download fueling growth outsourcing solutions for hedge funds

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Contents

Market Overview ................................2

Important Service Partners .............. 9

Challenges in Finding the Right Outsourcing Partner ..........................11

Considerations for Outsourcing .... 13

Road Map to Outsourcing .............. 15

External Evaluation ...........................16

Conclusion ..........................................19

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Fueling Growth: Outsourcing Solutions for Hedge Funds

The hedge fund industry has played a pivotal role in significantly altering the competitive landscape of capital markets, having grown exponentially both in size and complexity over the past decade. After years of unprecedented growth, however, the hedge fund industry now faces challenges as the global economy struggles to find stability in today’s volatile market climate. An increase in client redemption requests is threatening the viability of even the most well-managed funds. In response, hedge funds are reassessing both their investment strategies and operational infrastructures in search of additional efficiencies and positive impact to their bottom line, as well as to satisfy investor requests to outsource more operational and administrative functions to third parties. Areas of focus include counterparty risk and key service provider relationships, such as those with prime brokers, fund administrators and information technology (IT) vendors. In today’s complex economic environment, selecting the right combination of business partners is essential to the long-term success of a hedge fund.

Based on conversations with numerous hedge funds and prime brokers, Fueling Growth: Outsourcing Solutions for Hedge Funds, commissioned by Pershing LLC and produced by Aite Group LLC, examines critical hedge fund operations and their potential for outsourcing to drive business growth and free up valuable internal resources, as well as the increasing demand by investors to leverage more third-party service providers. This study provides a systematic framework for the internal and external assessments designed to assist hedge fund managers in selecting and developing productive outsourcing relationships.

While the overall market retrenched between 2001 and 2003, hedge fund assets boomed, pushing hedge funds to the forefront of the investment management industry. No other investment product grew at such a dramatic rate. By the end of 2007, hedge funds represented $1.87 trillion in assets under management (AUM). By the end of 2008, however, months of turbulent market conditions caused by the credit crisis began to negatively impact the hedge fund industry, leaving the market with approximately 6,800 hedge funds, which represent $1.4 trillion in AUM.1

1 HFR Global Hedge Fund Industry Report, Q4 2008, Hedge Fund Research, Inc. and research by Aite Group.

2 FuELInG GROWTH: OuTSOuRCInG SOLuTIOnS FOR HEdGE FundS

Figure 1. Declining Hedge Fund Market

AUM Number of Hedge Funds

Source: Hedge Fund Research, Inc., Aite Group estimates

2005 2006 2007 2008 2009 2010 20110.00.20.40.60.81.01.21.41.61.82.0

0

1.000

2.000

3.000

4.000

5.000

6.000

7.000

8.000

9.000

US$

Tril

lions

Num

ber of Hedge Funds

During their rise, hedge funds were innovators and drivers of sophisticated investment approaches, often adopting complex technical and statistical strategies. The hedge fund community fundamentally changed how global financial markets operate. Hedge funds contributed to a trading environment that now operates at unprecedented speed, increasing demand for a high-performance trading IT infrastructure and low-latency trading solutions.

The market influence of hedge funds created an entire outsourcing industry—ranging from prime brokers and hedge fund administrators to law firms and IT vendors—dedicated to the overall growth of hedge funds. Since the end of 2007, however, the hedge fund community has faced a tough investment environment. In 2009, as hedge funds struggle to recover from heavy losses, the need for outsourcing support may increase as fund managers concentrate on evaluating investment options and managing client relationships for higher returns. In the current market environment, hedge funds face mounting challenges in assessing the best direction for their business.

Market Overview

Reexamining Critical Functions of Hedge Fund Operations

With the high volatility and regulatory uncertainty of today’s market, hedge fund managers need to revisit their overall approach to operations. Identifying critical functions to determine which areas are suitable for outsourcing can result in more time available to spend on important client-facing activities and investment decisions.

Figure 2: Critical Functions of Hedge Fund Operations

– Trading and processing– Business continuity and disaster recovery planning– Investment process– Client servicing– IT infrastructure– Middle- and back-office processing– Legal compliance– Marketing and business development– Capital raising– Recruiting– Accounting

Source: Interviews with hedge funds and prime brokers, Aite Group

In order to successfully launch and operate a hedge fund, the responsibility for the vital functions outlined above should be assigned as early as possible. The primary undertaking of a hedge fund manager is to design, develop and implement an investment philosophy and strategy that aim to generate alpha for the firm and its investors. Three key positions within a hedge fund support this important endeavor:

> Chief investment officer (CIO). The CIO, a role typically occupied by the founder of a hedge fund, lays out the essential steps to constructing and maintaining a portfolio and the investment process by taking into account investable instruments, risk tolerance levels, asset allocation preferences and metrics for performance measurement. The investment process dictates the decisions of a fund.

> Risk manager. The risk manager supports the evaluation of the investment process by applying and monitoring the appropriate levels of risk assumed by the firm.

> Compliance officer. The compliance officer monitors adherence to investment guidelines and policies.

