Outsourcing for hedge funds: what are you waiting for?

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Launching a hedge fund has never been harder. It can also be expensive. These are two key reasons why emerging fund managers are increasingly outsourcing critical parts of their business, from trading to middle and back office, and even aspects of compliance.

Just a few years ago, outsourcing was often viewed with suspicion, as a loss of control, even a sign of weakness and a warning to allocators to look elsewhere.

No longer. Potential investors see outsourcing as an opportunity for funds to access best-in-class expertise efficiently and to extend their reach to new asset classes and geographies. Perhaps most importantly, outsourcing allows managers to focus on what they do best – investing.

The question today is not whether emerging or start-up fund managers should outsource; it is whether they can afford not to? And if they already outsource, shouldn’t they be doing more?

“Outsourcing has come a long way,” says Ortwin Gierhake, Hong Kong-based Director of Prime Brokerage sales for global investment bank Cowen. “It’s now acknowledged as the smart thing to do.”

In this third article looking at issues related to launching a hedge fund, Cowen sought the insight of two highly experienced experts on the business case for outsourcing, what should and should not be outsourced, and how to avoid potential pitfalls.

Alvin Fan is CEO of OP Investment Management, based in Hong Kong. He has worked in finance and strategy for more than 15 years, spanning managerial, private equity and fund of funds.

Liam Woods is Head of Business Development for the APAC region at Apex Group, which delivers a range of services for asset managers, capital markets, private clients and family offices.

COST AND COMPLEXITY

As Gierhake, Woods and Fan spoke, two drivers of outsourcing stood out: cost, – Gierhake described starting up a fund as hugely expensive – and the relentlessly growing complexity of the hedge fund industry.

With constantly evolving regulation, pressure to maintain best-of-breed technology, and no room for slip-ups in day-to-day management of the business as operational due diligence is critical to winning investment mandates, managers and investors alike see seeking outside help as the wise and most cost-effective choice.

“It’s almost expected now,” said Fan, adding the “most appealing” aspect of outsourcing is the impact on costs. “I can have a team of 20 people from an outsourcing provider to support what I need to do, versus hiring one headcount, and the cost is virtually the same.”

It’s not just about the money. Woods acknowledges cost is a major factor. “But access to a deep pool of talent to properly operate the business is seemingly the real driver in most cases,” he added. “There are always new things to manage, new things investors expect.”

It’s no coincidence that outsourcing is booming as hedge funds are tightening their belts. A joint survey of emerging managers by Cowen and the Alternative Asset Management Association (AIMA) found that average breakeven dropped by almost a quarter, to $64 million from $86 million when outsourcing is relied upon. While the costs to a fund launch are soaring, this is evidence that firms have put greater emphasis on finding efficiencies and containing costs. The survey also cited the pandemic as an accelerator, along with investors being more open minded about outsourcing, which aligns with recent research by KPMG and the AIMA.

Five reasons to outsource now
1. Cost efficiency, compared with keeping the entire business in-house.

2. Mitigate “key-person” risk plus access to best-in-class expertise, in all aspects of the business.

3. Utilize cutting-edge technology, without the cost of constant updates.

4. Ensure operational excellence and scale up and down efficiently and speedily.

5. Free-up fund managers to nurture their portfolios.  

ALL OR NOTHING?

If outsourcing is seen as a wise move with no negative impact on raising money, what should an emerging manager outsource? To be sure, most functions can be provided by subject matter experts these days. Cowen, for example, runs a highly successful outsourced trading business, which can save funds the cost of setting up an elaborate global technology infrastructure in-house, which provides much broader access to liquidity.

Other commonly outsourced services include compliance, regulatory hosting, back and middle office, technology platforms, risk management and HR. These operational functions now find themselves in the spotlight as competition among start-ups intensifies.

Rather than hiring a group of employees to look after these tasks and the associated overhead, outsource, save the money and mitigate the “key-person risk” of your hire leaving or even going on holiday. “If you are a small fund, the bench is very thin,” Gierhake said.

For Fan, a major benefit of outsourcing is to make the most of the new fund manager’s precious time. “Even if you have a have a COO, you’re still signing off on documentation, you still have to pay the rent and keep the air conditioning on.”

He also believes hard-pressed managers should not be shy about acknowledging their limitations. “You can tell investors, ‘I’m really good at trading, I’m really good at investment ideas, but for what I’m not good at, we are going to deploy this money more efficiently to someone who does know how to do it better,’ and I think investors who recognise this will appreciate it.”

