01/06/2010 Author: Akshaya Bhargava

Comment: Akshaya Bhargava

With the current spate of fund management M&A activity dominating the headlines, few will have noticed that the hedge fund administration sector is also undergoing a period of consolidation. You only have to look at the new, absent and compound names in this issue’s HFMWeek AuA survey (p17) to see the industry evolving, as funds and investors expect to deal with bigger businesses, with better balance sheets.

Yet still, and despite this activity, alternative fund administration is a segment that only a few people outside the industry truly understand. It is seen as a black box (incorrectly), complex (correctly), non-scalable (incorrectly) and with low margin activity (incorrectly). Fund admin companies can be an excellent investment, especially in current times where the role of the administrator is being redefined and valuations are low.

There are certain broad characteristics that make administrators an attractive investment:
Sticky customer relationships.Administration contracts are very hard to win and once won, equally hard to lose. Research from TABB group highlights administrators as one of the most important hedge fund counterparties and changing administrators is something that no fund manager would undertake lightly. From the standpoint of an investor in the administration company, this is an ideal profile.

Predictable process that lends itself to efficiency. An administration company is basically an operations business. It makes money providing a very carefully structured service, using a complex technology platform and employing highly trained staff to deliver expected output. However, at its heart there is a repeatable process which is amenable to six sigma discipline. This means that the process itself can be engineered to optimise cost, service, timeliness and accuracy. This makes an administration business highly scalable with very strong operating leverage – again very attractive investment characteristics.

Globalisation of demand and supply. Increasingly, demand for fund administration services is coming from around the globe and the traditional model of location-centric delivery is no longer the best way to meet customer needs. Making a global operating model an essential prerequisite to being able to leverage time zone and talent availability effectively. This is an attractive investment model that creates scalability at attractive cost structures.

High operating leverage. The administration revenue model, of a fee based on percentage of assets under administration, creates barriers to entry with high fixed costs, but also delivers high margins once scale is achieved. This again, represents a very attractive investment characteristic.

Low valuations. Fund administrators have tended to attract very high multiples in the past – due to all the factors mentioned above. However, with hedge funds attracting negative publicity, valuations of fund administrators have also fallen sharply. This makes it an attractive time to invest.

Naturally, there is more to alternative fund administration than just a few attractive investment characteristics.
In my view, 2009 was the year of the administrator and this fact will only become apparent over the next few years. For one, the hedge fund industry is awash with demands for greater transparency, liquidity, control and independence. Fund administrators are today the only source of independent and reconciled data on the fund.

Therefore, they are the best placed to meet increasing demands from both institutional investors and regulators.
The growth of managed accounts is another reason why fund administration will be in greater demand. Managed accounts are increasingly being adopted as the investment structures of choice by large investors, and while they provide the solution for transparency and control, they also multiply the workload of the investment manager by a considerable factor. This means that efficient and scalable administration companies will be well positioned to benefit from this trend.

The alternative fund administration is an industry that is poised for growth. It has attractive investment characteristics – particularly for other administrators and private equity firms, masters of building scale efficiently and quickly – such as long-term, sticky customer relationships; barriers to entry; and the opportunity for constant improvement. Further still, current market conditions make it a good time to invest.