All other roles support those primary functions and are essential to ensuring that hedge fund managers can maintain their focus on producing alpha and developing relationships. Some of the key operational functions of hedge funds include:

> Trading and processing. A few of the more actively traded hedge funds have developed sophisticated platforms to drive their trading. Some of the quantitatively driven funds have also applied automated trading strategies, which allow them to rely on internally developed infrastructure to conduct low-latency trading. Most hedge funds, however, rely on their prime brokers, as well as other third-party service providers for support, not only in terms of facilitating trading and providing post-trade services, but also with decisions on appropriate third-party trading tools such as order management systems (OMSs) and execution management systems (EMSs).

IdEAS WITHOuT LIMITS 3


Figure 3: Trading and Processing

Insource– Investment model development– Algorithm development– Tradesignal generation– Trading platforms

Outsource– Order capture and routing– Connectivity to execution venues– Post-trade processing– Trading platforms– Managed accounts

Leading Providers– Prime brokers– Execution brokers– Trading networks– Clearing firms– Third-party technology vendors


Hedge funds have far greater access to third-party technology systems in trading and portfolio management than they did even five years ago. Leading prime brokers have developed internal consulting functions to assist hedge funds in evaluating many of the available trading technology options. The broker-dealer community has also been very active in raising the adoption of electronic trading and marketing sophisticated algorithms to assist hedge funds in navigating through changing market conditions across multiple asset classes.

In the over-the-counter derivatives (OTCD) market, trading activities are still conducted over the phone and are typically negotiated privately. The processing of such trades is extremely complex, as the OTCD market is laden with complicated legal and confirmation paperwork. Prime brokers have been quite active in the OTCD market, providing for their clients the necessary operational and regulatory infrastructure, including:

> Client servicing. In this role, an individual or a team of client service specialists maintains communication with both prospective and existing investors. Critical responsibilities include developing and maintaining client distribution lists, constructing and distributing client reports in a timely manner and client onboarding. Client service is also particularly instrumental in cross-selling new funds to current investors as hedge funds grow and expand product offerings. Client-servicing functions can be done internally or outsourced.

New hedge funds typically outsource many client servicing functions so that they can focus on their core competencies. Funds with a robust middle-office operational infrastructure have built their client-servicing capabilities internally. However, as funds move into more sophisticated instruments such as OTCDs and attract clients globally, outsourcing client-servicing responsibilities enables fund managers to focus on generating alpha without fundamentally altering their middle-office capabilities.


Figure 4: Client Servicing

Insource– Communication with clients and prospects– Client reporting– Client distribution list– Client onboarding– Financial statements

Outsource– Communication with clients and prospects– Client reporting– Client distribution list– Client onboarding– Financial statements

Leading Providers– Prime brokers– Hedge fund administrators


> IT infrastructure. In today’s competitive and low-latency environment, the development of a robust IT infrastructure has become increasingly important to the longevity of a hedge fund. Foundational IT selections, such as integrated voice and electronic communications platforms, network infrastructure, security solutions and data center capacity and availability, help hedge funds more efficiently scale with their growing business. However, constructing and maintaining an effective IT infrastructure often taxes much-needed resources.

Figure 5: IT Infrastructure

Insource– Trading platform– Market data platform

Outsource– Trading turrets– Telecom– Trading and market data platform– Trading network– Collocation– Trading desks

Leading Providers– Prime brokers– Execution brokers– Turret vendors– Telecom providers– Third-party trading vendors– Exchanges and alternative trading systems (ATs)– Third-party network providers– data centers


> Middle-office and back-office processing. Fund administration, including record keeping, net asset value (NAV) calculations and fund statements, is essentially a commoditized service that hedge funds, particularly those in Europe, frequently outsource. The more difficult middle- and back-office functions, including portfolio accounting, risk management, performance measurement, collateral management and client reporting, may be performed in-house or by hedge fund administrators and prime brokers. Investment operational processing requires specialized skill sets. Whether done in-house or outsourced, these critical investment support functions are both complex and expensive.


Figure 6: Middle-Office and Back-Office Processing

Insource– Portfolio accounting– Risk management– Performance measurement– Collateral management

Outsource– Custody– nAV calculations– Fund statements– Portfolio accounting– Risk management– Performance measurement– Collateral management

Leading Providers– Prime brokers– Hedge fund administrators– Custodians


> Capital raising. Hedge funds often employ an institutional-quality sales person who, in addition to the founders of the fund, helps raise capital. Hedge funds also have the option to hire marketers to raise capital and maintain investor contact. These firms work on retainer or on a percentage of the hedge fund fees. In addition to direct sales to the end investor, a sales executive also contacts hedge funds of funds and investment consultants in the capital-raising initiative. Investment consultants are an active part of the institutional investor community.

Prime brokers serve to introduce capital to hedge funds by setting up private meetings and hosting invitation-only events and conferences. There are also independent firms that act as liaisons to match hedge funds with investors.

Social networking sites on the Internet are a recent development in hedge fund marketing. A few invitation-only web sites have been established for accredited investors. They seek to provide communication forums among hedge funds investors, who exchange stories, share ideas and research hedge funds for investment opportunities.

