Independent administrators need to be brave on pricing
According to a report produced last August by PwC entitled ‘Hedge Fund Administration – The quest for profitable growth’, there have been 27 HFA acquisitions since 2006, with 11 of those targets running USD20 billion or more in AuA. As the report points out, this helped bank-owned administrators increase their market share of outsourced hedge fund AUM from 47 per cent to 64 per cent.
State Street AIS acquired Goldman Sachs Administration Services in 2012 creating the world’s largest HFA with USD780 billion in AuA (as of October 2014); it remains the largest single manager HFA, having seen its assets grow 14 per cent year-on-year between October 2013 and October 2014.
In 2014, BNP Paribas Securities Services announced it would buy the fund administration arm of Credit Suisse creating an administrator creating a combined AuA of USD231 billion. And most recently, Citigroup announced this year that on the back of lower than expected earnings it was selling its HFA business.
Whilst investment banks consider their options, transaction-based banks are upping their game. US Bancorp Fund Services acquired Dublin-based Quintillion in 2013, having already purchased AIS Fund Administration in 2012, while Mitsubishi UFJ Financial Group acquired Butterfield Fulcrum and Meridian and is looking to make further acquisitions as it diversifies away from servicing long-only funds.
Big custodial banks are likely to dominate the HFA space in years to come, forming one part of a barbell with a number of well-run, well-capitalised independent HFAs on the other end. Mark Hedderman is the CEO of Custom House Fund Services. In March 2015, Custom House announced that it had agreed with TMF Group – a global provider of business services – to go back to being a fully independent administrator.
The deal, signed at the end of 2014, will allow Custom House to acquire TMF Group’s Fund Administration Services business.
Speaking about the consolidation taking place at the top of the market as investment banks pull out, Hedderman says: “When margins are being squeezed, and the risks remain as high as ever, there comes a point where they decide it’s no longer worth the hassle to be in this space at the wholesale level. One small mistake can put them out of business.
“However, if administration is your core focus, which it is for us and our independent contemporaries, we don’t have the same pressures as bank-owned administrators where they are just one small cog in a much bigger machine. Even with advances in technology, it’s not getting any easier to be a fund administrator. Regulation such as AIFMD and FATCA is quite onerous and more challenging to keep on top of.”
For a big investment bank, the idea of sweeping all before them and building HFA businesses a decade ago made a lot of sense; they could leverage complementary services such as custody, prime brokerage, treasury services and so on. Now, however, they need to account for every dollar being used on their balance sheets. Administration has never been a high margin game and the integrated model they pursued previously no longer works in a Basel 3 world.
Indeed, JP Morgan decided to exit its unprofitable UK fund transfer agency business last year. One of the bank’s key objectives is to improve its return on equity to approximately 15 per cent over the next two years. That is why custodian banks are becoming more acquisitive; they are better able to cope with the risks and complexities of administration. It’s a better fit for their business model.
“Various lawsuits and regulatory actions that have been filed against the banks in the last two years will likely have factored into their decision. We’ve just seen authorities in the US and the UK impose a record GBP3.7 billion in fines on five major banks for rigging the FX markets.
“Banks are taking a closer look at their business, their product lines, the respective risks, how they use their balance sheets, and reassessing what they do and how they do it,” suggests Robin Bedford, CEO of Opus Fund Services.
Bedford agrees with the barbell reference above in terms of the future landscape. In his mind, independent administrators like Opus have a crucial role to play supporting emerging managers with between USD10 million and USD250 million in AUM. “A lot of managers are simply not big enough to attract serious interest from an institutional administrator. They will continue to focus on servicing the largest managers, who pay the largest fees, and who need to stick with tier-one HFAs, because their institutional investors demand it,” adds Bedford.
Back in January 2014 Opus completed the acquisition of AlphaMetrix360, acting as a White Knight and providing a home to some 25 managers. But Bedford confirms that currently the focus is on growing organically.
“Valuation is dependent on who the buyer is. If the acquirer is pursuing a roll-up strategy, buying up other administrators, then they will likely focus on projected EBITDA factoring in cost savings. However, it’s a very difficult strategy to execute successfully, as price competition has caused margins to be significantly tighter than historically earned. With sellers therefore preferring to focus on top line revenue, and buyers looking at a calculation based on EBITDA, it’s difficult for parties to reach an agreement.
“Given tight margins, the payback of buying an administrator today is likely longer now, than it has ever been. Therefore for transactions to be successful, other factors have to be considered such as technology platforms, highly skilled and experienced workforce, and industry reputation,” confirms Bedford.
Michel van Zanten is a director of Circle Partners, an independent HFA who last year acquired Caledonian Global Fund Services Limited based in Florida, the BVI and the Cayman Islands, enabling it to extend its administration services to the US marketplace.
Referring to the opportunity set for finding new acquisitions, van Zanten notes that the de-merger of Custom House Fund Services from TMF Group could happen elsewhere in the market, particularly if a private equity group is looking for an exit strategy.
“One always has to be on the lookout in this business. You have to be active in this space, even if it is just to validate your own thoughts about valuations, your own ideas about growth, set priorities and how to build a profitable business,” says van Zanten.
Growing the business just for the sake of it is a dangerous precedent for independent players. It’s fine for bank-owned groups to pursue this strategy because even if it doesn’t work out, they’ve still got their core businesses in place. They’ve got the balance sheet.
