Supporting alternative investments

Shankar Subramanian
Principal – Practice Lead, Public & Government Funds, Cutter Associates

Connect with Shankar on LinkedIn

Read the article and learn about:

• The difficulties of supporting alternative assets
• Why data management is a key challenge for alternative investments
• The solutions and strategies firms can take to address these challenges
• The different types of vendor solution options available to clients

About the author

Shankar Subramanian has over 25 years of industry experience in investment management and technology solutions. At Cutter Associates, Shankar heads the Public Funds practice, providing thought leadership to the consulting practice as well as strategic and tactical advice to Cutter’s many public fund clients. He is a regular featured speaker at Cutter Associates member events. Shankar has significant experience with buy side asset management firms, insurance firms, government agencies and pension funds. Shankar brings a deep understanding of data management, portfolio management, risk management, and alternative investments. He earned his B.S. from the Indian Institute of Technology and his M.B.A. from the Indian Institute of Management.

Alternative investments represent one of the fastest growing asset classes, expected to reach USD 14 trillion by 2023. Pension funds with dwindling funding ratios look to these asset classes to boost their returns and many investment managers are gravitating to multi-asset class portfolios with higher allocations to alternate investments as investors seek higher returns.

In recent years, investment firms as well as system and service providers have enhanced their support for alternative investments. Nevertheless, supporting alternative investments continues to be more challenging than supporting public equity/fixed income investments, due to a number of factors explained in this article, which covers the following:

• the difficulties of supporting alternative assets
• the solutions and strategies firms can choose to address these challenges
• the different types of vendor solution options available to clients, including:
  • best-of-breed solutions
  • integrated bundled solutions:
    • integrated multi-asset class solutions
    • integrated solutions supporting alternatives only
  • outsourced services

This article is directed primarily toward asset owners (pension funds, insurance firms, endowments, etc.), but it is also relevant to asset managers (General Partner, multi-asset class managers). We focus on systems and services supporting front, middle, and back office functions for Private Equity & Debt, Real Estate, and other real assets such as agriculture, forestry, transportation, and infrastructure. We have not addressed sales, marketing, or fund-raising functions. Hedge funds and complex derivatives present special challenges related to processing, practices, and technologies that we don’t cover here.

Operational challenges

The results of a 2018 survey by WBR Insights/SimCorp¹ revealed that many investment management firms struggle to support alternative investments. Survey participants cited difficulties including performing manual tasks, gathering data required for reporting, and managing disconnects between the front and back office. The table below reveals the responses to the question, “Where are your THREE biggest challenges when supporting alternative investments?”

2019 North American InvestOps Report:¹

Where are your THREE biggest challenges when supporting alternative investments?

Data management

Through the challenges cited above runs a common thread: data management. Cutter Associates conducted similar surveys in 2012 and 2015 and found that data management was a singularly challenging area for alternative assets processing. Many of the data acquisition, integration, storage, and distribution solutions that work well in the public markets don’t work as well in private markets, for reasons we explore below.

Structure

Data supporting alternative investments is often unstructured. For example, stakeholders exchange alternative investment data through PDF files attached to emails. Automating acquisition, validation, and other tasks for processing unstructured data is technically challenging. Most ETL, EDM, and message/web services-based communication tools are not designed to process unstructured data. Vendors have recently begun to offer Natural Language Processing and Machine Learning technologies that can help to automate the extraction of unstructured data, but these solutions are still evolving, and many tasks still require manual processing.

Standardization

Data exchange methods and protocols for alternative investments are still largely non-standardized. No standards like SWIFT or FIX are in place for alternative investments. The Institutional Limited Partners Association (ILPA) has made progress developing standards over the past five years, but investment managers’ acceptance of ILPA is still evolving, and interpretation of the standards is not yet consistent enough to support technical solutions that automate the data exchange. A few vendors have created data exchange technology standards loosely based on ILPA, but these standards have not gained broad acceptance across vendors.

