Outsourcing’s many flavors put a new twist on the buy vs. build decision
Hedge funds have an increasing number of outsourcing choices for their IT infrastructures—a new twist on the buy vs. build question. This new array of alternatives can help fund managers, particularly the small-to-medium-sized firms and start-ups, in the battle for investor attention in a rebounding market, and can help them meet new regulatory obligations. Yet many of them will have to retain key IT systems and keep their providers in check.The choices have graduated from straightforward outsourcing deals to variations that include applications hosted by vendors or outsourcers, leased hardware and systems, on-demand computing, cutting-edge cloud computing services and farmed out business services coupled with IT support.
The outsourcing variations offer firms the chance to craft infrastructures that will help them as they attempt to distinguish themselves amid an inflow resurgence.
In mid-April, Hedge Fund Research reported that the total capital invested in the global hedge fund industry surpassed $2 trillion—a milestone for the sector. HFR says the total industry assets rose to $2.02 trillion, an increase of $102 billion in the first quarter of 2011. The record inflow eclipses the record of $1.93 trillion, set in second quarter of 2008. It also represents an increase of more than 50 percent from the Great Recession low of $1.33 Trillion in first quarter of 2009. “Investors allocated $32 billion in net new capital in 1Q, the largest quarterly net inflow since 3Q07,” according to the report.
The much-improved inflows do not necessarily translate into IT infrastructure overhauls, says Bob Guilbert, managing director of marketing and products at Eze Castle Integration, which offers virtualized IT staff support, application hosting, co-location, and cloud computing support for back office services, mobile devices, order and portfolio management systems, and customer relationship management (CRM) software.
The demand for IT among hedge funds “is based on their need to thrive and survive in the market by having competitive differentiation in market,” Guilbert says. “The new funds that are getting established are sub-$100 million.” The interesting thing is that these small shops with three to seven people want “cost-effective, resilient enterprise-level service.”
One of those new funds is L Plus, based in Stamford, Conn., but it is definitely above the $100 million mark. Founding member Bob Del Grande, who is also serving as chief operating officer (COO) for L Plus, says the start-up has spent a lot of time thinking about the technology it will need for “an aggressive launch” of a multi-Alpha approach that is also planning follow-on funds.
“Our five alpha managers, all 20-year veterans, currently manage approximately $240 million collectively and we are looking to match that at launch,” Del Grande says. Supporting a launch this complex requires a multi-faceted IT infrastructure.
“First, you need to determine the complexity of what your organization is going to look like. If you’re going to be a single model, simpler is probably better,” Del Grande says. Previously, Del Grande worked at UBS Investment Bank where he was an executive director and COO of Global Credit Strategies. He also worked within credit fixed income at UBS as senior financial product controller.
“However, if you’re targeting institutional clients like we are, you’re going to need something a lot more robust when it comes to making sure your infrastructure is fully operational and not only on a day-to-day basis but in a disaster recovery scenario,” Del Grande says. If L Plus wanted to be a single stream fund manager, it would have different IT needs.
“For a start-up, our IT infrastructure needs are higher than others because of the complexity of the book and our approach to operational risk management,” Del Grande says. “If you’re a simpler firm, you might be able to get away with an IT guy at the end of the desk who works part time. But if you’re trying to build an institutional platform, we feel it’s best to actually use a service provider who knows what it is doing.”
L Plus has narrowed down the list of potential suppliers to two “very attractive” offers, Del Grande says. One of the vendors would provide outsourced services and maintain the hardware that L Plus would buy. The other outsourcer would require L Plus to lease its hardware and systems.
“Prior to launch, we are maintaining complete flexibility, and there is no reason to commit to one over the other because committing doesn’t do anything for us,” Del Grande says. “We are fully ready now, and our plan is to sign contracts at launch minus 30 days with one or two of these other vendors.”
