Administration of Hedge Funds - A Risky Business?
a presentation by
DERMOT S. L. BUTLER
This presentation was given as part of
"The Ultimate Risk Control - Detecting and Preventing Fraud"
during the
European Alternative Investing Summit
held at
Le Grand Hotel Inter-Continental, Paris
on Monday October 8th, 2001
The risks that I am going to discuss include risks that the administrator must address, as well as risks that both the hedge fund manager and investors must address, with regard to both the administrator and the administration of hedge funds.
The first major risk that I would like to draw your attention to is one that investors should consider, particularly with regard to US hedge funds ? and that is whether the fund actually has an independent administrator, or not.
There have been three types of scandals in the hedge fund industry over the past few years which I think are epitomised by, firstly Long Term Capital, secondly, Manhattan and thirdly Maricopa and each of these highlighted different risks.
Taking the last first ? Maricopa was a US based fund, which was subject to what appears to have been blatant premeditated fraud. There was no hint of trying to recoup or disguise losses ? it was just old-fashioned stealing. The administration of Maricopa, such as it was, was carried out by the manager, without any independent oversight. Furthermore, the fund?s books were not even audited.
I think it is fair to say that most, if not all, of the recent US and I repeat US hedge fund frauds involved self-administered funds. I suspect that most of these had suffered losses and the manager started ?massaging? the monthly numbers to gain time, in the hope that he could trade back into the black - The Nick Leeson Syndrome if you like - inevitably they just dug a bigger and bigger hole, until the whole fund collapsed around them.
I am not trying to suggest that all US hedge fund managers are crooks, or even potential crooks ? after all the number of such frauds is only a fraction of a percent of the number of funds in the market place and even less as a percentage of aggregated assets. But I do suggest that self-administered funds present a temptation to hedge fund managers and are, therefore, a risk which investors should be aware of. Remember many of these frauds were committed by people who were quite honest until they lost money and thought they had the opportunity to recoup.
We, as administrators, have, in the last eighteen months or so received many more due diligence enquiries and visits from investors. In fact, prior to Maricopa and Manhattan, which I will refer to in a minute, we had never received a visit from an investor and indeed, only a few visits from hedge fund managers carrying out any due diligence on the services that we provide. And for the most part those managers? enquiries were restricted to fees and costs.
The collapse of the Manhattan fund highlighted another type of risk. Manhattan was an offshore (non-US) fund, which was administered by a first class name and had been audited by one of the big five. If I understand the reports that I have read correctly, Manhattan, was a classic Leeson Syndrome case ? the manager going off the rails in an attempt to cover up losses.
The main problem was that the manager was able to pull the wool over the administrator?s eyes by faxing statements and reports that were purported to have come from a prime broker. In fact, these reports were totally fictitious and apparently made up in the manager?s office.
The error that the administrator appears to have made was relying on information issued by fax and not getting direct electronic, or hard copy independent confirmation as to the veracity of those reports, from the prime broker itself.
This is one of the risks that investors should be aware of and should therefore check, when carrying out their due diligence, namely that the administrator obtains all of the information that it needs, for maintaining the books and records of the fund and calculating the NAV, independently from the manager.
The risk related to the Long-Term Capital debacle was one of investor judgement. From what I have read about Long-Term Capital, it appears that the managers had a very cavalier attitude towards client relations and were reluctant to advise any investor of their strategy or what they were investing in. This really has nothing to do with administration, but does stress one point with regard to due diligence and the need for transparency, about which there are always two points of view.
Investors would like full transparency, so that they can assess their risk, whereas hedge fund managers often do not wish, or are not prepared, to give full transparency because of their risk - which is the risk that, if the market knew what they were doing, they could be squeezed. Both are very valid risks that need to be addressed and neither attitude is 100% wrong or 100% right. What investors must decide is whether risks related to: lack of transparency; the manager carrying out its own administration; that the manager pricing the underlying investments, are risks that the investor is prepared to take.
If the investor is prepared to take those risks, then so be it ? but if the investor does not wish to take those risks, then their choice is not to invest.
This leads very smoothly onto the whole subject of due diligence.
Well not the whole subject. I propose to discuss the due diligence that administrators should carry out, with regard to promoters, managers and investors on the one hand, and that promoters, managers and investors should carry out, with regard to administrators, on the other.
Firstly I will address the thorny subject of money laundering, or anti-money laundering procedures and regulation, relating to investors into a fund. These are quite intrusive and onerous on the administrator and the penalties for non-compliance by the administrator and its staff are draconian and harsh ? in a word ? prison.
For example, the failure of a corporate investor in your fund, to disclose the beneficial owner, or to provide sufficient information to satisfy the administrator that the investor is a bone fida investor and that the money has come from a reputable source, is a reportable offence. And if the administrator fails to report it, the administrator could be for the high jump.
