There are several real and substantial differences between administering a 'long only' mutual fund and an alternative investment such as a hedge fund. Dermot Butler, chairman of Custom House, outlines what these differences are.

The following article by Dermot S. L. Butler appeared in "ifi" (International Fund Investment), 

August 2001

First of all, traditional mutual funds invest in listed securities, which are easily priced. Of course, many hedge funds invest in listed securities, but unlike mutual funds, they also invest in many more esoteric instruments including, for example, unlisted securities and derivatives, the valuation of which can be sometimes present problems.

UCITS funds are permitted to use futures of derivative products for "efficient portfolio management" which is Eurospeak for hedging - but there are tight restrictions on the type of derivatives or futures that can be used. I know of a specialist equity fund that was not allowed to even partially hedge using the S&P500 as it was considered too broad an index and using it would have been speculating on the whole US stock market which was outside the investment objectives of the fund.

Secondly, few traditional mutual funds sell short of anything - indeed, UCITS funds are specifically prohibited from making short sales. On the other hand, for hedge funds, where there are short sales there will be financial arrangements with the prime broker that have to be accounted for by the administrator. This is not a problem that the traditional mutual fund administrator has.

Thirdly, mutual funds will usually, by their very nature, have many small shareholders. This requires the administrator of these funds to maintain a very much larger shareholder register system than would be needed to a hedge fund administrator. This is because hedge funds are generally targeted at sophisticated, high net worth, professional, or institutional investors, with minimum investments of anything from US$100,000 to US$10 million - although the majority of larger hedge funds have minimums of between US$250,000 and US$1,000,000.

But the main difference is the fee structure and, particularly, the calculation of the incentive fees. I think it is fair to say that almost all traditional funds are structured in the same way. By which I mean to say that, to all intents and purposes, all SICAVS will be the same, all unit trusts will be the same, and all mutual funds will be the same, so the administration is relatively "boiler plate". This is largely because of the very restrictive regulations that apply to the structure and operation of traditional funds.

On the other hand, I think it is equally fair to say that the structure of hedge funds can vary from fund to fund, often in quite a fundamental way, particularly with regard to management and incentive fees.

It is this lack of conformity which causes problems for administrators of hedge funds and forces those administrators to operate on a much more flexible basis than the mutual fund administrator is used to.

For instance, the management fees of a hedge fund can be charged on the basis of opening NAV (Net Asset Value), at the beginning of the month, or on the closing NAV, at the end of the month. And are those fees charged on the gross NAV, before all other expenses, or on the net NAV, after all other expenses have been deducted?

But it is much more complicated with incentive fees: for example, are they paid monthly, quarterly, half yearly, or annually? Again, are they calculated on the gross profit, before charging other fees and expenses, or on the profit, net of all other expenses or just net of management fees? Does the profit include, or exclude, interest, interest on cash balances, is there a benchmark, or hurdle rate, that has to be achieved before any incentive fee is paid?

Incentive fees are usually charged on the basis of a "high watermark". That is to say the manager has to make new profits before he can charge his incentive fee, but, is that high watermark based on the NAV, before the incentive fee is paid, or the NAV, net of the last incentive fee payment? Also there are often rebates that have to be paid.

Sometimes a manager will permit certain investors to invest on a reduced fee basis. This cannot be done within the fund, because there is a basic legal requirement to treat all shareholders the same, which is a blessing because it would be an accounting nightmare.

Therefore, these rebates are paid by the fund manager, out of the fund manager's fees, as a special arrangement between the fund manger and the investor. And, of course, such rebates - i.e. the percentage of the fee - are quite likely to vary between investors.

Needless to say, it is the hedge fund's administrator who is required to calculate those rebates and often pay them, by way of issuing new shares in the fund, which are funded by the reinvestment into the fund of that portion of the fees, payable by the fund to the fund manager, which is to be rebated.

One other difference between traditional funds and offshore hedge funds, with regard to management and incentive fees, is the requirement that many, predominately American, hedge fund managers want to defer payment of their management and incentive fees, for tax planning purposes.  

This requires the administrator to calculate the accrued management and incentive fees, which are not actually paid to the manager, but are kept, net of any rebates to major shareholders, in a separate account within the fund. 

This account is then invested within the fund, alongside the shareholders' assets and participates, on a pro-rated basis, in the performance of the fund, like a quasi-shareholder.

But I have to say all this pales into absolute insignificance when we come to the complex subject of "equalisation". "Equalisation" is, in simple terms, an accounting methodology that tries to ensure the equitable allocation of incentive fees to each investor in a fund, not only to make sure that the hedge fund manager gets paid the right amount, but also to ensure that one shareholder is not effectively subsidising another.

Dermot S.L. Butler is Chairman of Dublin-based Custom House Administration & Corporate Services Limited ("Custom House"), a company that specialises in assisting clients in the organisation, establishment and administration of alternative investment and hedge funds. Custom House is authorised by the Irish Financial Services Regulatory Authority ("IFSRA"), (formerly the Central Bank of Ireland) under the Investment Intermediaries Act, 1995.

Custom House Administration & Corporate Services Ltd.
Address: 25 Eden Quay, Dublin 1, Ireland.
Tel: +353 (0)1 878 0807 / Fax: +353 (0)1 878 0827
E-mail: Dermot S.L. Butler (Chairman) dermot.butler@customhousegroup.com
        or David P.M. Blair (Managing Director) david.blair@customhousegroup.com