Alternatives Need a Robust Infrastructure to Attract Capital
Alternatives Need a Robust Infrastructure to Attract Capital
By Dave Shastri
It Takes a Lot of Skill(s)
Alternative investment firms seek out several key skills in their employees. Unsurprisingly, given the attractiveness of working in these organizations, several academic studies have researched the skills needed within successful alternatives’ firms.
For instance, one study has identified these to include the knowledge-based skills of financial instruments, markets, quantitative expertise, an understanding of risk and portfolio construction. It also showed that personal attributes of excellent communications ability, teamwork and risk tolerance are valuable1. One other study emphasizes the importance of the networks of past employment, especially prior work at investment banks 2. These all play a role in the success of the firm.
What is also clear is that a significant portion of investment responsibilities fall outside of these skills. All of the infrastructure, from technology through to operations and accounting, are increasingly important components in what was once a cottage industry., As the alternatives industry has matured and investors have become more adept at understanding how to evaluate alternative investment firms, so allocators’ focus has expanded from investment management to cover a comprehensive review of the infrastructure in which the firm operates, generally referred to as ‘operational due diligence’.
In practice, there are a significant number of diverse skills required as part of the knowledge matrix of successful alternatives investment firm, some critical, some foundational and others interchangeable. But overall, investors demand that these be performed well, and by competent and trustworthy entities.
Operations are Foundational
Experienced investors do not select managers to invest in because they have strong technology and operations, but the lack of robustness of these is certainly identified as a reason to not invest. There are several reasons for this: -
Quality investment decisions are supported by quality information. The data used in a firm needs to be timely and accurate and this relies on processes that ensure this level of quality. Investment firms have the concept of a source of truth, where information is tested against multiple sources to ensure the firm is using the right data. This is achieved with validation through reconciliation and correction.
This information is used everywhere in the firm – from valuation and exposure management to cash management and risk management. Getting it right and delivering it consistently throughout the firm is essential.
Setting positions and trading based on inaccurate data can cause problems in performance and compliance. None of these problems are acceptable to portfolio managers or indeed to investors.
Errors in numbers including investment performance numbers can be a disaster for a business that relies on numeracy. Any errors in the production of the valuation and performance can immediately sap investor confidence.
Employing internal controls. This means several separations of activities that occur in the business. This includes the segregation of duties between the traders and the team responsible for settling trades and other measures that are used to avoid fraud. Similarly, the use of an external accountant or fund administrator, backed up by external auditors, serves to ensure that the investment manager’s accounting, whose remuneration is determined by the numbers they produce, is performed independently. Even so, investment firms also check that these service providers are doing their job correctly, such as running shadow accounting to validate the work of the administrator. This circular check is now part of best practice.
Modern technology. Ultimately investors expect a well-run business. Firms that fail to use the most appropriate tools are seen as inefficient. Ultimately poor technology creates a greater squeeze on the investment firm as an inefficient business is clearly more expensive to run and since the industry is competitive, investors can easily select a better run manager. And the better run manager can be more profitable.
Cyber-security is a franchise risk. Poor or ageing infrastructure exposes the fund but also its investors to cyber-security risk. It is easily one of the greatest external risks, and one that can be reasonably avoided with the support of expert industry partners.
Delivering Infrastructure is Also a Skill
This article started by describing the key skills of alternatives managers. None of these involved technology and operations. But these are the complements and foundations for a successful firm. Implementing infrastructure takes skill, not just at the start, but on an ongoing basis as the firm develops and as the environment in which it operates evolves. Developed organizations typically describe these activities as Change the Business and Run the Business and they are specialized functions. These activities are usually accomplished with a combination of experience and expertise in setting the infrastructure plan, understanding best practices and tools and investor expectations, obtaining the tools and people to perform these and strong project management. There is a lot of skill needed to achieve this, and it is not to be underestimated. This also means it will have a cost that is not to be underestimated.