Figure 7: Capital Raising

Insource– Investor solicitation– Events– Ongoing investor contact

Outsource– Investor solicitation– Events– Ongoing investor contact– Capital introduction

Leading Providers– Prime brokers– Hedge fund administrators– Custodians


> Marketing and business development. The institutional-quality business development person who spearheads the initial capital-raising drive often also leads ongoing business development. While hedge fund firms are legally prohibited from advertising, there are a few marketing options. Generally, these options are available through intermediaries who validate that the end investor is suitable for a particular hedge fund investment.


Market visibility increases through participation with industry database providers. These databases serve accredited investors and qualified institutions who subscribe to various online search databases and newsletters. Hedge funds report basic information about their firm and funds, including investment performance, but they do not list fees. Graphic design and marketing firms also assist hedge funds with the development of marketing materials, including company brochures, profiles, performance supplements and investor presentations.

Figure 8: Marketing and Business Development

Insource– Investor solicitation– Relationship development with investment

consultants– Industry database participation– Marketing materials development

Outsource– Investor solicitation–Investor database participation– Marketing materials development

Leading Providers– Third-party marketers– Industry database providers


> Business Continuity and Disaster Recovery Planning. As reliance on technology increases, hedge funds are spending more time and resources on developing and maintaining long-term business continuity plans to protect against unforeseen natural or manmade disasters. These plans assist hedge funds with addressing potential communication and data access interruptions after unexpected system failures or disastrous events.

A disaster recovery plan enables a hedge fund to quickly recover business-critical information, redeploy human resources and resume systems operations. The frequent reliance of hedge funds on rapid trading, combined with volatile capital markets, has elevated the critical nature of business continuity planning. Pershing Prime Services’ Establishing Business Continuity and Disaster Recovery Plans: A Hedge Fund Manager’s Guide, was recently developed by Pershing LLC in partnership with colleagues across BNY Mellon and Eze Castle Integration. This guidebook provides hedge fund managers with concepts to consider when creating plans to minimize financial loss and the negative effects of downtime so their firms are better able to react swiftly and methodically when confronted with unexpected business disruptions.

Figure 9: Business Continuity and Disaster Recovery Planning

Insource– Business continuity plan development– In-house backup facility setup

Outsource– Business continuity plan development– Critical operations offsite hosting

Leading Providers– disaster recovery planning and business

continuity planning specialists– Prime brokers– data centers– Management consultants



> Legal, compliance and accounting. These functions are essential components of starting and operating a hedge fund, including registering the hedge fund as a legal entity, developing fund and tax structures, developing a compliance structure and maintaining documentation. Compliance is critical across fund structure, tax obligations and trading and investment decision requirements.

Figure 10: Legal, Compliance and Accounting

Insource– Compliance department– In-house counsel– In-house accounting group

Outsource– Fund registration and ongoing legal support– Accounting advice– Compliance documentation and support

Leading Providers– Law firms– Accounting firms– Prime brokers


> Human capital. A hedge fund’s success hinges on effective recruiting efforts. Recruiting specialists help to attract and identify leading portfolio managers, traders, analysts and IT experts. Talent retention and succession planning are also integral parts of an overall recruitment strategy. The area of alternative investments is experiencing a shortage of experienced staff. Hedge funds, traditional managers who are entering the alternative investments market, consultants and service and IT providers are competing for employees with experience in various instruments or processing.

Figure 11: Human Capital

Insource– development of recruiting strategy– Employee referrals

Outsource– Active recruiting support– development of recruiting strategy

Leading Providers– Recruiting agencies


> Office management and administration. Efficient office administration is extremely important to ensuring business continuity. The office administration unit makes crucial decisions about equipment, office leases, human resources (HR), employee performance measurement and nondiscrimination policies.

Figure 12: Office Management and Administration

Insource– Office Lease– Human resources– Employee benefits and payroll– Performance measurement– nondiscrimination policies

Outsource– Office Lease– Human resources– Employee benefits and payroll– Performance measurement– nondiscrimination policies

Leading Providers– Payroll and human resource specialists– Real estate brokers



Important Service PartnersHedge funds view service provider relationships as important business and operational partnerships that provide the essential foundation on which to build and grow the fund. Important business, legal and IT partners of hedge funds are outlined below.

Figure 13: Critical Functions and Sample Service Providers

Trading and Processing

– Prime brokers– Execution brokers

Client Servicing

– Hedge fund administrators

– Prime brokers

IT Infrastructure

– IT integrators– Management

consultants– Software vendors

Middle-Office and Back-Office

Processing

– Prime brokers– Hedge fund

administrators– Custodians

Business Continuity and Disaster Recovery

Planning

– disaster recovery and business continuity planning specialists

– Prime brokers– Management

consultants

Legal, Compliance and Accounting

– Law firms– Accounting firms

Recruitment

– Recruiting agencies

Office Management

– Payroll and HR specialists

– Real estate brokers

Marketing and Business Development

– Third-party marketers

– Industry database providers

Capital Raising

– Prime brokers– Third-party

marketers– Web-based social

networking sites


> Law firms. The need for initial setup, registration and ongoing legal guidance and support has made law firms essential business partners for many hedge funds. By relying on their law firm business partners to help them navigate through the complex legal environment, fund managers can focus on their core business operations.