And we cannot tell the candidate that, if they don?t give us the information, we will have to report them, because that could be deemed ?tipping off? and that is an offence in itself, also carrying harsh penalties on the so called ?Tipee?.
These oversight requirements apply to anyone, at any level, on the staff of the administrator, the investment manager, the bank or the prime broker. As a result, we now have to carry out strong due diligence on any individual, corporation, trust or, in fact, any investor that is not a ?designated body?, which means a suitably respectable financial institution based in an acceptable territory. This can cause offence, as people don?t like being doubted and so it is recommended that the information that will be required should be clearly stated either in the Offering Memorandum, or in the subscription form for all funds.
Due diligence on clients of administrators, that is the funds? promoter and/or manager, is not solely directed at the money laundering aspect, although there are certain jurisdictions which will tend to wave a red flag. For example, potential clients from the former Soviet Union or Nigeria will, whether justified or not, ring warning bells and very loudly too.
Client due diligence is also designed to eliminate, as far as possible, any reputational risk.
Such a risk exists if the Administrator accepts the appointment to a fund where, either the prices, or the transaction data ? or both ? are provided by the manager. Even if this is clearly stated in the Offering Memorandum, there would still be a reputational risk, by association, if there was a problem down the road.
We now require from anybody, who wishes to either set up a fund as a promoter or as a hedge fund manager, or indeed, from an investor into a fund, full due diligence information on all individuals involved. This includes directors, officers and shareholders, or partners in the entity and the information we require includes, inter alia, a notarised copy of their passport, an original or notarised copy of a recent utility bill, verifying their place of residence, a bank reference and a professional or commercial reference. In addition, we require copies of the statutory documentation ? that is the Charter or Memorandum and Articles of Association ? of the company in question, together with a Certificate of Good Standing in the jurisdiction in which the company is established.
If a shareholder in the company is a corporation, then we want all that same information on that corporation and its directors, officers and shareholders, until we get down to the ultimate beneficial owner.
If there is a trust involved, we need to see the Trust Deed and, if applicable, the Letter of Wishes and confirmation from the Trustees as to who the settlor of the Trust was and who is intended to be the beneficiaries of the Trust.
Furthermore, where possible, we require full details of any registration or authorisation by an appropriate regulatory body, such as the NFA, SEC, SFA etc.
If we cannot get all of this information, then we will not proceed with establishing the fund or carrying on any business with the individuals. As I mentioned earlier, if we are unable to get this information on an investor in the fund, it could be deemed a reportable offence under the money laundering regulations. This would not apply if we were unable to get similar details for the Manager of Promoter of a proposed hedge fund, because no money is involved and therefore it would be difficult to deem it a money laundering offence. Nevertheless, as an administrator, it would not be prudent to take on such a client, or do any business with the proposed fund, until we have all the back-up documentation on our files. To some extent of course, administrators will have some support from other service providers, because those service providers, whether they be the auditor, attorney, custodian or prime broker, will also require similar due diligence information for their files.
The reputational risk that an administrator, or other service provider, can suffer is not just limited to being involved in a fund that suffers a fraudulent loss. It can also be the case where the fund suffers extraordinary losses, as a result of overtrading, or not complying with investment restrictions and guidelines. This is an area where the investment manager has a clear fiduciary responsibility to comply with the investment restrictions imposed in the Offering Memorandum. It is also often the contractual responsibility of the administrator to oversee the investment manager?s compliance with these restrictions.
It can be seen therefore, that due diligence by investors on administrators should not just be limited to the obvious matters of their respectability and integrity, but also on their capability and methods of working. For example, as I have already mentioned, if the administrator does not ensure that it is getting independent verifiable data from the prime broker, or that the price sources that it uses are also independent and accurate, then the administrator may, albeit unwittingly, be enabling a fraud to take place. Therefore, if an investor wishes to avoid losing its money, or a service provider wishes to avoid losing its reputation through a fraud, it is necessary for all involved to make the appropriate checks.
It should also be remembered that the risk of loss is not necessarily limited to the performance and behaviour of an investment manager, or indeed the performance or behaviour of the administrator. It may be the knock-on effect as a result of some third party error or fraud. For example, the potential for loss as a result of a systematic failure, for instance, in the systems of either the administrator, the prime broker or the investment manager, is a real risk in today?s computer virus environment. There is also the risk that someone could hack into the administrator?s system and either destroy data, obtain confidential information or try and effect an unauthorised payment or trade on the fund?s account.
Therefore your due diligence should cover a review of the service providers? IT systems and an explanation of what protection they have, such as firewalls against hackers and virus infections. This leads on to what is in place with regard to disaster recovery.
