January 28th, 2015 The Future of Fund Administration Citibank Hedge Fund Administration Exit Convergence views and observations John Phinney George Evans Joseph Dello Russo Joseph Singh Convergence, LLC 114 Vista Road Wilton, CT 06987 info@convergenceinc.com www.convergenceinc.com To Contact a member of our team: John Phinney, Co- President (203) 461-0744 jphinney@convergenceinc.com George Evans, Co- President (215) 704-7100 gevans@convergenceinc.com Joseph Dello Russo, Senior Managing Director (781) 439-5125 jdellorusso@convergenceinc.com Joseph Singh, Corporate Strategy Advisor (917) 328-7633 JVS10@columbia.edu Citibank Exit - Convergence 2015-1 P age
Contents 1. Executive Overview... 2 2. Convergence Views and Observations... 3 Indicator #1: Cross- Selling Indicators... 4 Indicator #2: Fund Administration Customer Profile Indicators... 5 Indicator #3: Limited Partner Profile Indicators... 5 Takeaway Visual: Graphical Representation of the Indicators... 6 3. Footnotes and References... 6 4. About Convergence and Contact Information... 7
1. Executive Overview Citibank s recent announcement to exit the Hedge Fund Administration business may be the harbinger for similar reassessments by other universal banks providing Fund Accounting and Administration services. This event just may be the catalyst for the long overdue consolidation of the Fund Administration Industry. While Goldman s sale to State Street and Credit Suisse s sale to Paribas created the first ripples within the universal banking pond, Convergence believes that Citibank s exit is the strongest and most convincing evidence to date that the hedge fund administration business in universal banks continues to struggle financially. The real question is who is going to be the next to exit? What follows is an in- depth exploration by Convergence of what we consider to be seismic shifts in the industry. These are not simply lessons- learned, they are telling leading indicators to be heeded by the cognoscenti.
2. Convergence Views and Observations It s no wonder Citibank had trouble generating the levels of scale needed to generate acceptable profit levels. Convergence has identified 450+ unique named Administrators providing a variety of back- office services to the 6,200 Unique Manager Groups 1 that advise 43,000 private alternative funds. These Administrators, both large and small, compete fiercely for business because scale is the key to generating profits. While the vast majority of assets under management are held by the top 25 Administrators, it s the smaller clients who buy vanilla products and services that generate this desperately needed scale. And without scale, there are no profits, and well, it s simply a matter of time before sub- scale firms sell or exit. The toll that this competition has taken on Administrators of all sizes is significant. With so many providers, fees are perpetually under pressure and demands from clients, investors and regulators are increasing the cost of doing business. Was this combination of declining fees and higher expenses, enough to topple one of the industry s most promising competitors? What amazes many is that from a classic business school point of view, Citibank had all the capabilities needed to become a pre- eminent provider of Fund Accounting and Administration to alternative asset managers. They have the balance sheet, products, staff, technology and geographical footprint to service fast growing, complex and demanding hedge fund clients. They also have highly profitable products to cross sell to these clients including Prime Brokerage, Custody (custody itself may not be highly profitable, but coupled with add on products like Securities Lending, FX and Cash Management, turn from marginally profitable to very profitable), Trading and Investment Banking. So with such a compelling arsenal of capabilities, what kept Citibank from taking its position among the elite players in this market? Despite the size and potential of its Fund Administration business, is Citibank s decision to exit such a surprise after all? After an intense review of Citibank s book of business, Convergence is not surprised by this decision and believes that more consolidation among the universal banks is yet to come. Mining and analyzing our proprietary database of information on all clients served by all Fund Administrators and combining it with the confluence of regulatory and market factors faced by many of the universal banks, we found several indicators suggesting that Citibank s Fund Administration Business may have been under financial pressure for some time. These indicators include, but are not limited to, the size and strategy profile of its clients, the complexity of their book, their cross- selling rates of profitable Prime Brokerage services and low interest rates. The growth prospects of Citibank s Hedge Fund Administration business were simply not sufficient to continue investing the vast sums into people, process and technology to remain competitive. Citibank s decision raises a number of questions for its current clients that we are confident will be answered by Citibank or by the legions of aggressive and opportunistic competitors in this hotly contested marketplace. And of course, the question this raises is simply, who might be next? Convergence examined the detailed profile within its database of the Credit Suisse and Citi s exits and believes there is strong parallels between the two that may hold clues to which universal banks might be next to exit. Citibank Exit - Convergence 2015-3 P age
Indicator #1: Cross- Selling Indicators The promise of universal banking was compelling, or at least that s what the engineers of these behemoth institutions thought; be in a position to support your clients with the products they need, when they need them and where they need them. Just think about all the balanced scorecards used by the bank CEO s to measure the cross- selling by their divisional executives! The universal banking model is expensive! For this reason, certain clients are more attractive to universal banks than others, specifically those clients who can buy the most products from them. At the minimum, each product division within the bank needs to generate enough volume to cover the overhead costs in place to support their product. Once they achieve scale, products contribute to profits. Yet while the banks try and build product scale, they seek to generate EBITDA from all the other products they sell with an emphasis on those products that generate recurring fee revenue and net interest margin. Fee generating businesses required less capital because much of the risk was off balance sheet as was later learned during the financial market turmoil during the last decade. The more products the banks sell, the greater the possibility that a client contributes profits, in the aggregate, to the bank. Certain products will generally subsidize other products. Hedge Funds clients have long been attractive to universal banks