For an independent HFA, it’s all or nothing. They have nothing else to fall back on if an acquisition goes wrong. The stakes are much higher, which is why van Zanten and others take a cautious approach.
SEI is one of the largest non-banked owned HFAs with approximately USD135 billion in single manager hedge fund AuA and USD73 billion in FoHF AuA.
As Ross Ellis, Vice President and Managing Director of the Knowledge Partnership in the Investment Manager Services division at SEI confirms, “we are always open to discuss potential partnerships but we wouldn’t want to grow by acquisition just to gain scale. It would make more sense to look at something that was inefficient, using our workflows and integration to make them more efficient where we are able to clearly add value and make it a 1 + 1 = 3 proposition.
“Any transaction or partnership would need to give us something we don’t already have that would increase our solution set and benefit our clients: i.e. a different jurisdiction, a different product, access to a different investor base.”
One of the issues that HFAs have had to deal with is the expectation among managers for cheaper costs; they want more bang for their buck. This race to the bottom was partly down to the ability of bank-owned HFAs to offer bundled services (mentioned above), thinning their margins on administration services and making up for the shortfall elsewhere in the organisation.
This has hindered independent firms because they’ve not been able to rely on other revenue streams; administration services are their bread and butter. As such, independent firms have to take a more courageous stance. Those that succeed are the ones that can offer high quality customised services that may cost more but give managers, large and small, greater peace of mind.
“If you’re going after sophisticated fund managers who have institutional investors, they know that it makes no sense for them to join up with lower quality service providers and that if they want the best they are generally willing to pay for it.
“It’s all about value. Forward-looking managers aren’t against paying more, per se. They just want to see value from their payment. If a manager is getting charged 10 basis points from Administrator X, for example, and isn’t getting good service, and another firm is charging 13 basis points but offers a higher service level, then the manager may well go with the more expensive option if it gives him the confidence to launch new products. To me, it’s all about partnership based on mutual success rather than just choosing the cheapest option,” says Ellis.
This is an important point. As the PwC report highlights, Citi Prime Finance estimates that liquid alternative products will exceed USD900 billion in AUM by 2017. “At this rate of growth, the administration industry could capture incremental revenue in the range of USD600 million to USD825 million on an undiscounted basis for the period of 2013 – 2017”, writes the PwC report.
Ellis believes that the mindset of managers is changing. The risks have increased to such a level that they can’t afford to cut corners, or risk getting sub-standard service by saving a few basis points.
“Managers are looking to do the right thing for their businesses and their investors; if they want to be successful they need to ensure that their service provider partners including administrators have the revenues to also be successful,” adds Ellis.
Over at Custom House Fund Services, Hedderman is passionate about recovering some of the lost ground in terms of the way that managers perceive HFAs, particularly in respect of costs.
“Our discussions with managers are service-led not price-led. It’s important that you align your services with the client’s expectations. If there’s a mismatch in those expectations then you’re going to run into problems.
“We’ve walked away from pitches where we feel we can’t compete on price, or where we feel there’s an over-expectation on us. We won’t get drawn into discussions on reducing fees simply to match those of a competitor, unless it is for a compelling reason. I fail to understand why smaller administrators have such a simplistic approach to pricing: to win at all costs without taking the time to understand the nuances of what the client actually wants.
“You have to be brave and to be focused on relationships and service quality. Our strategy is to take our time to understand our clients, understand what it is we can and can’t do, and base our discussions on that as opposed to price and wrapping our services up, which has devalued the way managers view administrators. You’ve got to be free from the pressures of a larger financial construction to be able to do that,” comments Hedderman.
A decade ago, there were huge inefficiencies in the way that HFAs operated. Bluntly speaking, they could make money and be profitable without being that good. Technology advancements have changed that, helping reduce the barriers to entry and the costs of doing business; and subsequently the fees being charged.
Opus Fund Services takes a unique approach with respect to its price model.
Instead of taking a punt on 10 different managers, charging say 12 basis points in the hope that one manager will be successful, grow their AUM, and then allow the administrator to jack up its fees, Opus has come up with a more ethical way of pricing.
“We go through a detailed sales process to understand every element of a manager’s business and to identify the cost drivers that affect our work. We then use a proprietary model to determine our fees, based on those cost drivers. We consider such an approach ensures fees that are fair to both parties, preventing sudden right-sizing down the road which can leave managers feeling aggrieved.
“The point is this: rather than taking a gamble that required fees will be obtained as a manager grows its AUM, as long as those cost drivers stay the same, our fees work regardless of a managers success. With no need to give managers AUM growth ultimatums, we think it’s a more ethical way of working with our clients,” says Bedford.
Today’s fund manager is increasingly looking for a hedge fund administrator that they can partner with for the long-term as they look to launch new fund vehicles. This will benefit mid-tier administrators who have the capital to evolve their operating and pricing models, as well as the custody-based fund administrators who have the scale and global footprint needed to support LPs, AIFMD-compliant funds, liquid alternatives etc.
Ellis believes that managers are now looking at HFAs who will not hinder their growth but rather facilitate it.
“If a manager is teaming up with an administrator that is capital constrained, there’s a risk that they’re not going to be able to implement the right procedures, or possibly upgrade the necessary technologies. Whereas if the manager is working with an administrator with a history of innovation and investment, they are more likely to be investing on an ongoing basis for the long-term, building the best operational platform for the benefit of their clients,” says Ellis.
“As large managers look for alternative administrators that can offer a high quality service, we hope to step in to support them going forward,” concludes Hedderman.