The Road to Greater Hedge Fund Efficiency: Understanding Costs and Embracing Outsourcing

24th April 2023

Hedge funds are often seen as opaque and mysterious investment vehicles, but one thing is clear: they come with a lot of expenses. These expenses can be divided into three broad categories: economies of scale, diseconomies of scale, and other cost drivers. Reducing these factors should be crucial for CFO's who are looking to maximise returns while minimising costs.

Let's start with economies of scale. This refers to the phenomenon where larger hedge funds can spread fixed costs (such as rent, salaries, and technology) over a larger asset base, resulting in lower costs per unit of assets under management. For example, if a hedge fund with £1 billion in assets under management has a certain level of fixed costs, and that same fund grows to £2 billion in assets under management, the fixed costs will be spread over twice as many assets, resulting in lower costs per unit.

One specific example of an economy of scale in hedge funds is consolidated performance reporting. Many hedge funds manage money for multiple family members, trusts, and other entities. Rather than producing separate performance reports for each of these entities, the fund can consolidate the reporting into one document, resulting in lower costs and greater efficiency. However, diseconomies of scale can also be present in hedge funds. These refer to situations where costs increase as the fund grows larger, often due to increased complexity. One example of a diseconomy of scale is the overuse of legal entities. Many hedge funds use multiple legal entities (such as offshore corporations) for tax and regulatory reasons. However, if a hedge fund has too many legal entities, each with multiple banking accounts, the resulting administrative burden can be significant, resulting in higher costs and lower efficiency.

Other cost drivers to consider include the size of the firm, tax jurisdictions and residences, investment portfolio size, the complexity of the portfolio, and the use of active vs. passive investment vehicles. More complex investments (such as direct venture capital investments in start-up companies) require specialised staff expertise, resulting in higher costs. In addition, the total number of advisors and asset managers employed around the world can also be a cost driver.

Sometimes, the most significant costs are not transparent. For example, hedge fund or private equity investments, particularly fund-of-funds, may have several layers of issuer and manager fees, such as pass-through fees, expenses, carried interest, and sales charges. These fees can be significant and can erode investor returns.

While principals may be tempted to have hedge funds that perform a wide range of services, an inventory of the costs associated with each service element may result in foregoing or outsourcing certain services. This is why many hedge funds partner with managed service providers (MSPs) to take advantage of economies of scale.

MSPs are third-party firms that provide a wide range of services to hedge funds, including IT infrastructure, data management, reporting, and compliance. By outsourcing these services to MSPs, hedge funds can take advantage of the MSPs' economies of scale. MSPs typically have large, dedicated teams of experts who can provide these

services at a lower cost than a hedge fund could provide in-house. Additionally, MSPs have invested in technology and infrastructure that allows them to offer services that are often more advanced and robust than what a hedge fund could develop on its own.

For example, a hedge fund that manages £500 million in assets might struggle to justify the expense of building and maintaining its own data management and reporting infrastructure. However, by partnering with an MSP, the hedge fund can take advantage of the MSP's existing infrastructure and expertise, resulting in lower costs and greater efficiency. The MSP can also offer more advanced reporting and analytics capabilities than the hedge fund could develop on its own.

Another advantage of partnering with MSPs is that they can help hedge funds stay compliant with a wide range of regulations. As the regulatory landscape continues to evolve, it can be challenging for hedge funds to keep up with all the changes. MSPs, however, specialise in staying up to date with the latest regulations and can help hedge funds navigate complex compliance requirements.

Of course, partnering with MSPs is not without its challenges. One key challenge is ensuring that the MSP is a good fit for the hedge fund's specific needs. Every hedge fund is unique, and not every MSP will be able to provide the exact services and expertise that a particular hedge fund requires. Additionally, there is always a risk of data breaches or other security issues when working with third-party providers. It is important for hedge funds to carefully vet potential MSPs and ensure that they have robust security measures in place.

This can result in lower costs and higher efficiency, ultimately leading to higher returns for investors.