In a KPMG/AIMA Global Hedge Fund Industry Survey3, the three most pressing issues in supporting investors are consequential to the challenges in infrastructure: -
18% - Expanded risk management and portfolio information – necessitating a well-structured operating platform.
28% - Demand for customization and tailored products – recognizing the rise in separately managed accounts which demand the use of modern technology
30% - Expanded due diligence – bringing greater transparency in all aspects of the working of the investment firm to the investor
Infrastructure in the Age of Remote Working and Outsourcing
Operational requirements and investment demands are showing no letup. The technical obstacles involved—for example, with operational due diligence—remain considerable.
Alternative fund managers have overwhelmingly decided whether through the experience of their teams being dispersed or through their increasing reliance on external service providers, that they can support much of their operations and technology stack through efficient outsourcing.
The outsourcing option benefits include reduced costs and more flexibility. The variable cost model approach can be essential for most alternatives managers who want to stay competitive; other firms are taking active measures to identify non-core activities that could be suitable for outsourcing.
However, this operational model presents new challenges. Managing in-house teams and external service providers becomes an important skill.
Alternatives Managers Need to Adapt to Stay Competitive
Managers are being forced to adapt to compete. But how do you ensure that your teams continue collaborating as effectively as they did when they were all housed under the same roof? Flexibility and a more intimate culture can prove a boon for smaller fund managers, but technology can also help.
It is not surprising that concerns over diminished team building emerged as one of the top consequences of the original COVID lockdown: these were the findings in the noted KMPG/AIMA survey3 of 144 hedge fund managers globally. Over half the hedge fund managers interviewed—55%—pointed to this as a concern.
One study on remote working identified fragmentation issues within hedge funds’ operational models that have emerged. These include a lack of a robust computer environment, structure and routine, and concerns around decentralized supervision.
How to manage internal functions in the new reality
Smaller and emerging funds launched in the last few years may already have embraced a heavily outsourced model. However, mid-sized hedge funds may still grapple with how internal functions can be managed appropriately in this new environment.
The KPMG / AIMA report identified maintaining company culture, team building, and real-time collaboration as the most significant challenges within a remote/virtual environment. As hedge funds realize the technical limitations of their Business Continuity Plans (many designed to assist with breaks of literally only a few days out to a few weeks), more permanent solutions are now needed.
Outsourced enterprise-level technology can provide a valuable pillar at the center of your virtual portfolio management operation and can be effectively employed. It can bring some considerable assets to the table, helping to reinforce your remote operations:
Ensure reliable connectivity and data preservation, independently of a sometimes-unpredictable local environment where your employees work
Enhanced security access and permissions mean your fund does not need to trust employee security provisions blindly
Web-based systems that can replicate the functionality of services and programs that, up until now, have operated on in-office servers and systems
An established operational road map that can support remote supervision and assist with getting new staff up to speed without coming into the office
An independently verified operational environment can assist with operational due diligence
One of the challenges that hedge funds may be starting to face is how to assure new investors carrying out operational due diligence that they can continue to operate with integrity over the medium term in these conditions, even when investors cannot evaluate the fund’s whole operation at physical offices. Third-party validation from companies with the right sort of Statement of Compliance audits going a long way to achieving this.
References
Top Skills Hedge Funds Look for in Job Candidates. Shobit Seth. Updated April 29,2001
Where do Hedge Fund Managers Come from? Past Employment Experience and Managerial Performance - Nicolas Papageorgiou, Jerry T. Parwada, Kian M. Tan, Australian School of Business, University of New South Wales, UNSW Sydney, NSW 2052, Australia
Accelerating out of the pandemic- KPMG / AIMA, 2021
Dave Shastri
CEO
Truss Edge
At Truss Edge, we assist hedge funds with managing and operating complex virtual environments for their trading, portfolio management and data processing activities. Our clients come to us for complete or customized technology with front, middle and back-office solutions because we evolved as a multi-strategy firm’s portfolio management system and operations team. We have the people and the expertise to manage complex or simple outsourcing projects, including improving connectivity with other service providers and interacting seamlessly with your proprietary trade management systems where they exist.
