In this Dear COO series article, we explore the continued augmentation of middle office outsourcing into the front-office, as hedge fund managers seek out the cost and efficiency benefits of a fully integrated front to back outsourcing model.
A sometimes ill-defined area between front and back office, the middle office, is poised to play a more central role than ever in the hedge fund administration landscape. A convergence of heightened regulatory requirements and margin compression in the industry is bringing this more into focus.
Going back over the last 10 years, we have seen many articles written about how the middle office would emerge as the new growth area in hedge fund administration. To date, that theory has played out to mixed results and probably depends on your definition of exactly what the service entails. Some administrators have a broad definition, bringing in the trade capture, pricing and reconciliation processes that underpin the fund accounting function, while others have more specific definitions (including some, or all of the trade lifecycle, position lifecycle, collateral and treasury management processes).
For hedge fund managers, 2019 brings with it an ever changing regulatory landscape, a recovery from a tough end to 2018 (off to a good start recording the strongest first quarter in 13 years), as well as continued downward pressure on fees. We believe this will see the move to middle office outsourcing gather more momentum than ever before. In fact, recent research predicted growth at a CAGR of over 9% between 2018 and 2022. Before we look towards how this space will develop over the coming months, it’s worth reiterating why investment managers consider outsourcing in the first place.
- Cost pressure – Expenses related to an operating platform weighed down with legacy technology debt, multiple vendors and/or internal IT running costs and outdated operations, with inefficient processes and workarounds.
- Scalability and agility constraints – Increased portfolio complexity and growing importance of being able to quickly access and distribute in new markets globally, placing growing pressure on existing data management and operational processes.
- New regulations – As regulators tighten rules for the hedge fund industry, the total cost of compliance is rising. New rules governing collateral management and initial margin in particular expected to have a material operational impact in the coming years.
- Resourcing constraints – As the competitive landscape continues to evolve externally, hedge funds are facing growing internal pressures such as the attraction and retention of talent. Considerable time and resources are spent on the upkeep of legacy in-house systems and processes, which might be better diverted towards more strategic initiatives.
- Shifting investor demands – as today’s hedge fund investor expects greater flexibility around fees, liquidity and transparency, the ability to have systems that can facilitate more customised products and reporting is becoming increasingly crucial to attracting and maintaining capital.
It comes as no surprise that in the face of these operational challenges and a shifting industry landscape, hedge fund COOs have identified outsourcing as a viable solution and an enabler of much- needed agility. While drivers will vary across funds, core benefits that we see clients prioritising include the reduction of fixed cost base and improved predictability of operational costs; access to subject matter experts and best of breed technology to maximise efficiency and free up resources for core competencies; and the ability to quickly scale and distribute in new markets.
The new frontier
So what’s next? Where will the battle for middle office outsourcing take place as providers seek to best meet the challenges facing today’s hedge fund COO?
We see administrators moving up the value chain and away from the classic service-led model to be more technology and data-driven. Data itself and the ability to query it has become core to the service, as opposed to being simply a by-product.
In a 2019 Clearwater Analytics survey of operational leaders at top investment firms, the two largest hurdles identified by respondents to scaling their business were: 1) achieving a centralised source of investment accounting data (62%); and 2) having multiple systems across asset classes (57%) with 33% specifically calling out the integration of front, middle and back as priority. We take these results as evidence of a growing theme of centralising investment data and simplifying the IT infrastructure and underlying operating models that will continue to gain pace in 2019 and beyond.
Enter: Front to back
Our definition: An integrated end-to-end outsourcing system spanning order, execution and portfolio management, embedded risk and compliance modules, and a full suite of middle office operational services, feeding the accounting records of the fund and providing a platform for onward transparency to the investor.
In a front to back model with an outsourced provider, areas that once put strain on operational and IT resources such as new instrument classes and valuation methodologies are shifted to the provider. It also means easier access to upgrades and enhancements, including valuable scalability as firms launch new products. Not to be underestimated also is the ability to leverage the provider’s infrastructure for business continuity planning (BCP) and the ever crucial area of cybersecurity.
A full front to back outsourcing model can offer cost savings and a reduction in operational risk by reducing the number of vendors and/or in-house IT costs, eliminating redundant system integrations and operating from a shared data model across the organisation. In fact, for an expense conscious hedge fund COO in search of an optimised variable cost model, an integrated front to back system and service model ticks a lot of boxes.
A final word
The ability to scale quickly, meet changing investor expectations, reduce costs and divert finite resources towards core competencies, all while complying with an expanding set of regulatory requirements, is more vital than ever to successfully competing in this fast-paced and evolving sector. As the dynamic between the fund manager and their administrator also progresses from service provider to strategic partner, a real opportunity exists for the hedge fund COO to take advantage of a redefined middle office function which encompasses a true front to back operating model. For hedge fund managers, the transition is not so much about reinventing the wheel, but making some key upgrades to best prepare it for the road ahead.
How we can help
We firmly believe an all-encompassing front to back model will soon become the gold standard of the middle office as we know it. To provide our hedge fund clients with best of breed technology, we have selected Broadridge, a leading technology firm in the financial services industry, as our partner for front office infrastructure. By utilising Broadridge’s Portfolio Master – a full asset class portfolio management platform with integrated risk management and portfolio rebalancing capabilities – in our front to back solution, the full trade and position lifecycle is covered, with a suite of middle office support services. This model is integrated into our fund accounting records and the downstream platform to ensure transparency through to the end investor, and clients have the option of further enhancing the model with collateral management solutions, initial margin calculation and OTC valuations. If you would like to discuss our front to back outsourcing solution in more detail with a member of our Hedge Fund Services team, please contact us.