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Copyright Cor Financial Solutions 2013

Hedge Funds and the drive for Institutional Infrastructure to attract new investments

Published by Salerio November 2013

Copyright Cor Financial Solutions 2013

Hedge Funds and the drive for Institutional Infrastructure to attract new investments
With operational due diligence now a fact of everyday life for hedge funds large and small, the need for fund managers to be confident in the robustness of their systems and procedures is being increasingly recognised. It is commercial benefit the competitive advantages that automation can offer them - that should drive the appropriate use of technology in financial services, argues Ken Skehan, Head of Business Development at Cor Financial, Salerio. Will regulation be the catalyst to deliver those advantages? Along with the estimated 70%+ of new assets under management in hedge funds now secured from institutional investors comes increased scrutiny. Due diligence assessments play an ever more important role in investors determining who to entrust with their monies and thus also to fund managers looking to secure a share of it. Institutional Infrastructure is an expectation from investors that fund managers are hearing a lot more these days throughout the full trading cycle. Hedge fund COOs weve spoken with report that due diligence by investors is now far more detailed - and time consuming - than it has been in the past. Its no longer a couple of hours meeting where we tick boxes through discussion. commented one COO. We can have ODD consultants in here for a whole day or more to demonstrate operating systems to them. Which means front, middle and back office operations are all increasingly under the microscope. The Prime Broker relationship: Many hedge funds still place huge reliance on their Prime Brokers for what the fund managers see as their middle and back office operations. Understandably so. What new industry wouldnt be delighted that the worlds biggest banks created the concept of prime broking to provide them with access to global money markets that enabled leveraging of the funds assets, and - thanks to rehypothecation - collaterisation that was largely self-securing? This new way for asset managers to access capital combined with a bundled package of services such as clearing and contractual settlement led to prime brokers being viewed by hedge funds as very much their outsourcing provider dealing with their hassle and taking away their problems on many operational issues so that the manager could focus on investment. The alignment of the worlds premier investment banks to what at outset were investment firms barely understood beyond their inventors, undoubtedly provided those hedge fund pioneers with a sense of comfort and credibility. Is it enough now though, to give institutional investors the comfort they seek? Institutional Investment growth: There is no doubt that attitudes towards the hedge fund industry have altered in recent years. Since 2000, hedge funds avoidance of the dotcom bubble bursting, added to resilience of hedging strategies to recover after the 2008 crisis more quickly than traditional funds, fuelled the attention of institutional investors willing to seek higher risk-adjusted returns within their portfolios. They brought with them their own standards to be satisfied, above and beyond investment returns: greater transparency, better governance, more accurate and timely reporting, robust processes and systems to better manage operational risk. Trading is inevitably seen as the stimulating part of hedge fund management, and its no great surprise that for all but the largest hedge funds, their own investment in automation has to date focused to a great extent on the front office.

Copyright Cor Financial Solutions 2013 A hedge fund aspiring to attract institutional funds now has no choice but to ensure its people, processes and supporting technology are all sufficiently developed across the whole business, even to stand a chance of being selected for due diligence assessment, let alone withstand the scrutiny that determines to whom the monies are entrusted. Here is an extract from AIMAs Roadmap To Hedge Funds 2012 Edition: Due diligence includes a thorough analysis of the fund as a business and a validation of manager information, and covers operational infrastructure, financial and legal documentation, affiliates, investment terms, investor base, reference checks and so on. Along with many others, fund of funds manager Roxanne Martino (1999) argues that the due diligence process is an art, not a science and also stresses the point of prudence and integrity in a loosely regulated market where the hedge fund structure provides a manager with a great deal of freedom. As Warren Buffett puts it: In evaluating people, you look for three qualities: integrity, intelligence and energy. And if you dont have the first, the other two will kill you. This is certainly true for selecting hedge fund managers and is probably true for all other business endeavours too. However, the 2008 financial crisis has revealed some shortcomings unrelated to the investment professionals but related to the managers operations, business and controls. The influence and veto power of operational due diligence teams has increased considerably as a result. Furthermore, the length of the due diligence process has increased too. Two thirds of investors take between three and six months to complete due diligence on a manager whereas only a third did so in 2002. Improving Operations: So where should precious dollars be most appropriately invested by hedge funds on their own businesses, to deliver the kind of operational infrastructure now expected by institutional clients? As confidence rises in hedge fund investment strategies and performance in terms of return, volatility and risk, operational infrastructure shortcomings will potentially constrain hedge funds who rely entirely on their relationship with their prime brokers for middle and back office processing of trades. After all, the prime brokers can only work with the information provided to them. Flawed information into the prime broker through human error - however it arises - means flawed information out from that point forward. Clearly that applies equally to information provided to fund administrators and executing brokers, who are also key relationships in the trading cycle of a hedge fund besides prime brokers. Having discussed the issue with a number of the leading protagonists in each of these fields, we strongly believe that the priority for operational improvements should be in business critical areas where commercial benefit can be extracted. Having said that, clearly the appropriate priority at present would point towards compliance with AIFMD (if not already completed) in order to meet the 12 month transitional deadline for UK firms to comply, which expires in July 2014. To that point, as someone who as a regulated member has had a close working relationship with financial regulatory bodies in the past, I have long been of the opinion that the best compliance regulation does no more than document best business practice. During my years working with senior and junior managers in the UKs largest insurance sales force during the evolution of the regulatory framework in that industry, our Management Development team passionately spread the message that compliance was nothing to fear. Those managers who operated the kind of business practices we advocated would by default be compliant. 3

