Printer Friendly
 |
The financial crisis of 2008 has upset the relatively stable equilibrium previously enjoyed by hedge fund managers and their primary service providers. The basis of this equilibrium was the single prime model, which was particularly successful in allowing many early-stage hedge funds to develop into multi-billion dollar funds.
New, more costly requirements, resulting from the crisis are now converging to significantly increase the barriers to entry for new hedge fund managers. What's needed is a new model of prime brokerage, one that can support the new requirements in a cost-effective manner we are calling this new model The Multi-Prime Service Platform.
The sub-$500 million hedge fund segment represents the majority of all hedge funds and serves as the entry point for the vast majority of new entrants to the industry. It has always been a dynamic segment, with hundreds of funds entering and exiting on a yearly basis.
These funds follow a cycle of creative destruction, with only a few in each class graduating to multi-billion dollar status. This cycle and the relative ease with which funds can enter (and exit) is very much the basis for the success of the industry. This is also the segment that will be responsible for the regeneration of our industry with the launch of potentially thousands of new hedge funds in the coming years.
The two new requirements that are putting this recovery at risk are as follows:
Multi-Prime: The demise of Bear Stearns and Merrill Lynch, and the bankruptcy of Lehman Brothers in 2008, abruptly brought the subject of counter-party risk to center stage. Overnight multiple prime broker relationships became a prerequisite for all funds no matter the size and instantly increased the operational complexity (and cost) involved with launching a hedge fund.
Real-Time Technology: The credit crisis and the ensuing market volatility exposed some of the drawbacks of the legacy "T+1" technology used by hedge funds. Managers were forced to navigate the markets with systems that could only offer outdated views of risk and return. These legacy portfolio management systems (PMS) struggled with the real-time requirement because they pre-date the advent of the Financial Information Exchange (FIX) protocol and therefore cannot display the real-time impact of executions on a fund's risk and return profile. This lack of real-time transparency will no longer be tolerated Transparency begins with real-time data.
So what will this new real-time Multi-Prime Service Platform look like?
Outsourced - Historically hedge funds have resisted efforts to use outsourced solutions citing flexibility and privacy concerns. Firms now understand that the need to aggressively cut costs and focus solely on alpha generation trumps any past concerns about outsourcing. Fortunately, new real-time multi-prime solutions have emerged in the last few years that make outsourced technology much more compelling. These new integrated systems offer the breath of T+1 reporting of legacy systems combined with real-time aggregated views of critical data such as risk and P&L, all made available to a hedge fund manager via a thin client or browser.
Integrated - Hedge fund managers do not have the time or resources necessary to deal with multiple service providers. Ideally they want one point of contact through which they can access all of their critical services. The new Multi-Prime Service Platform model will mean that a fund can do business with one partner and still receive all the benefits of multiple prime relationships and state-of-the-art real-time technology. These service platforms could potentially include multi-prime services as well as fund administration on one common technology platform. There has always existed incredible duplication of effort across the hedge fund eco-system. In many cases hedge funds, prime brokers, and fund administrators all conduct the same middle and back-office processes using the same legacy technology. The industry can no longer support this inefficiency.
Flexible Pricing - The economies of scale achieved by an outsourced, integrated approach, will allow the providers of these Multi-Prime Service Platforms the ability to be much more flexible in the way that they charge for their services. Pricing will be competitive for even smaller hedge funds.
There is a major restructuring of the hedge fund industry underway. The traditional service providers to the segment, the top-tier primes, have signaled to the marketplace that without the assurance of the single prime model they can no longer service the sub-$500 million segment.
Other organizations such as the smaller primes, mini-primes and fund administrators are all now rushing to fill this service vacuum. Interestingly we are also seeing another group emerge these firms could not be adequately described as primes or fund administrators but rather hybrids of both.
The success of these providers to offer a cost-effective model that satisfies all the requirements now demanded by hedge fund investors—multi-prime capable, real-time data and transparency in reporting—will play a critical role in the rejuvenation of the hedge fund industry in the coming months and years.
Peter Curley is Managing Partner at Nirvana Solutions.
