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FundFire Alts Feature: Hedge Funds Cut Costs by Trimming Ops Shadowing Efforts

Article published on August 9, 2017
By Lydia Tomkiw


Hedge funds are increasingly looking to shadow only core areas of their fund administrators, amid performance pressure and a hunt for ways to cut costs, industry watchers say.

While full shadowing – essentially duplicating an administrator’s functions to verify and secure fund data – remains in the market, more managers are eyeing a model of “oversight and governance,” which entails shadowing only key areas of their administrators.

“It’s a significant shift and it does reflect the evolution of the hedge fund industry and the challenges the industry is facing – and how those drivers are shifting how a hedge fund is run,” says Samer Ojjeh, a principal in the financial services organization at Ernst & Young, who co-authored a recent paper on the subject.

Approximately 90% of the managers Ojjeh works with have debated moving to an oversight and governance model, including about 40% that have taken steps such as gradually shifting away from shadowing reconciliation or trade settlement activity, he says. Part of the process involves managers doing a lot of homework around their service providers and understanding the processes and procedures when it comes to business continuity plans.

“We are seeing a significant focus on this because of the cost pressure and the fee pressure they are under. It’s not sustainable to pay for two sets of books or two sets of back offices,” he adds.

Under an oversight and governance model, managers can reduce some operating costs by outsourcing those shadowing functions to admin firms, including back-office processes such as NAV calculation, according to the paper.

The overall market has improved so far in 2017, with inflows picking up and hedge funds posting their strongest performance of the year in July, gaining 1.2%, according to Hedge Fund Research’s weighted composite index. Despite the performance turnaround halfway through 2017, investors have become increasingly averse to fund pass-through expenses, including research and travel, according to EY’s 2016 global hedge fund survey. But the highest level of respondents, at 34%, said it was acceptable for managers to pass through expenses related to outsourcing back-office shadow functions.

Managers increasingly want to spend more time focused on trading and research, which is driving them to outsource other aspects to third party providers, says David Young, president at Gemini Hedge Fund Services.

“It reduces their cost structure internally, which allows them to be much more competitive from a fee perspective,” he says. “Obviously as funds are under fee pressure… it does put on additional constraints in regards to your ability to properly staff. And by outsourcing they can get the efficiency of what an outsourced third party can provide.”

Some hedge fund managers are now even looking to hire a second fund administrator to check the work of their current admin, Young says, noting approximately 15% of Gemini’s hedge funds clients are using it for this service.

Part of the process of deciding on a correct fit when it comes to shadowing arrangements is asking the right questions, he adds. “If you’re spending money to have a shadow process, whether internal or external, do you have the right process in place? Are you assured that you’re going to come up with a true secondary check?”

While some managers are eyeing the switch, the process is more of an evolution than a revolution, moving at a slower pace, argues John Phinney, co-founder of Convergence, Inc., a firm that identifies, tracks, and reports changes across the alternatives industry on a daily basis.

Mangers face a tough decision when settling on which model is right for them, prompting a lot of talk, but not as much action, he says. Part of the problem for managers is finding the right cultural fit with their admin providers.

“The reality of the opportunity is really rooted in culture. The advisor has to be willing to give up certain [control] or they have to create a whole different level of transparency around what they are doing,” Phinney says. “So while it has interesting economic [implications]…. more people opt not to do it because they do not want to give up certain [control] they have.”

Hedge funds employing the oversight and governance model range in size from those above the $25 billion assets under management mark to start-up managers and across strategies, the EY paper found.

Hedge funds have increasingly been looking at different shadowing arrangements, says Sidney Wigfall, managing partner at SCA Compliance and Consulting. From a compliance standpoint, “delegation without abdication” is the principle that has been reinforced by the Securities and Exchange Commission, with managers needing to have oversight of key service providers, he says.

“For those firms that were doing it at a full 100% shadowing, it shouldn’t be too difficult to get to a place where they pull back and only need to do cross validation on key areas,” he says.

While questions may arise over business continuity and cybersecurity, cost pressures are likely to keep driving hedge fund managers to reevaluate their set-ups, he says. “I think you’ll see more and more firms at least revisiting their structure to see if there are cost savings they can capture.”

