Managing Director & Senior Partner
Related Expertise: Financial Institutions, Wealth Management, Marketing and Sales
In early 2012, hedge fund assets under management (AuM) surpassed $2 trillion globally, exceeding for the first time the precrisis peak of $1.9 trillion observed in late 2007. Institutional investors seeking absolute returns have been the primary drivers of this growth. Compound annual growth rates of around 15 percent are expected though 2015, lifting hedge fund AuM to about $3.3 trillion. Moreover, convergence is expected to take hold, putting hedge fund managers and traditional asset managers in competition for the same pool of assets.
The shift of the hedge fund investor base toward institutions, combined with recent regulatory changes, has had some notable consequences: investors are expecting their hedge funds to bring to the table higher levels of transparency, lower levels of operational risk, less complexity, and strong reputations. Operational due diligences are increasingly becoming the norm among institutional investors.
It is against this backdrop that the hedge fund industry has reached an inflection point. Indeed, as the alternative-investments industry matures and becomes more competitive, consistent returns will no longer suffice. Investors are demanding that solid returns be accompanied by a robust operating model and a lower overall risk profile. A world class operating model will become a source of competitive advantage.
Of course, hedge fund managers can pursue this goal in many ways, including investing in world class core infrastructure, adopting solutions based on application service providers, making use of prime-brokerage relationships, and outsourcing aggressively. There is no one-size-fits-all solution for better operational performance and a brighter future. Yet the key challenge that most hedge funds face today is creating an operating model that is aligned with the fund’s strategic vision and flexible enough to enable the front office to evolve along critical dimensions. These dimensions include AuM growth, asset class mix, trading strategy, trading volume, investment vehicles (such as separately managed accounts, or SMAs), products (such as 40-Act and UCITS), and geographic expansion.
Fortunately, there are steps that hedge funds can take to build such an operating model and put themselves on a strong, positive trajectory. But first, it is important to understand how the industry has evolved in recent years.
Beginning around 2000, institutional investors—insurers, pension funds, corporations, governments, and other entities—began to aggressively increase their allocation to hedge funds. They saw hedge funds as good vehicles for delivering risk-adjusted returns and enhancing investors’ ability to control portfolio volatility. These institutional mandates differed from those of high-net-worth (HNW) individuals, who sought outsize returns on what they had already set aside as risk capital. Over time, institutional assets overtook HNW assets as the primary source of hedge fund assets and growth.
Hedge funds initially responded to this “institutionalization” by adapting their investment and service strategies to meet client demands. For example, some hedge funds expanded the availability of SMAs and accepted the process of working with investment consultants as intermediaries. By 2010, however, the financial crisis had ushered in a new level of scrutiny both from institutional investors and regulators. Thus began the current era in which institutional investors must focus not just on risk-adjusted returns and volatility but also on effectively managing operational risk.
A recent survey conducted by SEI Knowledge Partnership and Greenwich Associates found that 70 percent of institutional investors reported lack of transparency as their greatest worry (up from 56 percent in 2009). The Alternative Investment Management Association confirmed this trend, revealing that 90 percent of hedge fund respondents to a different survey reported greater investor demands for transparency as a top concern. Moreover, as scrutiny increased, hedge funds expanded in size and complexity, with many outgrowing legacy operating models. Currently, hedge funds with more than $1 billion in AuM represent less than 20 percent of all hedge funds—but they hold 90 percent of hedge fund assets. (See the exhibit below.) Since such funds are driving a disproportionate share of industry growth, this concentration of assets is expected to increase.
As the height of the crisis faded further into the past, funds that had survived by remaining relatively small found themselves hitting size and complexity thresholds that required more sophisticated infrastructure and more rigorous management. Institutional investors began demanding not only greater transparency but also robust operations and strong risk management. Ultimately, the institutionalization of the hedge fund investor base signaled a far-reaching need to significantly upgrade the industry’s infrastructure.
Obviously, the need for more-robust operations, higher levels of transparency, and stronger infrastructure is not new to most hedge-fund managers. Nonetheless, we have seen many managers surprised by the present inadequacy and inefficiency of their own operational setups. Many hedge-fund chief operating officers face serious difficulties in ensuring that their back and middle offices are capable of the following:
Challenges such as these are increasingly giving hedge fund managers reason to pause and take hard looks at their operating models. They realize that these weaknesses are increasing the likelihood of failures that could put their entire organizations at risk. Managers are asking themselves what the financial and reputational cost would be of an error on a multimillion-dollar trade or on a net asset value or fee calculation. They are even wondering what the consequences would be if they were unable to trade for a full day—a less likely scenario but one that we have nonetheless observed in the past.
As management teams discuss the impact of these types of potential operational failures—and the growing probability that they could occur—they will see a clear need for action.
The first step in the journey toward a better operating model is to clearly define the strategic vision for your fund—“What does the fund want to be when it grows up?”—and to place your answer within the context of implications for the back and middle offices. You will have to take a detailed look at what is working and what is not working in your operations. This strategic lens, along with input from your clients, will help you make the leap from planning incremental changes that don’t really accomplish much to planning a broad transformation program that will create true competitive advantage.
Once aligned on the strategic vision (the “what”), you will then need to define the “how” by analyzing key target operating-model decisions. These choices will vary by fund but they typically include the following:
What does a world class hedge-fund back office look like? Again, there is no one-size-fits-all answer. There are, however, a set of capabilities that virtually all winning models share:
Once the “how” has been established for achieving the envisioned target operating model, hedge fund managers need to define a migration path for getting from point A to point B. For some, this journey will be short and relatively straightforward. But for most, the transformation will be a longer, more winding road. For large, complicated funds with legacy technology and processes to cope with, a true transformation is typically a 12- to 36-month endeavor involving stakeholders from across the organization.
What differentiates hedge funds that have successfully reworked their operating models to adapt to the increasing demands of institutional investors from those that have lagged behind? These are some of the main attributes:
Yet hedge funds that are willing to invest—to define their vision and cascade that vision into a scalable and flexible operating model—will be well equipped to handle changing market and investor dynamics. These players will be positioned to turn a very tall challenge into an opportunity to become market leaders.