Maximising value from custody: Key considerations for hedge funds and liquid alternative managers

As the funds landscape continues to evolve, custody is increasingly becoming a value-adding function for hedge fund and liquid alternative managers’ distribution and investment growth strategies.

As the funds landscape continues to evolve, custody is increasingly becoming a value-adding function for hedge fund and liquid alternative managers’ distribution and investment growth strategies. BNP Paribas Securities Services looks at the drivers behind this – together with some of the criteria which hedge funds should consider when selecting their custodians.

Demand for custody on the ascent

While hedge fund assets stormed past the $4 trillion mark in 2021 off the back of excellent returns, liquid alternatives (i.e. alternative UCITS, Liquid Alternative products regulated under the US 40 Act Rules, etc.) are also enjoying something of a resurgence.  

After a multi-year absence following a period of disappointing performance and AuM (assets under management) slippage, investors are returning to liquid alternatives amid growing client demand for transparency and liquidity,

comments Declan McCluskey, Global Hedge Fund Products & Solutions Manager at BNP Paribas Securities Services.

As liquid alternatives are required by regulation to appoint a custodian, McCluskey says demand for custody products has inevitably increased.

The recent exit by several banks from prime brokerage following a high-profile family office failure will also encourage hedge funds to collaborate more closely with custodians. McCluskey notes this particular episode is prompting growing numbers of hedge funds to engage with banks which can offer integrated prime brokerage and custody solutions.

Nonetheless, hedge funds are turning to custodians to supplement – rather than replace – the services already provided to them by their existing prime brokers. Cyrille Saulnier-Arrighi, Global Head of Financing Solutions at BNP Paribas Securities Services, highlights custodians can – for instance – help hedge fund managers earn incremental  yield by enabling them to more easily lend out some of their assets under custody in exchange for bps (basis points).

In addition, he notes custodians can also provide clients with a full gamut of financing solutions – including fund of hedge fund financing and committed secured overdrafts for single hedge funds.

Clients benefit from having access to a stable funding source which does not come from the wholesale market but rather the custodian’s cash balances, which are independent of the repo market,

says Saulnier-Arrighi.

These benefits have also given rise to innovations in the custody solution space in recent years. “We have seen some providers emerge with advanced custody products to meet these additional financing requirements. In fact, BNP Paribas Securities Services recently launched a solution in this area called Agency Prime, which offers transparent cash and securities financing through a segregated custody account,” says McCluskey. “This gives clients full control over their collateral, backed by the classic asset safety of a custodian, and supported by a high-touch client service layer with customised reporting. Ultimately, this is about giving clients options when it comes to addressing their liquidity needs but also meeting their expectations from a user experience standpoint.”

Finally, Saulnier-Arrighi says custodians can assist hedge funds with managing their risk and volatility through the delivery of currency hedging tools. BNP Paribas Securities Services notably offers Passive Currency Overlay for portfolio hedging and share class hedging.

Managers turn to custody all-rounders

It is vital that hedge funds choose the right custody provider if they are to flourish amid the volatile market backdrop. 

At the very minimum, hedge funds need to choose providers who have a proven custody model, an extensive geographical footprint to facilitate distribution, and a stable balance sheet,

says McCluskey.

It is equally imperative that hedge funds appoint firms who can support a wide range of different asset classes. This is because the asset management industry – in general – is becoming very hybridised as managers launch strategies outside of their traditional remits in order to diversify returns and generate interest from new investor markets. For example, more hedge funds are moving further along the illiquidity spectrum by unveiling private equity and private debt products – both of which are strategies that have generated spectacular returns and benefited from record fundraising.

A pure custody player will struggle to address the needs of managers as they move further down the illiquidity spectrum. In an ideal world, managers should work with providers who can offer them custody, depositary, middle and back office, core administration, financing and prime services. By covering the full ecosystem, providers can help managers future proof their businesses by enabling them to expand into new strategies and instruments,

according to McCluskey.

Beyond the pivot towards illiquids, client demand and regulatory pressure is resulting in more hedge funds embracing ESG (Environmental, Social, Governance) – and this is something service providers need to accommodate for.  

For instance, managers are regularly asking their bank counterparties to provide them with sustainable financing.

We are having discussions with fund manager clients about sustainability-linked lending facilities. We discuss and structure KPIs (key performance indicators) with clients, and if the client meets the pre-agreed KPI targets, then they can obtain margin benefits on the funds borrowed. If they do not meet their KPIs, then the margin will increase,

says Saulnier-Arrighi.

Saulnier-Arrighi also says managers are scrutinising whether providers are up to speed with the latest industry developments in areas such as data analytics and digital assets. “The right custodian can add enormous value by helping fund managers standardise, aggregate and make sense of complex data feeds across multiple asset classes. By leveraging their technology and post-trade expertise, they can transform these data sets into actionable insights that support the decision-making processes of their clients.”

Custody balances as an enabler

Against a backdrop of shifting regulation, rising allocation, and convergence across strategies, the strategic value that custodians can add is increasingly coming into focus. For hedge fund and liquid alternative managers, the right custodian can enable growth strategies via additional yield generation, cash optimisation, hedging, financing, and distribution benefits.

If you have any questions or would like to know how we can support your growth strategy, please contact us.