A large percentage of the approximately 10,000 active hedge fund operations in what is estimated to be a US$2 trillion industry use manual spreadsheets to track, manage, and reconcile complex financial transactions. This requires a significant level of manual effort by hedge funds to reconcile positions, and it leaves them blind to net cash positions with prime brokers or banks.
Hedge fund operations have relied upon core or sub-system basic reconciliation report output and used spreadsheets to match transactions, reconcile accounts and to certify results. Some have implemented automated reconciliation systems, mostly in a decentralised, siloed structure. Manual reconciliation between prime broker accounts, fund administrators, and internal general ledger accounts can be time-consuming and inefficient. In some instances, unresolved transactions result in write-offs or losses for the fund.
To address these challenges, hedge fund operations take either a traditional or tool-based approach. A traditional approach includes using basic reconciliation tools that are built into trading or transaction systems, downloading data into spreadsheets, and matching data to general ledger or bank statements/reports. A tool-based approach focuses on using solutions to automate the majority of the transaction reconciliation, with exceptions managed through a pre-defined workflow to achieve resolution.
These solutions can effectively automate reconciliation processes, increasing accuracy and timeliness of reporting, as well as improve accounting controls, enhance compliance, mitigate risk, and prevent cash losses. Automated transaction reconciliation solutions can help hedge funds transform operational efficiency by:
- Protecting the trade validation process in the front office.
- Providing position management, post-trade compliance, settlement, and trade matching in the middle office.
- Providing enhanced reporting and strengthening decision-making processes in the back office.
When hedge fund operations implement automated enterprise-wide solutions, they can centralise processes, increase internal controls, and process detailed transaction reports that strengthen decision-making processes. Additionally, they gain the ability to reconcile over 90% of the following accounts:
- Prime broker accounts.
- Fund administrator systems.
- Bank accounts – cash balances.
- Dozens of other departmental accounts.
Providing Investors a Calculated Risk
A failure of certain institutions and their boards – and other potential hedge fund investors – to understand transaction and balance reconciliation has contributed to some companies decreasing investment in hedge fund operations. Certainly, recent meltdowns in hedge funds, which were heavily invested in the sub-prime markets, served to support the fears of already jittery investors.
According to a Bank of New York and Casey, Quirk & Associates Survey, automated transaction and balance reconciliation solutions solve challenges that hedge fund operations face today, including headline risk, lack of transparency, and operational excellence.
Headline risk
For institutions scrutinised by the press, the perceived risk of hedge fund losses can be an insurmountable hurdle to overcome. While many of these institutions have been successful using alternative assets (hedge funds, private equity, real property), some trustees remain uncomfortable in regards to headline risk. Automated reconciliation can support hedge funds and calm investor fears in terms of financial transparency and operational excellence.
Transparency
Investors have become accustomed to complete transparency across their portfolio. In comparison, hedge funds typically lack financial transparency. By automating the majority of transaction and balance reconciliations, hedge fund operators gain visibility into all reconciliation processes. Additionally, they gain accounting controls that enhance compliance, as well as increase the accuracy and the timeliness of reporting, both internally and to investors. By mitigating risk, hedge funds prevent cash losses. For corporate investors who are required to track the single trades their in-house managers make as part of their regulatory policy, transparency is especially important.
Operational excellence
Institutions repeatedly mention well-designed trading infrastructure that links trade order management, portfolio accounting, and risk management among their chief operational concerns. Investors are placing increasing emphasis on hedge fund firms’ business infrastructure, and meeting these increased standards for operational excellence continues to be a significant challenge to hedge fund firms.
Reconciling the Front Office
GSO Capital used manual spreadsheets for years to track, manage, and reconcile increasingly complex financial transactions. “The cost of manual reconciliation efforts, in terms of maintaining an accurate view of cash positions as well as validating the trade process and reconciling our positions, was disproportionate prior to implementing an automated reconciliation solution throughout our treasury and accounting operations,” said a GSO Capital representative.
Without the benefit of reconciliation management tools, front office reconciliation can be labour intensive, prone to errors, require long completion timelines, and result in increased exposure to risks. By implementing an automated reconciliation solution, hedge fund operations can centralise their operational environment and come to rely on immediately available and accurate data.
Transforming the Middle Office
Meeting increased standards for operational excellence continue to present a significant challenge for many firms, primarily in the areas of position management, post-trade compliance, settlement, and trade matching.
According to a Bank of New York survey, a majority of institutions expect hedge fund managers to systematically address ’embedded alpha’ (the less apparent frictional costs of managing an investment portfolio) on a more frequent basis going forward, dramatically transforming the standards for operational excellence in the middle office. Specifically, these costs include:
- Portfolio financing.
- The opportunity cost of failing to execute trades efficiently.
- The negative market impact of trading.
- Ineffective cash and collateral management – the area most easily corrected by tool-based reconciliation.
The survey found that embedded alpha costs have been estimated to be 100 to 200 basis points or more per annum. With lower expected hedge fund returns, embedded alpha costs become more relevant, even for hedge fund managers that may not have explicitly managed them in the past.
Achieving Five Key Back Office Goals
Automated reconciliation enables a hedge fund back office to effectively support five key areas including: P&L, trade inventory, custodian services, collateral management, transfer agency, and client reporting. This results in five back office achievements:
- Acquiring accurate and timely information.
- Reducing cash losses.
- Automating reconciliation.
- Increasing operational controls.
- Achieving reporting transparency.
Hedge fund managers must acquire reliable cash position information that supports their decision-making. Spreadsheets do not provide information to the detail level. An automated and transparent system provides managers with daily reports that detail the net cash position at all of their prime brokers, in addition to reconciling the cash position to hedge fund trading and the general ledger.
In order to transform the back office, hedge fund managers need to reduce the losses associated with unreconciled transaction write-offs. Automation provides a hedge fund with the ability to know when trade transactions with prime brokers don’t match hedge fund accounting systems. The sooner a hedge fund can track down these ‘breaks’, the sooner backroom hedge fund operators can retrieve the funds due – reducing potential write-offs associated with reconciling item backlogs.
Automating reconciliation processes increases efficiency and productivity. A hedge fund operation can significantly reduce the time required to complete daily, weekly, and monthly bank account transaction reconciliation with fewer resources. Automated daily reconciliation improves internal hedge fund operational controls and can prevent unauthorised transactions and funds movement.
Conclusion
Economic uncertainty has fanned the flames on what some companies and investors consider to be an already hot area, hedge fund investments. Automated reconciliation can change that situation by providing hedge funds with improved internal controls that mitigate risk and reduce errors, increase financial transparency, and accurate and timely reporting.
Increased financial transparency is one of the most important back office benefits. All transaction information and reconciliation processes can be located in one robust system, where it is managed by configurable business rules (business rules are configured to hedge fund firms’ requirements). An automated reconciliation system can breathe new life into the back office by providing hedge fund managers with reporting accuracy, transactional transparency, and net value positions that ultimately give investors the confidence they need to invest boldly and successfully.