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Strapped Pension Funds and the Hefty Investment Fees They Pay

Every Pension Plan CIO, Board Member, Due Diligence Director and their Plan participants should carefully read the Gretchen Morgenson’s piece titled “Strapped Pension Funds, and the Hefty Investment Fees They Pay” recently published by the NY Times on May 14, 2017.  While many Pension Plans are actively working to reduce the management and incentive fees they pay, Convergence believes that Pension Plans and their Investment Consultants can further improve their ability to negotiate lower fee and expense levels by understanding the organizational “complexity” and operating risk for all Advisers they invest with today and those they may add in the future.

Click here to read the full report!

Originally posted on LikedIn


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May 20, 2017 Premiere of HBO Movie “The Wizard of Lies” The Story of Bernie Madoff – Convergence is Working to Make Sure it Does Not Happen Again

On May 20th, The HBO movie “The Wizard of Lies” (airing Saturday) showcases the legendary talents of both its star and director, Robert De Niro and director Barry Levinson, by re-telling this shocking tale of greed and betrayal. Yet, despite the very public stories shared by his many victims and the myriad lessons supposedly learned, investors continue to be skinned by frauds and scams and cleverly disguised fee and expense skimming operations by unsavory Advisers. While the SEC cannot save investors from fraud, investors can help avoid it themselves by paying closer attention to Form ADV, a regulatory filing requirement for exempt and non-exempt State and SEC registered Advisers. Had today’s version of the Form ADV been in place when Madoff was up to no good, investors would have seen some important red-flags that may have spooked them enough to avoid what was, for many, a life shattering experience.

It seems like only yesterday that a Wall Street scion named Bernie Madoff was publicly cuffed and arrested for concocting the biggest Ponzi scheme in history, literally in plain sight, despite the facts that clues to his malfeasance were abundantly available. So, what clues existed then and why did so many who suspected Madoff of fraud choose to remain silent? Was it out of their fear of political, business and social reprisals or was it simple greed? Who knows, yet Convergence has stepped into the breach by developing a clear and simple way to communicate these potential red-flags, or clues, to investors and other members in the Advisers eco-system.

Convergence uses the terms “complexity profiles and factors” to describe the operating risks in an Investment Adviser based on the responses they provide to questions raised in their SEC Form ADV and other regulatory filings. We have identified 40 business conditions derived from the Advisers Form ADV responses that provide key insights into operating risk. Operating risks need to be understood and may be well-controlled by the Investment Adviser’s staff and their group of third party service providers. Yet, if they are ignored, or are not being managed, then investors beware, it will cost you dearly.

Harry Markopoulos presented a compelling analysis to the SEC pointing out 30-red flags to support his view that Madoff could not have generated the returns he boasted without either (1) running a massive Ponzi scheme or 2) illegally front-running client trades, twenty-nine of his thirty red-flags required advanced math and market aptitude, well beyond the grasp of mere mortals, to understand Mr. Markopoulos. The one red-flag that could be understood by mere mortals, was the simple fact that his brother-in law, a strip mall accountant, was the only accounting firm allowed to see into the “Madoff secret sauce”.

Convergence reviewed Madoff’s last Form ADV filing dated 1/7/2008 and, while not nearly as robust as today’s form, identified additional red-flags worthy of review by investors at the time.

  1. Madoff did not disclose management or incentive fees, he earned commissions. He would have collected much more by charging Management and Incentive based-on his asset levels and performance returns than the Brokerage Commissions he claimed to generate. This was noted in the Markopoulos research.
  2. Madoff was a broker dealer and traded and cleared his own securities, not a Prime Broker, so he manufactured his own trade confirmations.
  3. Madoff was not the General Partner or Investment Adviser to a registered fund-What form of account held the $17bn in assets he reported.
  4. Madoff disclosed that he had no employees or third-party firms soliciting clients on his behalf.

Well who was raised the $17bn?

  1. Madoff disclosed 10-25 clients yet disclosed a broad distribution of client types, suggesting massive average client account holdings.
  2. Madoff reported 51-100 employees yet only 1-5 that performed investment advisory functions, including research. The percentage of non-investment-to-investment staff ratio is between 9:1 (46/5) and 19:1 (95/5), which is unheard of and suggests an army of non- investment staff. What type of work did they do, given the highly-automated type of trading being conducted by Madoff?
  3. Madoff disclosed providing continuous supervision over securities portfolios yet disclosed that he did not Advise a private fund. What type of account or fund held his $17bn?
  4. Madoff’s Chief Compliance Officer was also his Director of Trading, not exactly the segregation of duties one would expect in a $17bn fund.
  5. Madoff disclosed several regulatory violations on his Disclosure Reporting Pages (DRPs).

