It's Time for a New Business Model for Hedge Funds

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This piece was originally published on TabbFORUM.

Competitive advantage is no longer based on performance alone. The new hedge fund business model hinges on world-class infrastructure and innovative ways of managing costs. With demands from investors and regulatory bodies steadily escalating, hedge fund managers have little choice but to focus relentlessly on operational efficiency and overall cost management to preserve margins and grow their businesses. This “creative disruption” of the industry is resulting in fundamental, accepted notions of the hedge fund business model being completely re-written.

The rise of a new business model for hedge funds is rooted in a highly challenging investment market and a dramatic escalation of regulatory oversight combined with unprecedented investor demands that range from reporting to infrastructure, all of which would have been unimaginable a decade ago.

At the heart of this new business model is a drive by managers to leverage technological advances to substantially redefine efficiency. Lowering head count, a traditional means of reducing costs, is being surpassed by the use of innovative tactics aimed at integrating the front, middle and back office, significantly raising data management practices, employing best-in-class technology in doing so.

Material enhancements of infrastructure have become a principal way to optimize growth models in the face of steadily shrinking margins, and that has meant the steady growth of process automation and outsourcing. This is corroborated by a recent survey of the global hedge fund market conducted by EY. According to the survey, two in three hedge fund managers reported an increase in revenues in the past year as performance improved and assets grew. However, just half of managers reported improvements in margins, while one in three managers said margins declined.

A significant contributor to compressed margins is the costs of developing infrastructure to meet the demands of heightened regulatory reporting, substantial upgrades in technology and other steps aimed at scaling the business to handle growing assets. Despite these challenges, in my discussions with COOs and managers, there is a distinct sense of optimism when it comes to growth prospects. Not despite but because of the many challenges it faces, the industry is more vital than ever.

In addition to investing in new strategies and products, managers are developing distribution networks and channels in which they have traditionally not been engaged. The most prominent example of this is the advent of more hybrid-style hedge fund models that incorporate 40-Act products. This is occurring against the backdrop of traditionally liquid 40-Act firms cultivating more alternative-style strategies. The bottom line for hedge funds is increasing pressure to diversify in the pursuit of alpha.

But the pressures on hedge funds today are not equally distributed. Size, not surprisingly, matters.

According to the latest Citi Prime Finance 2013 Business Expense Benchmark Survey, institutional-size hedge funds, with assets of $1 billion to $5 billion, begin to realize higher operating margins as they surpass $1.5 billion, and begin to see appreciable profits as they approach and move beyond the $5.0 billion AUM mark.

The need for smarter data management – a response to what I term the “data deluge” – is a big part of this new hedge fund model. Hedge fund managers today think they’re in the investment management business, but more than ever they face being drawn into the vortex of the data management business. Only 5% of managers responding to the EY survey said they did not face data challenges.

Hedge funds need service providers that can help them manage and employ data in ways that are collaborative and allow them to focus on their core competency – that is, the pursuit of alpha. The demand for operational efficiency has fueled a desire for innovative outsourcing solutions.

That innovation has been taking shape for a while now, spawning a rich array of outsourced services that have been increasingly adopted by hedge fund managers. Back-office functions have been outsourced for some time now. In this latest phase, hedge fund managers seek additional operational efficiencies by outsourcing other non-core activities, notably risk management and analytics, middle-office operations, technology, legal, and compliance and middle-office reporting functions. There are several facets to this evolution, including, for example, availability of integrated front- and middle-office platforms, as well as collateral management capabilities. Just as important, funds are partnering with service providers to innovate and implement services that leverage technology. These are aimed at not only solving specific functional needs, but also improving overall organizational efficiency.

The new hedge fund business model is a model that leverages technology, people and processes in just the right ways to ensure a sustainable competitive advantage. Competitive advantage is no longer based on performance alone. The new hedge fund business model hinges on world-class infrastructure and innovative ways of managing costs in ways that enhance scalability. And this is not to mention the challenges posed by the reality that funds operate these days in an “always-on” environment. Hedge fund staff are accessing and managing information 24/7 from remote devices far from the office. This has created entirely new security, auditability and risk management challenges.

We are only at the beginning of this new era of collaborative outsourcing as part of a new hedge fund business model. Based on early returns, the result is shaping up to be a golden age for asset managers as they are increasingly able to return their focus to generating alpha.