The challenging conditions within markets on both the liquid and illiquid spectrums, has seen firms widen their search for alpha generation opportunities within previously less considered areas of their businesses. One of the areas that has greatly benefitted from this re-consideration, is the treasury and financing space. Forward thinking hedge funds, asset managers and investment managers, are beginning to re-evaluate the purpose and worth of their treasury and portfolio financing functions, as they look to enhance yield and optimise the cash that is encumbered outside of their longer-term strategies.
The opportunity for treasury and financing experts to deploy their expertise within margin optimisation is also ripe, as new liquidity and margin requirements constrain the more operational functions to hire specialists to manage these projects. Another key factor in this space been the increased appetite from CIO/CEO’s, to use non-invested capital into low-risk yield enhancing vehicles such as money market funds or by setting up securities-lending books in-house. Both strategies are proving to be successful for the larger managers that are gradually being replicated by smaller managers.
This piece will look to answer some questions commonly asked by firms interested in developing a treasury division. The piece will also aim to provide insight into how existing treasury functions can amplify their offering to consider revenue generation element.
How do funds value Treasury savings/gains?
The key question that looms in the minds of decision makers (COO’s, CEO’s, CIO’s) and those responsible for treasury/ financing functions is often: How should compensation be measured? Is treasury and financing part of the profit centre, or does it form part of the operational infrastructure mandated to save/cut costs?
Historically, the treasury function, which encompassed financing as part of its remit, has been considered a part of the wider finance and operations divisions. This element of the business was usually run by individuals who came from non-investment backgrounds and had no particular mandate beyond trying to cut costs and efficiently manage the excess cash held on funds’ balance sheets. This is changing at a rapid rate, which leads to the next question.
The current trend amongst alternative investment firms, (hedge fund managers and family offices in particular), sees them explore a more alpha generating approach to cash management and have taken a far more detailed and analytical approach to management of collateral and liquidity. Treasurer and Financing and optimisation profiles are now of a far more technical background and will usually have a background in trading or risk management within the front office, that is easily translated to treasury.
Equity fund managers were the first to consider the added value that individuals from a more revenue generating mindset could add. Managers in this space have explored the optimisation opportunities available for several years now, especially within the context of prime broker financing and re-negotiation of rates with the sell-side. These, in turn, allow for extra operating liquidity for investment in the shorter term, low-risk strategies such as within the growingly popular Delta One strategy.
Managers like Millennium were the first to try to re-package their financing businesses as internal mini-prime brokers’, a move that has proved highly successful and that has allowed the firm to be actively viewed across the market as a pioneer in the efficiency of excess cash deployment as well as gaining a reputation as a skilled negotiator of financing terms with the sell-side. The individuals that built out this division, have gone on to successfully replicate this model at other managers such as Balyasny, Lighthouse, Schonfeld and Point 72.
Fixed Income Macro and Credit businesses have recently also increased their efforts in this space. The focus is to optimise balance sheet usage and to ensure that margin and collateral posting is as efficient as can be. New regulatory constraints for derivative trading businesses are amplifying the need for a specialist profile to cater for optimisation across the portfolios. In this type of manager, individuals from fixed income structured desks, STIR as well as Collateral financing traders are particularly in demand, as they hold a breadth of knowledge of liquidity and funding requirements which are correlated with an excellent market understanding and easily transition to an alpha generating approach.
Current recruitment trends in Treasury and Portfolio Financing
This space has seen a lot of movement due to the changing perception of the treasury function. As of such, a key decision to be made from a talent acquisition / recruitment perspective is; what direction the hiring firm are looking to take for their treasury division? i.e. are they keen to hire an individual to focus on the financing and treasury from a high level, as part of a broader operational remit? Or, are they keen to hire an individual with proven experience in adding value within optimisation and with a remit to explore revenue generation within these parameters?
This distinction is key, as it will inevitably impact the budget required to make the hire both in the short and then longer term. A pure operations candidate will not have significantly different average base salary when compared to a treasury and financing candidate (£15,000 to £20,000 typically). The variable compensation element and its structure will however tend to differentiate quite significantly. Those individuals with a track record of established relationships, that can demonstrate both savings and optimisation that leads to generation of (operational) alpha, will be compensated with a structure to reflect this.
The bar is further raised if the firm has appetite to create or develop an existing function, into a self-sufficient financing engine, that actively seeks yield enhancement/arbitrage opportunities within the pre-defined risk parameters. Firms that seek to generate returns from the encumbered cash that would otherwise be unused, could simply make the decision to invest into money market funds or participate in T-Bill auctions via their existing functions. However, an experienced hire from a market making desk or from a firm that actively manages their treasury/financing business, will be given a mandate to generate returns and in turn will also guarantee a wider supervision of margin control.
Hedge Fund Managers have also begun to actively target individuals from structured products desks, tasked to replicate money market or index trades with a more complex pay-off structure that can guarantee higher returns whilst not raising the risk profile extensively. Additionally, these profiles will allow for the internalisation of collateral management processes and, most importantly, will provide a greater focus on consistent monitoring of financing costs, spreads and constant strategic re-pricing which will all contribute to significant decreases in expenditure.
