Proven strategies for selecting hedge fund services providers.
By Ian Bickerstaffe, Founding Partner and COO, Rye Bay Capital LLP.
In this report, a hedge fund industry expert provides thoughtful advice on how to evaluate service providers and make more-informed decisions.
Main takeaways:
1. Due diligence is key — service providers should be assessed on the basis of reputation, expertise and growth. 2. Legal representation is first priority, as they will help set up the business and fund structure and negotiate contracts with other providers. 3. Prime brokers are the second priority and an equally important choice as the right broker will help turn prospects into investors.
After the core management team is finalized, the next step for a start-up hedge fund is selecting the service providers that will turn your strategy into a fully operational business. These choices are anything but simple, and play a greater role in the success of the business than many realize.
Ian Bickerstaffe uses a simple acronym for how start-ups should assess service providers: REG, which stands for reputation, expertise, and growth.
Assessing providers:
“The reputation of the provider is critical, because if investors aren’t familiar with them it could be an issue,” he said. “Expertise means asking whether the provider retains the specific expertise your business requires. Do they have a track record in your strategy? Have they worked with other successful start-ups? And, finally, can the provider grow with you? You’re not going to be a start-up forever, and you don’t want to have to redo all your due diligence two years later.”
Legal representation:
The order in which you choose providers is also important. Legal representation is typically the first priority, because this individual will set up the fund structure and negotiate contracts with other
providers as well as offer advice on how to set up the business.
While much of the initial legal work is commoditized, strategy does play a role in selection. For many funds, choosing a “tier one” law firm is the most straightforward approach. But an esoteric credit strategy with more sensitive regulatory and tax implications, or a business regulated by UCITS with additional compliance concerns, may require more specialized advice.
After applying the REG test, businesses can narrow down their choices by establishing personal rapport.
“Ideally, you want people who are on your wavelength, so you can work with them effectively,” Bickerstaffe said. “The downside of the tier one firms is they are expensive, but these costs will in all likelihood be amortized, so it pays to go best of breed. Investors expect to see law firms they recognize and are well known in your strategic space.”
Picking a prime broker
After choosing legal representation, picking a prime broker comes next. The choice is extremely important because the broker’s reputation helps turn prospects into investors. In other words, who you use reflects the quality of your business. It is ideal to work with a bulge bracket bank that knows the asset classes your business is trading. Typically, the portfolio manager will know which broker offers the right pricing, services, and financing for your strategy.
The decision, however, is more complex than it first appears. A prime broker, for example, may accept your business as a matter of course but have a stronger internal preference for other types of strategies. It is up to you to determine whether your relationship with the broker is one of convenience or true connection.
“It’s important to have a transparent conversation with your prime broker to understand how they view your strategy,” Bickerstaffe added.
Consultant & cap intro teams:
Keep in mind, the relationship with a prime broker goes both ways. Brokers offer a wide variety of services in addition to execution, including trading services, financing services, research, consulting, and capital introduction. The last two can be particularly valuable to start-ups. Consultants provide seasoned advice about business setup, while the cap intro team serves as a bridge between new businesses and potential investors.
“You should understand the benefits of cap intro as well as its limitations,” Bickerstaffe said. “It’s a service. You get the introduction, but that’s it. It’s not a commitment to allocate capital.”
By the same token, you should expect to help the prime broker meet its revenue targets. The point is to think beyond execution and understand that the prime broker relationship works best when it works equally well for both parties.
Finding a fund administrator
One service the prime broker consulting team can provide is helping compile a short list of fund administrators for your strategy and facilitating the introduction. Not every administrator wants to work with start-ups, and some strategies require administrators with more specialization. Of course, if you have a high-pedigree team and are positioned to raise a lot of capital, your business will be more attractive to the fund administrator.
Generally speaking, it is critical to find a fund administrator that is reputable, well-recognized, and can provide proper controls. Most important, however, is finding the right fit between your needs and the fund administrator’s capabilities.
“It’s imperative for start-ups to figure out what they really need,” Bickerstaffe said. “In the last number of years, we’ve seen a shift toward outsourcing. Traditionally, the fund admin would cut the NAV once a month, send out your investor statements, and that was it. Today, they might also handle trade settlement, matching, and a variety of other trade support services.”
Again, strategy may be a determining factor. A complex debt strategy could require your business to keep more middle office functions in-house. Simpler strategies, however, can use outsourcing to keep overhead low.
“Once you have your needs figured out, you can start looking for a fund administrator with a proven track record with start-ups,” Bickerstaffe said. “You don’t want to get a year into the relationship and have to replace them because they gave you a great deal for the first 12 months, but now you can’t afford the service.”
Assessing audit and tax
Much like legal services, audit and tax services for hedge funds are somewhat commoditized. Businesses can’t go wrong by choosing one of the Big Four firms.
However, Bickerstaffe draws an important distinction between the audit side and the tax side. “Tax and audit are often the same provider, but not always,” he said.
In other words, remember REG. A global equity fund trading in numerous jurisdictions needs a tax adviser that understands these markets — not one that knows one country very well but isn’t comfortable outside it.
In fact, where the tax adviser’s office is located can come into play. Because you are not just selecting the provider. You’re selecting the office to call when you need help.
If you’re trading in Asia, for example, you need support from an office in Asia. It won’t work if you only have a two-hour window when you can communicate.
Bickerstaffe warns that choosing a Big Four firm doesn’t necessarily mean you get the same treatment as everyone else. Start-ups may be a lower priority for a big-name firm, resulting in a headache when you need end-of-year statements by March, but the auditor can’t schedule you until June.
Fielding a solid team
Ironically, if you make all the right choices and surround your business with helpful, collaborative, competent providers, nobody notices. The business simply operates as expected.
“If everything is running smoothly, you can rest assured you’ve done your job,” Bickerstaffe said. “On the other hand, if you’re seeing cracks in the operation after a few months, that’s worrying. The good news is, you can mitigate this risk with a rigorous due diligence process.”
Ideally, the person conducting the due diligence should be a COO with sufficient experience to make informed decisions, and should be involved as early as possible.
If the COO comes in after providers are in place, it can be a bad omen — especially if up-front costs have been prioritized over long-term value. Again,
proper due diligence can help start-ups avoid the trap of having unreliable service providers and, at the same time, wanting to avoid replacing them. From the investor’s point of view, a switch in any area is a red flag. The decision will need to be explained in detail, including why you selected the provider in the first place and how you discovered your mistake. If you replace your legal counsel, auditor, and fund administrator in the first year, that is evidence of poor due diligence.
Investors themselves are a key source of information when it comes to choosing the right service providers. Making these decisions collaboratively typically leads to better results. For example, one of the most helpful things any business can do is ask early investors for feedback.
At the end of the day, the investor is paying the fees, so it makes sense that they should have input. If they make a valuable suggestion and help your business avoid a pitfall, it pays off for everyone in the end.
About the contributor
Ian Bickerstaffe is a founding partner and COO of Rye Bay Capital LLP, a London-based long/short equity manager.
He has more than 20 years of relevant financial services experience and is a member of the Institute of Chartered Accountants in Ireland.