In the revised Form ADV post-Madoff, Advisers are required to report additional information that would have raised additional red-flags had they been in place during the Madoff era. These include:

  1. Disclosures around the names of the funds that he was sub-advising
  2. Amount of Cash and Securities held in Custody for clients
  3. If he disclosed a private fund he would have had to disclose its Fund Administrator, which would have probably been “Self-Administered”
  4. Its Fund Auditor, who we know was his brother in law and not a Big 4 firm, would be considered unusual for a fund of that size.
  5. Its Custodian Bank, which was a small local community bank, was not known to have the competency to perform the activities expected to administer the billions of dollars in cash and securities it was deemed to control.
  6. Its Prime Broker, which was himself or his related affiliate.
  7. Disclosures on whether the valuation of fund and account assets are done by parties unrelated to the Adviser would have been answered 0%. Unusual for a portfolio comprising public securities and OTC options.

Convergence invites investors, service providers and Advisers to call us to learn more about the factors and conditions that can lead to operating risk and fraud that may be developing in the markets.

Working together, we will evaluate and expose red-flags that will help many from becoming another unwitting victim of fraud.

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Alternative Asset Managers See Increase In “Complexity” During The Quarter

Total new regulatory disclosures up; 2% of managers experience higher complexity in the period

SOUTH NORWALK, Conn. (April18, 2017) – Alternative asset managers saw an increase in “complexity” during the first quarter of 2017, with 152 Managers, or 2%, moving to a High Complexity Profile in their operational and business model, according to Convergence, a leading provider of data and insights to the alternative investment industry. The increase in complexity was led by hedge funds, with 78 funds moving to High Complexity, compared to 34 private equity funds, 10 real estate funds, and 28 “other category”.

Convergence assesses manager risk by tracking and monitoring 40 business and operational factors, including internal valuation, self-administration, and qualified audits. Convergence data has demonstrated a strong historical correlation between growth in fund complexity and levels of alternative manager risk.

“The quarter saw movements up and down the complexity curve across all Fund Types, and we expect to see continued changes as 225 new Managers were added, based on our most recent view of Q1 data,” said John Phinney, co-president at Convergence.

Other data from the quarter includes:

  • New regulatory actions disclosed by alternative Managers during Q1 increased by 135, comprised of 120 Regulatory Actions, 8 Civil Actions and 7 Criminal Actions.
  • 121 Managers experienced a decline in Complexity from High to Medium Complexity, led by 39 HF Managers, 44 PE Managers, 12 RE Managers and 57 Other Fund Managers.
  • 225 New Managers were added during the quarter, 9 receiving a High Complexity Rating, 110 Medium and 106 Low.

About Complexity

Convergence’s Advisor Complexity Profile (“Complexity”), launched earlier this year, is designed to address the challenge of operational and business model transparency in the alternative asset management industry. Complexity provides insight into all the major alternative asset classes, including hedge funds, private equity, real estate, venture capital, and structured asset funds, incorporating approximately 8,300 managers in more than 50 countries, and assigns each of them a high, medium or low complexity profile. It is designed to meet the needs for improved transparency and analysis for all the major industry participants: investors and asset allocators, assets managers, and service providers.

About Convergence, Inc.

Founded in 2013, Convergence is an independent growth company that has created an entirely new platform comprising (1) data, (2) research and analytical products, and, (3) surveillance / monitoring services, all providing transparency into the infrastructure of the alternative asset management industry. The firm’s leadership team has 120+ years of experience managing operating risk in many of the world’s leading asset management organizations. The depth and breadth of this industry expertise differentiates Convergence from any research players in the industry who provide data but fail to provide actionable context. Convergence does not render investment advice.

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Identifying and Mitigating Operational Risk through Data Analytics

This post, written by Convergence’s John Phinney and George Evans, was originally posted on GARP – Global Association of Risk Professionals on March 10, 2017.

Massive amounts of siloed and unstructured data complicate the huge challenge of managing operational risk in the rapidly growing alternative assets industry. However, advanced data analysis can temper this risk by uncovering the impact of operating model decisions and by detecting complex patterns that are not otherwise readily transparent.

Last year, in a feat that was thought to be impossible not too long ago, an artificial intelligence program created by Google beat an established master at the Chinese board game “Go” for the first time. The program, AlphaGo, did so in part by recognizing and taking advantage of complex patterns in the movement of the stones used by the game’s players — patterns that were invisible to its human competitor.

