Alternative investment fund managers reassess their service provider relationships

This INDOS Financial article was first published by HFM Week and can be read here.

The latter half of 2018 will be a period of relative contemplation for the fund management industry, having spent the last few years priming itself for compliance with MiFID II and GDPR, both of which have been labour and cost-intensive exercises. The volume of regulations introduced following the crisis has diverted managers’ stretched resources, and deterred them from reassessing or revisiting historic service provider relationships and outsourcing arrangements, but the coming legislative hiatus could change all of that.

In a world of reduced margins, cost sensitivities are high at many managers and they are looking for operational efficiencies and ways to manage costs more effectively across their businesses. Competition for business in fund administration remains high, while market rates for services have reduced, even despite the M&A activity that has taken place in the sector. The range of outsourced services on offer is also much broader.

In areas such as depositary, managers typically accepted the pricing proposed by providers in 2014 when AIFMD was introduced.  While administrators typically scale down their fees as clients’ Assets under Management (AuM) grow, depositary costs were frequently fixed at around two basis points. This means a $250 million fund will pay $50,000 per year in depositary fees, but if it were to increase its AuM to $1 billion, those costs would shoot up to $200,000. This has prompted some managers to question the value of the service received.

A May 2017 study by Preqin found that 55% of hedge funds who changed service providers did so because of costs. Cost is not the sole reason for shifting business, with a growing number of smaller managers changing providers because they require a more focused service delivery versus what they are receiving already. Larger firms, or those whose AuM has grown significantly in recent years, are looking for more tailored fee structures that reflect the current size of their business.

Service provider change could also be driven by the recent Financial Conduct Authority’s (FCA) Asset Management Market Study final report, which despite targeting traditional UK asset management companies, may permeate into the alternative funds’ sector. The FCA wants to see firms focus on value for money as part of their duty to act in the best interests of their investors.

The same FCA report also put a lot of emphasis on fund governance, acknowledging it was an area that required substantive improvements. The regulator will require managers of UK authorised funds to appoint a minimum of two independent directors, and for them to comprise at least 25% of the total board membership. While these rules do not currently affect hedge funds, it is reflective of the continued focus being placed by regulators generally on strong independent boards and fund governance more generally.

Some providers have come under criticism for inactivity or poor service delivery. The Preqin study also found that 41% of hedge funds who switched provider did so because the service was inadequate.  Over the past year, INDOS has seen managers and independent fund board members ask more questions about the value and quality of service provided by third party vendors. This has led to several managers transitioning a variety of business to different providers across fund administration, depositary, or audit.

Robust governance will continue to lead to more unbundling of depositary and administration for fears that that these consolidated offerings are vulnerable to conflict of interest risk. A strong, independent depositary and administrator can help complement governance practices, by providing regular and detailed information flows about the funds’ operations and assets to directors.

Inefficiencies or poor service provider delivery have frequently been tolerated by managers, often because they incorrectly assume that switching fund administrator is a disruptive and expensive process, and one that could be viewed negatively by investors. While it used to be quite operationally onerous to change providers, improvements in technology and transition management have made the process more straight forward and investors now recognise a change in service provider relationships can also be in their best interests.

This rare regulatory interlude is an excellent opportunity for managers to scrutinise their providers and identify whether they are getting the service and value that is expected. During the remainder of 2018 and 2019, there is likely to be more movement as managers start issuing RFPs.