Administration of Hedge Funds - Is it a Complex Question?

The following article by Dermot S. L. Butler appeared in "epn", July 2001

It is probably fair to say that it is only recently that the average investor has given any thought to the subject of administration at all, let alone begun to appreciate that there may be a difference between administering the traditional Mutual Fund, or SICAV and the more esoteric Alternative Investment or Hedge Fund. Even many Hedge Fund managers have tended to limit their concerns, primarily to cost factors.

Historically, the "Mainstream Funds", in which I include the traditional Mutual Fund, the Anglo-Saxon Unit Trust and the Franco-Benelux SICAV and, of course UCITS, which is sort of Euro-speak for all of the above, has been targeted at the retail investor. These retail investors' primary concern was who was managing the money, and the choice of manager was often recommended to them by their IFA ("Independent Financial Advisor"), broker or bank. Often the "broker" or "bank" was also the Manager of the Fund and was a big household name. As such, the administration was assumed to be properly handled and, of course, 99.999% of the time, it was and is. It is also a fact that Mainstream retail funds are, for the most part, "boiler plate" structures and highly regulated. As a result, the administration of one such fund is much the same as for another - this is not the case with the Alternative Investment or Hedge Funds ("Hedge Funds"). I will expand on this below.

What has changed in the past few years is the interest shown, not only by managers, but also by investors in Hedge Funds in the administration of those funds. And, of course, we know why this has happened. There are two major causes.

- Firstly, the result of the demand for transparency following the Long Term Capital Management ("LTCM") debacle, which caused investors in Hedge Funds to determine what, if any, independent information on the portfolio they could glean from the administrator of those funds.

- Secondly, the recent scandals involving hedge funds, including, for example, the Marioca Fund and Manhattan. It was this blatant long-term fraud that rang the alarm bells and woke up the Hedge Fund investor.

The Offshore Fund industry has, with some justification, prided itself that it is, to a greater or lesser extent, regulated and there is no doubt that that regulation has grown very much stronger in the past few years. Of course, regulation in Dublin and Luxembourg is extremely strong and has set a high standard acceptable in most other jurisdictions. It is also fair to say that regulation in the Caribbean, which had lagged behind Bermuda and the Channel Islands, is now catching up fast and, with regard to money laundering, has definitely caught up.

On the other hand, the US Hedge Fund is unregulated and, although regulation is being discussed, it appears that such proposals are largely targeted at the larger funds, such as LTCM. It is, I think, a unique case of regulators being more concerned with protecting the financial system, rather than the investor, once again, working on the recognised principle that sophisticated investor should be capable of looking after themselves. (Does this assume that the banking industry is not so capable?).

Because of the lack of regulation, the vast majority of Hedge Funds in the US are administered by the Manager. Of course, in the vast majority of cases, the Managers do a very good job - it is only a tiny fraction of the total where fraud has been committed, but as the number of Hedge Funds grows, so the number of scandals grow, although the total of all scandals reported in the past two or three years still probably represents less than 0.01% of the total (number and value) of Hedge Funds in existence today. I say "probably" because there are no reliable statistics.

Manhattan sent tremors around the market was because it was an offshore fund (BVI domiciled) that had appointed an approved administrator, based in Bermuda - a company associated with one of the "Big Five" accounting firms. Furthermore, Manhattan's accounts had been audited for a number of years by another of the "Big Five" companies, who subsequently withdrew their earlier audit reports. It is, in my opinion, this case that has caused the upsurge in due diligence activity over the past couple of years. Investors have realised that they cannot rely on a name; they must know and understand how the administrator does the job and if it can do that job. Managers are also taking a much more active due diligence role when selecting an administrator. It is no longer deemed sufficient for a Manager just to negotiate the best price. The irony of the situation is that few investors - and, indeed, Managers - had any clear idea of what an administrator did, let alone how it did it and, of course, it is impossible to carry out any meaningful due diligence if you don't know what you are looking for.

The first thing that must be realised is that the administration of Hedge Funds is very different and, in some ways, very much more complex than the administration of Mainstream Funds. It is fair to say that, apart from the actual investment strategy, there is very little difference between the structure and operation of one Unit Trust and another Unit Trust, or between one SICAV and another SICAV. There are standard practices laid down, sometimes supported by regulation, as to how fees and expenses may be charged and even how much those fees can be. This is not the case with Hedge Funds. One Hedge Fund is very rarely a clone of another, unless they are products managed and promoted by the same house. In fact, Hedge Funds vary from each other and, of course, Mainstream Funds, in many ways. This is not only in the context of a wide range of esoteric investment strategies employed by Hedge Funds.

