It has been widely reported that some fund administrators have been exiting a number of client relationships to refocus their efforts on larger, more profitable clients. Some prime brokers have been taking similar steps. At a time when hedge funds are facing many challenges, not least because of the significant increase in regulation over recent years, these actions are placing small to medium-sized managers under more unwelcome pressure and causing business disruption.
Given the maturity of the traditional hedge fund market, administrators have faced limited opportunities to grow organically and many of the larger players have grown scale through acquisition over recent years. Competition for new business has been intense. Managers impacted by the changes have therefore often not been expecting to be on the receiving end of the notice phone call. On closer inspection, there are likely to be a range of contributing factors behind the decisions.
Competition to win business and pressure from managers seeking to reduce costs has meant fund administration fees have reduced over recent years. Some administrators, faced with increasing costs from a continual need to invest in and upgrade (often legacy) technology, and to meet increasing demands from managers in areas such as regulatory reporting, are finding that some relationships are no-longer profitable once direct and indirect business overhead costs are allocated down to the client level. Administrators either need to re-price their businesses or exit less profitable relationships. Some are simply opting for the latter.
Another reason which impacts larger bank owned administrators more-so than other independent providers stems from pressure on other higher margin services such as securities lending and foreign exchange which firms have cross sold to fund administration clients. Once accepted business practices in these and other ancillary service lines have been subject to regulatory or other challenge over recent year. This has also impacted the overall level of revenue and profitability clients generate for the group.
Risk aversion could also be playing a part. Since the financial crisis there has been a general increase in fines and regulatory sanctions on service providers as a whole for control failures and operational shortcomings. This has resulted in some service providers becoming more risk averse and scaling back the number of client relationships to a smaller number of larger clients.
Finally, some administrators are now re-allocating resources to capitalise on growth areas, such as the growing liquid alternatives industry in the US and the increasing outsourcing of administration by private equity firms.
The reasons are clearer in the prime brokerage market. The principal driver is Basel III, new regulations which impose capital and liquidity requirements on banks. These rules adversely affect a prime broker’s ability or willingness to provide financing to hedge funds. As a result, a number of prime brokers have been reviewing their client base to focus on more profitable relationships or those running strategies less impacted by the changes. As a result, reports suggest we may see a substantial increase in synthetic prime brokerage or new entrants from outside the traditional PB industry offering alternative sources of financing to funds.
Some industry predictions suggested that factors such as increasing regulation would result in a consolidation of business with the largest providers and that it would become harder for smaller players to compete. Instead we are seeing an increasing bifurcation of the providers and solutions available to large and small-to-mid sized (say up to $500m) managers. Going forward small-to-mid sized managers will increasingly need to look to other service providers that are more suited, able and willing to meet their financing and administration requirements. This should spell an opportunity for tier two banks, independent administrators and other niche service providers. Time will tell whether the decision to exit relationships is short-sighted given some smaller managers of today will no-doubt become some of the big managers of the future.
An abridged version of this article has also appeared in HFM Week (www.hfmweek.com).