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 Matthew Nelson
Director, Market Intelligence
The results from Greenwich Associates’ recent survey, “A New Dawn for Hedge Fund Operations”, provides interesting insights into the changed role of operations in the hedge fund industry. Historically operations were an afterthought, with portfolio managers and traders getting all the attention. But as a result of the Madoff scandal, the Lehman Brothers collapse, and several other high profile incidents that had a direct connection to operations, the paradigm has changed.
One of, if not the most important statistics to come out of the Greenwich survey is that 66% of the respondents directly correlate operations with their firm’s ability to attract investors and raise capital. Although no definite number exists, there are estimates that 20% of hedge fund managers closed shop as a result of the recent economic crisis, with many more managers sinking deeply below their high watermarks (the asset minimum necessary to trigger performance based fees, usually 20% of profits). This has resulted in a more concentrated industry, marked by high levels of competition. The struggle to attract investor capital has never been harder and it’s clear that demonstrating sound operational infrastructure, policies, and procedures are a necessary to attract and retain capital.
What exactly are hedge funds changing from an operations perspective? Based on the results of the survey, funds are looking to automate position reconciliation, cash management, collateral management, and pricing. Not surprisingly, given recent counterparty-related events, the majority of funds have taken steps to mitigate counterparty risk, including increasing their number of prime brokers. In the past, funds would add prime brokers as their assets grew to access new sources of funding and pools of liquidity in order to spread their book around, not allowing any one broker to see their entire strategy. Today, the possibility of another Bear Stearns or Lehman “event” is a key reason for adding prime brokers. Eighteen months after Lehman’s bankruptcy, clients of the London prime brokerage unit were still attempting to recapture their rehypothecated assets (“rehypothecation” refers to the practice of brokers pledging their clients’ collateral to secure their own loans). Adding a prime broker is not without challenges because it increases the operational and technological burden placed on the fund manager who must manage connectivity and data, among other things, in-house.
Clearly, it’s a new world for hedge funds, one which requires more than just a novel trading strategy and a desktop terminal. To attract institutional and high net worth assets, hedge funds need to show that they are as trustworthy as the biggest firms and have all of the same operational infrastructure in place. Failure to do so will leave them out in the cold.
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