This content is from: Portfolio

Middle Worth

Hedge funds use middle-office systems to create alpha.

In the constant pursuit of alpha, hedge funds are using technology to enhance performance in an unlikely place — middle-office operations.

A red “$10,000” flashes on the large wall-mounted flat-panel computer monitor in the Madison Avenue office of Robert Herin, chief technology officer and head of risk management for New York–based Drake Management. The flashing number flags a trade in the firm’s portfolio, indicating a $10,000 discrepancy between what Drake believes an over-the-counter derivative is worth and the value ascribed to it by its counterparty.

Such inconsistencies are not uncommon in the world of hedge funds, which often rely on complicated investment strategies involving opaque and illiquid securities, where a missed principal payment or a sale price that is off by 5 percent can easily go unnoticed. To catch such irregularities — and to capture the money that can be lost to them — Drake, which has roughly $3.7 billion in assets under management in three multistrategy fixed-income hedge funds, has spent millions of dollars and thousands of hours creating a technology platform to handle processing tasks

that generally fall between the initiation of trades and their settlements, commonly called middle-office operations.

“Middle office is a task that you have to oversee yourself,” says Herin, 41, the architect of Cygnet, a suite of proprietary trading, compliance and risk management software applications developed by Drake. “Who has the most at stake with your checkbook? You or your accountant?”

Reconciling hedge funds’ accounts with those of their counterparties and custodians isn’t sexy, but the potential to save tens of thousands of dollars has made customized in-house management of middle-office functions appealing to managers seeking ways to boost returns. Although the tasks involved vary among hedge funds, depending upon the complexity of the funds’ investment strategies, middle-office management in its simplest form is about controlling risk and information technology resources. Middle-office functions include everything from issuing instructions to transfer funds to pricing daily positions to processing tender offers.

Handling middle-office functions in-house is not new. Needham, Massachusetts–based research and consulting firm TowerGroup estimates that only about 10 percent of hedge funds outsource their middle office. Most have been content to manage theirs with rudimentary systems that often combine off-the-shelf products, like San Francisco–based Advent Software’s Geneva investment accounting system.

But as hedge fund managers turn to more elaborate strategies to generate higher returns, a growing number of firms have begun plowing millions of dollars into creating proprietary technologies. Cost savings has been the driver for most hedge funds. Some, like New York–based BlueMountain Capital Management, believe that customized systems can generate alpha.

For Drake, middle office has been a cornerstone of its business plan since its founders, Anthony Faillace and Steven Luttrell, left New York–based fixed-income behemoth BlackRock in 2001 to create a firm that would combine hedge funds with long-only mutual funds and traditional managed accounts. The pair called upon the expertise of former colleagues like Herin, who worked with them at BlackRock and before that at Newport Beach, California–based Pacific Investment Management Co., to help create the middle-office technology they knew would be instrumental in their success.

Part of Drake’s strategy involves investing in transitional markets, like Poland and South Africa, where valuing and tracking illiquid securities can be extremely difficult. Even plain-vanilla interest rate swaps can be a challenge. Although Drake’s middle office may not physically receive swap contracts until days after an agreement is made, it is responsible for ensuring that the documents are correct, special deal terms are verified and margin payments are accurate.

The middle office is also essential to managing collateral. For an interest rate swap, counterparties hold collateral, depending on the terms of the contract. As the value of the swap fluctuates with movements in the underlying interest rates, the middle office adjusts the collateral up or down.

“We’re a levered fund; we have to know exactly where we stand at all times,” says Herin, who led a team of 12 software programmers and risk management professionals to develop Cygnet. They needed to ensure that the system would not only be able to integrate large amounts of data across Drake’s portfolios but also concurrently measure the real-time risk and compliance of the firm’s hedge funds, mutual funds and individual accounts.

“We don’t want to be surprised,” explains Herin, who says Drake’s in-house portfolio monitoring has already paid off in improved performance and profitability by reducing the size of the firm’s margin accounts. Cygnet’s cash management feature provides fund managers with daily status reports of all trades and transactions by 7:30 a.m.; external middle-office service providers often can’t provide that information until the next day.

Like Drake, BlueMountain believes that internalizing its middle office has helped generate higher returns by allowing the firm to use capital more efficiently. “It creates alpha for us,” says Samuel Cole, chief operating officer of BlueMountain, which manages roughly $3 billion in credit-related hedge fund strategies. He estimates that his firm spends roughly $7 million a year on operations and technology development, in large part because of the complicated nature of its OTC derivatives trading. BlueMountain is a big user of credit default swaps.

