Making Money Out Of Hedge Fund Administration
Speech given by Dermot S. L. Butler
at the Fund Admin: Derivatives & Hedge Funds At The Cutting Edge Conference, Alexander Hotel, Dublin
1st May 2007
I feel I must have had a very weak moment, or it must have been very early in the morning perhaps, following a very late night, when I agreed to give a presentation on the subject of Making Money Out Of Hedge Fund Administration.
My initial reaction to this question was to say not easily, but I understand that those of you who have flattered me with your presence probably expect some meat on them bones. Nevertheless not easily is, I believe, a fairly accurate answer, despite the fact that the concept of providing a full administration service is a relatively simple one.
Let me backtrack a bit and try and explain what it is that a full service hedge fund administrator does on a daily, weekly and monthly basis.
First of all, in the vast majority of cases, the hedge fund administrator will not only provide administration, but also provide Registrar and Transfer Agency services or Shareholder Services, as we describe them.
However, the main function of the hedge fund administrator is to calculate the Net Asset Value (NAV) of the fund and the NAV per Share of the fund. To do this, the administrator must use as much information as possible that it can source independently of the hedge fund manager i.e. prices should come from a recognized independent price source, such as Bloomberg, Reuters or ValueLink, for example, or some other source able to provide an independent price. This is relatively simple in the context of exchange traded securities, but the problems arise where you get the more illiquid complex OTC transactions or other illiquid assets, such as property funds and private equity, but that is another subject. It is my intention to limit my comments today to the problems related to the administration of hedge funds and how to do it profitably.
I have already mentioned a couple of times the need for independent pricing and this is important from an investor protection point of view. However, there are some strategies where the fairest valuation will probably be one provided by the manager. Nevertheless, for the most part, hedge fund portfolios are valued on the basis of independent price sources.
In addition to producing the NAVs, calculated on the basis of independent price sources, the administrator is also expected to produce that NAV within the shortest timeframe possible, following the valuation date. However, an administrator is totally dependant upon when it can get the information, as clearly demonstrated by Funds of Funds, where the administrator has to wait for the NAVs of the underlying funds to be produced by the administrator of those funds.
Historically, hedge funds have offered monthly liquidity and, therefore, monthly NAVs, however, there has been a noticeable trend towards weekly and now, daily, NAVs, which, given the complexity of hedge fund administration, imposes quite a substantial strain on the administrator.
So, the real question that is being asked today is, firstly, what does the average fund manager look for in an administrator, combined with the explicit question as to how the administrator can provide the required service and still make a reasonable profit and by reasonable, I mean one that will encourage him to get up in the morning.
Historically and, to a certain extent, currently, fund administration and, particularly, hedge fund administration is a labour intensive business and, of course, labour is a very expensive commodity in this day and age, wherever you go. What has changed in the past few years is the recognition that technology, although also a very expensive commodity, can, in fact, do much of the work that, hitherto, human beings have done and, for the most part, quicker, more efficiently, more accurately and, ultimately, at reduced cost.
All this is of no consequence if you havent got any business in the first place and that is, obviously, crucial, particularly in the very competitive market that administrators find themselves today.
Therefore, the next question is how do you obtain and retain clients, who are, of course, represented by the hedge fund managers.
In my opinion and I stress this is my opinion, the most important factor is the ability to provide to the hedge fund manager all the obvious services efficiency, speed, timeliness, accuracy, etc., but, most importantly, a personal service. Hedge fund managers are individuals and individuals who like to be recognized as human beings (albeit most of them would deem themselves very important human beings and would, therefore, want a very personal service).
They also want a full service and, indeed, proactive, rather than reactive, behavior from their administrator with regard to new technology and how to improve efficiency.
Little of what Ive said so far is anything except blatantly obvious. However, none of it can be achieved easily.
Firstly, let us consider technology. Ask almost any administrator and they will tell you that one of their primary concerns is ensuring that they are technologically superior to the competition. This is, of course, an ongoing problem and rather like a star-studded Olympics where a new world record is broken in every heat, so, in technology, once one system is promoted as state of the art, another one comes along a couple of weeks later and offers extra bells and whistles or some method of increasing efficiency and it takes the pole position.
