Ronan Daly explains why it is essential when setting up a hedge fund to work with specialist service providers to help minimise the risks associated with your product and streamline your operation
Hedge funds have been making the news in recent months for the right reasons. Against a backdrop of long-only funds losing investor assets across the board, hedge funds have outperformed all major equity indices and have, by and large, been able to demonstrate an ability to make returns for their clients when markets are going up or down. As a result, investors have been pouring money into hedge funds and investment houses have been falling over themselves to develop in-house hedge funds.
The change in perception of hedge funds illustrates a key issue ' there is general confusion about what a hedge fund is. The asset class, that was a dirty word only a few years ago in the wake of Long Term Capital Management, is now the hot ticket for the investment community.
Much of the confusion surrounding hedge funds stems from the fact that the term encompasses a whole range of management styles, some of which are hedged and some of which are not. The term describes many of the current range of European long/short equity funds which, in today's turbulent markets, might have a gross market exposure of less than 50% and it is also used to describe highly leveraged directional strategies which encompass few or no hedging techniques. What is not in doubt, however, is that the term tends to define non-traditional investment strategies which permit the use of short selling and leverage and which typically attract performance fees for the manager.
It is important for those of us working in the hedge fund business to critically analyse the strategies employed by managers and to understand the complexities and risks involved with each different strategy. This article will attempt to explain why it is important when setting up a hedge fund to understand the specific issues and risks associated with your product and to take steps to minimise those risks and to streamline your operation. Usually this involves working with specialist service providers who are focused on this business sector.
The hedge fund universe is full of terms that seem almost designed to confuse the layman ' equalisation, side pockets, PFIC, UBTI, statistical arbitrage and so on. To the uninitiated, one can be made to feel like a painter and decorator at a fine art exhibition ' you understand that its about putting paint on the wall but you are at a loss after that.
Hedge funds need to be surrounded by service providers who understand their particular needs and who are adaptable enough to cope with their often esoteric structures and reporting requirements. The key service providers selected by hedge fund managers tend to be the prime broker, the systems vendor and the administrator.
Prime brokers, rather than traditional custodians, are usually required to handle execution, securities lending and asset finance and specialists are also desirable in selecting other service providers. Certain prime brokerage houses specialise in equity and stress the depth of their stock loan departments, while others specialise in areas such as fixed income or emerging markets. It is important to select the correct specialist when choosing the prime broker. Additionally, hedge funds usually require the manager to employ some type of specialist trading system. In the past few years, several names have emerged as being customised systems targeted directly at the hedge fund market place. Hedge fund managers would be well advised to look at these systems before setting up their fund.
Potential hedge fund managers should also seriously consider using a specialist hedge fund administrator.
It is essential that any company charged with the administration of a hedge fund has both people with the knowledge and experience of these matters, systems and processes which can deal with the complexities which are specific to hedge funds. The following are the primary reasons for looking at a non-traditional administrator:
• Investment Strategy
Unlike traditional investment products, hedge funds commonly employ a whole range of exotic financial instruments to achieve their strategy. While virtually every administrator will be familiar with equities and bonds, not all will be so familiar with futures, options, swaps, contracts for differences and forwards.
Of even more importance than familiarity with the types of instruments being traded is a deeper understanding of the strategy that the manager is employing. It would be very difficult to produce a satisfactory level of administrative support to a fund following a convertible arbitrage strategy if one did not understand what the manager was trying to do. The same could be said for managers doing pairs trades, statistical arbitrage and, indeed, most hedge fund strategies.
The particular strategy being employed by a hedge fund poses challenges for an administrator on a number of levels: are the staff working on the account of a sufficient calibre to understand the product? Can the company provide training to assist the staff? This is not an easy item. It is not possible to buy an 'off-the-shelf' training manual on how to administer a hedge fund. Training programmes usually have to be customised and tailored to meet the specific needs of the hedge fund administrator.
Can the administrator's systems cope with the strategy? Again, 'off-the-shelf' systems designed for the mutual fund environment usually cannot deal with the challenges posed by hedge funds.
Is the administrator sufficiently aware of the risks involved in a particular strategy? For instance, unlisted and emerging markets securities often give rise to considerable pricing issues. If a security's price is not available from the usual sources, does the administrator have a clear set of procedures to follow in order to obtain a prudent price?
Usually these areas can only be satisfied by working with an administration company that has a dedicated hedge fund group with a deep and experienced infrastructure around it.
• Fund Structures
Hedge funds are typically set up in lightly regulated jurisdictions such as the Caribbean Islands. These jurisdictions pride themselves on the flexibility and breadth of choice of the legal structures that are available. Lawyers, most notably in New York and London, have utilised this flexibility so that it is now possible for a fund manager in London to set up a single hedge fund product which has specific attributes tailored to the needs of specific investor groups such as US taxpayers and tax exempt organisations, Japanese institutions, UK high net worth individuals and Swiss institutions.
Whilst this provides a great deal of flexibility for the fund manager, it poses many complications for the fund administrator. The administrator must be comfortable dealing with corporate entities, unit trusts, limited partnerships, hybrid limited liability and limited duration companies. The administrator must also possess a strong knowledge base on the fundamentals of various tax systems and be able to deal with multiple class structures with differing currency classifications, differing fee structures and differing abilities to participate in certain of the fund's investments.
This usually means that it is desirable for the administration company to have in-house legal staff with a strong commercial background and that specific training is provided to all staff. It also usually requires systems that are flexible enough to withstand the demands of constantly evolving legal structures. At the very least, systems need to be able to treat funds in both a corporate manner, resulting in a net asset value per share figure, and as limited partnerships, which requires the necessity to maintain partners' capital accounts.
l Reporting requirements
Hedge funds lend themselves to quite different reporting standards to more traditional investment vehicles. Equalisation of incentive fees is a particular peculiarity unique to hedge fund structures. Essentially, this involves an accounting treatment whereby each shareholder in a fund is charged an equitable performance fee based upon the return generated by the fund for the period of time they have been in the fund. Without some type of equalisation methodology, there is a danger that individual investors may suffer a fee not in line with the actual returns generated during the period of time the shareholder has been in the fund.
Equalisation is quite a complex concept that can be carried out in a number of different ways. It places demands on an administrator's reporting capabilities and systems and it also demands that the administrators' staff is able to explain the concept to managers and their investors. It is vital that the adjustments associated with equalisation are carried out in an automated fashion with the minimum of manual involvement.
Increasingly, hedge fund administrators are also being asked to prepare tax reporting for different classes of investors. Whilst it is unrealistic to expect administrators to be experts in several fields of taxation, it is now essential for them to have a good working knowledge of the tax reporting requirements of US and non-US investors.
Hedge funds are specialised products that require specialised service providers. New hedge fund managers should ensure they carry out extensive due diligence on fund administrators to ensure they have the competency to fully support the manager's business.
They should also make sure that the administrator has the people, the systems and processes in place to reduce risk in the hedge fund structure. Failure to do so will result in damage to the hedge fund manager's reputation and, at worst, lead to losses and scandals which the industry has worked hard to distance itself from.
• Hedge funds are specialised products that require specialised service providers.
• It is important for those working in the hedge fund industry to critically analyse the strategies employed by managers and to understand the complexities and risks involved with each different strategy.
Succeeding co-founder Simon Rogerson
Janus Henderson Global Dividend Index
More than 10 million shares allocated
Long-term strategic holding
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