Five Forces That Shape the True Cost of Hedge Fund Operations

In part one of our investment operations total cost of ownership (TCO) series, we detailed how TCO equations should consider how much operational friction comes with hedge funds' attempts to scale; and why firms tread water with run-the-business tech upgrades instead of change-the-business transformations that set them up for future scale.

Now, we seek to help hedge funds understand the true, fully loaded cost of running modern investment operations and make high-stakes, complex decisions on how to adapt their operating models to account for growth in AUM, transaction volume, or product complexity. Here is a holistic way to measure TCO that accounts for the under-the-radar economics of the hedge fund operating model, hidden costs that accrue over time.

Cost #1: Coordination of vendors across disconnected systems

Many funds run several disconnected point solutions for functions such as investor accounting, reconciliation, treasury, and reporting. This was a perfectly reasonable approach in the earlier phase of digital transformation when funds integrated an array of vendor-made, best-of-breed SaaS offerings with their in-house tech stacks in the 2010s. Then some chief technology officers opted for the one-stop-shop platform in which their vendor manages everything. But the trade-off was that they forfeited autonomy.ⁱ Then, things changed. Market structures evolved, disruptions descended, and investment technology advanced.

Funds trying to launch a new credit derivative strategy, for instance, require coordinating up to five different vendors to adjust their product roadmaps simultaneously. In appraising the cost to run the current model, the fund should consider how much time is spent moving, checking, or reconciling information between systems. Plus, firms are frequently forced to wait months for vendors to prioritize these changes on their product roadmaps.

It is the structural cost of a patchwork architecture. Every day the front office waits on the back-office system to get up to speed is a lost day of alpha generation.

Cost #2: Paying the interest on technical debt

In large, technology-forward firms, the infrastructure can absorb the costs of adapting the operating model to a change in regulations, a big jump in transaction data volumes, or a new asset class. A pivotal factor in TCO is the amount of engineering capacity required to maintain existing infrastructure. A fund that has postponed modernization needs to consider the cost of retrofitting a proprietary system for a new regulation, the cost of development and process redesign for a new esoteric credit derivatives business, and the cost of testing, reconciliation, and engineering capacity for platform upgrades.

When firms utilize disparate legacy systems, developers are forced to manually cobble them together with proprietary internal code. If a fund manager wants to bring in a large private equity LP interest or co-investment vehicle, the back office now has to hire new people or write custom code to deal with performance measurements and valuations for complicated entity structures and the underlying portfolio companies.

These configurations quickly become non-scalable. In the financial industry, this compounding inefficiency is known as technical debt: legacy technology that requires upkeep, maintenance, and syncing with other disparate systems. Paying technical debt down slowly comes with considerable interest costs, which should be incorporated into TCO measurement.

Cost #3: Salaries to make up for operational inefficiency

If a manager unearths an opportunity to execute a strategy a little outside the norm for the fund, such as cross-currency swaps, esoteric credit derivatives, or fixed-income repo financing, the subject-matter experts and operations people they hire and their salaries are not hidden costs of ownership. The process of recruiting, hiring, and onboarding costs several thousand dollars, and that's during the best of times. Right now, for example, junior operations and accounting talent are in exceptionally high demand. In a seller's market during an ongoing war for talent,ⁱⁱ rising compensation expectations and recruiter premium placement fees make the entire endeavor more expensive.

The TCO for a single employee seat includes a wide range of essential hidden expenses, with the fully loaded cost of an in-house employee typically running between 150% to 180% of their base salary. But the real hidden cost is not the TCO of human talent. It is an operating model overly reliant on the manual processes to absorb transaction volume, product complexity, reporting requirements, or AUM. Hiring a full-time senior expert with niche experience is extremely expensive, and firms often only need a tiny fraction of their capacity. But they cannot hire one-fourth or one-fifth of an employee. It is essential to include these hidden costs and quantify periods of lost productivity in any TCO calculation. If the TCO is unreasonable, a new operating model may be necessary.

Cost #4: Key person risk

When they set out to track the TCO of operating models, most firms don't chart the intellectual capital dependencies that are well understood internally but rarely quantified. We have all experienced key person risk when a colleague goes on maternity leave, is out sick, or leaves the organization. When a single developer builds custom infrastructure at a fund, they hold the Rosetta Stone to the firm's critical downstream systems. If they leave, the firm is exposed to severe operational risk, requiring incoming engineers to perform forensic deep dives to decode how the system was originally put together. Key person risk can also come in the form of the sole engineer who handles software integrations. Further, it can be the sole person with a good relationship with a key tech vendor.