The perception of the responsibilities of alternative investment or hedge fund administrators has ch...
The perception of the responsibilities of alternative investment or hedge fund administrators has changed dramatically in the past year or so following the LTCM debacle and, more recently, a number of scandals, the latter of which all appear to have been deliberate fraud perpetuated by the fund managers, who published totally false performance numbers. As a result, two questions are being asked - how could this have happened? and how can it be stopped from happening again?
In the case of the first question, with regard to US domestic funds, many do not have an independent administrator and investors rely on the manager to fulfil that function. There is no doubt that 99.9% of managers are honest, but it only takes that rogue 0.01% to create the headlines.
The offshore fund market has always required a separate custodian and administrator for two reasons. First, the regulations in most of the jurisdictions of domicile or where it is being sold require this and second, the high net worth and professional investors - investors in such funds in Europe - usually invest through private banks. European private banks are inherently cautious and concerned with the security of the fund. They therefore require a higher standard of independent oversight and control.
It is fair to say that not many changes have taken place in the way most administrators do their job - the change has been in the attitude of the investor who is now carrying out the sort of sensible due diligence that was never, or rarely, carried out two years ago. This trend started with LTCM, which resulted in a greater demand for transparency, but this is not generally something the administrator can provide without the manager's consent.
However, since the scandals investors' concern has been the independence of price sourcing. Suddenly they are asking what administrators do and how they do their job. For most funds, it is possible to get independent pricing from one of the data suppliers - Reuters or Bloomberg, for example. Furthermore, the administrator can obtain the portfolio details from the relevant bank, clearinghouse or prime broker, not from the manager. In many cases, this information can be downloaded by the administrator electronically. The only input from the manager will (or should) be confirming to the administrator that the information received is complete and accurate.
Problems can occur in valuing very illiquid or esoteric investment products which do not feature on the data supplier. In these cases, it is essential a valuation procedure is agreed and fully disclosed in the offering memoranda or prospectuses, particularly if the fund is relying on the input of the manager. Wherever possible, an independent source or verification should be identified and the auditor should be consulted in the event of a problem or if the administrator has strong doubts about the pricing proposed.
In the case of funds of funds, the administrator will have to rely on the numbers published by the underlying funds. It will be the manager's responsibility to carry out the investors' due diligence on those funds and to satisfy themselves that they are administered and valued properly.
Another demand from investors is for standardisation in the reporting of fund performance on a regular basis. This may seem like a simple request, but the main problem with providing standardised reporting is that the fund is not a standardised product.
An alternative investment fund can be defined as a non-traditional, long-only vanilla securities fund and, as such, includes both hedge funds and other non-traditional investments, such as futures, commodities and currencies. A hedge fund is generally considered to be a fund that employs some form of hedging technique, such as a long-short portfolio or one of the varieties of arbitrage trading techniques. It is not necessarily market neutral, because a true market neutral fund must be profit-neutral.
It is not just the wide range of investment strategies that makes standardisation difficult. There is also the wide variety of fund structures commonly used, especially the various capital protection structures offered. There is also the amount and method of charging investment management fees - are they charged on the opening monthly values or at month-end? Are they charged on the NAV after all other operating expenses or before? Is the incentive fee charged on interest earned and on profits net of all expenses or just net of the investment management fees and transaction costs? Is there a benchmark? Are losses carried forward in perpetuity or just during each calendar year?
Then there is the thorny question of 'equalisation' - avoiding the 'free ride' and ensuring the manager is paid and each investor pays an equitable incentive fee. Once a manager is paid an incentive fee, they cannot charge another until the NAV per share has risen above the previous high watermark. So if the fund has a drawdown, the manager has to wait until they have recouped all the losses. The free ride occurs when a new subscriber invests at drawdown and does not pay any incentive fee until the fund price has risen to the previous highs. Equalisation describes the various complex accounting methodologies used to ensure each investor pays a fair incentive fee. This is easily achieved in a partnership with 'capital accounting, but is complicated in a company that issues shares.
Some level of standard reporting can be achieved once the industry has set such a standard, something AIMA is working on at this time. For the administrator, the ability to provide the information required in any standard format will be made much easier as technology improves.
Most administrators now calculate the most complex fees and equalisation programmes using spreadsheets, which is time-consuming and labour intensive, especially if some component, such as the price of an investment
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