Something similar is happening with efforts to manage operational risk in the alternative asset management industry, which includes hedge funds, private equity, real estate and structured assets. With more than 17,000 registered investment advisors, 58,000 alternative funds and an expected $20 trillion in assets by year-end 2020, the industry is vastly complicated. Moreover, a massive and expanding publicly-accessible digital footprint comprised of ADV filings, vendor relationships and RFPs adds to its complexity.

Indeed, in 2016, alternative asset managers filed 40,000 ADVs — and, what’s more, 40% filed more than once (up 28% from 2015). Historically, this data has been mostly siloed and unstructured. Now, however, newer technologies are emerging that can capture this information in a normalized, structured database.

The Data Analysis Payoff

While the data flow can be massive (as much as a terabyte a day), the payoff from providing daily analysis can be significant. As with artificial intelligence and Go, patterns start to emerge that were previously undiscoverable. The data algorithms typically look for change at the margin among factors that include internal valuation, self-administration and qualified audits, for example.

The working thesis behind the expanding use of advanced data analysis is straightforward: complex systems can add risk, and unnecessarily complex systems can add unnecessary risk. A corollary would be that, as an investor or allocator, you want to know that a manager has systems in place that are commensurate with the level of operational risk inherent in the fund.

While many of the operational changes flagged by data analysis may not seem especially worrying in isolation, patterns that emerge through such analysis may suggest otherwise. Detection of complex patterns could have, for example, come in handy for the eight percent of alternative asset advisors that incurred a regulatory violation over a recent 36-month period (see Figure 1, below).

Figure 1: Managers Reporting Regulatory Actions by Primary Fund Type

Prior to their regulatory issues surfacing, 80 percent of the regulatory “violators” had a medium or high complexity profile. Of course, provided that systems are in place to manage it properly, a high level of complexity (see Figure 2, below) isn’t an issue in and of itself. Moreover, the patterns discerned by the algorithms are worth knowing, regardless of whether or not they portend a regulatory issue.

Figure 2: Complexity Profiles of Managers Reporting Regulatory Actions

In the case of the alternative asset managers that incurred a regulatory violation, identifying these patterns may or may not have saved the day — but it would have at least suggested that a closer look under the hood was in order. These kinds of operational metrics may have been largely invisible in the traditional due diligence process.

Human beings are geared to detect patterns, but can be quickly overwhelmed by the kinds of massive data now available in the alternative assets space. Fortunately, technology has reached the point where high volume and multiple sources are no longer insurmountable obstacles.

In fact, the measurement of operational risk can now provide significant insight across the entire industry, from allocators to the managers themselves. Like AlphaGo, it’s just a matter of seeing what’s in front of our eyes in new ways.

John Phinney and George Evans are co-founders of South Norwalk, CT-based Convergence Inc., which identifies, tracks and reports changes across the alternative asset management industry on a daily basis.

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Convergence Launches Advisor Complexity Profile, New Technology Designed To Deliver Complete Transparency Into The Alternative Asset Industry

First standardized reporting that measures and contextualizes changing levels of operating complexity of alternative asset managers

Convergence, a financial technology company founded by industry veterans, has launched Advisor Complexity Profile (“Complexity”), a new service designed to address the challenge of operational and business model transparency in the alternative asset management industry, it was announced today.

Complexity provides insight into all the major alternative asset classes, including hedge funds, private equity, real estate, venture capital, and structured asset funds, incorporating approximately 8,300 managers in more than 50 countries, and assigns each of them a high, medium or low complexity profile. It is designed to meet the needs for improved transparency and analysis for all the major industry participants: investors and asset allocators, assets managers, and service providers.

“The digital footprint being created by thousands of asset managers continues to expand making it harder to identify the critical data points that can provide insight into operational due diligence and risk management. Until now there has been no unifying product to capture, normalize and structure the kind of information that can give users an insightful and timely view into the complexity of an asset manager’s business model,” said John Phinney, Chairman & Co-President at Convergence. “Complexity Profiling does just that, allowing asset managers and asset owners to proactively protect against risks that may have previously gone undiscovered in a manager’s operating model.”

Complexity captures approximately 2,000 data points per manager, allowing Convergence and its clients to objectively compare manager complexity over time using a consistent set of metrics to track change and identify potential issues. Proprietary algorithms are used to create a “Complexity Profile” based on 40+ un-weighted factors identified in the manager’s business model. Profiles are updated daily.