Copyright Cor Financial Solutions 2013 Although the extent of the financial crisis may have caused what many regard as a more stringent approach to introducing new regulation now than then (and many will no doubt say overkill), the fact remains that regulators believe the measures they take are to codify business best practices across the industry. Regulation is, of course, here to stay, and is likely to spread its tentacles wider. However, future additions to legislation neednt be feared by funds who manage the operational side of their business with the same enthusiasm and conviction as their trading strategies. After all, the fund is first and foremost a business. AIFMD: Accepting that the scope of AIFMD covers virtually every aspect of hedge fund businesses, the Organisational Requirements part of the legislation includes the general principle that AIFMs require for use, at all times, adequate and appropriate human and technical resources, including administrative and accounting procedures and adequate internal control mechanisms. Furthermore, a key specified general requirement of AIFMD relates to the effective flow of information between all parties involved. Hedge funds might therefore choose to address information flow issues affecting the core of their business the trading cycle as a priority. The diagram below illustrates in simple form the flow of post trade information between the key parties involved, when there is no confirmation of the trade prior to the information being passed to brokers or administrator (illustrated by the broken red line):

The first time the two separate strands of information about the trade will be compared is when the two reach the CSD, possibly on T+2 or T+3. If there is a mismatch at that stage the likelihood is the trade will fail before the brokers can repair the problem. So what? Many hedge funds might simply not see this as a problem for them - the benefit of contractual settlement being cited while expressing the opinion that Its the Prime Brokers job to sort it out for me. We believe its not quite as simple as that - not that we advocate any disruption of that key relationship. 4