> Accounting firms. Hedge funds rely on experienced accounting firms to advise them on the tax structures of the fund and provide them with ongoing accounting-related advice and audit services.

> Prime brokers. Prime brokers provide the fundamental services of execution, clearing and settlement, custody, financing, securities lending and reporting. Additional services may include assistance in capital introduction, initial public offering (IPO) access, portfolio systems, trading systems, partnership accounting, risk analytics, real-time risk monitoring, margins and cross margins, aggregated reporting, research, office space and fund start-up services. A hedge fund’s relationship with a prime broker is essential to the overall operations of the fund.


A prime broker often serves as a trusted advisor in helping a hedge fund select other service providers. Driven by concerns over counterparty risk, the practice of forming multiple prime brokerage relationships has increased substantially in recent months.

> Custodians. Custodians typically work closely with prime brokers and hedge fund administrators to provide valuable services associated with the safekeeping of assets and portfolio servicing. A tri-party custody account arrangement involving a prime broker and a custodian can provide a stable financial structure that can help hedge funds look for growth opportunities, while at the same time efficiently managing counterparty risk. This approach allows the custodial bank partner of a prime broker to custody the fully paid—for long positions and then post the collateral to the prime broker for the short securities, thereby effectively supporting the long/short strategies of its hedge fund clients within a single company with one technology platform. While this strategy can be accomplished using a bank and an unrelated prime broker, having an integrated tri-party custody arrangement creates efficiency, minimizes paperwork and legal issues and helps mitigate counterparty risk.

> Hedge fund administrators. Hedge fund administrators are independent service providers. These firms generally do not offer trade execution or financing as their role is purely operational. Since 2002, hedge fund administrators have been consolidating and pushing deeper into investment operational outsourcing. All hedge fund administrators offer traditional fund administration, many provide back-office portfolio and partnership accounting and some offer middle-office services.

> Payroll and HR specialists. As most smaller businesses can attest, third-party payroll and HR specialists take care of the vital, but time-consuming issues related to payroll and HR.

> Human capital. Finding highly qualified fund managers, analysts and traders is a challenging task. A recruiting agency can help to identify gaps within a hedge fund’s talent pool and target specific individuals for recruitment. Agencies frequently assist in developing competitive compensation plans for the recruitment and retention of talent.

> Real estate brokers. While most hedge funds start at temporary spaces offered by prime brokers or hedge fund administrators, a fund will need the assistance of real estate brokers as it looks for permanent office space options.

> IT integrators and outsourcing firms. IT integrators are increasing their profile in the hedge fund market as funds become more reliant on technology to run their overall critical operations. The need for IT integrators will continue to grow as more hedge funds decide to bring additional technology in-house to better manage their disparate applications.

> Software vendors. Leading software vendors are directly marketing to hedge funds while maintaining their traditional distribution channels via prime brokers and hedge fund administrators. Software vendors provide flexibility to hedge funds interested in taking control of some of their fundamental operational activities such as trading, reporting and portfolio management.

> Management consultants. To make informed decisions regarding technology, business and legal services, some larger hedge funds have begun to turn to management consultants for advice. Management consultants offer guidance on long-term strategic decisions regarding operations and provide implementation and integration services customized to meet specific goals of hedge fund clients. This allows a fund to make


better-informed decisions using the best-of-breed approach, whereby the fund may choose to outsource, host in-house or implement a combination of both.

In addition to providing the typical execution, securities lending, financing and clearing and settlement services, prime brokers also offer consulting services to both established and new hedge funds, including assistance in technology evaluation, operational review, ongoing market education and various start-up services.

Challenges in Finding the Right Outsourcing PartnerChallenges abound in determining the most productive outsourcing relationships. Most difficulties arise from the ongoing internal tension between limited resources and a multitude of choices. Some of the most oft-cited challenges that hedge funds face in determining outsourcing relationships include:

> Evaluating disparate information. Most hedge fund managers have an incredible number of sources for recommendations and referrals when examining potential outsourcing solutions. Unfortunately, too much information can lead to information overload, especially for fund managers who lack the time or interest in learning about the administrative aspects of running a business. An abundance of conflicting information with little objective guidance may lead hedge fund managers to defer decisions regarding much-needed service relationships.

> Balancing internal resources. Hedge fund managers face daily battles over balancing internal resources. Before making decisions on which functions to outsource and to whom, managers must first determine which internal resources are most valuable and crucial to the overall operation of the fund.

> Prioritizing short-term versus long-term business goals. Hedge fund managers need to prioritize short- and long-term business goals to ensure continual growth. As a hedge fund begins operations, most of the focus may be on identifying prospective clients and raising capital. During this phase, managers often view office administration and IT as peripheral functions that easily can be outsourced.

As a hedge fund grows, however, managers will concentrate on building a stronger administrative foundation and begin to view IT infrastructure as a potential competitive advantage. These changing priorities have an immediate impact on third-party service provider relationships, as outsourcing solutions that cannot evolve with the changing needs of the client will impede the overall growth of the hedge fund.