At the same time that hedge fund managers are gearing up for a surging market, they also face new rules to register with the Securities and Exchange Commission (SEC) because of the Dodd-Frank Act. (In addition, commodity pool operators and commodity trading advisors registered with the Commodity Futures Trading Commission (CFTC) will also face new SEC requirements if they register with the SEC as investment advisors and provide guidance for one or more private funds.)
“If you’re a simpler firm, you might be able to get away with an IT guy at the end of the desk who works part time. But if you’re trying to build an institutional platform, we feel it’s best to actually use a service provider who knows what it is doing.”
Bob Del Grande, COO for L Plus
The SEC registration requirement will have a major impact on hedge funds, causing them to consider outsourcing much of their new compliance obligations to a hedge fund administrator, says Denise Valentine, an analyst at Aite Group, a market research firm based in Boston. Firms may have to consider expanding their staffing for compliance, creating new policies and procedures for governance risk, compliance, and ethics—in short, a lot of new documentation, Valentine says.
The registration push will provide the government and investors with “a better view into how hedge funds operate,” Guilbert says. To satisfy investors, some hedge funds may need to get a better understanding of the impacts on trading and risk systems caused by IT outages and the complications that come via support for a wide variety of systems, Guilbert says.
“We have to take a look at the infrastructure and determine whether or not the applications will work seamlessly and in a robust and high availability way with the applications,” says Guilbert, adding that it’s a question of whether the technology is properly married to the application. “Will the iPads work with the CRM package or the order management system? We’ll validate and test those to see that it does work. Obviously, we’re concerned about security and encryption and keeping information private.”
Small firms and start-ups are willing to outsource as much as they can, including CRM systems, execution, risk management, email, desktop and network support, trade flow management, phones, backup, and compliance archival, according to John-Peter Lee, managing member of MetaFrame Technology Solutions, a brand new consultancy that helps small-to-medium fund managers build their infrastructures and/or finds outsourcers. “Think of it as an outsourced Chief Technology Officer,” says Lee, who until recently was the CTO at hedge fund AM Investment Partners.
“The barrier for entry for a start-up firm faces is pretty high,” Lee says. “There are requirements from prime brokers, custodians, and the SEC that can be daunting. A fund needs to navigate the numerous options in the marketplace and answer the fundamental question of buy vs. build. When you take into account the pressure from the seed investors to get up and going as soon as possible, more firms are choosing to outsource to trusted firms.”
Valentine is in agreement with Lee, adding that while some firms may have the IT expertise to develop an IT infrastructure, most small shops will opt to outsource. The buy-or-build decision is “really a function of how much IT expertise they have internally,” Valentine says. If they have it, systems will have to be built quickly. “Most firms are in the business of managing money not building software. If they’re not proficient with the skill set, they’re not likely to do it.”
What firms have been doing is turning to hosted applications in the software-as-a-service (SaaS) model. This has become a critical option for small-to-medium sized firms, Lee says.
“A hosted application runs on the vendor’s server and network,” Lee says. “From the application provider’s perspective, it’s a way to deliver applications to the end user while maintaining a minimum application and network performance guarantee.” While hedge fund customers need to have end-user desktops that are powerful enough for hosted apps, they can take comfort in the generally lower hardware and infrastructure costs.
Some outsources are working with application vendors to take over the hosting.
“We’re finding that many of the app vendors don’t want to be in the hosting business—that’s not their core competency,” Guilbert says. “So they’d rather work with a company that has hosting service capabilities.” In fact, Eze Castle Integration is slated to announce soon an arrangement with a portfolio management system provider, he says.
In addition to the hosting model, on-demand and cloud computing services have tipped the scale in favor of the buy decision, Lee says.
Cloud computing, for instance, has become very popular for hedge funds permeating many business processes. “Companies are using cloud computing whether they know it or not,” Lee says. The virtualization of datacenters “across major technology companies” results in cost savings and advantages for fund manager customers. “The cost/benefit is phenomenal,” Lee says.
