The 2015 Alpha Awards: Top Administrators

The need for ever-more-advanced technology is changing the hedge fund administration industry — and cutting into an important decision that big banks have to make about whether to build or shed their administration businesses.

James Kelly set out to distinguish HedgeServ as the hedge fund administration firm with the most advanced technology possible from the start, when he co-founded HedgeServ in 2007 with Justin Nadler, Robert Aaron and Eugene Mannella. But a year ago chairman Kelly decided it was time to invest in a big technology upgrade, and he brought in new experts. Some came from outside the traditional financial services industry — a move Kelly says will help bring a broader perspective to the firm’s technological capabilities and functionality. Kelly also brought in experts in cybersecurity, just in time for the U.S. Securities and Exchange Commission’s first-ever roundtable on the subject, last April. Since that meeting the SEC has begun to demand that hedge fund managers be able to demonstrate their ability to guard their data against cybercriminals seeking to expose their trading secrets or steal their capital.

Increasingly, fund managers are turning to their administrators for advice on protecting their in-house data — and expecting the administrators to have stringent safeguards on the client data that is under their care. “We think advanced technology is going to be the key to providing the best administration services in the future,” Kelly says.

Perhaps in part because of its focus on technology, HedgeServ ranks No. 1 among administrators in the Alpha Awards for the third year in a row. The awards are based on a survey of more than 625 hedge fund firms. We asked fund managers to rate the quality of service they received from their administrators over the past year in nine major areas.

HedgeServ is midsize by administrator standards, with $240 billion in assets under administration and 750 employees in its offices in New York, Boston, the U.K., Grand Cayman and Australia.

Besides sounding warnings to clients about potential cyberleaks, HedgeServ tracks trades and the costs associated with trading in real time and updates data daily, making it easier for clients to keep up with a constant barrage of regulatory reports, including documentation required by the SEC, the U.S. Foreign Account Tax Compliance Act and the Alternative Investment Fund Managers Directive for all funds that market in the European Union.

The administrators that rank at the top of the survey have been investing heavily in advanced technology for the past few years, both for cybersecurity and for trading (the latter helps clients see what they’re spending versus what they’re earning on their portfolio positions each day). It may be significant that those in the top four slots are either independent administrators (HedgeServ and No. 3 Citco Fund Services) or administration businesses owned by custodian banks rather than investment banks (second-ranked Northern Trust Hedge Fund Services and No. 4 State Street Alternative Investment Solutions). The administrators themselves say that now more than ever it is important for them to be able to make quick decisions, especially about technology spending, without having to go through too many management layers.

At the end of every year, London-based industry research firm Preqin produces a 100-plus-page survey looking at the state of the hedge fund industry and its service providers. Last year Preqin’s study called 2013 “the year of increased collaboration between administrators and hedge fund managers” and 2012 the year “characterized by consolidation activity.” The study for 2014, which came out in January, didn’t have a label for the year, but Jay Peller, global head of sales and marketing at Citco in New York, offers one: “It was the year of big data,” he says.

About 15 to 20 percent of Citco’s annual revenue is invested in technology, with the goals of letting clients know where all aspects of their trading and their businesses stand at any given moment and protecting clients’ data from cyberintrusions, says Peller. When the Swiss National Bank unexpectedly removed the cap on the value of the Swiss franc against the euro in January, for example, Citco had to quickly provide hedge fund clients with data on how the rising franc was affecting their portfolio holdings.

Peller says clients also need daily reporting on their tax liabilities, which is something an administrator used to provide once a year. Others say hedge fund managers now are more worried about how taxes will affect their earnings because it has become harder to produce strong returns — a fact of life that adds to the need for administrators to churn out data throughout the trading day and beyond.

“Everything is faster now than it was a few years ago,” Peller says. “Real time is where you need to be. Managers need to think about how they are going to manage big data. The velocity and volume of the data are the key reason we continue to invest in our reporting infrastructure.”

Citco is the second-largest administrator in the world after State Street, with $840 billion in assets under administration, and serves about 13 percent of all hedge fund firms, according to Preqin. The firm has about 700 people around the world on its technology staff. “There are huge opportunities for administrators, all revolving around providing data,” Peller adds.

For Northern Trust, advanced technology was an important factor in bringing the administration business into Alpha’s top rankings. The firm, which rises to the No. 2 spot from No. 8 last year, has grown by some 85 percent since the middle of 2014, with $301.5 billion in assets under administration and 3 percent of hedge fund market share, according to the Preqin study. The rapid growth was largely the result of gaining Bridgewater Associates as a client; the relationship went live in August 2014. Bridgewater retains Northern Trust to shadow its main administrator, BNY Mellon Alternative Investment Services, replicating BNY Mellon’s processes so that Bridgewater can compare the data from accounting, net asset value calculations, collateral management and other standard services.

In the Alpha Awards survey, Northern Trust scored particularly high in the very data-dependent areas of Cash & Collateral Management (No. 1), Clearing & Settlement (No. 1) and Reporting & Reporting Technology (No. 2), as well as Hedge Fund Expertise (No. 2). Peter Sanchez, CEO at Chicago-based Northern Trust Hedge Fund Services, says the firm’s managers have been paying particular attention to technology that is designed to shadow other administrators and follow a hedge fund’s daily activities. “We have technology that can trace the whole life cycle of a fund’s NAV,” he says. “The fund manager can trace each transaction and see its cash flows, profit and loss and related impact on positions as they’re getting produced.”

