Start-ups will find that third parties cannot do it all
Many in financial services are preparing to join the hedge fund fray as evidenced by the high attendance at last week’s “How to Launch a Hedge Fund” conference, sponsored by FTF. One of the key takeaways from the event is that while start-ups will rely heavily on third-party service providers, they will still have much to do on their own.As they start calling for legal, accounting, prime brokerage and fund administration services, though, hedge fund start-ups will also have to contend with the general perception that the hedge fund industry has become safe and more mainstream than the days when upstart firms, headed by fund management stars, could outperform established players and grab headlines. Recently, though, the headlines have been about the ebb and flow of redemptions and multiple scandals.
Yet the basic appeal of hedge funds—their shorter investment patterns versus the long-term strategies of traditional asset managers—remains popular, says Axel Pierron, a Paris-based senior vice president and analyst for Celent, the market research division of Oliver Wyman, Inc. Their appeal holds despite troubling conditions such as market volatility. “The volatility that we see in the market is not all detrimental to the return that a hedge fund can get. It really depends on the strategy,” Pierron says.
While economic conditions are challenging in North America and Western Europe, “we’re seeing a huge increase of investment flow toward Latin American nations,” Pierron says. In addition, hedge funds applying high frequency trading strategies in Asia are on the rise. “Actually, many exchanges in Asia are adapting their technology to that customer segment. … What we’re seeing is that more and more hedge funds are implementing global strategies … across asset classes.”
Another encouraging factor is that large sell-side firms have abandoned their proprietary trading desks because of pending moves by regulators and are creating an unexpected institutional flow of investment money. “I think we’re very likely to see some migration [of that flow] toward hedge funds being set up,” Pierron says.
Start-ups will have many steps to take before they can capture any of those flows, says Christopher Kundro, co-head of the New York-based LaCrosse Global Fund Services, a Well Fargo company that provides operational, middle-office and fund administration services. Kundro focused on those first steps during his FTF event presentation, stressing that managing a hedge fund is a lot more than running money. There are critical requirements for operational, accounting and IT systems support that either a third party or the start-up will have to take on. “Whatever you can’t source, you have to do yourself,” he says.
“The volatility that we see in the market is not all detrimental to the return that a hedge fund can get. It really depends on the strategy.”
—Axel Pierron, an analyst for Celent
Start-ups will have to become familiar with the operational and accounting requirements they will need to launch a new fund and a new management company, Kundro says. Gauging requirements is not an exact science as even established firms find that their requirements change and grow over time—eventually leading to fairly sizable and expensive middle and back office environments, he says.
Most start-ups will find that they need four main service providers: a lawyer, an accountant, a prime broker, and a fund administrator, Kundro says.
Lawyers assist with the structure of the management company, the fund structure, the preparation of offering memoranda, and other contractual or legal issues related to a launch. Accountants help with tax structures and serve as fund auditors, preparers of investor accounts and tax documents.
Another FTF event presenter, commenting on partnership accounting and performance measurement, says that, among other issues, start-ups will discover that:
- Investing in and moving out of illiquid instruments such as some over-the-counter (OTC) derivatives and distressed assets will be complicated and may present major valuation problems;
- Auditors have to remain independent and should not be allowed to keep the books;
- Reconciliations with brokers will require views into cash positions, possible restrictions on collateral, and will be impacted by market volatility;
- High organizational costs—the expenses incurred for launching—could seriously undercut a hedge fund’s performance;
- And tracking closely the P&L for each investor is a must because it helps determine management fees and keeps investors happy.
Kundro says that once the lawyers and accountants have done their part, a start-up has to work with a fund administrator to manage the books for the funds, oversee investor transactions, and issue financial statements. Middle and back office activities are often handled by operations service providers, which can also serve as the fund administrator. The fourth major partner, the prime broker, facilitates trade clearance, settlement, asset servicing and financing. Prime brokers have traditionally focused on equities, but increasingly service other asset classes.
Prime brokers and fund administrators cannot do everything and Kundro says that start-ups will most likely have to:
- Estimate, and reconcile daily/weekly/monthly P&L;
- Resolve any reconciliation breaks (position, price, FX, etc.);
- Manage communications and resolve issues with prime brokers and custodians;
- Settle and maintain positions in OTC derivatives and instruments that prime brokerages can’t handle;
- Monitor margin and collateral accounts;
- Manage and move cash/collateral;
- Confirm trades and review confirms (such as long-form OTC derivative confirms);
- Consolidate positions across multiple prime brokerages, OTC counterparties, custodians, banks, and non-custodian assets;
- Negotiate, track and manage counterparty documents (such as those from ISDA, etc.);
- Handle investor transaction documents, perform compliance checks for anti-money laundering, Patriot Act, and so forth;
- Coordinate fund audits and answer accountant inquiries.
Start-ups may be able to shift some of the aforementioned items to their service providers as they broaden their offerings. “Some administrators, like LaCrosse, have expanded offerings to include these operational services as well,” Kundro says.
“Whatever you can’t source, you have to do yourself.”
—Chris Kundro, co-head of LaCrosse Global Fund Services
While most firms will outsource as much of their IT infrastructures as possible, some start-ups may choose to exploit technology such as ultra-low latency connections to exchanges and other trading venues if there is a clear advantage, Pierron says. “They don’t have to rely on anyone else. The technology is a differentiator.”
Another important differentiator is the “level of transparency” that hedge funds will provide to their customers, Pierron says. For instance, the frequency of P&L reports and the views of risk exposure made available on an almost real time basis will be effective in keeping customers satisfied. “This is to convince them that they will not end up in the situation they may have experienced in 2008,” he says.
New hedge fund managers with strategies that yield impressive results might also return as differentiators, Pierron says. Despite the maturity of the market, start-ups will have many chances to make their marks. “I think we will have very strong performers in the market anyways,” he says.
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