For instance, Lee cites the off-site, real-time backup costs of $4 per month for 10GB via Rackspace.com, email services at $7.50/month via Intermedia.net and server rentals at $0.085/hour through Amazon.com. “Gone are the long-term contracts and commitments to more computing power than is required,” he says. “Computing is becoming an on-demand service.”
Going to the cloud isn’t always a slam dunk for firms. “We considered it but for our purposes it didn’t fit our business model,” says Del Grande of L Plus.
Aite’s Valentine cautions that even with cloud providers and others, “Nobody solves all your needs. You have to work in partnership. You have to monitor what your vendors are doing. You can’t just give it off to someone—even if you gave it to a fund administrator or outsourcing agent.”
While IT support is not their main offering, service providers such as HedgeMark International also provide hosted applications and systems. HedgeMark is a separately managed accounts (SMA) platform that serves large institutional investors and hedge funds.
The HedgeMark platform includes integrated technology modules that cover fund due diligence, portfolio construction and back-testing, holdings-based risk monitoring, stress test analytics and compliance surveillance. Industry observers say the SMA model can be a mixed blessing for hedge funds because SMAs can result in more opportunities but also more operational and administrative costs and resource demands.
“Primarily, the advantages to the hedge fund managers are from a distribution standpoint, but we also provide analytics toolkits, and software on our online portal for our fund managers,” explains Thomas V. Brown, CTO for the platform. (In February, BNY Mellon’s Pershing Unit, a provider of clearing and execution services, solutions for RIAs, and prime brokerage support, secured a non-controlling investment in HedgeMark and obtained the rights to acquire HedgeMark.)
When they become part of platform, hedge finds “will log in and on a daily basis they’ll have automated data feeds loading their positions from the administrator to our system via secure FTP. We’ll post the funds on the system on a daily basis and they’ll employ stress tests,” Brown says.
The SMA and the hosted services are intended to appeal to fund managers that tend to outsource because of staffing shortages, Brown says. “Our service is offered on an ASP (application service provider) basis and a web service. And we’re using one of our vendors on a software-as-a-service basis over the Internet … I’m seeing a long-term trend toward software-as-a-service. … The world has changed in terms of the infrastructure that’s required to support these businesses.”
For now, the mindsets for outsourcing run the gamut from “either very open to bringing as much of their environment to an outsourced structure as possible,” or “they’re not willing at all to consider outsourcing any aspect where they don’t have to,” Guilbert says.
To illustrate his point, Guilbert refers to a recent hedge fund customer’s COO who issued a directive specifying that “everything will be outsourced wherever possible. He wants as little as infrastructure as possible … He wants everything hosted and delivered via a fat pipe.” The COO does not want to have to constantly maintain and refresh an infrastructure—he’d prefer the fixed cost predictability offered via outsourcing.
Some fund managers grow to a point where they want to develop their own IT infrastructure, which is usually when a firm’s asset base is more than $1 billion, says Guilbert. At that point, firms might consider “building something that is unique for themselves and dependent upon asset classes that they’re trying to trade. … When you surpass 25, 50, 60 users, it’s more cost effective to have your own infrastructure dedicated.”
It’s also the case that firms of all sizes will retain mission-critical platforms such as those for trading, risk management and compliance, and even build systems that they cannot purchase off the shelf. L Plus had to do so for its risk management system.
“Given the multiple asset classes we have and the complexities tied to our book, this was one of the few situations where we decided to design something internally after reviewing 13 different systems,” Del Grande says. “We have significant expertise in house, and want to leverage a lot of things that exist within Bloomberg and tweak it from there—no one risk system did everything very well.”
To expand on that point, no one outsourcer can do it all either and fund managers must keep their options open.
“Firms that can leverage the new generation of IT services will stay agile, keep a lean operational budget, and stay focused on developing their core business without the complexities of managing the infrastructure,” says MetaFrame’s Lee.
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