Naturally, we at Custom House believe we have that state of the art system and, in fact, believe that state of the art system PFS PAXUS has been and has remained at the cutting edge of hedge fund administrative systems since we first implemented it in 2001 and a mere five years is a very long time in the techno world.
I have a particular abhorrence of spreadsheets and one of the great advantages of PAXUS is that it is a fully integrated, fully automated system, provided, of course, that the information is available in electronic format. When we introduced PAXUS, most other systems were and, indeed, I think it is still the case, were modular, by which I mean that they had
separate modules for shareholder service or registrar and transfer agency;
a separate module for the portfolio and trading;
a separate module for fee calculations, which, with hedge funds, are more complex than with mutual funds
another module for equalization, etc., etc.
One of the great disadvantages of separate modules is that the information created on one module has to be transferred to another module, in order to get the final NAV and each of these transfers of data from one module to another creates an Error Zone, therefore, checking has to be paramount.
Often the fee calculation module and the equalization module were and still are spreadsheets. Spreadsheets, by their very nature, produce an Error Zone for each column of the spreadsheet, if that spreadsheet is used so that the information is transferred from month to month or valuation date to valuation date. Thus, the spreadsheet must be carefully checked and I repeat, carefully checked - by, not only the person carrying out the work, but their colleagues.
This, in itself, negates part of the advantage of technology, which, of course, is to reduce the cost of human labour and streamline the human element. If, as I believe is the case with multi-modular systems, you have to carry out a considerable amount more checking than you do with PAXUS, then that reduces the efficiency.
Obviously, not everything in PAXUS can be automated or fed electronically. New stocks have to be entered into the security master and, obviously, any information relating to new shareholders is a manual input. Similarly, many OTC instruments have unique characteristics, which cannot always be handled automatically within the system and, therefore, some form of manual intervention is necessary and, in some cases, sadly, spreadsheets are necessary.
I am happy to say, however, that great strides are being made in order to enable a quicker movement of the more complex derivatives instruments into the automated field and that will assist administrators enormously.
Obviously, the main aim of improved technology is not just to eliminate personnel, but to make the personnel employed more efficient and capable of handling more funds. If you can do this, then, of course, you can increase your margin return and, thus, you can increase the profitability of the administrator.
Of course, as I have already said, none of this is of any consequence, unless the administrator can attract business in the first place.
The factors that go towards making the administrator the service provider of choice to a hedge fund manager will vary from manager to manager, but will always include a combination of costs i.e. fees and expenses and the ability to provide the services required, but also on time. Which takes us full circle to the fact that, for an administrator to make money, he has to be able to provide the service needed in a timely fashion, at a price, that the client is willing to pay.
As I said in my opening remarks, it is the quality of the technology that will determine whether the service provided is accurate, efficient and on time and it is the ability to reduce the manpower needed to administer a fund and replace that manpower with technology that will largely determine if and how a hedge fund administrator makes money.
But, although the mantra of many, technology is not the miracle answer to all of a hedge fund administrators problems. Technology does not eliminate labour costs. Ironically, although it may reduce the numbers of employees required, the administrator needs to upgrade its staff to more senior administrators and, of course, it needs to upgrade its IT and development staff. That can happen to any business that aims to benefit from technology.
The skill is applying technology AND reducing or controlling costs elsewhere in the business.
As you may already know, we at Custom House are still independent, whereas the majority of the larger independent administrators have been gobbled up by big institutional banks playing PacMan. The Bank of Bermuda went to HSBC, DPM went to Mellon, Tranault went to JP Morgan, Hemisphere went to Bisys and the list goes on. All these institutions have very high operating overheads and, therefore, in order to meet this high operating cost, they have to have large ticket clients, which means, in the hedge fund industry, funds of at least US$200 million or more. As a result, we have seen many of the new institutional administrators, increasing their minimum fees and, effectively, pricing themselves out of the market for funds at the US$50, US$100 or even US$150 million level, where we can make a reasonable profit and at a lower price.