Copyright Cor Financial Solutions 2013 Yes, under contractual settlement the hedge fund gets its stock and the executing broker its money. But where contractual settlement is applied to a delayed or failed trade the Prime Broker takes on the additional risk until the trade is settled. This raises a number of points: 1. Risk carries cost. The hedge fund will ordinarily pay extra fees for contractual settlement of failed or delayed trades - the more failed trades the higher the risk to the Prime Broker, the higher the added fees to the hedge fund. Since the EU made clear its preference for harmonisation of settlement cycles across Europe at T+2, a number of investment managers are turning their attention to their level of trades needing repair to enable settlement, as well as the dreaded failed trades. If the figures reported last year in a survey of the US markets are to be believed its easy to understand why they might be concerned. It was reported that 60 per cent of instructions need to be repaired at a an average cost of $6 per trade, 10 per cent of confirmations are mismatched, costing $16 per trade, and 15 per cent of all trades are unable to be settled in time, resulting in an average cost of $50 per trade. Even as few as 25 trades a day could result in over 50,000 annually of largely avoidable operating costs in such circumstances. 100 trades a day would exceed 200,000. Added to which, nobody knows what level of penalty will add to those operating costs when CSD-R is implemented. If those or your own statistics and/or costs are ringing alarm bells for you, whos paying it now? 2. The daily collaterisation reports produced by the Prime Broker assume all trades that they have processed for settlement will settle. Where a trade subsequently fails to settle on schedule, the reports must to some degree have been inaccurate in the intervening period. 3. The advent of T+2 settlement under CSD-R is widely anticipated to increase the number of failed trades for hedge funds who havent accurately confirmed trades before sending information to brokers. There would then be extra cost through the corresponding increases in instances of fees payable, plus the addition of compulsory penalties for failed trades yet to be announced by the EU. Asset managers with electronic trade confirmation systems already in place have few concerns over the impact to them of T+2. 4. Will Executing Brokers examine the costs of doing business with individual clients (as opposed to aggregating middle and back office costs charged back to their trading operation as a whole) and review their relationships with those that cause them the biggest headaches? 5. Can Prime Brokers see a time in the not very distant future when the increased risk they assume as a consequence of failed trades is no longer is acceptable, whatever price the hedge fund pays? If the answer to points 4 and/or 5 is Yes, wed suggest the hedge funds who are currently experiencing higher levels of failed trades, or dont yet have post trade automation to confirm trades, should seriously consider the implications if their Prime Brokers decide the risk of doing business with them is unacceptable. What chance of attracting institutional investment does a hedge fund have if their principle business partner (and risk assessor) severs the relationship? Brian Godins, Global Head of Equities Operations for HSBC, is responsible for all Equities related post trade services for Global Markets Operations, which covers executing and prime broker and institutional client activities. He gives the strongest indication yet that both types of brokers are thinking along those lines: We at HSBC are putting more focus on understanding the operational efficiency of our clients, and are actually doing peer analysis based on the key post trade measurements in the Securities space. This allows us to talk to clients and illustrate to them where there are inefficiencies in their process, where they rate highly, and give them some comparative information versus buy-side peers. We see this as a collaborative approach with our clients that delivers benefit to all participants in the market as a whole. Were really pleased with 5

Copyright Cor Financial Solutions 2013 how our clients are responding to this dialogue, especially the interest shown from the Trading management of our clients as well as Operations management. An Appropriate Technology example: It is a City given that hedge fund managers and their staff who manually reconcile the days trades go home when the last trade is matched and the days trade files are despatched to their prime broker often late in the evening. Manual post-trade processing introduces the risk of human error, and not just at the hedge fund - both sets of brokers have to translate data into a format suitable to go through their systems. Let alone the simple fact that manual processing takes significantly more time even if the trades match perfectly. There is a school of thought that electronic matching of trades should be made compulsory. (Admittedly that was most recently expressed to me by a senior executive of a business with a vested interest in such legislation, into which camp the business I work for clearly falls as well). But is it such a far fetched idea? The trading cycle and flow of information within it is clearly business critical to any investment management firm. Some of the inherent operational risks of that cycle - including operational risks to hedge funds interdependent partners are all but obviated by this simple step. Deutsche Banks 2012 Study of Investor Operational Due Diligence states: Where key functions have been outsourced, investors are keen to see an internal owner responsible for the accuracy, completeness and timeliness of the end deliverable. Effectively reiterating AIFMDs information flow point as best practice. This is how the simple process flow earlier would change with Electronic Trade Confirmation in place.

In this instance trades that can be affirmed are done so on the same day as execution. All parties know on T+0 there is no reason a trade should subsequently fail, other than unavailability of stock or funds. Trades that dont match are flagged for repair as an exception at the earliest possible point in the trading cycle. 6

