To date, alternative investment managers have invested in technology to reduce costs by automating their routine manual operators. Digitization has the potencital to enhance this process to create joined-up businesses that go from being product-centric to client-centric, while delivering strong operating leverage. The implied step change will occur as future asset growth will most likely come from organic means instead of market rises, as in the recent past.
From process automation to business Transformation
a. Current state of play
Hedge fund managers have long embraced technology in many functional areas.
For example, 'dashboard' systems are now common in compliance management, in response to the tsunami of regulation on both sides of the Atlantic in the wake of the 2008 global financial crisis. New rules on Know Your Costumer (KYC) and Anti Money Laundering (AML) have given rise to a new industry - 'Regtech' - that provides a raft of end-to-end solutions in the compliance space.
Similarly, with front-office research, hedge fund managers have been accessing information from a wide variety of sources and doing extensive data crunching to support their investment process. Mifid II, for example, is changing the market for research.
In the middle and back offices too, portfolio accounting, risk management and fund adminsitration systems have been used widely. Systems that support investor relations have also become common. The smaller managers have outsourced most of these activities to third party fund administrators, while the rest have been building dedicated, in-house capability.
For their part, until the start of this decade, private, private equity managers have been less inclined to big technology spend for two related reasons. First, their deals are highly bespoke, each with a unique complex structure. Second, private equity is a highly relationship-based business that relies on personal networks for deal flows far more than hedge funds.
However, as the decade has progressed, regulatory reporting requirements under the Dodd Frank Act in the US and the Alternative Investment Fund Managers Directive in Europe have turned the spotlight on technology infrastructure in private equity houses too.
This has been further reinforced by ever more stringent due diligence now undertaken by end-clients who place operational excellence high on their checklist. In fact, they now employs armies of advisors to find out why they should not invest with a particular manager. The burden of proof has shifted.
The precise nature and extent of the adoption of technology systems in hedge funds and private equity currently is a matter of detail. The substantive point is that most of them are stand-alone or, at any rate, have limited connectivity because of the differences in the chronological age of the systems. Even in a critical area like client reporting, extensive reliance on Excel spreadsheets is not uncommon.
Up until today, investment in technology aimed to industrialize the business to make it more scalable via a twin-track approach. On the one hand, there has been rising automation of the routine processes in front, middle and back offices in order to achieve cost-effective growth. Novel approaches such as cloud computing, data warehousing and ‘software-as-a-service’ have been going mainstream. On the other hand, core activities in the front and middle offices continue to work along the traditional craft line, being skills intensive and knowledge based.
The key aim behind technology spend has been to create a scalable business model by industrializing the routine labour-intensive activities or outsourcing them. Hedge funds are ahead of their private equity peers in this respect.
In the past, with business growth there often came a rising cost: income ratio — in a chain reaction. Growth created jobs, which created bureaucracy, which created complexity, which created diseconomies of scale. Technology has helped to reverse this trait, which has long been associated with all craft-based businesses.
b. Facing the future
The next step is to create more joined-up businesses as they scale, where revenue rises much faster than costs. This has been made possible by the latest advances in the 60-year evolution of information technology. In the 1960s, the arrival of semiconductor-based microprocessors created digital data for the purpose of model building, complex calculations or general storage.
In the 1970s, this evolved into mainframe computers, capable of processing ever-larger batches of data in one location. In the 1980s, this spread to distribute data processing via remotely connected mini computers. This decade also saw the arrival of personal computers. In the 1990s, the evolution continued to encompass mobile phones.
With the rise of the internet, the 2000s witnessed the proliferation of smart phones, permitting immediacy, connectivity and ubiquity. Since then, thanks to Moore’s Law, which states that the processing power of computers doubles every two years, the global economy has mushroomed into the largest digital network imaginable. The rise of quantum computing, which harnesses the power of atoms and molecules, instead of silicon chips, may well render Moore’s Law obsolete.
The latest phase of digital evolution is now encompassing revolutionary technologies like blockchain, machine learning and robotic process automation. Speed, connectivity, insights, transparency and disintermediation are their hallmarks. Indeed, they also constitute the third phase in the evolution of the alternative investment industry (Figure 1.5 in Executive Summary). They are reshaping business models in finance. Retail banks have taken the lead; alternative investment managers have taken note. The winds of change are evident.
The article “Drivers of digitalization: Business as usual is not an option” by Anthony Cowell, Tom Brown, Al Fichera, Jim Suglia, Ravi Beegun, Brian Clavin, Bonn Liu, Claire Griffin, Jonathan Cohen, Andrew Schofield, Richard Scott-Hopkins, Gordon Rajamohan and Kevin Lloyd, KPMG International, and Amin Rajan, CREATE-Research, was taken from KPMG’s publication entitled Alternative investments 3.0.