because they utilize many products and services to run their business, particularly the larger, complex and global managers. These services may include: Investment Banking Prime Brokerage Transaction Services Corporate Banking Asset Management IPOs Margin Financing Fund Accounting & Administration Debt Issuance Securities Lending Treasury and Cash Management Corporate Checking Fund Distribution Payroll Services Trade Execution Clearing & Settlement Trust Services Lending Services Hedging Position Reporting Custody Services Foreign Currency Custody Services In addition to people costs, the technology needed to service the hundreds of hedge fund clients who trade everything from simple public equities to litigation claims can be staggering. Annual IT budgets for these businesses can easily run into the $100mm+ range and to cover these costs, Banks need scale, defined as lots of hedge fund clients buying lots of similar products offered by different divisions of the banks. And once they have these clients, the clients need to grow their assets in order for banks to make more money on each fund. So with this in mind and given just how hard and expensive it is to win and maintain hedge fund clients, why would a bank exit a Hedge Fund Administration, a product line that is must have for all hedge fund managers and is a gateway into other lucrative cross- selling opportunities? Citibank Exit - Convergence 2015-4 P age
Perhaps some of the reasons can be found by looking at the cross- sell rates of the banks, and Citibank in particular, given its decision to exit. Convergence developed a cross- selling indicator to examine the number of other linked products and services that universal banks like to sell to hedge fund clients, including, but not limited to: Prime Broker Cross- Sell Ratio Custody Cross Selling Ratio Citibank s Prime Brokerage and Custody cross- sales to hedge fund clients 2 are materially below their peer group universal banks Indicator #2: Fund Administration Customer Profile Indicators The profile of the customers that make up the Hedge Fund Administrator s book can also give us a glimpse into the bank s profitability of an Administrator s book. Convergence tracks the number, size, complexity and strategy of all of the Administrator s customers. Each of these factors can directly impact the Administrators revenue and expense. Size of Managers 3 The PFRAUM reported by 87% of Citibank s Hedge Funds are below $1bn, which is higher than their universal banking peers. While the basis points charged to smaller clients on AUA tend to be higher due to minimum fee levels, the actual revenues per client are lower which can result in reduced service levels and higher attrition rates. Complexity of Unique Managers 4 The Complexity of Citibank s Client book is below their universal banking peers. Lower complexity may result in lower revenues because complex funds are priced higher to offset higher costs. Hedge Fund Administrators are built to service complex clients and carry higher fixed cost. A less complex client base will not generate enough margin to cover these costs. Primary Trading Strategy of Managers 5 The Primary Trading Strategies of 75% of Citibank s Hedge Fund Clients are concentrated in 4 of the 10 major strategy types. Trading Strategy concentrations suggest the book is less diverse, and may create more revenue and profit volatility during periods of specific asset class stress. Because much of the Fund Administrators costs are relatively fixed, lower asset values can have a very negative effect on EBITDA. Indicator #3: Limited Partner Profile Indicators The profile of the Limited Partners that make up the Hedge Fund Administrator s book can also give us a glimpse into the bank s profitability of an Administrator s book. Non- US Domiciled Limited Partners Citibank s Client book has a materially higher percentage of non- US domiciled clients per fund than their universal banking peers. Non- US domiciled limited partners may require a greater level of support than US- domiciled limited partners. AVG # of Limited Partners per Fund Citibank Exit - Convergence 2015-5 P age
Citibank s Client book has among the highest number of limited partners per fund than their universal banking peers. High numbers of limited partners may require greater levels of resources than fewer limited partners per fund and negatively impact EBITDA. Takeaway Visual: Graphical Representation of the Indicators A consolidated and directional view of the Indicators, from Cross- Selling to Customer Profile, to Limited Partner Profile, can be represented in terms of the faces of a Rubix Cube, whereby the Indicators serve as drivers of profitability of the Administrator s book. The desired (and profitable) region is stamped with the Convergence logo). 3. Footnotes and References 1. A Unique Manager Group is comprised of affiliated Advisors. There are 7,800 Advisors of private alternative funds who map into 6,200 Unique Manager Groups. 2. Based Prime Brokerage Disclosures in Form ADV listing the Administrator, Prime Broker, Custodian and third Party Marketer for each fund. 3. Size of Manager is segmented as follow: >25bn, >10bn<25bn, >5bn<10bn, >1bn<5bn, >.500bn<1bn, >.100bn<.500bn, <.100bn and 0. Citibank Exit - Convergence 2015-6 P age
4. Complexity factors are designed to capture the amount of work that Administrators may be required to perform for a given fund. Convergence tracks 20+ complexity factors. Complexity drives the amount and diversity of revenue and also the cost of servicing the book. 5. Primary Trading Strategy refers to the dominant asset class used by the Manager to generate alpha. Convergence s database tracks 30 different Trading Strategies. 4. About Convergence and Contact Information Convergence provides relevant data and over 60 years of advisory experience in the Alternative Asset Industry. Our focus is effective, efficient infrastructure and the maximum use of data. We have successfully increased the interaction among Service Providers and Managers in solving critical infrastructure needs. We are: ü Industry veterans having served as CFOs, COOs and Global Head of Business Development for multiple Managers and Administrators ü Experienced in creating integrated infrastructure platforms across management companies, funds and service providers ü Data and results driven which ensures specific, measurable action plans to achieve high levels of efficiency across infrastructure platforms ü We utilize all manager supplied data to enrich the business models of all constituencies that service the Manager As experienced industry veterans we bring an insider s perspective to Managers and Service Providers creating differentiated value propositions that resonate and focus on the significant spend at Management Companies that may be better served by third- parties. For General Inquiries: Convergence, LLC 114 Vista Road Wilton, CT 06987 info@convergenceinc.com www.convergenceinc.com Citibank Exit - Convergence 2015-7 P age