As investors agitate for third-party valuation of assets, fund administrators see a big opportunity for growth. The increasing demand for independent valuation comes on the heels of an explosion in the amount of reconciliation work that administrators are already doing as concerns about credit risk expand the use of multiple prime brokers and other counterparties. But meeting that demand will come with sizable overhead costs because producing reliable numbers on hard-to-value illiquid securities can be expensive. The bottom line: New technology will likely prove the route to success, but upgrading is pricey, which means consolidation in the fund administration industry is probable. Servicing hedge funds is suddenly a much more complicated job — and potentially a much less profitable one too.
Many of the changes can be traced straight to last year’s collapse of Bear Stearns Cos. and Lehman Brothers Holdings, both of which were important prime brokerages for hedge funds. Add to that the fact that most banks are struggling and undercapitalized, leaving hedge funds in the position of having to spread counterparty risk around to more players than in the past. The result is a bewildering proliferation of parties from whom administrators must gather and reconcile pricing data to produce credible figures.
“Whereas you would previously have been reconciling with a single prime broker that held all cash and securities, you are now dealing with two to three prime brokers, five to ten over-the-counter derivatives counterparties, a custodian and an independent cash manager,” notes David Aldrich, a managing director of alternative investments and broker-dealer services at Bank of New York Mellon in London. “It is just a vast amount of reconciliation work.”
Handling the tangle of counterparties means increased operational costs for administrators, so — in spite of the new demand — fund administration as a stand-alone service is becoming less profitable. Some industry watchers suggest that where there was perhaps one administrator for sale this time last year there are six or seven today that would welcome a suitor.
The September 2008 merger of specialist hedge fund administrator Fulcrum Group and the funds servicing division of Bermuda-based Butterfield Fund Services illustrates the sort of investment that is required: The deal was facilitated by an $82 million cash injection by London-based private equity firm 3i Group, which will hold part ownership.
The merged company, Butterfield Fulcrum Group, is using some of the 3i money to launch a single, integrated-technology platform for clients across its seven office locations in Europe, North America and Asia. BFG, which has about $100 billion in assets under administration, expects to have the system fully operational by June and to begin to realize savings associated with the new economies of scale in the second half of the year.
In contrast with the aggressive positioning of such midtier hedge fund specialists, banks — which control about 60 percent of the administrative services market — may be unable or unwilling to maintain their market share. Although the smaller providers are almost all specialist administrators, banks with lucrative prime brokerage arms — such as Goldman Sachs Group and Citigroup — have traditionally used fund administration as a means to sell other services, principally stock lending, leverage and trade execution.
For banks the newly complex reconciliation and pricing services that are the backbone of independent valuation might be more costly than they are worth. This may only fuel the trend toward consolidation.
“I think we are likely to see sellers among universal banking groups divesting noncore assets to help recapitalization efforts,” concludes Steven Forsyth of London-based management consulting firm Morse. “This will be mirrored by consolidation on the part of those small or midtier suppliers unable to contain higher operating costs or loss-leading services.”