The trend in 2019 amongst the larger ($3billion +) multi-strategy managers, has been to follow the example set by the largest funds like Citadel, Capula and Millennium that have established functions, by considering these revenue generating profiles. This has in turn, meant that competition for talent is fierce, and the most determined managers have begun to compete with the former, for the most talented funding traders and optimisation experts.
In early 2018 a multi-billion dollar Hedge Fund manager recently (hired 2 individuals from a structured products background to manage the encumbered cash/collateral and unencumbered cash of its funds. In the 2 years’ the pair have been at the firm, the business has outperformed the SOFR benchmark by more than $20 million in both years, having previously been under-performing by circa $15 million owing to suboptimal margin postings to prime brokers and exchanges and not optimally investing the un-used USD cash. Now, more than half of the firms’ cash Investment strategies orient themselves around repacks (via Repo or outright bill purchases) or via investment into the AUD repo market. The firm has also explored picking up funding carry from the gilt TRS market, to accommodate investment in the USD repo market, as well as purchases of outright T-bills or short dated off the run bonds to lower cost of funding.
The treasury investment manager in question, having established a risk framework and policy for the treasury division, has now created a synthetic equity Index replication book for their Index investors. This book was able to out-perform SOFR by more than 20 bps in 2019, by moving the replication strategy to the synthetic space, using index TRS to replicate and then use the cash to pick up the carry from USD/JPY FX swap basis. This was then invested into repo's on a weekly basis.
Is technology automation going to replace the physical treasury function?
Within the treasury and financing space, some consideration must also be made on the rapid increase in technology that is being adopted by buy-side firms. The wider use of data and analytics to drive returns is no longer within the scope solely of quantitative funds, indeed it is being now continually implemented even in the more traditional discretionary businesses in multiple functions and treasury is one that is seeing major change.
Treasurers and financing traders can access real-time data from their PB’s directly through their TMS’s for a variety of different fields including margin, collateral and short colour. Some more elaborate treasury management solutions even provide direct access to money market funds to facilitate encumbered cash trading whilst using an economies of scale model to bring down access costs.
Companies are encompassing wider offerings to managers who are keen on acting upon data and insight from research teams, to more efficiently manage balance sheets and provide excellent insight into spread/financing data. This intelligence is sourced directly from the PB’s that funds trade through, thus enhancing the scope for constant re-pricing of the books and more importantly, justifying their license fees.
However, these systems are only worth as much as the individuals that interact with them and act upon the insights they provide. Technical profiles are in high demand for this reason. These profiles are tasked to generate insight that is valuable to portfolio managers, combining their ability to streamline and automate manual processes which lead to more time to focus on value-add projects within portfolio optimisation. This is beginning to be valued as highly as the contributions made to PnL by another area of the business.
How is talent retained within this space?
The progression opportunities of these roles are a key topic of discussion for this area. In the past, it had proven difficult to demonstrate the value that these functions add. This was illustrated by COO’s difficulties in weighing up compensation from an operational “bonus pool”. In recent times, with the advancement of the function, progression has been pitched at a more junior level, as towards the investment side. This would lead to taking risk, perhaps initially via a small mandate inside the wider financing book and then eventually enlarged to encompass the firms longer-term risk-taking mandates.
The need to remove talent from the treasury division is decreasing however, as more funds assign unencumbered capital on a longer-term basis to their treasury arms to explore arbitrage opportunities, thus satisfying the risk appetite of their talent. Some of the more progressive managers (especially the family office structures), have even begun to explore 1+ year lending opportunities within illiquid markets, (where yield is significantly enhanced) to complement the more liquid day to day trading that funds their portfolios. When speaking to directors at funds that have adopted this mindset, the sentiment is that, whilst the process is not a simple transition and it requires extensive buy-in from senior decision makers (CIO’s and PM’s), the decision can be more than justified by, the well above average returns that these funds generate whilst continuing to maintain a relatively low risk profile in adherence to the parameters of their main funds.
In managers like these, the full transition has been made and treasury is by all means, a revenue generating element of the front office. These teams will be mandated to take risk and, as of such, the components can expect to be paid similarly to what a material risk taker would do in a bank or a trader/PM would do in other managers. Their comp however, is of course not on the same scale as PM’s who run their own books as the treasury’s mandate is still split at least 50/50 with the funding piece.
Following on from the previous topic, Mondrian Alpha recently included the treasury and portfolio financing roles as a part of their annual compensation and salary survey using data pooled by 128 London based hedge funds. The below is data pooled regarding total compensation in 2018 and predicted total compensation for 2019. To give context to the arguments made above, the data is split into operational treasury and investment treasury functions according to the following descriptions.
“Operational Treasury Function”
A team or individual, responsible for the fund financing and margining in funds’ preferred currency cash or collateral. The main remit is to manage the financing across all funds and currencies including handling all post trade repo life cycle events e.g. re-pricing, re-rates and all other amendments. This person will have ownership and management of broker relationships and presentation of new opportunities for cost reduction/margin and portfolio optimisation as well as project work and ad-hoc tasks such as setting up of new funds and accounts and managing funding and liquidity requirements. They’ll lead projects on adherence to new regulation e.g. Uncleared Margin rules. This role will most likely report into the COO/Head of Operations.
