There's little doubt that hedge fund administration (HFA), or back-office outsourcing, is a maturing industry, as over 80% of hedge fund AUM is administered by a third party. Unsurprisingly, over the past seven years, 43% of the asset growth among top 10 administrators came from acquisitions.
However, despite 27 acquisitions of hedge fund administrators since 2006 (11 involving firms that administer at least $20 billion or more in assets), M&A activity in 2013 slowed due to an increase in valuations and a decrease in the number of viable acquisition candidates.
Because HFA demand is triggered primarily by external forces - such as post-crisis investor pressure placed on hedge funds to outsource their books and records - organic growth in hedge fund administration will be challenging as firms are forced to compete for a relatively static group of clients.
As organic and inorganic HFA growth opportunities decrease, will there be new demand for administration services? And if so, where will this demand come from?
The answer lies in the competitive forces now shaping the asset management industry. We've found that four trends in particular appear poised to drive new growth in hedge fund administration (see below).
|1||Increased need for regulatory reporting||Demand for regulatory reporting services, such as AIFMD, Solvency II, and Form PF, remains strong.
|2||Manager and product convergence||Strong growth in assets under management (AUM) is expected for liquid alternative products. Citi Prime Finance estimates that these products will exceed $900 billion in AUM by 2017.1 At this rate of growth, the administration industry could capture incremental revenue in the range of $600 million to $825 million on an undiscounted basis for the period of 2013 – 2017.|
|3||Cost-efficient fee operations||Asset managers are looking to become more cost-efficient in response to pressure from institutional investors. Administrators may want to develop new services that help asset managers achieve higher levels of operational and cost efficiency.|
|4||Expanded outsourcing||Opportunities exist for administrators to offer private equity administration services. The US addressable market for private equity administration remains large, at 73% of invested capital (or ~$1.7 trillion). If private equity outsourcing were to reach 50% by 2018 (it’s currently at 30% today) then the incremental revenue opportunity for the fund administration industry is $660 to $880 million on an undiscounted basis for the period of 2014 – 2018.
1Citi Investor Services white paper: “The rise of liquid alternatives and the changing dynamics of alternative manufacturing and distribution,” May 2013.
As these trends take hold, administrators will invariably follow different paths toward growth, many of which will be influenced by such characteristics as size, ownership structure and service mix.
Small, undercapitalised administrators may focus on making improvements to both cost efficiency and their core competencies as a way to increase profit margins.
And well-capitalised administrators, small or large, may pursue one or more of these four growth opportunities to the extent they are not already doing so. However, it's important for well-capitalised administrators to remember that their financial capital will enable the pursuit of growth, but it will not guarantee the creation of value. Achieving profitable growth and shareholder value creation will come from a strategy that focuses on creating and sustaining a competitive advantage.
We believe the HFA firms that define a growth strategy which complements their core competencies, activities and assets will create more value over the long term.
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