Valuations

By their very nature, valuations for private equity and real estate investments cannot be made quickly or frequently. They do not have publicly available, market driven pricing—the valuations often depend as much on opinion as on mathematical calculations—and they may not reflect the true disposal value of the asset at the point of valuation. So, at month-end when the books are about to close, stale prices must often suffice.

Transparency

In recent years, clients, regulators, and investment management executives around the world have called for greater transparency into investments. But transparency into alternative investments is inherently difficult to achieve. Managers often consider information on their underlying holdings to be a core component of their competitive edge, so they are unwilling to freely share this information with investors. Further, unlike public market securities, data on alternative instruments is not publicly available. Regulations are requiring increasing transparency into alternative investments, but the threshold for reporting is still lower than in public markets.

Latency

Data for alternate investments is often stale, with latencies in excess of three months for manager quarterly reports being fairly typical.

Strategies and solutions

To overcome the challenges related to supporting alternative investments, investment management firms have tried various approaches which can be broadly classified as follows:

• “Buy” solutions provided by vendors
• “Build” solutions internally
• “Outsource” specific business processes

When adopting vendor solutions, our clients typically select one of the following basic approaches:

• “Best-of-breed”
• “Bundled” for alternatives
• “Cross-asset bundled” for multi-assets including alternatives

Best-of-breed solutions

The best-of-breed approach entails integrating multiple industry-leading business applications deployed for specific business functions and / or asset classes.

Pros:

• Strong functionality targeted at specific asset classes or business capabilities
• Support for competitive advantage
• Specialized vendor expertise

Cons:

• Integration challenges
• Inconsistent user interfaces and workflows
• Higher vendor management effort
• Higher internal maintenance/ support effort
• Generally higher total cost of ownership

Best-of-breed solutions are more common in the alternative space. Specialized systems are often needed in the front office especially, where the characteristics and analytical needs of each asset class differ significantly. The WBR Insights/SimCorp survey referred to above asked, “What strategies are you putting in place in the next 24 months to mitigate the cost and challenges of supporting alternatives?” Among respondents, 82% replied: “Investing in ‘best-of-breed’ tools for specialized asset classes.”

Best-of-breed solutions in the front office fulfill one or more of the following functions:

• Capital Allocation and Portfolio Construction (allocation between asset classes, strategies as well as funds within a portfolio). This is an area where we often see proprietary systems supplemented by Excel and manual processes.
• Portfolio and asset-level analytics. Specialization by asset classes is more common here.
• Fund analysis and manager selection includes specialized systems, supplemented by manual process or CRM systems
• Risk management
• Portfolio monitoring

Best-of-breed, industry-agnostic solutions are also being used in the following areas:

• Document management (including the ability to process unstructured data)
• Workflow
• Financial planning

Contact & Relationship Management

These solutions may be broadly grouped under CRM, though there are point solutions that specialize in specific areas named above.

Bundled solutions

Bundled solutions are integrated front-to-back solutions from a single vendor spanning multiple functions and covering either:

• Alternatives only

• Multi-asset classes including alternatives

Depending on which of these solution types is chosen, the following pros and cons should be considered:

Pros:

• Reduced integration and support efforts (to a lesser extent with an alternatives-only solution)
• Generally lower total cost of ownership (TCO) (to a lesser extent with an alternatives-only solution)

Cons:

• Compromises in specific functions/asset classes (to a lesser extent with an alternatives-only solution)
• Significant dependence on a single vendor
• Lower flexibility for change

Demand for bundled solutions is increasing among asset owners and managers of alternative investments. The WBR Insights/SimCorp survey asked, “What strategies are you putting in place in the next 24 months to mitigate the cost and challenges of supporting alternatives?” Among respondents, 74% replied: “Consolidating alternatives and private debt with other asset classes on a single investment platform.”

Bundled, or integrated solutions, are prevalent in public markets, where several vendors offer “front-to-back” solutions across the different public asset classes (including derivatives). But “front-to-back” solutions across public and private markets are typically less mature for alternative investments. Some bundled solutions support multiple asset classes either by interfacing with separate alternative solutions, or by leveraging workarounds built upon existing traditional market solutions instead of developing core alternative assets functionality. Other software providers are evolving quickly and offer middle and back office functions while strategically carving out front office functionality such as deal flow and CRM.