Well-established funds likely will have met some of their important short-term goals. In order to continue their overall growth model, larger and well-established hedge funds must take a longer-term, strategic perspective on their outsourcing relationships. For example, even though a fund might have the resources to add in-house trading technology, as it moves into more complex instruments, it may be better for the hedge fund to continue to leverage its prime broker relationships to help it conquer new markets in a more cost-effective manner.


> Considering cost. Cost is always an important consideration when making outsourcing decisions. Expense will be a much larger issue during the initial formation phase, especially for firms who lack the funding to have any relationship that does not improve its bottom line or free up internal resources.

> Assessing whether a relationship can evolve with a hedge fund’s business goals. As a hedge fund grows, existing outsourcing relationships must evolve with the fund. The needs of a smaller hedge fund differ from the needs of a fund in a rapid growth phase.

For example, start-up funds typically rely on a payroll provider to quickly establish their payroll infrastructure to start operations. As the firm grows and the total number of employees increases, the firm may look to payroll service providers for other services including HR and training, benefits support and access to retirement services. The outsourcing providers must present a set of products and services that meets a firm’s immediate needs, but these providers must also have the flexibility to change with the life cycle of a growing hedge fund.

> Establishing appropriate relationship metrics. Perhaps one of the most important elements of any outsourcing relationship is a clear measurement for overall performance. The measurement of a recruiting agency’s performance may involve an assessment of the agency’s ability to fill a specific number of positions within a given period. The performance measurement of a prime broker may include the assessment of the prime broker’s ability to provide hard-to-borrow securities or to provide credit when needed.

Whatever the relationship metric might be, identifying and agreeing on performance expectations is important. The needs of a hedge fund and the capabilities of the outsourcing solution provider should be evaluated thoroughly to build a successful, long-term business partnership. While evaluating the many options of service providers is challenging, yet essential, hedge funds must take the time to make informed decisions.


Considerations for OutsourcingHedge funds typically have leveraged internal resources to handle specific confidential functions, such as the development of algorithms, while building outsourcing relationships to support essential operational functions including accounting, IT infrastructure and compliance. At the highest level, hedge funds have three options for operations models:

Figure 14: Options for the Hedge Fund Community

Infrastructure Alternatives

Insource

Hedge Fund Outsource

Hybrid

Source: Aite Group

> Insourcing model. Hedge funds with extensive resources and plenty of in-house expertise may opt to insource all functions, which provides greater operational control, as well as the highest level of customization. However, a complete insourcing model may leave a hedge fund vulnerable to staff turnover, maintenance issues, ballooning bureaucracy and potentially prohibitive costs.

Figure 15: Insourcing Model

Insource

Advantages– Market-tested systems– Greater operational control– Operational customization

disadvantages– Staff turnover, hiring and training costs in

high-demand market– Technology maintenance– Implementation and conversion delays

Source: Aite Group

> Outsourcing model. Outsourcing all functions is often attractive to new or smaller hedge funds. This model enables a hedge fund to jump-start operations and helps fund managers focus on their core business.

In addition, using industry-accepted solutions can increase transparency and investor confidence in overall operations. However, completely relying on outsourcing solutions offers less flexibility in terms of customization and leaves the hedge fund vulnerable to the outsourcing providers’ business viability.


Figure 16: Outsourcing Model

Outsource

Advantages– Speed to implementation– Focus on investment-centric activities– Industry standardization of processes– Potentially greater investor confidence

in operations– Reduced staffing requirements

and expenditures– Some complimentary services by third-

party providers– Safety and soundness– Increased transparency

disadvantages– Third-party service-level agreement

establishment and oversight– no control over quality of staff or

retention issues– need for knowledgeable person to serve as

key contact for troubleshooting

Source: Aite Group

> Hybrid model. Most hedge funds choose the hybrid model, which enables them to establish outsourcing relationships that can improve their overall operations while nurturing in-house capabilities in mission-critical areas to support future growth.

Figure 17: Hybrid Model

Hybrid

Advantages– Combination of the advantages and

disadvantages of alternative decisions– Flexibility of choosing specific areas for

internal versus external focus– Support for complete customization

of infrastructure

disadvantages– Potential high cost of implementation

and support– Challenges to key staff retention

Source: Aite Group

The hybrid model enables a hedge fund to customize their overall infrastructure by building best-of-breed outsourcing relationships, as well as developing internal capabilities to complement services provided by outsourcing business partners. In short, the hybrid model provides operational flexibility to meet short-term goals while allowing the fund to develop internal capabilities for long-term expansion.

Once the decision has been made to outsource certain components of a hedge fund’s business, the hedge fund must undertake the challenging tasks of conducting an internal assessment and external vendor evaluations to select the appropriate partners.


Road Map to OutsourcingThe first step in making a decision to outsource a function is to perform an internal assessment. A hedge fund must objectively gauge the fund’s internal needs in four particular areas.

