The Future of Fund Administration John Phinney George Evans Joseph Dello Russo January 28, 2015

Transcription

1 The Future of Fund Administration John Phinney George Evans Joseph Dello Russo January 28, 2015 Citibank s recent announcement to exit the Hedge Fund Administration business may be the harbinger for similar reassessments by other universal banks providing Fund Accounting and Administration services. This event just may be the catalyst for the long overdue consolidation of the Fund Administration Industry. While Goldman s sale to State Street and Credit Suisse s sale to Paribas created the first ripples within the universal banking crowd, Convergence believes that Citibank s exit is the strongest and most convincing evidence to date that hedge fund administration businesses in universal banks continue to struggle financially. The real question is who is going to be the next to exit? It s no wonder Citibank had trouble generating the levels of scale needed to generate acceptable profit levels. Convergence has identified 450+ unique named Administrators providing a variety of backoffice services to the 6,200 Unique Manager Groups 1 that advise 43,000 private alternative funds. These Administrators, both large and small, compete fiercely for business because scale is the key to generating profits. While the vast majority of assets under management are held by the top 25 Administrators, it s the smaller clients who buy vanilla products and services that generate this desperately needed scale. And without scale, there are no profits, and well, it s simply a matter of time before sub-scale firms sell or exit. The toll that this competition has taken on Administrators of all sizes is significant. With so many providers, fees are perpetually under pressure and demands from clients, investors and regulators are increasing the cost of doing business. Was this combination of declining fees and higher expenses, enough to topple one of the industry s most promising competitors? What amazes many is that from a classic business school point of view, Citibank had all the capabilities needed to become a pre-eminent provider of Fund Accounting and Administration to alternative asset managers. They had the Balance Sheet, products, staff, technology and geographical footprint to service fast growing, complex and demanding hedge fund clients. They also have highly profitable products, like Prime Brokerage, Custody (custody itself may not be highly profitable, but coupled with add on products could be sec lending, FX, etc.) and Investment Banking, to cross-sell to these 1 A Unique Manager Group is comprised of affiliated Advisors. There are 7,800 Advisors of private alternative funds who map into 6,200 Unique Manager Groups.

2 clients. So with such a compelling arsenal of capabilities, what kept Citibank from taking its position among the elite players in this market? Despite the size and potential of its Fund Administration business, is Citibank s decision to exit such a surprise after all? After an intense review of Citibank s book of business, Convergence is not surprised by this decision and believes that more consolidation among the universal banks is yet to come. Mining and analyzing our proprietary database of information on all clients served by all Fund Administrators and combining it with the confluence of regulatory and market factors faced by many of the universal banks, we found several indicators suggesting that Citibank s Fund Administration Business may have been under financial pressure for some time. These indicators include, but are not limited to, the size and strategy profile of its clients, the complexity of their book, their cross-selling rates of profitable Prime Brokerage services and the low interest rates. The growth prospects of Citibank s Hedge Fund Administration business were simply not sufficient to continue investing the vast sums into people, process and technology to remain competitive. Citibank s decision raises a number of questions for its current clients that we are confident will be answered by Citibank or by the legions of aggressive and opportunistic competitors in this hotly contested marketplace. For a detailed assessment of these indicators and thoughts and trends in Fund Administration go to and register for our free research.

