There have been many predictions that hedge funds will grow enormously in Europe over the next few y...
There have been many predictions that hedge funds will grow enormously in Europe over the next few years. This has led to participants in all areas of the money management business getting excited about the potential growth likely to take place.
A word of caution is needed - hedge funds are specialist structures requiring specialist service providers. Mainstream providers hoping to reap massive rewards from servicing hedge funds need to be cautious. This business is the domain of the specialist, not the generalist.
To the European investment professional used to the world of regulated funds, virtually all aspects of hedge funds are unusual:
l Funds are set up in locations such as the Cayman Islands and Bermuda with little regulatory oversight or statutory investor protection.
l Fund management companies often comprise a handful of young individuals without teams of settlement, compliance and back office support.
l Managers can earn performance fees in addition to standard management fees.
l Leverage and short trading are standard procedures.
The result, unique to hedge funds, is that a specialist group of service providers has developed to service the industry. This group, comprising prime brokers, lawyers, accountants and administrators, have developed and tailored their practices to deal with the unusual nature of the industry. Newcomers are frequently surprised to discover that only a handful of law firms in London profess to have a specialist hedge fund team. Similarly, the prime brokerage arena is dominated by only a few names, as are accountants and administrators.
To service this niche business, providers need to invest heavily in people and technology to acquire the necessary expertise.
The administration of hedge funds raises particular challenges. Probably the most fundamental is to really understand what the manager is doing. Hedge fund strategies can be complex and it is vital for the administrator to fully understand the instruments being traded and the strategies involved. Such strategies often involve heavy volumes of trading and large portfolios. As they can be complex and unique to individual managers, the administrator will often have to tailor solutions to the specific needs of individual clients. Accordingly, hedge fund administration is not a commodity business.
Administrators have to be comfortable dealing with prime brokers rather than custodian banks. This gives rise to complexities relating to securities being borrowed and the format of reporting received. Unlike traditional custodians, prime brokers often take little responsibility for dividend collection. Again, this will present particular problems with respect to corporate actions.
Particular expertise and flexibility is needed to work with innovative fund structures. Hedge funds are at the cutting edge of developing new structures that can be targeted at different investor groups. Administrators must have lawyers that can work with external solicitors and counsel in developing these. It is common to be working on structures where there is no legal precedent. Consequently, providers need to be dynamic.
The raw materials of any fund administration business amount to having top quality staff and tailored systems. No system on the market will satisfy all the needs of a full service hedge fund administrator. Most major players have either developed their own systems or acquired a system that they have extensively modified.
As the business becomes more international, it is necessary to report to differing investor groups - taxpayers and tax-exempt individuals and institutions in the US, Europe and elsewhere. Each requires different reports and different tax information. Administrators need to develop flexible systems. Hedge funds employ concepts such as incentive fee equalisation that need to be understood and automated to avoid offline errors. Staff also need to be able to think 'outside the box' to deal with the complexity of the products.
A final issue is the law of supply and demand. Administrators have been attracted to centres such as Dublin because of its large labour pool and convenient location. The demand for good staff is intense. But here administrators are competing with banks, investment firms, insurance and software companies for the same staff, another impediment to the expansion of a hedge fund administration business.
The issues discussed above make it difficult for existing service providers to radically increase client numbers and attain suitable service standards. It is possible that over the coming years, the service side of the industry will struggle to keep up with the demands of clients issuing new hedge fund products. The challenge for service providers in this niche area is to maintain the individual service required from clients while at the same time expanding to meet the increased demand.
Ronan Daly is managing director at Hemisphere Management, Ireland
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