Figure 18: Sample Internal Assessment Guide

– Identification of critical functions: •Investmentprocess •Trading •IT •Administration

– Identification of functions for potential outsourcing

– Breakdown of employees by function and skill sets

– Prioritization of short-term versus long-term business goals: •Capitalraising •NewITinfrastructyure •Investmentsinnewassetclass •Expansionintootherregions

– Anticipated return on investment

– Expected capacity created for growth

– Analysis of expected cost: •Full-timeemployeeversusoutsourcedrelationship •Start-upcostversusmaintenancecost

– Ranking of functions for potential outsourcing: •Required •Optional •Bluesky

Source: Aite Group

> Corporate culture. Many partnerships fail due to an incompatibility of corporate cultures. To a certain degree, outsourcing partners should share the traits of a fund’s own corporate environment. Before seeking any type of outsourcing relationship, a hedge fund must first acknowledge the type of corporate culture it currently has, or hopes to have, and plan outsourcing relationships accordingly.

The fund managers should speak with the service provider’s top clients to get a better sense of the overall cultural attitude of the provider and how it would positively contribute to the hedge fund’s culture.

An evaluation of a service provider’s client services team is also important. Mature vendors with an extensive client list should have a large, experienced service team. A client-centric vendor typically fosters a corporate culture that is compatible with hedge funds.


> Cost analysis. For all outsourcing relationships, a hedge fund must take into account cost analysis. Funds should examine the costs associated with a full-time hire versus outsourcing that particular function. Funds should also consider whether an initial low cost of starting an outsourcing relationship may be overshadowed by higher long-term maintenance expenses.

For smaller hedge funds, building relationships with smaller, niche-focused vendors may be more appropriate in terms of client support. Depending on the results of a comprehensive cost analysis, certain trade-offs may have to be made to establish the most productive outsourcing relationships.

> Long-term growth strategy. Outsourcing relationships should be evaluated to ensure that the fund’s long-term growth strategy can be supported. For example, a fund might focus primarily on U.S. equities as its core investment instrument in the short-term due to resource constraints. However, if the fund’s long-term plan includes aggressive expansion into other asset classes and other geographical regions, the hedge fund should develop relationships with service providers capable of evolving with the fund’s business plans.

> Pros and cons of outsourcing specific functions. Before agreeing to any outsourcing solution, a hedge fund should assess the advantages and disadvantages. For example, using an EMS from a specific prime broker helps hedge funds ramp up quickly and cost-effectively in the short term, but if the EMS platform offers access only to the products and services from that particular prime broker, the long-term growth of the hedge fund could be stunted.

When outsourcing a specific function, detailed requirements must be gathered, preferably by a knowledgeable business analyst, to ensure that the needs of the specific area being outsourced align with the capability of the service provider. A successful requirements-gathering exercise begins with a list of prioritization.

Outsourcing expectations should be ranked in terms of functionality and separated into three categories: 1) required, 2) optional and 3) blue sky. The outsourcing relationship can commence with, at minimum, the required functionality, but the outsourcing partner should demonstrate its ability to deliver on the optional features in the mid-term, as well as tackle the blue sky “wish list” in the long run, by presenting a concise, strategic road map to achieving those goals.

Accurately understanding internal requirements helps a hedge fund develop a better firmwide strategy for cultivating effective outsourcing relationships.

External EvaluationOnce an internal assessment has been completed, hedge funds can assess the capability of each provider. While the actual duration of external evaluation can vary widely depending on the type of service sought, the entire process should take no more than 14 weeks.


Figure 19: Sample External Evaluation Guide

– Company background: •Yearcompanywasfounded •Locationofheadquarter •Numberofemployeesbyfunction •Annualrevenueforpreviousfiveyears •Profitability •Annualresearchanddevelopmentbudget(ifapplicable) •Five-yeargrowthplan

– Features of products and services: •Requiredfeatures •Optionalfeatures

– Client service: •Detailedanalysisofexistingservice-levelagreement •Sizeofclientservicegroup •Designationofdedicatedservicemanager •Clientserviceavailability •Metricsforclientserviceperformancemeasurement •Businesscontinuityanddisasterrecoveryplanning •Confidentiality •Customization

– Security issues: •Vendorprocedureforclientconfidentialityandsecurity •Evaluationofvendoroperationalworkflow

– Client references: •Minimumofthreereferences •Peergroupreference

Source: Aite Group

During the external assessment phase, a hedge fund analyzes and ranks vendors based on their ability to meet the range of requirements that the firm has identified as essential to its operations. It is also important for the hedge fund to form an internal committee that represents the key decision makers in the specific areas of search.

For example, if the hedge fund is looking to outsource part of its trading function, the committee should include the fund manager, current head trader, IT manager and potentially an external consultant to add insight. Some of the best industry practices applied by hedge funds in performing external evaluations include:

> Financial and reputational stability. A fund needs to assess the industry reputation and financial viability of the vendor by closely examining the sales pipeline and client retention rates.

> Functionality match. An analysis of essential product and service offerings by vendor must be conducted, ensuring those products and services map back to the fund’s internal requirements.