Our minimum fee level is currently 3,500 for a fairly straightforward single strategy fund, whereas I think our competition is nearer $6,500 these are monthly fees for monthly valuations. But even for a US$50 million start-up fund, our minimum fees are somewhat penal and so we look for ways of reducing them, if we feel that the start-up fund has a reasonable chance of success. One way we do this is to reduce the monthly minimum fee from 3,500 to 2,500 for up to a year, providing the fund will accept receipt of its NAV in the fourth week of the month following the valuation date. This, obviously, reduces their overheads substantially, but it also enables us to better plan our workflow so that their NAV is calculated in the quieter period of the month for our administrators.
The pressure by managers on administrators to produce their NAVs as soon as possible after the month-end is immense and, if we are able some way to reduce this pressure, then we can, obviously, also reduce the fee.
We are also able to contain costs or shave fees if the client will agree to the NAVs being calculated in Chicago or Singapore, both of which are much lower cost centres in Dublin, but, inevitably, this will result in some delays, albeit, perhaps, only a day or two in delivering those NAVs.
In simple terms, the profitability for a company like ours and, for that matter, any other administrator, is obviously determined by the revenue generated, less the operating costs. Although we are still less expensive than most of our competition here in Dublin, our fees have risen with the Irish market real estate and labour but we have still managed to operate at a lower minimum fee rate than most of our competition. How long we will be able to keep this up is anybodys guess and local Irish costs are one of the reasons that we now have representative offices in Chicago and Singapore indeed, we consider Singapore to be our India.
We believe that, by concentrating on technology not only with regard to PFS-PAXUS and the fund administration, but also ensuring first-class connectivity between Dublin, Chicago and Singapore and by developing highly skilled staff in each of these three offices, we will be able to contain costs and improve efficiency, which also means improving our service.
One other main advantages of Chicago and Singapore offices to Custom House and this is probably more a Custom House benefit than any other administrator, is that they help us to mitigate the currency trap. For several years now, we, in Dublin, have suffered from having a largely US revenue decimated by a large Euro overhead. We, of course, hedged, but today that is expensive and, in the end, you are hedging into a black hole. To hedge when there was Euro/Dollar parity was very sensible and useful insurance. Hedging now at $1.35 per Euro is a practical insurance in the current market, but it just locks in a conversion of our revenue at todays exchange rate. It may save further losses in case the Euro improves, but it doesnt help the fact that many of our contracts may have been struck at a lower exchange rate. By introducing Dollar denominated overheads in Chicago, we eliminate the exchange rate differential at a stroke.
Finally, one short story to illustrate the benefit of the centralized service systems we have installed, which enables the book to be rolled to Chicago, when Dublin closes and then on to Singapore, when Chicago closes and from Singapore to Dublin, when Singapore closes.
We currently administer several daily dealing funds and, with the three offices, we are able to carry out the trade capture and reconciliation, largely in Singapore, which is then forwarded to Dublin, who complete the trade capture and reconciliation work and commences on the NAVs, which are then all rolled forward to Chicago, who completes them. This enables us to meet a deadline for publishing the daily NAVs of 3.30pm Chicago time t+1, which suits our client very well.
On or around the 6th of March you may have read about a serious earthquake in Indonesia, which registered at 6.6 on the Richter Scale in Singapore and resulted in buildings shaking, but not falling down. Nevertheless, the buildings had to be evacuated, ours included. As a result, the Singapore office was unable to carry out any of the trade recapture or reconciliation they were supposed to do on that day, as we found out in Dublin when we opened the doors in the morning. Our reconciliation team, however, was able to pick up everything off the system and progress it all through, with the net result that the NAVs were distributed to the client at about 6.45pm 3 hours late, which we consider to be quite a major achievement under the circumstances.
Our client also thought that we had proven that our technology worked and that we were able to provide an efficient, proactive service and so this effort has probably, in fact, strengthened our relationship and, in the end, it is maintaining a good relationship that makes the money.
Thank you very much.