Rumors abound in the market concerning pending sales by investment banks of their hedge fund administration units. Irrespective of whether these rumors become a reality, it is worth considering the reasons for such action.
I have always believed that custody and fund administration, a transaction banking service, sits badly with investment banking, a transaction execution service. Many may align custody and administration to their prime services divisions within investment banking, but, in reality, prime services and custody/administration are related offerings to similar clients rather than single products. Prime services are about leverage products, asset finance, derivative clearing, execution and a raft of other classical investment bank offerings. Administration and custody are about fiduciaries, cash and securities administration, reporting, commercial banking, stock loan intermediation and other related products. Of course there is overlap, and there are synergies. Sensible firms with both competencies collaborate rather than duplicate as appropriate. But the very fact that the product (as well as the culture and people) is distinct makes it an awkward fit for investment banking.
Recently, one of the leading financial sector private equity firms told me they would not touch the sector for fear of wipe out risk the risk that they lose their entire investment. This was their interpretation of the current risk profile of the sector. They were not concerned at risk profiles of funds in search of an ever more elusive alpha, but they were concerned at AIFMD and UCITS V with their attribution of risk to the administrator. Their view was that it was irresponsible to accept investment strategy risk, country risk, intermediary risk and almost any other event risk as primary guarantor to investors or, in some cases, as secondary guarantor after the fund manager. And, given the nominal net worth of many fund managers in the alternative space, they did not see the secondary guarantee as merely a contingent one.
From an investment banking perspective, given the returns on capital that can still be enjoyed elsewhere on their (still quite leveraged) equity, there must surely be two concerns. The first is whether, given the increased risk profile of their administration unit (although a good part of it may still be out of scope of European regulation but surely a tightening of the noose globally cannot be excluded), they should not dispose of the unit. The second is when, rather than whether, the regulators will require capital to be set against the risks in the business.
The level of capital that could be required is a difficult assessment to make as there is little precedent, for the new risk-laden regulatory regime is just nascent. But on the basis that the administrators are giving a financial guarantee on enormous sums (total global fund assets are estimated at $20 trillion-plus worldwide), it is illogical that regulators proclaim that P&Ls can carry the burden, and no capital buffer is needed.
Over and above the capital risk, recent events have highlighted the reputational risk of any alleged bad practice. The new political mantra of the court of public opinion means basically that, if someone loses money on any non-classical product, the bank is likely to be penalized financially and ostracized commercially. Taking such a risk as an alternative manager charging up to 200 basis points and a share of profits is painful. Taking such a risk as an administrator on a few basis points or less is seen as nonsensical. And hedge funds are typical non-classical products. Moreover, the trend is to require these to be brought on shore, and the tendency is for them to be sold into the affluent (also known as the politically aware and well-connected) mid-net-worth retail market.
As an owner of a non-core business with a high financial and reputational risk profile, one must be tempted to sell. Especially if there remain buyers of substance and undoubted expertise who may be able to manage the risks better and who are willing to pay a substantial premium for the privilege.