Lean on Them: Funds Increasingly Turn to Administrators

The word “lean” has several definitions. Take, for example, how musician Bill Withers famously sang, “Lean on me, when you’re not strong, and I’ll be your friend, I’ll help you carry on.”

Publicly, this is how hedge funds and fund administrators would like to portray their relationships. Since the global financial crisis, hedge funds have been embattled as assets under management fell by over 30 percent between 2007 and 2008, according to consultancy Capgemini. Hedge funds had never had the regulatory reporting obligations of investment banks and brokers, but that all changed, starting with Form PF, stemming from the Dodd–Frank Act in the US, and the Alternative Investment Managers Fund Directive (AIFMD) in Europe.

Transparency is now the battle cry of regulators worldwide. And it’s the fund administrators that have been there to lend a helping hand for new reporting and valuation requirements, the results of which have been positive for the fund administration segment of the market.

According to a recent survey conducted by Custody Risk, a sibling publication of Waters, hedge fund administrators hold a collective $2.2 trillion in assets under administration (AUA), with most experiencing double-digit increases—percentage wise—in AUA in 2014 over 2013. According to consultancy eVestment, through 2013, total alternative assets under management—encompassing the entire buy side, as opposed to just hedge funds—have skyrocketed from 2008 through 2013, seeing an annual rate of increase of 3.83 percent since the crisis.

So it’s a positive story, one might think—lean on me, indeed. But “lean” has another definition, and this one has more to do with applying pressure than providing support. As the fund administration business has become more competitive, where differentiation can be challenging, hedge funds have increasingly leaned on their fund administrators to provide more support for valuations, reporting, and even risk management functions.

“How can all these things that the regulators are asking you to do help you to manage your business better? It would be disappointing if all we did was bring all this data together so that all we could do was generate some extracts for the regulator. We want our clients to gain some benefit internally, as well.” Jim Warren, SEI

The services in demand are common across hedge funds, but they are also data-intensive and require a significant investment in infrastructure and warehousing. Hedge funds, which pared down staff post-2008, and where IT budgets have remained largely flat at best, are not looking to make these investments. So they’ve turned to their administrators, saying that if they want the funds’ business, they’ll need to help carry this burden of reporting.

As a result, it is the fund administrators that have been building out their capabilities and services. Jim Warren, head of solutions at SEI, which has over $350 billion under administration, says that in order to continue to grow, firms like his will have to be able to provide more than simple reporting services.

“We’ve aggregated all this information—now how can all these things that the regulators are asking you to do help you to manage your business better? It would be disappointing if all we did was bring all this data together so that all we could do was generate some extracts for the regulator. We want our clients to gain some benefit internally, as well,” Warren says.

Monitoring for Systemic Risk
Post-2008, the first great change for fund administrators came in the form of reporting. The Dodd–Frank Act spawned Form PF, which required—for the first time ever—hedge funds and other buy-side organizations to provide an unprecedented level of detail into their business so that the regulators could better monitor systemic risk. Similarly, Form CPO-PQR requires a comparable level of detail from commodity pool operators. And in Europe, AIFMD was rolled out by the European Commission in 2013, and is geared toward closing the regulatory gap in terms of how hedge funds and private equity firms are policed, versus mutual funds and pension funds, which have historically had stricter oversight. These new mandates require hedge funds to produce onerous reports that can strain a back office.

George Sullivan, global head of State Street’s alternative investment solutions group, which has over $800 billion under administration, says these rules required the bank to build technology to support those regulations. For Sullivan’s unit, the important thing was to be able to have a system that they could easily adapt to new regulations or changes to existing rules as they are amended.

“There will always be tweaks needed, but we want to leverage data once and not multiple times,” he says. “We look to leverage that data once and have it once, and not in multiple systems and places, because that leads to inefficiencies and errors. So we have it set up in a warehouse and we leverage it one time.”

It’s also about utilizing scale, according to Steve Farlese, head of client service delivery for BNY Mellon’s alternative investment services division, which has over $640 billion under administration. BNY has developed a system that extracts the data from processing systems and feeds the info into a data warehouse, where BNY can better organize data points.

Farlese says that through this system, as an administrator, BNY can go to hedge fund clients and show them how they answered a question previously, how that’s changed this time around, and they can then compare this information over time so that it’s more than a tick-the-box regulatory solution—it’s a way for the firm to better understand how organizations are performing over time.

“We’ve become a big filing cabinet, but in an automated way, for a lot of our clients, which is really what they need because their job is to manage the money. If we can help them on the other side, it makes their lives a little easier,” Farlese says.

BNY has also leveraged Eagle Investment Systems, a subsidiary of BNY, for warehousing and data mapping to ensure clients are getting their data at the most detailed level. It has also tapped into BNY’s Risk View product, which combines data and visualization technology to help firms to use that data to better manage risk.

The Next Big Haul
While Form PF and AIFMD are meant to monitor systemic risk, the Foreign Accounts Tax Compliance Act (Fatca) is aimed at making sure investors aren’t skirting tax laws and that they’re covered by the right jurisdiction. While Fatca is still being rolled out and questions persist, hedge funds are already turning to their fund administrators to help them solve for this.

