Less is more: Complexities prompt hedge funds to optimise outsourcing

To thrive in a complex and evolving market, hedge funds and managers of liquid alternatives can leverage outsourcing to optimise their operations.

Running a hedge fund has become increasingly complicated as managers diversify their strategies into new asset classes, widen their distribution footprints, and face renewed pressure from clients and regulators alike. To enable growth and ease the operational burden, it is vital managers partner with service providers with integrated product sets capable of supporting multiple strategies and distribution channels.

A ramp up in complexity and diversification

Diversification has been a recurrent theme over the last few years in the alternative asset management space. Fund managers across the spectrum are branching into new asset classes. More hedge funds and liquid alternative managers are accessing private markets, as they try and capitalise on the growing investor appetite for illiquid assets. For instance, a study by Preqin found 89% of investors plan to maintain or increase their commitments to private equity over the course of 2021. Preqin also noted that 87% of investors also intend to maintain or increase their allocations to private debt this year. Conversely, other managers running illiquid private equity type strategies are becoming hybrids as they launch hedge or more liquid funds.

Diversification is not just happening in the alternatives world. Traditional managers are also looking to launch alternative product suites to offer investors greater diversification and additional sources of risk-adjusted returns. Alpha FMC, a consultancy, revealed that 60% of asset managers said that developing alternative strategies was their main priority in terms of product launches for 2020. However, broadening the product mix to include alternative assets brings with it added strain on operational infrastructure. Multi-strategy managers will look to outsourcing as a way to industrialise platforms and processes and meet evolving scale and reporting demands, without taking resources away from navigating markets.

As managers look to grow their businesses amid market uncertainty, many are also expanding their distribution footprints into new geographies. For instance, US managers are increasingly targeting wallet share in Asia and Europe, while a number of emerging hedge funds are looking to leverage UCITS and other EU fund structures to access global investors. With more managers diversifying into different markets and unveiling new products, they will need to ensure their outsourcing partners are capable of providing the right levels of support across multiple jurisdictions and asset classes.

Mounting costs catalyse the outsourcing model

Up until relatively recently, hedge fund performance was facing growing scrutiny from investors, many of whom were demanding lower fees as a result. Making matters worse for managers was that the industry was facing a stack of new post-financial crisis regulations. Rules such as the EU’s AIFMD (Alternative Investment Fund Managers Directive) along with the Dodd-Frank Act in the US have increased the cost of doing business. In fact, these overheads have proven to be  prohibitively expensive for some smaller hedge fund managers. In addition to the post-financial crisis outgoings, many hedge funds are bracing themselves for even higher costs once COVID-19 subsides as managers are forced to invest more cash into business continuity planning and cyber-security. These rapidly expanding overlays will encourage more hedge funds to look for cost synergies through outsourcing.

Meeting the demands of investors

Historically, institutional investors were perfectly satisfied with receiving their monthly NAV (net asset value) reports via post from their hedge fund managers. This is now no longer the case. Today, investors are increasingly sophisticated and are demanding more transparency from managers of all categories. Many investors are asking hedge funds for more transparency into performance and risk data.

Moreover, with the growing regulatory and investor emphasis on sustainability, clients (and regulators) are demanding reports from managers demonstrating compliance with ESG (environment, social, governance). Our survey into the integration of ESG among hedge funds confirmed that top two drivers behind ESG are client demand (71%) and investor requirements (67%).  As hedge funds move towards a tipping point of majority ESG integration by mid-2022, and with key regulatory developments such as SFDR being rolled out, these demands will only grow stronger.

While it is possible for hedge funds to produce reports internally for clients, it can be a costly and resource intensive exercise, especially if firms have to enhance their technology infrastructure and/or hire new people to accommodate growing expectations. Managers recognise this problem, and are turning to providers for support.

Finding the right partner

Universal banks – including BNP Paribas – provide a diverse range of services across their global markets and securities services businesses. Within securities services, fund administrators can support clients with their middle office, treasury and collateral management in addition to core services as providers increasingly develop full front to back offerings. Furthermore, hedge funds and liquid alternative managers can leverage universal banks for other services such as prime brokerage; depositary; custody and clearing making it more straightforward and cost efficient than relying on multiple vendors. Universal banks will also have deep-rooted relationships with leading fintechs and other technology companies which lets them develop cutting edge tools and solutions for clients. Most significantly, these large banking groups have significant balance sheet strength and excellent credit ratings making them ideal partners for hedge funds and other institutional clients.  With liquid alternatives becoming increasingly complex, they need to work with providers who can meet their evolving demands.