Automate Or Fail: Key Man Risk And Poor Performance No Longer Biggest Hazards For Hedge Funds

Sep 7 2011 | 6:11am ET

By Ron Suber, Merlin Securities -- The business landscape has changed dramatically for both hedge fund managers and the investment community over the past several years. Managers must cater to the needs of institutional investors in order to grow and thrive.

In addition, new risk, reporting and regulatory requirements, along with volatile markets, make having reliable automated processes essential components to running an efficient hedge fund. Manual work, key-man risk and a reliance on spreadsheets will be clear red flags to investors and prospects alike.

In this Merlin white paper we discuss the importance of business process automation within an asset management firm at all stages of development and how these organizations can measure their current processes versus investor expectations.

The diagram below, when used in conjunction with the Process Automation Score Sheet, shows fund managers if they have under- or over-invested in the systems and processes to run their fund based on its stage of development. When a fund is operating in the Sweet Spot, its systems and processes match the expectations of their investors.

The Importance Of Business Process Automation

Managers, investors and due diligence teams all analyze and measure the business risk and process maturity of a fund. As such, funds must continually review both their organizational structure as well as the level of automation resident in their systems and procedures. For example, there is clearly key-man risk when one person holds numerous senior positions in a fund versus each role being occupied by a distinct experienced professional.

Identifying business process risk is also critical. Data containing performance, financial, research and investor information may be stored or compiled in ways that increase the risk of corruption, loss or simple human error. For example, when trade reporting and position monitoring is cobbled together by one person from a number of disparate sources, that process represents a risk. Automating processes like these at the right time is essential.

The Risks Of Ignoring Business Process Maturity And Automation

As a hedge fund grows, there is invariably a strain on the processes it used as a startup. Spreadsheets, for example, are embedded in many funds precisely because they are so powerful and easy to use. As a fund’s investors become increasingly institutional, however, spreadsheets can be cumbersome and appear unprofessional. In the worst case, errors caused by spreadsheet use can seriously jeopardize a fund’s credibility.

Furthermore, increasingly sophisticated investors expect a certain level of process maturity. They not only want to see scalable businesses and repeatable performance, but also automated systems, processes and tools that are being used by sophisticated professionals.

As funds grow it is imperative that their business processes have the rules, controls and a level of automation that is commensurate with the growth of the fund and the type of investor being serviced. Funds that ignore the natural progression of process maturity will do so at their peril.

Measuring Business Process Automation

Merlin has created the Process Automation Score Sheet (PASS) to assess and measure a fund’s process automation risk. The analysis extends to:

  • The processes and procedures for keeping track of a fund’s critical information (performance, attribution, risk, investors, multi-primed assets, etc.); and,
  • Reliance on either manual spreadsheets or automated tools that are scalable and not dependent on specific individuals.

Most fund managers aspire to attract large institutional investors. To do that, funds must build out certain processes today to attract the investors it wishes to have tomorrow (see Merlin Spectrum of Hedge Fund Investors white paper). Knowing when to upgrade processes and technology and when to hire additional people is a common challenge for all businesses. The Process Automation Score Sheet (PASS) measures a fund’s current stage of automation across ten high-level process components.

The Business Process Automation Sweet Spot

The PASS score is then placed on the Automation Sweet Spot chart so that managers can see if they are ahead of or behind the curve in automating the processes that govern their business based on their fund’s stage of development. A score below the Sweet Spot means that its processes are overly manual and represent risk to the principals and investors, while placement over the Sweet Spot means that they’ve invested too much or too early in their systems. The PASS scores shows managers where the technology and process gaps exist.

The PASS results enable managers to map expenditures to the achievement of specific fund milestones such as asset growth or number of strategies. Having this roadmap makes it easier for them to invest for growth in the right areas at the right time rather than try to rapidly catch up to it. As such, managers avoid investing in unnecessary processes that exceed their actual needs or people who will put their firms and their client’s money at risk.

The Challenge: Getting To The Sweet Spot

There are three basic ways a fund can institutionalize processes:

  • Build new systems in-house;
  • Buy prepackaged solutions, integrate and customize them to meet its needs; or,
  • Outsource to a third-party technology provider.

Most funds have a general bias toward one of these options, but can, where appropriate, utilize a mix of solutions to create the optimal process. As detailed in a previous Merlin white paper called The Business of Running a Hedge Fund, the most cost-effective way for smaller and mid-size funds to implement mature processes is typically through outsourcing. Larger funds, on the other hand, with significant assets, strong recurring revenues and an existing technology infrastructure, may be best served by building their own process solutions alongside the systems they already have in place.

The case for third-party solutions is compelling even for large funds. It can represent a variable rather than fixed cost and can scale in capacity as needed without additional servers and data center space. Third-party solutions can also lower the overall technology spend and leverage the scale those providers have achieved by selling solutions to a broad marketplace of clients. Finally, outsourced technology providers have a very strong market-driven motivation to stay on the cutting edge – to keep pace with changing asset classes and securities, as well as the demands of regulators, investors and, of course, managers.


Hedge funds seeking to retain institutional assets, grow their AUM and attract sophisticated investors must look ahead and be prepared to invest in and proactively deploy long-term solutions. To do this, managers must truly understand where the current and future gaps exist in their businesses’ process maturity and automation and what technology solutions they will need to remedy those gaps. Understanding this through the PASS analysis, and then striving to remain in the Automation Sweet Spot, gives managers a navigable plan as to when to commit the capital and resources required to achieve the process maturity and automation that is commensurate with both the current stage of the fund and where they wish to be in the future.

Ron Suber is senior partner and head of global sales and marketing at Merlin Securities, a leading prime brokerage services and technology provider for hedge funds and managed account platforms.

View the white paper as a PDF

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