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Operations a Concern as Hedge Funds Expand Globally

As smaller hedge funds increasingly expand into foreign countries, they must pay as much attention to building solid operational infrastructure as they do to chasing alpha.

Although grappling with such infrastructure may be the last thing hard-charging money managers want to do, it's essential for growth and stability, said Michael Serota, co-head of Ernst & Young's hedge fund practice.

"If you don't put the infrastructure in place, you hurt your ability to perform, manage risk and generate returns," he said.

By early this year, there were about 350 hedge funds with more than $1 billion under management, Serota said. Of that number, 200 or so are global or are thinking of going global, he estimated.

As fund groups reach $1.5 billion to $2 billion in assets under management, they first start trading in foreign markets' companies or products, and then typically open offices in those markets, Serota explained.

Such globalization has gained speed over the past three to five years, driven by competition for returns and the evolution of hedge firms, he added. Their leadership is maturing; they are buying companies and getting into private equity deals.

"Years ago, that may have been expected only of private equity firms or investment banks," Serota said. "Right now, hedge funds are doing it all."

Of course, it's not necessary to have a physical location in a new market for trading purposes, said Mayiz Habbal, managing director for securities and investments at research firm Celent. Electronic trading and direct market access platforms mean a trader can work the Dubai Bourse from a desk in New York, he said.

"But when it comes to dealing with local investors, doing proper accounting and regulations," he said, "it helps for you to be there in order to make use of the local expertise."

In gaining footholds in multiple countries, the funds often step into unfamiliar tax and regulatory requirements that force them, for example, to beef up compliance and reporting and adapt their auditing to handle transactions across multiple tax zones, Serota said.

Among the areas that need to grow up as funds globalize are risk management, operations, tax, regulatory and legal, he added.

As hedge funds grow and expand, third-party administrators are springing up, said Denise Valentine, senior analyst with research firm Aite Group.

"We have a plethora of fund administrators getting into this business," she said. "Citco and HSBC have dominated this for a long time, but new people are stepping up to the plate, recognizing there isn't enough infrastructure."

There is no sign of hedge funds' globalization slowing. Aite and research firm Eurekahedge project that by 2010, North America will account for only 43% of hedge fund assets, down from nearly 70% at present.

"Hedge funds are trying to go where the money is," Habbal said. "They want to be closer to the people who are going to invest in them."

The global expansion scenario is beginning to involve not just, say, a U.S.-based firm moving into the United Kingdom. Firms are increasingly investing in, and seeking investors in, Asia, the Middle East and even Africa, experts said.

Hedge fund investing has heated up in the Middle East, for example, over the last two to three years, Habbal said, thanks to oil money in Kuwait, Saudi Arabia, The United Arab Emirates, Bahrain and Quatar. Within five years, hedge funds should have a solid foothold in such frontier markets, Serota added.

"The growth in the high-net-worth sector is just phenomenal," thanks to surging economies in Asia, Valentine noted.

But even vendors are facing challenges, and hedge funds must be selective about which ones they partner with.

"It's clear how to open operations in the U.K., Singapore or Hong Kong," Serota said. "It's less straightforward if you're talking about Mumbai, Vietnam, Shanghai or the Middle East."

"Funds need be very careful to make sure they follow all the same steps they followed getting into the more established markets," Serota suggested.

Smaller hedge funds, those with less than $1 billion under management, should consider outsourcing software functions to application service providers, Habbal said. One of the most comprehensive one-stop shops is Paladyne Systems, he said.

According to Valentine, even larger hedge funds are turning to business process outsourcing for core operations, in part to allow company leadership to focus more on investing.

Operations outsourcing has a checkered past, however. In 2003 and 2004, many high-profile money management firms in the United States and the United Kingdom turned to outsourcing, only to take the work back in-house amid concerns about quality. Investment firms failed to properly set expectations and oversee the outsourced work, Valentine said.

"They lost internal knowledge, let go of people, sold [operations units] to outsourcers," she said. "You can't outsource and forget about it-you have to partner and recognize that this is still your back office."

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