Critical Infrastructure: Primary Instrument to Generate Operational Alpha

The New Asset Class
Prime brokers and hedge funds have a longstanding relationship in the overall hedge fund ecosystem. Through primes, fund managers have access to a suite of specialized services, including cap intro, trade execution, securities lending, margining, international market access, cash trading, derivatives financing, and reporting, all with the goal of enabling managers to generate alpha and communicate performance back to their investors.

Prime brokers have been the indispensable infrastructure partner and one of the most important relationships for any fund managerⁱ.

Today, relationships between the two are evolving. The alternatives industry is transforming from a pedigree- oriented, performance-based environment to a transparency-focused ecosystem, with expanded fund manager requirements.

Fund managers are starting to take advantage of services that not only enable the generation of alpha from an investment strategy, but also uncover ‘operational alpha’ - hidden capital usually locked up within unduly expensive operations.

The ability to extract a return on investment from operations will have a direct impact on how competitive fund managers remain going forward and the amount of capital that will be free to invest in alpha generating research, analytics, personnel, and core fund marketing activities over time. In essence, operations represent a new quantifiable asset class—one that not only supports performance but is a source of capital through the elimination of overhead costs.

The Infrastructure Instrument
According to a November 2013 Preqin survey, investor satisfaction is not solely predicated on returns and performance when it comes to alternative investments. Consistency and the ability to adjust risk are important as wellⁱⁱ. Long-term consistency and real-time adjustment strategies are core components of today’s new fund reality, and like any business the ability to lower overhead costs and extend operating runway will determine success.

Investors are now basing allocation selections, in part, on the presence of key infrastructure elements that provide controls to mitigate risk and stay within mandates.

The challenge for funds is to address investor expectations while simultaneously minimizing overhead costs in order to execute on long-term business plans. Harnessing operational alpha from the early stages of the business through to maturation will keep funds competitive.

By focusing on operational alpha as they would any other instrument in their portfolio, fund managers can position their infrastructure as a direct source of capital that not only buys runway, but attracts and retains new allocations, in three business stages:

• At launch
• In acquisition
• Over time





At Launch
With regulation continuing; the single-prime model breaking down; and investors seeking more transparency and reporting than ever before, fund managers have an uphill battle when entering the hedge fund market. In tackling these challenges, operational alpha strategies are gaining popularity and momentum with fund managersⁱⁱⁱ.

The right technology behind a new entrant’s infrastructure can not only lower upfront costs in terms of initial overhead but also allows a new entrant to more predictably project costs 24 to 36 months down the line as the business matures, eliminate the gulf space between the business and investors, and create new operational options at every point in the trade lifecycle.

For any manager, the ability to look horizontally at internal costs and vertically at long-term development can directly influence critical decisions such as bringing on the right headcount to manage investments.

In Acquisition
As competition increases for new allocations, attracting new investors will require the ability to meet general regulatory demands as well as demonstrate a transparent and real-time environment achieved from the use of institutional-grade infrastructure and controls.

Investors expect more than just absolute return^v, and when they look to a fund’s capability beyond the manager’s pedigree, their key requirements include controls such as:

• Cost containment
• Risk adjustment
• Fee flexibility
• Adherence to mandates

Ultimately, funds need the ability to pull the levers on these controls in real-time and at-will to attract new investors. With these same investors more plugged into the intra-day activities of their allocations, they will look to a fund’s capabilities to demonstrate access and transparency at the outset.

An infrastructure that supports these needs can satisfy expectations, but only when delivered in real-time and in an environment that survives adverse events like outages or even disaster scenarios.

Over Time
While pitching and investor acquisition are crucial to a fund’s development, keeping those clients and maintaining their investments is the true test of a fund’s viability. An infrastructure that empowers accurate cost views while delivering real-time order, execution and risk management (OERMS) as well as shadow NAV, and outsourced middle- and back-office services, ensures the fund operates off of a single set of books and records in real-time while eliminating unnecessary and costly operations costs.

Over time, the ability to predict long-term infrastructure costs keeps funds ahead of investor expectations and protects against unforeseen or hidden costs eating away management and/or performance fees. Home grown or vendor-led legacy systems, outdated interfaces, lack of vendor consolidation, maintenance, and burdensome contracts can all erode operational alpha within years or even months of implementation.

Thus, it will be critical for fund managers to not only look at upfront costs of their infrastructure, but to also have a window into Total Cost of Ownership (TCO), including long-term infrastructure requirements and costs over 24 to 36 months.

Accurate TCO empowered by a single set of books and records that reside on one end-to-end platform allows for full-view, transparent reporting that provides managers and investors with the opportunity to follow their allocations when they want.

To take this a step further, if this platform exists as a cloud-based solution, investors can be granted access to investment management tools and unique insights into their portfolios anywhere, at anytime, and on multiple devices.

This capability not only provides measures to counteract disaster scenarios or adverse events, but allows funds to generate and disseminate reports at will—an activity that has been traditionally governed by prime brokers— bringing funds closer to their clients and simultaneously de-risking counter-party exposure.

Beyond Portfolio Alpha
When it comes to building a business, a hedge fund needs every modern tool to stay competitive. Investors’ priorities have shifted to a new emphasis on the structure and credibility of the fund’s processes and systems, rather than focusing solely on past performance.

While pedigree and access are still important in fund management and allocation acquisition, new expectations of institutional grade infrastructures, and the power of real-time choice and transparency are becoming the norm for investors as de facto regulators. And they expect them from day one.

Operational alpha represents a critical alignment of external investor mandates and internal runway projections. By staying on top of internal costs at the outset and over time, capital that was once reserved to fund high operational costs can be allocated to the front office at the early stages of the business for greater alpha- generating activity.


i Hedgeweek.com, Hedge Fund Start-Up Resource Centre, 2013
ii Preqin, Investor Satisfaction / 2014 Hedge Fund Outlook Survey; November 2013
iii Cambridge Associates, Hedge Funds: Value Proposition, Fees, and Future; August 2013
iv Global Custodian, Customization Improves Scalability; Winter 2013
v Preqin, Investor Satisfaction / 2014 Hedge Fund Outlook Survey; November 2013


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