August 12, 2013

Financial institutions are no strangers to outsourcing of back and middle office tasks, but their hedge fund peers did not often partake. Their typically small-sized operations and wish to protect their secret sauce would hold them back from outsourcing, and not so long ago, money flowed freer, causing them to overlook the cost benefits. No longer.

“Outsourcing in institutional world is a mature market,” explains Gary Brackenridge, Linedata's Global Head of Business for Hedge Funds. “It’s been happening for years. We had never really seen the same trend in hedge funds; they are at a different scale and think they have different needs. If you go to visit them, it’s usually the guy in the corner doing their back office work.”

But over the past few years, Brackenridge has seen tremendous interest in hedge funds getting their back end out of the office. “We talk with clients every day, many clients are just calling to ask what we think.” Today, he conservatively guesses 25-30% of hedge funds are actively searching for outsourcers or have some process underway, while another 30% are in discussion internally, asking themselves if outsourcing is right for them. “Five to ten years ago those numbers would be closer to 5% and 0%.”

Rumor Has It

Of the 20-25% of hedge funds actively outsourcing, it’s typically back office and middle office functions like reconciliations, trade breaks, reporting pieces, and the daily care and feed of trading.

“Beyond the back office we are now seeing interest from some clients thinking ‘what else can we outsource?’” explains Brackenridge. “Understand, if they are a business meant to raise and invest, everything else they do they could technically have others doing for them.” It’s this sort of thinking that has led to some surprising demand for front-office outsourcing.

[For more on alpha generating tools read: 3 Ways IBOR Can Improve Alpha, see Rick McCarthy's related story.]

So what high-level tasks are on the cutting block? Brackenridge says research, or the collecting and managing of data. Analytics, which includes investment decisions support and compiling risk components, and actual trading work like trade executions. Historically, hedge funds always did these tasks themselves. “There is finally interest in U.S. in exploring third party front end functions. That never happened before in the institutional side in significant way, but there's at least 5 discussions from hedge funds I'm aware of in the US in that vein.”

He adds that service providers are rising to the challenge when they can, but there really isn’t an industry for this yet. “We didn't see this trend before. On the institutional side, portfolio managers were locked away in trading towers, this outsourcing would be new to any market.”

Time to Make a Change

“Control, complexity, costs, scale, and knowledge of talent available in markets are the underpinning of why people are outsourcing,” says Brackenridge. He explains:

Complexity is a problem in hedge funds, their teams are having a more difficult time making returns now that the equity market is loaded with cheap money from the government. In their quest for alpha, many have turned to investing in more unusual assets like mortality bonds and bank debt. This comes with some unique back-end responsibilities. “When you invest in those things, you have to account for them, know where they are, your exposure, management, etc. As a rule, [hedge funds] always did that, but it is driving complexity way up, especially as they are struggling to make profits.” Consequentially, they are struggling with the idea of hiring more back-end workers who aren't exactly making money for the firm.

This alludes to the serious issues of cost. Administrative tasks are still bogging down high-level workers, but blatantly allocating sources to more low-end work comes as an assault to their money-saving ambitions. “Imagine,” says Brackenridge. “You're not hitting hurdle rates and not getting fees. You’re trying to run the business with smallest cost base you can find.” He recalls a client who has outsourced mid and back functions, and reported an operating cost reduction of 27%. “It took 6 months longer than they had hoped but they still have an ROI and they’re confident they made the right choice.

“Before cost wasn't as important, they didn't make business and tech decisions purely on cost, if they were making money and returns then there was money enough to go around. They weren't required to be efficient.”

Control has also been a significant challenge with outsourcing. For some, outsourcing to big providers is per acceptability, they have to be comfortable it will work. Many of the existing outsourcers for institutional clients are enhancing their offerings so hedge fund clients still feel they are in control.

Outsourcing Compliance? Forget It.

Of all the outsourcing, back, middle and soon the front end, nowhere will you see the complete outsourcing of compliance. Despite regulation’s placement as a top priority for all financial firms, the risk of outsourcing it is too great and no service provider is willing to offer a solution to take on others' compliance as the penalties for mistakes are too high. All outsourcers and service providers can do is help through tools and services.

That’s not to say there’s no demand for compliance outsourcing, it’s just such a new and complex problem that there’s no standard solution. Brackenridge puts its best, “Compliance outsourcing is being talked to death and still nobody knows what to do, there's no actual effective outcome to people talking. The issue is over-talked and under-delivered. There's a lot of change coming and it's going to be hard.”

Complicating the matter of regulation, hedge funds are struggling to stay on top of what's happening globally, because that’s where they are looking for returns. Each jurisdiction where they trade makes their own rules, and the various complex instruments they trade will also be subject to complex regulations and disclosures. “There’s a need for transparency, complexity is going up, costs must come down, regulation pieces are constantly changing and always unclear, and nobody around to tell you what to do,” says Brackenridge. “To manage their regulatory obligations hedge funds need special expertise and a set of easily consumed technology as a service."

Linedata is one of the firms heavily investing in assistive products and services, from reporting, PNL, evaluations, trade processing, and more. “Big providers like ours work to expand compliance side solutions but it's not really clear where it all ends. It's such a new and complex problem that it's still wide open. Some people do in house, some outsource, some buy a solution, some buy advice and then continue to use excel,” says Brackenridge.

“We believe this is where the market is going. Our expertise, budget, staff, discussions are all centered on helping clients understand outsourcing, introducing them to providers we think are good and have the technology to offer control." Linedata is also launching a new business just around compliance as a managed service. "We’re taking the data where we have it and applying it to a set of rules to let them know how it reacts with regulations. We are also beefing up in-house expertise because clients are desperate for advice.”

He adds. “This is an offering nobody was asking for 3 years ago. People were managing with spreadsheets but it’s a new deal now.”

ABOUT THE AUTHOR
Before joining UBM Becca served as Editor-In-Chief at Kapitall Wire, the sister site to an online brokerage firm that combines the challenges of the stock market with the thrill of ...