless of how many outside valuation experts they call in.”

Butler says in thinly traded markets such as distressed debt even independent agencies can sometimes face challenges in striking values.

A manager may buy a block of distressed bonds or securities pre-IPO, say at 70 pence on the accepted basis of the last trade made of a meaningful size. The manager and its investors may accept this valuation as reasonable but then find the next month no-one will make the same-sized trade in one chunk at that price so the price could soften to 64p or firm up to 76p.

“The manager would have to work to persuade me the fair price is not at 64p or 76p,” Butler says. “But the manager may argue not enough shares have changed hands to justify the [new price] or maybe that such a huge chunk in a distressed situation changed hands at 64p that bloc now is no longer hanging over the market so the price should in fact be higher.”

Butler says it is crucial managers do not price in-house but compare agencies before striking a NAV. They must be consistent and not rotate between agencies at whim cherry-picking the best price each time.

BNY Mellon’s Aldrich says where managers still strike their own valuations, it is not uncommon for administrators to be enlisted by funds, often large and complex operations, to validate the manager’s valuation and all the accounting methodology as well as to verify all the assets exist and where they are being held. “It is akin to a slimmed-down administration service,” he explains.

Investors wanting independent validation have not been the only reason hedge fund managers have outsourced tasks.

Regulation, both existing in Ucits and forthcoming European Union alternative investment fund managers (AIFM) directive, is another driving force.

Each set of rules pushes for independent valuations and for service providers such as custodians to be taken on.

GlobeOp’s Barback says: “After the collapse of Lehman Brothers, adding custodians is seen as a way to hedge away their counterparty risk rather than just enlisting prime brokers. There is also an understanding when it comes to governance that it is a good idea to segregate duties between the custodian and administrator. The motto is ‘trust and verify’ and having someone not directly involved in the trades or depository action put a value on shareholdings and the portfolio.”

Some hedge fund managers may also have enlisted custodians for the first time as they launch Ucits-compliant hedge funds.

Richard Day, chief operating officer at platform provider ML Capital Asset Management, says: “The operational complexities that go with having a Ucits fund cannot be overestimated. From higher liquidity to more frequent dealing to pre- and post-trade compliance, it can be a lot more for a manager to do than for offshore hedge funds.”

With this in mind managers launching onshore products are using third parties such as ML Capital for technology, regulatory authorisation and distribution/capital raising, he notes.

ML Capital has 12 salespeople, including former independent financial advisers (IFAs) with experience of retail markets.

“Small boutiques may have one or two people dedicated to client relationships and sales and trying to sell to markets from retail to institutional is a pretty meaty job,” he concludes.