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Jul 23 2009 | 2:33am ET
By Hung Tran & Jonathan Shazar -- Bernard Madoff has gone up the river, unlikely to ever return. But the specter of his $65 billion Ponzi scheme continues to hang over the alternative investments industry.
For many investors, especially those of the all-important institutional variety, the only way to combat Madoff’s dark cloud is to shine a bright light on what have long been the more secretive corners of the industry. One-page monthly statements from hedge fund and private equity managers are no longer enough; these clients are demanding transparency, due diligence and risk management previously anathema to many of the industry. They want detailed reports on everything from how managers are selected and who their prime brokers are to how those managers reconcile their trades and balance their books.
“Since the Madoff scandal, we’ve been dealing with multi-billion dollar endowments and pension funds that are looking to automate and create an [audit trail] around their research and diligence process,” says Jeremie Bacon, a Goldman Sachs veteran and founder of Backstop Solutions, which offers a wide array of customer relationship management, sales, marketing and accounting services. Chicago-based Backstop has a total of 185 customers on its platform, 105 of them being hedge funds. Bacon says the firm has continued to grow, despite the recent trials and travails of the alternative investment industry.
“We’ve obviously had clients fold, but we’ve continued to add more clients than we’ve lost,” he says.
Erol Dusi of Imagineer Technology, which provides software and tools to help hedge funds and other investors run their businesses more efficiently, has also seen his firm benefit from growing demand for transparency in the wake of the Madoff scandal. He says hedge funds that previously did not report their numbers to databases are now rushing to get their information out.
“We’re seeing a tremendous [movement] in that direction, and it’s all a result of what has happened within the last six months,” he says.
Baseball fans spend countless hours debating a player’s “intangibles,” the things that don’t show up in box scores or statistics but that can be the difference between winning and losing. There is a similar focus today from investors—spooked, no doubt, by the shadiness of Madoff’s operations—on the things that don’t have a metric represented by a letter of the Greek alphabet.
“The fact is, you’re investing in the managers’ ability to manage during tough markets, and you’re investing in his integrity and personality,” Dusi says. “Those things are not going to be captured in returns. Rather, they are going to be calculated from your meetings with them and data from background checks. We provide all of this information on one platform.”
In fact, it is those intangible details that are often the deciding factor in whether a fund manager wins a mandate, according to one consultant from Cambridge Associates, who asked not to be named.
“I take detailed notes on every manager I meet, from whether they seem fidgety to what they order at lunch,” said the consultant. “If the guy I’m meeting with has whisky on his breath and bags under his eyes, you can bet that I’m not going to recommend him to my client, even if his numbers are out of the park.”
Specter Of Regulation Looms Large
Fear of being taken in by the next Bernard Madoff is not the only factor driving the demand for a paper trail. New regulation of the alternative investment industry looming both in the U.S. and in Europe has managers rushing to anticipate what will be required of them by authorities.
While it’s still unclear what form those new regulations will take—certainly, there is little in common between the approach of Washington and that of Brussels—that there will be new regulations is a certainty. It seems equally clear that those new regulations will, at a minimum, force hedge fund and private equity managers to offer greater transparency and impose stricter compliance requirements.
Research and advisory firm Celent expects that global information technology spending associated with governance, operational risk and compliance activities will increase from $1.4 billion in 2008 to $1.7 billion in 2011.
“There is now a 'get big or get out' theme at play,” says Cubillas Ding, a senior analyst at Celent. “Firms and vendors need to position themselves accordingly in terms of purchasing or developing solutions. Significant investments are required in an end-user market which is increasingly sophisticated in its demands.”
Ding’s colleague, Isabel Schauerte, concurs.
“Regulation is sure to place greater burdens on the middle- and back-office functions of hedge funds,” says Schauerte, a capital markets analyst at Celent. “Here, the last years have seen great progress in terms of technological sophistication. In many cases, funds have grown to a size and scope that forces managers to run their business more formally. This has spurred technology adoption rates.”
Schauerte also credits the increase in institutional investors' allocations to hedge funds for the push to adopt better technology.
“The growth in assets from this breed of investors comes with requirements on operations and risk management that have forced hedge funds to embrace IT to a greater extent,” says Schauerte.
“Another aspect to consider is that hedge funds today massively rely on third-party providers for back-office operations, and, more recently, also for middle-office activities,” she adds. “Going forward, regulatory compliance is also going to be a greater issue for hedge fund administrators.”
But despite the inevitability of stricter regulation, many firms have not accorded improved compliance systems the priority they deserve, according to Bill Mulligan of New York-based HedgeOp Compliance, which provides compliance, operational and due diligence reporting to the alternative investment industry.
“When we get involved, we make sure that there are not other priorities that are going to push compliance issues to the back of the line. We keep the process pushing forward,” he says. “Compliance is very detail-oriented, and there’s a lot of paperwork involved.”
And according to Backstop Solutions’ Bacon, the time to prepare for the looming regulations is now.
“Each vendor out there has had to make sure that their systems can help to buoy the compliance and regulatory requirements as related to the products that they’re offering,” he says.
This article first appeared in FINalternatives Hedge Fund Technology & Trading. Download Complete Issue: Hedge Fund Technology & Trading (PDF)