A low/medium/high complexity profile is assigned to the asset manager based on the number of high complexity factors present in their business model. Among the factors captured and analyzed are internal valuation, self-administration, and qualified audits. Asset managers would be expected to have the infrastructure in place to manage the level of complexity inherent across their organization.

Complexity Profiles are designed to be used for a variety of purposes including fund raising, manager research and selection; ongoing surveillance and due diligence; pricing services and assessing risk, benchmarking versus peers and competitors, and in sales support. Complexity Profiles allow users to pinpoint specific complexity areas where risk exists and where risks have been created since the initial due diligence was conducted.

“Complex operating models do add risk, and unnecessarily complex models can add unnecessary risk,” said George Evans, Co-President at Convergence, noting that Convergence estimates that as many as seven percent of asset managers may be under major operating model stress at any given point.

“These potential issues have historically been invisible to investors and allocators. With Complexity, we are bringing unconstrained transparency to the operating risk in each manager’s structure and in the industry overall, while also allowing managers to gauge the complexity of their own businesses,” he added.

Convergence founders Phinney and Evans bring a long track record of financial industry success to the new company. Prior to starting Convergence, Mr. Phinney held a number of senior positions, including CFO/COO with Apollo Global Management, The Rohatyn Group and JPMorgan.

Mr. Evans was previously Managing Director with The Gladstone Group, and Global Head of Business Development with GlobeOp Financial, BISYS and JPMorgan Investor Services.

Convergence currently counts among its users many leading fund administrators and auditors, pensions, endowments and foundations, as well as large established and emerging asset managers. With Complexity, it is targeting a market comprised of more than 17,000 registered investment advisors, 58,000 alternative funds, and an expected $20 trillion in assets by year-end 2020.

“If you’re an asset manager, you want to know where you have issues compared to your peer groups that might be costing you business. If you’re an allocator, you want to identify the best managers, and flag any potential issues early in the process. For a service provider, there’s a need to identify where to market your products and price them accordingly. Our research and analytics are designed to provide insight for all these constituencies,” said Phinney.

About Convergence, Inc.

Founded in 2013, Convergence is an independent growth company that has created an entirely new platform comprising (1) data, (2) research and analytical products, and, (3) surveillance / monitoring services, all providing transparency into the infrastructure of the alternative asset management industry. The firm’s leadership team has 120+ years of experience managing operating risk in many of the world’s leading asset management organizations. The depth and breadth of this industry expertise differentiates Convergence from any research players in the industry who provide data but fail to provide actionable context. Convergence does not render investment advice.

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Talking Hedge April 5th – The Modernization of Due Diligence for Alternative Investments

Convergence’s John Phinney will be participating in Talking Hedge’s April 5, 2017 event in New York City. Event registration info is available here.

The Modernization of Due Diligence for Alternative Investments

April 5, 2017

Harvard Club of New York City

Register Today for Early Bird Rate of $695

Institutional Investors Complimentary

Look Who’s Raising the Bar on Due Diligence

  • John D’Agostino, Managing Director, DMS Governance
  • Benjamin Alimansky, Managing Director, Director of Manager Research, Glenmede
  • Ranjan Bhaduri, Chief Research Officer, Sigma Analysis & Management, Ltd.
  • Westley Chapman, CEO and Founder, AlphaPipe
  • Kevin Edwards, Senior Investment Director, Hartford HealthCare
  • Lionel Erdely, Head and CIO, Alternative Investment Solutions, Investcorp Investment Advisors
  • Steven Kahn, Head of Operations, Talpion Fund Management
  • Edward Lund, Senior Vice President, Institutional Sales, The Gemini Companies
  • Judith Posnikoff, Founding Partner, Pacific Alternative Asset Management Company
  • John Phinney, Co-President, Convergence Inc.
  • Shakil Riaz, Managing Director, Head of U.S. Alternative Portfolio Management and Global CIO, Rothschild Asset Management
  • Adrian Sales, Head of Operational Due Diligence, Albourne America LLC
  • Alessandra Tocco, Managing Director, Global Head of Capital Introduction, Consulting and Content, J. P. Morgan

Join them for straight talk between institutional investors, managers and solutions providers. We’ll discuss the modern tools available to improve due diligence efficiencies and the latest thinking on evaluating culture, talent, transparency, alignment of interests, operations and ongoing diligence.

This educational program will highlight investor expectations of alternative investment managers and how managers are raising the bar with improved technologies, high touch client service and tailored solutions.