SS&C GlobeOp, which has over $500 billion under administration, has developed a new application that tracks investor due diligence and leverages data points that the administrator collects for anti-money laundering/know-your-customer (AML/KYC) rules, but that also allows clients to take share registers and do classifications in order to come up with a plan to get investors back into compliance. In this regard, it is more of a proactive system that helps buy-side firms to get investors back in line than a simple flagging tool. SS&C has also added tax experts to know the regulations and stipulations, so that the firm can provide supplementary consulting services.

“The trouble with Fatca is that it’s an evolving regulation,” says Michael Megaw, managing director at SS&C GlobeOp. “That’s not to say that the others aren’t evolving, as well, but with Fatca, it’s moving a little bit faster because other governments are signing up for Fatca-type initiatives. Eventually, these regulations will require more data points, tracking, and more due diligence and then ultimately you will have to prove that you’ve done that to the regulator. That’s the point of Fatca: It puts the onus on managers to conduct due diligence, and as a result of that due diligence you have to document what you’ve done to prove the fact that you’ve implemented procedures to prevent investors from getting around paying taxes.”

State Street’s Sullivan adds that while Fatca is very different from AML/KYC—Fatca is tax-driven while AML/KYC is more about performing due diligence on one’s customers—investor records have similar data elements, so it’s about bringing that data into one warehouse and mapping to it so as to only have to access it from one place. “Most of what we try to do is improve cycle times,” Sullivan says. “We want to be able to create this information as much on a real-time basis as is possible. So a lot of our technology spend is going that way.”

The Client’s Client
This investor dynamic has proven to be the greatest change, Sullivan adds. The biggest change in the fund administration business, he says, is that the predominant investor base is now institutional—large pension funds and sovereign wealth funds—as high-net-worth individuals and endowment investment has shrunk. Much like the regulators, these new investors are seeking transparency.

“They have pushed managers to be more transparent, and that’s put us in the position of trying to provide that transparency,” Sullivan says.

To answer this need, in the wake of the financial crisis, State Street built a “transparency report” so that hedge fund managers could share information with investors to show how the fund is structured, shed light on which assets in the fund aren’t easily valued, and explain what percentage of the fund those difficult-to-value assets entail and who the pricing agent is.

Not only are investors satisfied with this information, Sullivan says, but it also helps the hedge fund to better manage its own risk. “All of that allows them to have much more transparency into where the risk is within their own portfolio,” he says.

BNY Mellon’s Farlese explains that when it comes to risk, funds are seeking greater transparency into their underlying portfolios, the securities for the funds themselves, and the cash flows of people entering and exiting the fund. And they want this information on a daily basis, when it used to be more of a monthly look.

“While we might not be helping them make their risk decisions, most of their data is coming from us,” he says. “That’s one of the things that almost every customer asks when they come on board: Are you able to give us a risk-based file of our portfolio data at the end of the day?”

Additionally, investors—especially institutional investors—are more diversified than in years past.

[● For more on how shadow accountants and IBORs play into this sea change, click here.]

SEI’s Warren says it is important to be able to piece together a full investor profile, whether the investor is in a hedge fund, private equity fund, or fund-of-funds product. While the accounting may be different, clients still want to be able to look at the investor across their different products.

“It allows us to consolidate and clean investor data for customer relationship management (CRM) integration, but it also allows us to capture data points necessary for regulatory processes,” he says. “Additionally, it helps to address the issue that arises if you have an investor in a private equity product, as well as a fund-of-funds product. Those are different accounting systems, but this creates one global copy of an investor record.”

It’s Only Going to Grow
There are assets to be gained for those fund administrators that can prove their data warehousing, mapping, and valuation processes are clean. According to Hedge Fund Research, while capital gains have been tough to come by, in 2014, investors increased hedge fund allocations globally by $3.6 billion in the fourth quarter. For the year, inflows passed $76 billion, the highest calendar year of inflows since 2007, according to the HFR Global Hedge Fund Industry Report.

It’s also important to remember that administrators aren’t going to be held responsible by regulators for incorrect information submitted for Fatca, Form PF or other rules—the responsibility still ultimately lies with the fund itself. So hedge funds are still going to be conducting strict due diligence on their administrators, even if they’re at the same time leaning on those same administrators to assume more reporting and valuation responsibilities.

The hedge fund–fund administrator relationship is not meant to be a combative one, nor is it one of friendship. It’s a relationship of necessity. A hedge fund’s job is to raise capital and return alpha, SS&C’s Megaw notes. “Once you get away from that mission, you have to devote staff and time to become experts in these things,” he says.

It makes sense to turn to a third party for these needs. It’s a game that buy-side firms aren’t looking to play. And regulators would prefer this information to come from an independent institution.

The regulatory landscape will continue to evolve—perhaps even dramatically change, depending on economic factors, politics, and so on—and so, too, will the buy side’s reporting requirements. The fund administration business will grow accordingly, although the differentiator will be the ability to handle and manipulate the rising tide of data.

Salient Points

• Hedge funds are increasingly turning to their fund administrators to help with regulatory reporting, valuations, and even risk management, as they don’t want to spend too much on their back office when their job is to raise capital and return alpha.
• Form PF and the Alternative Investment Managers Fund Directive (AIFMD) were the first great hurdles that firms had to face in terms of providing regulators with specific data; that has turned into anti-money laundering, know-your-customer, and Fatca mandates. The key is to be able to tap into one data warehouse that can map and distribute that information when there is overlap.
• Investor demand for transparency has been a significant driver in addition to the regulatory mandates.