Copyright Cor Financial Solutions 2013 Which means there are no surprises on T+2 or T+3 at the CSD. Some might argue that Prime Brokers have an opportunity to extend their services to offer Electronic Trade Confirmation to their clients and do the job themselves. Thats certainly a perfectly feasible possibility. However, it seems to me that if you want to solve a problem permanently, treat the root cause. Which means as early in the trading cycle as possible and with the hedge fund taking responsibility itself. What are the instant obvious process benefits to the hedge fund? 1. Hedge funds will incur less instances of contractual settlements that attract a fee, saving them money immediately 2. Prime brokers take on less risk and produce collaterisation reports that can be relied on as completely accurate 3. Compliance with AIFMD information flow requirement in a business critical operational area trades are fed through to prime brokers and administrators intraday rather than end of day 4. The hedge funds working relationship with both sets of brokers is likely to improve 5. Administrative staff can be working on more productive activities while the trades that can be processed without human intervention are handled automatically by the software More importantly perhaps, are the risk related benefits to the hedge fund: Cost savings: For a hedge fund starting up its business, the margin and fee levels charged by the Prime Broker are determined by the risk profile the PB undertakes. The Prime Broker bundle of services will be priced according to the risk to them of dealing with that fund which must be lower if the fund has Electronic Trade Confirmation than if it doesnt. Therefore, savings will be made throughout the life of the fund on the business critical Prime Broker services to the fund of leverage and stock loans. For those existing funds looking to transition to institutional infrastructure, the immediate cost savings may be more oblique. Although they are likely to save costs in the future by resisting if Prime Brokers do look to increase fees for higher levels of risk they assume, right at this moment it may be the opportunity cost of not automating thats the real driver failure to attract institutional investors, or if PBs begin to sever relationships with those hedge funds failing to meet their operating requirements criteria. Operational Due Diligence (ODD): For an institutional investor seeking a particular strategy, clearly investment performance is a primary indicator of the fund managers expertise although, of course, we all know you cannot buy historic returns. Dont think a start-up cant attract institutional investment. Deutsche Banks 2012 Investor ODD Study also reported: 67% of investors have either already made a Day 1 investment or would consider it. This is in contrast to 2004, when only 21% of respondents invested in early stage managers. Getting it right on Day 1 can clearly pay dividends. At the other end of the spectrum, all indications seem to be that even stellar past performance can be insufficient to persuade institutional investors that a fund should be entrusted with their money. Phillip Chapple of Organisational Due Diligence consultants KB Associates advises both start-up hedge funds as well as undertaking ODD evaluations for fund managers seeking to attract institutional investors. We recently worked with a fund whose innovative strategy and impressive results had attracted a procession of institutional investors to visit them. Yet they were consistently being politely told the investors 7

Copyright Cor Financial Solutions 2013 would monitor their progress, and saw no new funds. Our evaluation identified 360 potential operational issues including at least 30 that were straight red flags for institutional investors. Meaning that continuing outstanding investment performance wouldnt be enough to persuade investors to place funds with them. Putting the key operational issues right took less than 3 weeks. Within 12 months they had grown from a sub-$250 million fund to $1.3 billion, all the extra funds coming from institutions. The message is clear to hedge fund managers. Invest in the technology that is most appropriate to your business needs technology that delivers real business benefits. Making it even more appropriate! In addition to suitability for purpose, which would definitely relate to the business needs, most dictionary definitions of appropriate also include the word fitting, which would relate to the size, scope and means of the user. So a technology provider considering its appeal to the SME hedge fund community would need to make its software fitting to the size, scope and means of that sector. For a company whose customers have always been larger institutions, that meant rethinking our proposition almost entirely. We know back office processing technology is never going to overly excite fund managers. Research also told us that non-IT managers harbour deep suspicions and scepticism about IT projects in general - perhaps why smaller asset managers have resisted post-trade technology investment for so long. The perception is often that: IT is expensive particularly the up-front costs of licences and implementation consultants IT projects usually overrun adding to the costs IT projects often dont deliver what was promised

All of which makes Return on Investment a bit of a gamble on the part of the project sponsor the paying customer. If perception is reality, IT vendors need to set about changing that reality. How weve gone about doing that is less for a paper like this than for our marketing literature. Suffice to say, changing that perception to make it easier for potential clients to make a decision to buy appropriate software involved changing a few of our own perceptions none the least of which was to take on a share of the risks for entry level users. Which, for example, means the smallest hedge fund, including start-ups, can now have the same kind of processing power and functionality that Europes largest hedge fund enjoys - specifically packaged and priced to suit the SME sector and the choices available to them. Improving the flow of business critical information between all parties in their trading cycle can play a small but potentially significant part in a hedge fund managers quest to secure new institutional investment. Or put another way, appropriate use of automation should deliver real commercial benefits to SME Hedge Funds from software thats fitting for their business.

Copyright Cor Financial Solutions 2013

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