Bundled solutions across asset classes typically cover the following middle and back office functions:

• Capital call processing
• Distribution processing
• Commitment tracking
• Performance reporting
• Look through and exposure calculation
• ABOR
• Reconciliation

For the front office, some bundled solutions provide CRM capabilities for managing data, documents, workflows, contacts, and relationships across asset classes or dedicated to alternatives. Some vendors offer front-to-back functionality specific to a single asset class like Real Estate or Private Debt, including some of the analytic and decision support functions required by the front office.

Vendors are constantly upgrading their capabilities, and some are starting to move toward “front-to-back” office support across all asset classes. Front to back cross asset software are facing similar challenges as the alternatives asset front to back software are facing. Vendor solutions are challenged to meet the needs of clients with a complex mix of assets, with front offices investing directly or co-investing in alternatives (in addition to an LP model) and with more active analysis of investments. This has led to a rise in dedicated best-of-breed valuation and financial planning solutions.

Outsourcing

As we’ve seen in public markets, firms have sought to outsource some of their routine, non-value-added functions related to alternatives. Outsourcing can be attractive in alternative systems due to the many manual data management tasks that firms need to support. Recently, many of the service providers have been investing in the alternative space.

Accounting

Some of the larger custodians, the usual suspects for back office outsourcing, also provide accounting services for alternative investments. But their offerings here are less mature than their offerings for public markets. At best, they can provide an Accounting Book of Record (ABOR) but not an Investment Book of Record (IBOR), although the definition of IBOR for alternative investments is up for debate.

Capital call processing 

Processing capital calls is often one of the most time-consuming and frenetic activities for an asset owner in an LP arrangement. The services required here include collecting, validating, and processing payments (including approval workflows) and updating commitment levels. While most of the process remains manual, we have seen some interesting projects leveraging machine learning to facilitate the process.

Fee verification

Asset owners are increasingly demanding transparency into the fees charged by investment managers. Staff members are tasked with placing fees into categories (management fees, carry-interest, investment expense, operational expense, etc.). This is challenging since the managers often do not provide this data with the clarity required by the asset owners. Calculation of carry-interest is particularly difficult since it is based on investment performance, which presents additional methodological issues for alternative investments.

Fee verification is required to confirm that manager fees are in line with contractual stipulations, and to render greater accuracy in performance calculations and reporting.

Performance and reporting

Performance and reporting services include calculating performance and producing a variety of reports intended for portfolio managers, senior management, and boards.

Other data services

When firms implement alternative investment systems, they often underestimate the data management efforts required to maximize the benefits they get out of the system. Many of these efforts are routine, time consuming tasks that service providers are increasingly covering, such as gathering from managers and other third parties the quarterly reports and other data needed for the following:

• Reconciliation of transactions
• Valuations
• Data on underlying investments, required for risk management and other portfolio analysis decisions

While these data services are reducing the operational effort to collect information, they do not easily solve the quarterly reporting lag the industry has been relying on for decades forcing them to perpetually rely on stale data.

Moving forward

The WBR Insights/SimCorp survey asked, “What asset classes would you like to see consolidated onto a single platform for front-to-back office processing?” Among respondents, 80% replied “Alternatives.” In the long term, bringing alternatives on to a single front-to-back multi-asset solution has so many benefits that it should be a consideration for many firms. However, not all are ready to take the full step in one go. Firms need to bring a strategic perspective to deploying the solution most appropriate for their current situation and for the future, i.e. should it be point solutions, or a bundled front-to-back multi-asset class solution, or some combination thereof. Firms also need to be cognizant of the evolving vendor offerings. As the bundled systems and services mature, movement towards consolidated multi-asset class solutions will accelerate. Supporting alternative investments requires a judicious combination of technology and services that takes careful planning to onboard.

1. ‘2019 North American InvestOps Report: Empowering Multi-Asset Front-to-Back Investment Operations’, WBR Insights, 2018.