In the context of the investment strategy, a UCITS (which means a "Unitised Collective Investment in Transferable Securities") is subject to EU regulation and can be a SICAV, Unit Trust or investment company. A UCITS may not sell short, nor use derivatives, including futures, except for "Efficient Portfolio Management", which means targeted hedging of specific risks. For example, a geographically specific UCITS cannot use the S&P 500 futures contract as a general hedge against the overall decline of the world's stock markets - it can only use a geographically relevant index future. Thus, most traditional funds are long only Equity, or Fixed Income Funds investing in listed securities, with several reliable price sources available for valuation purposes.

Whereas many Hedge Funds invest in a range of unlisted or OTC securities, where verifiable prices may be difficult to get. For example, some derivative instruments can only be priced by the issuer and getting a third-party verification can be often impossible. Furthermore, there are entirely different valuation techniques required when it comes to valuing Private Equity, Venture Capital, Real Estate and other illiquid assets. And then there are the more complicated investment vehicles and some relatively new instruments, such as "Contracts for Differences", which have the characteristics of a combination of a quasi-equity and a quasi-futures transaction.

I am not trying to suggest that none of the major Mainstream administrators are incapable of handling Hedge Funds, although that is true in some cases. It is just that many don't have the interest or inclination to do so. I was present, less than two years ago, at a meeting with a major Irish bank, which has a joint venture with one of the largest US custodians and Mainstream administrators. We were discussing a relatively simple Euro denominated fixed income fund. However, the assets were going to be invested almost exclusively in US denominated securities and, therefore, the Manager wished to incorporate a straightforward currency hedge overlay programme within the strategy. The reaction of the bank official was "We don't do hedge funds" (I know what you are thinking - this wasn't a hedge fund. Quite true, but that only exacerbates the point I am making). There is do doubt that this attitude has changed and that the Mainstream administrator is having to take on Hedge Funds, or risk losing their market share, as the Hedge Fund market grows. Furthermore, the more adventurous of the Mainstream Fund Managers are now offering both Funds of Funds and long/short equity funds as relatively core products and, as a matter of preference, want to use one administrator for their family of funds, which is putting pressure on the Mainstream Administrator, to expand their operation.

I have already indicated that, apart from investment strategies, the main differences between the Mainstream and Hedge Funds are the fee structures. Whereas a Mainstream Fund has a fixed fee structure, usually determined by the market, Hedge Funds have the freedom to charge what they like. And, of course, Hedge Funds charge incentive or profit sharing fees, which is not the case with Mainstream Funds. Thus, the fees charged by Hedge Funds can vary from an ad valorem management fee, of anything from 0.5% to 3% of the NAV per annum, plus incentive (profit sharing) fees, levied at anything from 5% to 30% of new profits. Sometimes there are benchmarks, which are set as a level of return, that has to be achieved for the investor before any incentive fee can be charged. Sometimes the fees are charged: before or after interest; or before or after all other fees. Sometimes the fees are not paid to the Manager but left in the Fund, indexed to the performance of the Fund. (This usually only applies to US managers, who are thus able to defer recognition of their income and tax liability on those fees.

Then there is the complex subject of "Equalisation", which, in the context of the offshore (non-US) Hedge Funds, is an accounting method used to ensure that each investor is charged the correct incentive fee. This means that, in effect, each shareholders' holding is valued separately, in order to avoid one shareholder subsidising another.

None of these individual quirks in Hedge Funds present any major problem to a Hedge Fund administrator - with the possible exception of Equalisation, which is a horror - but, collectively they mean that a Hedge Fund administrator has very different skill sets and has to be very much more flexible than the Mainstream administrator. It is probably fair to say that, whereas the Mainstream administrator is usually able to apply their standard procedures/operations manual to each of their fund clients, a Hedge Fund administrator often has to customise their procedures/operation manuals to the requirements of each of their fund clients.

Returning to my original point, what I have tried to show is that, when carrying out their due diligence it is the Managers' and the investors' task to satisfy themselves, before anything else, not only that the administrator they have selected is capable of handling all of the specific idiosyncrasies of the individual Hedge Fund (experienced staff, technology, etc.), but also that the administrator understands the fund's investment strategy, as well as the investment instruments in which the fund will trade and is capable of valuing the portfolio.

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.