“Investment Treasury Function”
This individual/team will cover the non-operational (settlements/re-pricing etc) remit of the former but, is focused primarily on the identification and capitalizing on of revenue/alpha generating opportunities within the financing sphere. The individual will be responsible for managing and executing the repo/money markets trading used to finance the funds as well as competitively seeking yield enhancement via low-risk trading strategies. They will also be responsible for active management of PB/Counterparty relationships, consistently re-negotiating rates to optimise costs as well as providing colour on recent developments in the repo and FX/STIR markets and threats to long-term positions for the firm. This individual will typically have an extensive network of well-developed sell-side relationships with counterparties, that will positively impact balance sheet allocation for their business.
The role will report to the COO or to the CIO depending on the size of the firm and, depending on this variable, will be split into different asset classes, with equity finance and fixed income financing usually the main division made.
We can extract interesting insights from the data above, all of which contributes to the on-going debate as to how the treasury and portfolio finance divisions should be viewed in the hedge fund/alternatives space.
- Total compensation within both operational and investment focused treasury divisions is growing at a similar rate at roughly 5% year on year.
- Operational Treasury functions perceive a median circa 50% bonus on top of their base salaries, aligning them roughly with the compensation obtained from the wider operational functions, regardless of potential savings/earning that positively impacted the PnL of the firm.
- Operational Treasury total compensation packages are split roughly 75-25 between base salary and bonus paid.
- Bonus payments are circa 4x higher for treasury professionals within investment mandated functions, whilst total compensation is more than 100% higher for these firms as opposed to operational treasury divisions.
- Base salaries for “revenue generating” treasury managers are circa 30% higher than their counterparties in firms that consider treasury to be a part of the operations division.
What’s next for the treasury and portfolio financing space?
Whilst there is still a stigma surrounding the infrastructure and staffing costs that operating an “investment-focused” treasury function entail, 2019 has been a highly productive year in this space. Mondrian Alpha has successfully contributed to the development of 4 treasury divisions, helping to align them with a more revenue generating approach, as well as having successfully seen through an entire treasury build out with a further two hedge funds that had previously never considered the alpha generation angle of treasury. The profiles introduced to these firms have contributed actively from day one.
Two different sets of regulation will heavily impact the alternatives space in 2020 and a further large regulatory imposition will burden funds in 2021. New reporting requirements under SFTR (Securities Financing Transaction Regulation) and the mandatory buy-in element imposed under the new CSDR (Central Securities Depositories Regulation) will see managers under a lot of pressure to comply within the parameters set by the regulators. In turn, those managers that have made hires in the past years, will have dedicated professionals with experience in the space that are able to facilitate the process, that would otherwise become additional workload to be spread out within the operations and compliance divisions of the funds.
Further regulatory constraints will impact funds that trade derivatives in 2021, following the delay of the previously announced for September 2020, 5th phase of the Uncleared Margin Rules which now impacts all funds/trusts and trading outfits that have a trading volume over $50 billion in notional amounts. The Uncleared Margin Rules will require firms to post collateral to a segregated custodian for their non-cleared derivatives trades, including FX forwards, cross-currency swaps, exotics and equity options, either on a tri-party or third-party basis. BNY Mellon estimated that more than 640 institutions would be affected by the rules, and cover thousands of custodial relationships.
The delay from the regulator was requested as it became clear managers had not been able to put in place frameworks to comply to the regulation. In fact, according to a report in April from SimCorp, only 7% of buy-side firms surveyed (out of 200) said they were fully compliant with the upcoming changes to their initial margin processes. Another study from Greenwich Associate in June also showed just 20% of buy-side firms had begun to examine the impact of the rules on their trading costs.
This intensified regulatory environment is the perfect moment for hedge funds to make an impactful decision which would help the operational infrastructure to alleviate a heavy restraint from the new regulation and would then see an additional benefit from the potential revenue generation angle adding to their treasury function with correct skillset.
Can Treasury be a source of growth in the coming years?
The transition from old-fashioned and clunky operational treasury divisions to far more optimised, technologically advanced functions has been in full swing this year and, the direction is set for this to continue and increase in the coming years, as proved by the above statistics and data. However, many hedge fund managers still lack the direction and or guidance to notice and act upon the impact that the expertise of a dedicated treasury professional can make.
Regardless of a mandate to generate revenue, the case study illustrated in the previous section, is proof as to how, having a dedicated collateral and counterparty risk and relationship manager can actively contribute to positive PnL. Suboptimal margin postings, inefficient management of prime broker relationships and exchanges can all bear a weight on a firms’ liquidity and, not optimally investing the un-used cash also creates extra regulatory and operational weight on the funds’ balance sheet. One individual with the right technical skillset and well-established relationships can solve this, allowing for the perfect launch point to prove the worth of a dedicated treasury function.