> Ability to scale. Hedge funds will need to review the domain knowledge and scalability of a service provider to confirm that it understands the critical requirements of supporting a growing hedge fund. The service provider’s flexibility is also critical in terms of its ability to customize its products and services to meet specific needs of the fund.

> Level of client service. An evaluation of the operational effectiveness and efficiency of a vendor, including robust business continuity and disaster recovery planning, must be conducted to ensure the delivery of quality services and on-demand client service support. Funds should also request and examine service-level agreements from each potential vendor.

> Security and confidentiality. Hedge funds will need to examine a vendor’s controls and procedures to understand the level of security and confidentiality assumed in the relationship, as well as operational stability.

> Client references. A minimum of three references for clients of similar size and profile must be verified to confirm that the vendor has been able to provide effective support for its existing clients. Information gathered through this process helps a hedge fund validate its ultimate selection.

Often, fund managers are intimately involved in every step of the evaluation process. Depending on the type of solution, fund managers may rely on guidance from various advisors including prime brokers, hedge fund administrators, lawyers, accountants and consulting firms.


ConclusionThe needs of a single hedge fund are never static. Some hedge funds want to keep information close to the firm, as well as have the flexibility to modify structure, process or client servicing at will. On the other hand, some hedge funds are actively seeking outsourcing partners that can support their mission-critical functions while addressing the increasing demand by investors to leverage more third-party service providers.

Building outsourcing partnerships has never been an all-or-nothing proposition, however, evidenced by the growing popularity of the hybrid model, which attempts to balance the strengths and weaknesses of insourcing and outsourcing approaches. Figure 20 illustrates non-prime-brokerage–related services and likely areas for outsourcing.

Figure 20: Outsourcing Patterns of Hedge Funds


Total AUM

Like

lihoo

d of

Out

sour

cing

Fun

ctio

ns

Start-Up

– Portfolio system– Registrar and

transfer agent– NAV– Statements– Administration– Custody– Legal and tax– Investor

communication– O�ce space– Network support

AUM:<$100 Million




AUM:$100-$500 Million




AUM:>$500 Million

– Registrar and transfer agent

– NAV– Custody– Legal and tax

AUM:>$1 Billion

– Registrar and transfer agent

– Custody– Legal and tax

The decision to keep operations in-house is not solely based on size. AUM growth is only one of many variables used to determine whether to outsource specific functions. Certain funds seek to increase their overall capacity in order to enter new markets or face increasing competition and therefore engage an outsourcing partner to scale rapidly. As more service providers create market reputation—whether working through post-acquisition integration, helping an established firm cope with new competition or assisting a newly launched firm to carve out its market niche—hedge funds will be forced to make their outsourcing decisions from a constantly evolving pool of service providers. Considerations for outsourcing will vary depending on the overall size of a fund.


Smaller Hedge Funds and Resource Restrictions

Today’s hedge fund market is dominated by smaller- and mid-size funds with limited resources. As a result, those funds have opted to outsource a significant portion of their functions to service providers.

This type of resource restriction–led outsourcing relationship is driven by necessity and short-term goals. In this case, a hedge fund focuses on its core business of making investment decisions and generating capital by relying on partners for all operational support.

At the same time, a hedge fund should use this period to learn the different aspects of its operations and identify those functions that may play a critical role in its long-term growth. Ongoing analysis helps a hedge fund gain a better understanding of which functions ultimately can be kept in-house versus which functions should be outsourced as a long-term strategic decision. Smaller- or mid-size funds should consider the following questions before committing to an outsourcing option:

> What are the company resources, such as finance, employee skill sets, technology, structure, legal, compliance and risk management?

> What are the revenue and investor goals? How quickly will the firm grow?

> What are the current and future staffing expectations?


Larger Hedge Funds and Strategic Outsourcing

Most larger funds have opted for a best-of-breed approach by actively using outsourcing relationships while retaining internal staff for functions they consider critical to their overall growth. Once a larger hedge fund establishes a solid foundation, outsourcing is no longer pursued out of necessity. Instead, outsourcing becomes part of an overall strategic approach in which specific functions are outsourced to maintain the fund’s continued growth. Larger funds should consider the following questions before committing to an outsourcing option:

> What are the firm’s structural strengths and weaknesses?

> What are the industry norms regarding infrastructure and are they changing?

> Is the technology specialized or a commodity?

> Who are the firm’s investors? How much control is needed to customize service to meet investor requirements?

> Will additional capacity be generated?

Hedge funds with strong outsourcing relationships experience substantial benefits, but selecting the right vendors is a complex process with many pitfalls. If a hedge fund is not fully committed to the concept of outsourcing, the process will draw out, leaving the hedge fund without much-needed support. Finding a reliable, trusted advisor in this process can help a hedge fund grow its business.

Prime brokers can play an important and cost-effective role in advising the vendor selection process. Most leading prime brokers have established internal consulting teams with relationships that include law firms, real estate agencies, recruiting firms, software vendors and office administration firms, and can facilitate introductions to vendors who may help meet the unique needs of the hedge fund.