Woods said investors often recommend funds adopt a more outsourced model, saying, “Do you have the ability to manage complex regulatory infrastructure and compliance and similar functions? That might not be a great use of time and energy when you’ve got proper expertise and teams on the ground already that you can leverage.”

Size is not crucial in any decision to outsource, although, a fund with billions under management might feel they are expected to cover more functions in-house than a start-up.

The key to a fund’s success is its investment strategy and it was here that Woods cautioned against outsourcing what differentiates the fund from the competition.

“What is it that allows me to achieve my goals and achieve my investors’ expectations? Anything else you can probably outsource.”

Fan said some funds dealt in such plain vanilla assets that investors didn’t much care who the portfolio manager was as long as the fund performed.  

“But if you manage a quant fund where clients expect a proprietary infrastructure and a very fleshed-out team, you would not want to tell your investors you are outsourcing your chief technology officer.”

Five things to think about before outsourcing
1. It can save emerging managers a fortune.

2. Forget fears of losing control. Whatever the outsourcing agent does, ultimate responsibility lies with the fund.

3. Remember outsourcers take instructions, not deliver them. You cannot outsource discretion, ensure oversight is rock-solid.

4. Don’t outsource any attribute that distinguishes a hedge fund from the competition.

5. Funds need not outsource any aspect of the business in its entirety. It’s not an all or nothing proposition.  

OUTSOURCE TO GROW

Given soaring costs and regulatory complexity, is it even possible to launch a fund without outsourcing?

“We see very few people with an entirely ‘insourced’ business model but, as the business grows, it almost becomes unrealistic,” Woods said, adding that scaling up required funds to adapt quickly to changes in the market and in regulation. Outsourcing can help make that happen.

“The quickest and easiest and most efficient way to scale a business without having to really scale up internally is to have an outsourced business model,” he added.

In Fan’s view, it is possible to start a hedge fund in Asia with very little capital as a single/two-person operation; but he questioned whether it would be marketable. “You can build it as a one-man band but what you end up with is just too shaky or doesn’t inspire confidence in investors. From a marketing perspective, it may not be the smartest thing to do.”

Yet everyone agreed that while pretty much anything can be outsourced, responsibility for those operations rests with the fund. Some functions are fiduciary, “close to the front-line defence of the fund,” said Fan. “Outsourcing agents are taking instruction, not giving it. That discretion ultimately lies in the power of the investment manager. You can never outsource discretion.”

Outsourcing is not an “all or nothing” relationship. Some funds may have in-house expertise in equity trading but less in fixed income, for example, which they might outsource. The buzzword is co-sourcing or supplementing.

The same is true of compliance. Whilst compliance responsibility will always rest with the fund, especially the COO, the workflow in gathering evidence of how the fund has fulfilled its regulatory duties is easily outsourced.

For optimal outsourcing, Woods said, it is vital that the outsourcing provider and the fund manager agree on expectations and responsibilities. “When a fund manager, who has a responsibility for whatever it is being outsourced, doesn’t have a really good understanding of what is being provided, or vice versa, then a big gap will become obvious very quickly.”

Gierhake said it was clear where the buck stopped, “It is imperative that whatever you outsource you ensure you have complete oversight.”

Another advantage of outsourcing for Woods is that it reduces wear and tear on a small team. “Having good providers in certain fields, certain tasks that you can outsource, takes time and stress off these people’s days that will improve the longevity of your team and your team is your business.”

Five things to access via outsourcing now
 
1. Complementary skills to fill critical skills gaps with outsourcing and access capabilities you would otherwise have to bypass.

2. Non-core function personnel to facilitate operational efficiency.

3. Extend reach and liquidity in less familiar geographies, asset classes or markets by using outsourcers trading ecosystem and expertise.

4. Scale to grow and adapt quicker to changes in the market and regulatory environment.

5. Free up time to allow the senior team to keep an open line to their investors.  

HERE TO STAY

Outsourcing has come a very long way in the last few years. The list of services that can be outsourced continues to grow. This growth reflects the economic reality of compressed fees, the  high cost of launching a fund, and the need to embrace efficiencies.

Outsourcing is also increasingly accepted – indeed expected – by investors who want to see the operational side of the business run “beyond smoothly”, as Gierhake puts it.

It’s also time to banish the idea that outsourcing means a loss of control. Whether in compliance, operational support, crowdsourced idea generation, or any other outsourced input, the ultimate responsibility whether to use it rests with the fund.

For emerging managers, Gierhake says it’s time they look again at their business models and consider the alternatives to keeping everything in-house. “Be smart where you spend your money and your time.”

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