Among the top-ranking administrators, the highest marks for Bank Debt & Derivatives Support — another technology-heavy service — go to State Street (No. 1) and Citco (No. 2). These days, hedge funds trade less bank debt but a great many derivative instruments. An administrator has to play a very active role in establishing the valuation for over-the-counter derivatives and reconciling it with the value set by the prime broker and other counterparties.

“There’s a science to reconciling derivatives, especially the more esoteric ones,” says George Sullivan, global head of Boston-based State Street Alternative Investment Solutions. “We build models that take input from the marketplace, then we process those numbers through our algorithms.”

The hedge fund administration industry is no stranger to mergers and acquisitions. The biggest firms have long had an advantage in being equipped to offer the range of expertise that large hedge funds need, and consolidation has been a way to achieve growth.

Now the industry is on the verge of further reshuffling, in large part because to compete in the current climate an administrator has to be part of a company that is willing to invest heavily in technology and continuous upgrades. And although the capital requirements of the Basel III accord affect custodian banks and investment banks alike, it’s often easier for custodian banks to justify having an administration business than it is for an investment bank or a big bank that has both investment banking and custodian divisions. In the past, the biggest investment banks offered a wide range of products and services, but now, to comply with Basel III, they have to examine which divisions contribute revenue that can add to capital reserves and shed those businesses that require too much expenditure in proportion to the revenue they bring in. Revenue from administration has to justify the effort needed to run the business — not just the technology investment but also the increasing amount of time that must be devoted to such services as establishing NAVs and talking to investors to provide the details they demand about hedge fund clients’ earnings, expenses, regulatory compliance, cybersecurity and the like.

“Hedge fund administration doesn’t rise to the level of strategic importance with many investment banks,” Sullivan says. “We’re a trust and custodian, so being a bank that provides administration to client assets is part of our core. When you can tell an institutional investor that you’re the custodian of a certain percentage of a hedge fund’s assets, it plays well to the investor’s mind-set.”

As head of State Street’s administration business, Sullivan knows there can be a big difference between an administrative unit that belongs to a custodian bank and one that belongs to an investment bank. In the summer of 2012, State Street, which now has $896.6 billion in hedge fund assets, bought Goldman Sachs Group’s administration division. Goldman sold the business, with $200 billion in assets under administration, because it wasn’t prepared to invest in the in-house regulatory expertise that administrators needed as the Dodd-Frank Wall Street Reform and Consumer Protection Act came into full effect.

This trend includes the No. 5 administrator in this year’s Alpha Awards, Citi Hedge Fund Services, which has $380 billion under administration. In January of this year, Citigroup CEO Michael Corbat announced in the bank’s fourth-quarter 2014 earnings call that Citi was going to exit the hedge fund administration business.

Clients might like Citi Hedge Fund Services, but Citigroup’s senior managers determined that hedge fund administration wasn’t critical to the bank’s future growth strategy. The administration division is now under the umbrella of Citi Holdings, where the bank houses noncore businesses. Its operations will continue while the bank determines how it will shed the operation. People familiar with the situation say Bank of New York Mellon Corp. is the leading potential acquirer, although there is a possibility that a private equity group will buy it, as well as one or more independent administrators.

Administration is a highly competitive industry, and some of Citi’s competitors view the new development with optimism, if not outright glee. “Sometimes banks go through different phases of determining what they are,” says HedgeServ’s Kelly. As an independent administrator, however, “we don’t have to figure out who we are and what we want to be.” Northern Trust’s Sanchez thinks that because big banks with prime broker businesses need to be selective about their capital and balance-sheet usage, administrators have an opportunity in the next few years to expand their services, possibly even supplementing prime brokers as securities lenders to some extent.

But some of the bigger banks are looking at administration as a business that might work well for them. JPMorgan Chase & Co. has plans to boost its administration business, J.P. Morgan Global Fund Services, which now has about $137 billion in assets under administration. And in the first half of this year, BNP Paribas is expected to complete an acquisition of the fund administration unit of Credit Suisse Prime Fund Services. Preqin’s new survey says the acquisition could move BNP Paribas into the top ten administrative businesses by asset size and market share, capturing about 3 percent of hedge funds globally. Credit Suisse’s plan, according to a spokeswoman, is to sell the administration unit and focus on prime brokerage services.

“Last year wasn’t the busiest year for consolidation, but there will be more over time,” says Sullivan. a

— Jan Alexander

HOW WE COMPILED THE RANKINGS
Institutional Investor’s Alpha compiled the 2015 Alpha Awards ranking of top prime brokers, hedge fund administrators, law firms and accounting firms based on voting from last fall and early winter by more than 625 hedge fund firms, including many in the 2014 Hedge Fund 100, our ranking of the world’s 100 largest hedge fund firms. This year’s survey voter universe was based on hedge fund contacts supplied by Ipreo’s Bigdough database of global institutional contacts, profiles and ownership data, in addition to Institutional Investor’s own internal contact files. Hedge funds were asked to rate the quality of service they received for the 12 months ended August 31, 2014, across a variety of attributes. The scores were weighted according to a voting firm’s assets under management and then averaged for each service provider within each attribute. In the accompanying tables we rank only those firms for which we received a minimum number of responses. To be considered for the overall ranking, prime brokers needed to rank in at least seven of the ten prime brokerage attributes; administrators needed to rank in at least five of the nine hedge fund administration attributes; law firms needed to rank in at least four of the six law firm attributes; and accounting firms needed to rank in at least four of the five attributes. The Alpha Awards survey was conducted by Senior Research Editor Jane B. Kenney.