Figure 21: Best Practices in Evaluation of Outsourcing Vendors

Source: Aite Group

Key

Play

ers

Assessing needfor outsourcingand collectingdetailedrequirementsD

etai

ls

InternalNeeds

Analysis

PerformanceMetrics

Measurement

ExternalVendor

Evaluation

VendorSelection

SuccessMeasurement

One week Eight to ten weeks Two weeks One week Ongoing

Distributingrequests for proposals andevaluating basedon internalrequirementsand vendorcapability

Selecting a vendor that meets internalrequirements from a short-listed vendor pool

Setting realisticguidelines forwhat to expectfrom vendors

Constant monitoringand creating a feedback loop with the vendor to ensure high-quality service

Hedge fund’svendor searchcommittee,external advisor

Hedge fund’svendor searchcommittee,external advisor,vendors

Hedge fund’svendor searchcommittee, external advisor

Hedge fund’svendor searchcommittee,external advisor,vendor

Hedge fund’spoint personand vendor

In today’s market environment, outsourcing business-critical functions to a trusted outsourcing partner can have the added benefit of helping hedge funds build investor confidence. To ensure a successful outsourcing vendor relationship, hedge funds should consider the following key factors:

> Do not lose sight of the long-term goal. While it is easy to rely on various external outsourcing partners when starting a hedge fund, it is much harder to maintain those relationships as the fund continues to grow. Every outsourcing relationship must be continually scrutinized to ensure that the products and services of the current outsourcing partners can help the hedge fund meet its long-term goals.

> Balance outsourcing with insourcing. Most hedge funds have opted for the hybrid model in which funds can develop a best-of-breed approach to managing outsourcing partners, while at the same time identifying specific critical functions that can be operated by internal staff. The hybrid approach enables hedge funds to address the initial concerns with start-up costs while at the same time holding onto the flexibility, which can drive innovations as the fund matures.

> Identify performance metrics. Once an outsourcing partner has been selected, a meeting should be scheduled to review in detail all aspects of the business relationship. While most vendors provide a generic service-level agreement, more customized and realistic guidelines should be established during this time to ensure objective measurement in overall performance. A hedge fund and a selected vendor should be able to outline an acceptable performance metric in one week.

> Measure success. Perhaps the most dificult aspect of the entire process is the continual monitoring and feedback loop that must be set up to ensure that a vendor is delivering high-quality service. This should be an ongoing process.


A hedge fund’s long-term outsourcing strategy and support requirements should not outpace the capabilities of existing outsourcing vendor partners. Once a reliable outsourcing strategy is in place, hedge fund managers can focus on generating profitable returns on their investment decisions.

Ideas Without Limits

This white paper is part of Ideas Without Limits, a program designed to help financial services firms and investment professionals identify trends, enhance operations and grow revenue. It represents Pershing Prime Services’ unique approach to practice management support—going beyond high-level guidance to offer actionable information, personalized consulting and ready-to-execute programs.

To learn more about Pershing Prime Services, visit us on the web at www.pershingprimeservices.com.

Pershing Prime Services is a service of Pershing LLC, member FINRA, NYSE, SIPC. Pershing is a subsidiary of The Bank of New York Mellon Corporation. Trademark(s) belong to their respective owners. For professional use only. Not for distribution to the public.

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About Pershing Prime Services

PershingPrimeServicesdeliversanunconflicted,comprehensivesuiteofglobalprimebrokeragesolutions,includingextensiveaccesstosecuritieslending,

dedicated client service, robust technology and reporting tools, worldwide execution and order management capabilities, a broad array of cash management

productsandtheintegratedplatformofBNYMellon.PershingPrimeServicesisaserviceofPershingLLC.

Jeremy Todd, director, Pershing Prime Services (201) 413-4617

BNYMellonisthecorporatebrandofTheBankofNewYorkMellonCorporation.BNYMellonisaglobalfinancialservicescompanyfocusedonhelpingclients

manage and service their financial assets, operating in 34 countries and serving more than 100 markets. The company is a leading provider of financial services for

institutions, corporations and high-net-worth individuals, providing superior asset management and wealth management, asset servicing, issuer services, clearing

services and treasury services through a worldwide client-focused team. It has $20.7 trillion in assets under custody and administration, $926 billion in assets

under management, services $11.8 trillion in outstanding debt and processes global payments averaging $1.8 trillion per day. Additional information is available

at www.bnymellon.com.

Marina Lewin, Managing director, Alternative Investment Services (212) 815-6973

Jim Whitaker, Managing director, Alternative Funds Client Management (212) 635-8843

About Aite Group, LLC

Aite Group is a leading independent research and advisory firm focused on business, technology and regulatory issues and their impact on the financial services

industry. It was founded by leading industry experts in Banking and Securities & Investments. Aite Group brings together a team of business strategy, technology

and regulatory experts to deliver comprehensive, timely and actionable advice to financial institutions and technology vendors. It seeks to become a true partner,

advisor and catalyst by exchanging ideas with and challenging basic assumptions of its clients, ensuring that they always stay one step ahead of the competition.

Sang Lee, Managing Partner, Aite Group, LL C (617) 338-6015

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