In the OTC world, dealers execute trades, collateralize and margin them, send cash payments and generate confirmations on their own. Stephen Siderow, president of BlueMountain, says his firm couldn’t trade with all of its current 28 counterparties if it hadn’t made a major investment in its own middle office. Known within the firm as IMS, short for Investment Management Analysis and Support, the hybrid platform handles capital management, risk and P&L reporting, risk and capital analysis, and operations.

Using IMS, BlueMountain’s operations team validates trades upon execution, monitors and investigates cash flows between the firm and its dealers and confirms all OTC derivatives transactions. Additionally, the group manages the daily flow of information between the firm and its prime brokers and is responsible for reviewing, simplifying and automating its processes to cut costs and reduce posttrade execution risks. BlueMountain is continually enhancing its technology platform.

“If another hedge fund came up with the same trade ideas but didn’t have the same middle-office capabilities, it might be overmargined and have less capital working for it,” says COO Cole.

BlueMountain integrates products and services from outside providers into IMS. It uses White Plains, New York–based financial technology firm Communicator’s compliance hub for trade confirmations and New York–based Depository Trust & Clearing Corp.’s Deriv/SERV trade-matching service and Markit Group for valuations. Daily, weekly and monthly P&L and net asset values are generated by Advent Software’s Geneva platform, which is run by Advent’s administrator, GlobeOp Financial Services. By the end of 2007, BlueMountain expects to bring P&L generation in-house and will use New York–based GlobeOp to double-check the numbers on a monthly basis.

Complex trading strategies were the driver behind Agamas Capital Management’s decision to build its own middle-office system. A New York–based multistrategy fund specializing in relative-value trading with less than $500 million in assets, it began constructing the system nearly a year before its April 2005 launch.

“Running a good middle-office operation produces tangible results that drop to the fund’s bottom line,” says George Roeck, 48, chief financial officer and chief compliance officer at Agamas. Roeck oversees the firm’s operating business and relies on technology to stay on top of its liabilities and assets at all times. The system handles everything from trade entry to confirmation and settlement, including margin, cash management and document management.

“It is an integral part of our investment and risk management processes,” says Roeck, whose previous positions include a stint with Bank of New York, where, as the firm’s director of administration and tax services, he oversaw financial reporting, compliance and tax services for roughly $250 billion in assets. Additionally, he served as CFO for both Florham Park, New Jersey–based institutional investment manager GSC Partners and Greenwich, Connecticut–based mergers and acquisitions firm Greenbridge Group, where he was responsible for monitoring any investment gains or losses in early-stage companies and reporting results to investors.

Although Agamas developed its own middle- and back-office systems in-house, the firm uses Visual Portfolio Manager, the accounting package of Melville, New York–based Integrated Business Systems, to calculate P&Ls and generate internal financial reports. “Having books and records that are parallel to our administrator’s affords our daily reconciliation process a higher level of accuracy and operates as a cross-check on what they report to us,” says Roeck. He adds that it makes sense for firms that pursue less-complicated investment strategies — specifically, long-short equities — to outsource their middle office. In major equity markets, he explains, the pricing and valuation of securities is much less of an issue because there is more transparency, and third-party systems are able to manage such information more easily.

Still, most long-short hedge fund firms see value in keeping middle-office management in-house. Joseph O’Neill, the chief financial officer for Otter Creek, a $120 million value-oriented long-short manager in Palm Beach, Florida, says the real-time information his firm’s in-house middle office generates allows its managers to make more efficient moves in the market. O’Neill is so certain internalizing Otter Creek’s middle office will pay off that his incentive compensation is partially tied to how much the system he oversees improves performance.

Of course, not all firms are capable of customizing their middle office — or have an interest in doing so. Third-party service providers like Dublin-based PFPC International are betting that hedge fund firms that have previously managed to get by with off-the-shelf products will be more willing to outsource to them if they can cater to managers’ increasingly complex investment strategies. PFPC is enhancing its platform to better handle OTC derivatives, including linking to London-based SwapsWire to automate the confirmation process.

Citigroup Corporate and Investment Banking recently launched a service that offers hedge funds an integrated front-, middle- and back-office platform. J.P. Morgan Worldwide Securities Services, which acquired the back-office operations of Paloma Partners Management Co. earlier this year, has been expanding its services. Both J.P. Morgan and Citigroup are betting that more hedge funds will ultimately choose to outsource their middle office to focus their energy and resources on investments.

But for hedge funds with complicated strategies that have invested heavily in customizing their middle-office systems, it is unlikely that outsourcing will ever be a consideration. Back at Drake’s Madison Avenue headquarters, Herin points to his monitor and Cygnet’s color-coded flagging system, proudly describing it as “a bird’s-eye view of pricing.” On this particular day nearly all the prices of its positions are yellow, indicating they are within 0.5 percent of where they should be — and that Cygnet is doing the job it was designed to do.

Related Content