As an investor, I suggest that part of your due diligence should be a very tight review of the Offering Memorandum. Furthermore, it is not necessarily what is in the Memorandum that should trigger that warning bell ? it is what is not in the Memorandum that is important. And here I get back to investment restrictions. If there are no, or very skimpy investment restrictions, then you are at risk that the investment manager may overtrade, or may trade in areas in which he may not have the appropriate expertise. The same applies if there are no limits on leverage.
I have told this story before ? but I think it is worth retelling. When I first moved to Ireland in 1989, I was looking for someone to help us look after our house and my solicitor told me to get references and, to be sure to note what was missing. If it did not say the candidate was sober and honest ? that meant that he was a drunken thief. You should apply the same principle to offering memoranda.
Basically, if you are not comfortable, don?t invest.
Similarly, any arrangements that give the manager the right to determine the price of assets for the valuation, without consultation with the broker, the administrator, or ultimately, the auditor, are dangerous.
It goes without saying that many investors will take comfort from the fact that the fund they are investing in holds accounts at first class, major prime brokers, rather than a small broker, such as ?First Prime Brokerage of Tuscaloosa?, if there is such a company. There is no doubt in my mind that, if investors had been aware that the money they had invested in Manhattan was not being held with Bear Sterns but was alleged to have been with some unknown mid-western brokerage house, some of them might have made a different assessment as to the attractiveness of the investment.
There are numerous other risks that I think investors should consider when investing in a fund and fund managers should consider when appointing an administrator, but we are today restricted to discussing risks related to fraud. I have tried to show that some of the risks that should be considered are not just the risk of the primary fraud being committed, and the likelihood that a particular individual may commit that fraud. It is, I think, also important for investors, in particular, to satisfy themselves that service providers, and particularly administrators, are providing a service that will in itself prevent fraud.
I have given some examples, but of course there are many other factors which should be considered, including the actual capability and efficiency of the administrator, the integrity of their systems and the security inherent in those systems. For example, you should check how many people are authorised to gain access to the administrator?s computer system in the first place and what limitations are there with regard to access to information on your particular fund and what checking protocols in the administration process exist.
Whilst on the subject of controls ? you must check who has signatory powers over cash movements out of the fund. It is, of course, essential that the manager has a Power of Attorney and full authority to trade for the fund within the established accounts at the prime broker ? but not on third party payments. There must be independent signatory authority over such payments ? either the administrator on its own, or jointly with the manager. If temptation is removed, it cannot be give in to.
On the subject of cash management, there is one last contingent risk, which I would like to discuss which relates to the possibility that your fund could suffer a loss as a result of a third party failure. This reverts back to Horizon?s* area of expertise ? cash management - which, not only largely relates to futures and commodity funds, but also can be applied to the broader based alternative investment and hedge funds. As we all know, a futures fund maintains a very high proportion of all of its assets in cash. A large proportion of that cash is surplus to the margin requirements of the clearing broker.
In the normal course of events, such surplus cash is held with the Clearing Broker in a Customer?s Pooled Segregated Account (the ?Pool?). The regulations relating to the Pool do not, despite what the name might indicate, actually segregate the assets from all third party risk. It is a fact, which appears to be little known, although it should be widely known, that all clients, with any assets held in the Pool, have a potential ?partnership? type liability, should the Broker suffer a loss in one of its client accounts, in excess of that client?s interest in the Pool. Let me give you an example:
Assume a client of a broker suffers a loss of, say, $600 million and only has US$200 million in the Pool, then there will obviously be a shortfall of US$400 million, which would initially be the liability of the broker. If the broker only had assets of US$300 million, then the balance of US$100 million would be met out of the Pool and all of the customers with assets in the Pool would be legally liable to pay a prorated portion of that loss. You may say that this is an insignificant risk, given the size of the Clearing Broker that you use, however, I would point out that a billion dollar loss is not what it used to be. Anyway is it a risk worth taking, when, by transferring those assets out of the broker?s account into a cash management account held and operated through a trust account at an independent bank, you are thereby not only eliminating that unnecessary risk, but also, in all likelihood, achieving an enhanced return over the rates that the broker would have paid on those cash surpluses?
The first step in risk management is recognising the risk. It is only then that you can take the second step, which is to avoid it.
Thank you.
* Diane Mix, President of Horizon Cash Management LLC, was a scheduled speaker on the same panel when this presentation was given.
Dermot S. L. Butler is the Chairman of Custom House Administration & Corporate Services Limited (?Custom House?), which specialises in advising and assisting clients on the structure and the incorporation of offshore funds and, once established, providing a full administrative service. Custom House is authorised by the Central Bank of Ireland under the Investment Intermediaries Act, 1995.
Mon 08.Oct