The rise in hedge fund assets under management (AUM) from some about $200 billion in 1997 to about $1.3 trillion early this year, and the increasing complexity of the 10 or more different trading strategies hedge funds use are placing ever higher demands on primes.

Primes, or prime brokers as they used to be called, are a special class of financial services providers dedicated to helping hedge funds capture alpha and keep their books straight. Various sources indicate that about half of prime brokerage income, which now is perhaps more than $6 billion annually, comes from lending securities to cover short positions and a third come from brokerage. The rest is divided between margin lending and service fees.

Capturing alpha is the raison d’etre of hedge funds. It is that portion of return that is greater than a benchmark like the S&P 500 or, perhaps, a Capital Asset Pricing Model (CAPM). Simply put, positive alpha is the extra return earned for taking additional risk.

MULTIPLE PRIMES

Some seven or eight years ago, large hedge funds began using more than one prime, in part because they found that it was better to have more than one source from which to borrow securities. As AUM for hedge funds grew, the funds found that some primes were marginally better at a particular service than the others.

Most of the larger prime brokers are focused on servicing large hedge funds. Funds larger than $1 billion comprise two percent of the hedge fund universe, but have 23 percent of the total AUM according to a 2006 white paper produced by Paladyne Systems in New York.

In its 2005 annual prime brokerage survey, Global Custodian reported that on average, hedge funds with AUM of more than $1 billion reported using more than four primes. The average number of primes used by funds with under $100 million was 1.3 primes. On average, hedge funds used 1.9 primes. The average now is probably over 2 primes per hedge fund.

THORNY PROBLEMS

Most hedge funds rely extensively on prime brokers to provide and run the middle- and back-office software they need. Often their the middle- and back-office software, however, can accommodate just one prime, so hedge funds using multiple primes faced some thorny problems.

One problem was having to aggregate data from several primes with software that could accommodate only a single prime. This meant data transfer, which could be a serious source of errors. Another was that primes were forced to share what they were doing with their hedge fund clients with other primes who were their competitors. This also raised a problem of confidentiality. Hedge funds do not want to tell any prime broker what they are doing with their other primes.

Enter Paladyne Systems, which was formed in 2005 through an acquisition of its technology platform from a multi-billion, multi-strategy US-based hedge fund. From its inception, the company has solved this specific multi-prime problem. Paladyne produced the first suite of software products that aggregates data for hedge funds from multiple primes, maintains the confidentiality that hedge funds wanted, and performs all of the many different and complex tracking, accounting and reporting functions hedge funds need to do, according to its CEO, Sameer Shalaby.

Shalaby is no stranger to the hedge fund business. He earned an MS in computer science from MIT and has done academic research in artificial intelligence and natural language programming. After practical experience at Oracle, TenFold Corporation and as CEO of Cogency Software, he and three other industry veterans have long been familiar with the problems of data aggregation and reporting for the hedge fund industry.

BREAKTHROUGH

In June 2006, Credit Suisse reported that its Prime Services, which is part of its Investment Banking division, picked Paladyne Systems in New York in order to solve these problems for their hedge fund clients.

Philip Vasan, managing director and head of Prime Services for Credit Suisse, said at that time that Paladyne Systems in New York would be able to “…integrate front-, middle- and back-office capabilities.”

Why would a prime broker give its hedge fund clients a product that allows it to better manage multiple primes? Because increasingly, the hedge fund industry is demanding it. Having anticipated this development, Shalaby maintains that, “It is most important that hedge funds aggregate all the data relevant to their activities among different primes while protecting the confidentiality of their trading activity.”

Paladyne offers a hosted front-to-back office suite of products that include Portfolio Master for broker-neutral order management and allocation, real-time P&L, portfolio management and performance tracking. Another product, Security Master, is a global repository and distribution engine of securities terms and conditions with real-time updates and corporate actions alerts. Price Master automates collection, storage and analysis of prices and market data from third-party sources. Analytics Master provides portfolio analytics, data aggregation and warehousing and custom reporting tools for analysts, researchers and traders. Client Master provides client relationship management and reporting. All these tools are available to Credit Suisse’s hedge fund clients.

This suite of products is developed exclusively on Microsoft technology. “We are leveraging Microsoft for a complete straight-through process between our different products,” Shalaby says, “It’s thanks to Microsoft that we can do this.”

HOSTED APPROACH

The hosted approach, rather than running the software on its own hardware, allows Credit Suisse’s hedge fund clients to manage their IT budgets while providing them with a complete front-to-back infrastructure to support their major business functions, including order management, accounting, customized reporting and real-time profit and loss reporting. In addition, the hosted Paladyne platform protects clients’ confidentiality and access control by limiting brokers, including Credit Suisse, from gaining access to clients’ aggregated positions across multiple primes.

Portfolio Master enables Credit Suisse’s hedge fund clients to electronically route their orders to other brokers in addition to Credit Suisse. Portfolio Master is integrated with several brokers’ algorithms, including Credit Suisse’s advanced execution services (AES), and easily supports hedge funds’ needs for electronic routing and execution.

Analytics Master enables hedge fund clients to aggregate data from multiple sources, and consolidate it into a data warehouse. It provides a flexible reporting and analysis tool that can address complex and ever-evolving demands placed on hedge fund analysts and researchers.

Security Master gives the hedge funds a repository of securities terms and conditions for tracking listed and non-listed securities. Security Master has built-in interfaces to leading market data vendors and provides arbitration techniques between the various vendors, into a “golden copy” database that can be used for the front, middle, and back office. Additionally, Security Master tracks corporate actions and provides alerts for managing internally mandated changes.

Price Master provides hedge fund clients a repository for pricing and market data. It automates the data collection process for tracking prices and other market data and enables clients to define and apply their own “pricing policy” for automatically pricing their portfolios on a daily basis. It also offers an audit trail of pricing techniques that can be used for compliance. Client Master provides hedge fund clients an easy way to manage communication with their investors, including monthly investor reports.

Paladyne has a reseller’s agreement with Advent Software in San Francisco to offer Advent’s Geneva accounting system. The hosted platform includes Advent Geneva, the industry’s leading standard for providing complete portfolio accounting including general ledger reporting, performance measurement, and portfolio reporting.

As well as doing all of the standard accounting functions like calculating NAVs, Geneva’s open-architecture platform can eliminate manual data entry and errors. It is fast, and scalable for large, 24/7 fund management operations. It can automate investor reporting and multi-currency record-keeping and calculate performance fees. It also has GAAP accounting features, and offers its users accounting for onshore and offshore funds.

COSTS

There are two costs for this service. The initial set-up cost varies depending on how much legacy data needs to be transferred. There is also a periodic cost figured in basis points on AUM per specified time periods.

The management problems that hedge funds face are now very complicated, and will become more so. New trading strategies are being developed all the time. New risk management tools are being created even as the now-standard risk management tools like RAROC (risk-adjusted returns on capital) or VAR (value at risk) are being modified.

With the spectacular growth of hedge fund AUM world-wide, government regulators are now keenly interested in hedge funds. Their demands for ever-more granular reporting will continue to grow now that so-called alternative asset management strategies, and the hedge funds that use them, are accepted widely as mainstream investment vehicles by virtually all investment institutions.

One should expect to see more solutions of this nature. By the end of this decade, one should expect that most prime brokers will be offering similar services to protect confidentiality their hedge fund clients typically demand.

www.paladynesys.com
www.credit-suisse.com

By Desmond MacRae