3 Indicator #1: Cross-Selling Indicators The promise of universal banking was compelling, or at least that s what the engineers of these behemoth institutions thought; be in a position to support your clients with the products they need, when they need them and where they need them. Just think about all the balanced scorecards used by the banks to measure the cross-selling by divisional executives! The universal banking model is expensive! For this reason, certain clients are more attractive to universal banks than others, specifically those clients who can buy the most products from them. At the minimum, each product division within the bank needs to generate enough volume to cover the overhead costs in place to support their product. One they achieve scale, products contribute to profits. Yet while the banks try and build product scale, they seek to generate EBITDA from all the other products they sell with an emphasis on those products that generate recurring fee revenue and net interest margin. Fee generating businesses required less capital because much of the risk was off balance sheet as was later learned during the financial market turmoil during the last decade. The more products the banks sell, the greater the possibility that a client contributes profits, in the aggregate, to the bank. Certain products will generally subsidize other products. Hedge Funds clients have long been attractive to universal banks because they utilize many products and services to run their business, particularly the larger, complex and global managers. These services may include: Investment Banking Prime Brokerage Transaction Services Corporate Banking Asset Management IPOs Margin Financing Fund Acounting & Administration Corporate Checking Fund Distribution Debt Issuance Securities Lending Treasury & Cash Management Payroll Services Trade Execution Clearing & Settlement Trust Services Lending Services Hedging Position Reporting Custody Services Foreign Currency Custody Services In addition to people costs, the technology needed to service the hundreds of hedge fund clients who trade everything from simple public equities to litigation claims can be staggering. Annual IT budgets for these businesses can easily run into the $100mm+ range and to to cover these costs, Banks need scale, defined as lots of hedge fund clients buying lots of similar products offered by different divisions of the banks. And once they have these clients, the clients need to grow their assets in order for banks to make more money on their existing base. So with this in mind and given just how hard and expensive it is to win and maintain hedge fund clients, why would a bank exit a Hedge Fund Administration, a product line that is must have for all hedge fund managers and is a gateway into other lucrative cross-selling opportunities? Perhaps some of the reasons can be found by looking at the cross-sell rates of the banks, and Citibank in particular given its decision to exit. Convergence developed a cross-selling indicator to examine the number of other linked products and services that universal banks like to sell to hedge fund clients, including, but not limited to: Prime Broker Cross-Sell Ratio Custody Cross Selling Ratio

4 Citibank s Prime Brokerage and Custody cross-sales to hedge fund clients 2 are materially below their universal banking peer group. Many universal banks look at client profitability across all products to determine whether they should continue to offer their clients products that on a stand-alone basis don t meet risk-adjusted return requirements. Indicator #2: Fund Administration Customer Profile Indicators The profile of the customers that make up the Hedge Fund Administrator s book can also give us a glimpse into the bank s profitability of an Administrator s book. Convergence tracks the number, size, complexity and strategy of all of the Administrator s customers. Each of these factors can directly impacts the Administrators revenue and expense. Size of Managers 3 The PFRAUM reported by 90% of Citibank s Hedge Fund Clients is below $1bn, which is higher than their universal banking peers. While the basis points charged to smaller clients on AUA tend to be higher due to minimum fee levels, the actual revenues per client are lower which can result in reduced service levels and higher attrition higher. Complexity of Unique Managers 4 The Complexity of Citibank s Client book is below their universal banking peers. Lower complexity may result in lower revenues because complex funds are priced higher to offset higher costs. Hedge Fund Administrators are built to service complex and non-complex clients and thus carry higher fixed costs. A less complex client base will not generate enough margin to cover these costs. 2 Based Prime Brokerage Disclosures in Form ADV listing the Administrator, Prime Broker, Custodian and Third Party Marketer for each fund. 3 Size of Manager is segmented as follow: >25bn, >10bn<25bn, >5bn<10bn, >1bn<5bn, >.500bn<1bn, >.100bn<.500bn, <.100bn and 0. 4 Complexity factors are designed to capture the amount of work that Administrators may be required to perform for a given fund. Convergence tracks 20+ complexity factors. Complexity drives the amount and diversity of revenue and also the cost of servicing the book.

5 Primary Trading Strategy of Managers 5 The Primary Trading Strategies of 75% of Citibank s Hedge Fund Clients are concentrated in 4 of the 10 major strategy types. Trading Strategy concentrations suggest the book is less diverse, and may create more revenue and profit volatility during periods of specific asset class stress. Because much of the Fund Administrators costs are relatively fixed, lower asset values can have a very negative effect on EBITDA. Indicator #3: Limited Partner Profile Indicators Non-US Domiciled Limited Partners Citibank s Client book has a materially higher percentage of non-us domiciled clients per fund than their universal banking peers. Non-US domiciled limited partners may require a greater level of support than US-domiciled limited partners. AVG # of Limited Partners per Fund Citibank s Client book has among the highest number of limited partners per fund than their universal banking peers. High numbers of limited partners may require greater levels of resources than fewer limited partners per fund and negatively impact EBITDA. 5 Primary Trading Strategy refers to the dominant asset class used by the Manager to generate alpha. Convergence s database tracks 30 different Trading Strategies.