Difference Between Conventional Hedge Funds and UCITs

Good afternoon ladies and gentlemen.

 

It was some time ago after I had agreed not only to speak, but also the subject I was to speak on today. Later I received a copy of the Conference Programme, which showed that I was supposed to be talking about Establishing a fully-fledged Off-Shore Hedge Fund and that topic has been divided in to 5 sub-topics. However, when I received the full program, it appeared to me that most of what I was going to say would overlap on presentations made by other speakers.

 

For example, the first sub-topic is What do European regulations say about establishing off-shore funds for the European market. Well the answer is, of course, a hell of a lot but, that is largely covered by Richard Perrys presentation tomorrow morning, which is called Operating Within Europes Regulatory Maze. As indeed is the third sub-topic of my suggested presentation, which is entitled Domiciling Your New Fund Within The Reach of Investors.

 

My second and fourth sub-topics were Accurately assessing competitive pressures in an increasingly crowded European alternative investment market and Establishing a presence within Europes distribution networks. I think that it is fair to say that both of those topics were largely and very effectively covered in Sandra Normans presentation this morning. This left one topic Solving the problem of transparency and layered fees, which was more than adequately covered by Dr. Coleman earlier this afternoon.

 

I am therefore, in somewhat of a quandary.

 

Should I bore you by making my presentation as per the program, which hopefully will provide the same wise advice that you have already got or will get from the other three speakers, but probably bore you in the process, because repetition is never exciting. Or should I go on to a totally different topic all together.

 

You may be please to hear that I have decided on the latter course, and will therefore be talking predominantly about two subjects.

 

The first will be an attempt to explain the differences between acting as an administrator for an Alternative Investment or Hedge Fund and acting as an administrator for a conventional unit trust, UCITS or Mutual Fund. That will, surprising as that may seem, lead in to the subject of Equalization, by which I mean both the equitable allocation and the accounting of the equitable allocation of incentive fees between shareholders in a fund.

 

I will also briefly touch on a third subject, which relates to a question that I was asked about recently and that relates to the loyalty of the administrator should it be to the Fund Manager or investors.

So, on to the first topic What is the Difference Between Administering Alternative Investments and Hedge Funds and Administering Traditional or Conventional Unit Trusts, Mutual Funds or UCITs.

 

This begs the question: Is there a real difference in acting as an Administrator for a Hedge Fund and acting as an Administrator for a Traditional Fund (By the way, please note that when I use the term Hedge Fund today, I am including all funds that use any Alternative Investment or Hedge Fund strategy and when I use the term Traditional Fund I am referring to retail investment funds such as Mutual Funds, Unit Trusts, UCITS and Sicavs.) 

 

In fact, there are some very definite differences, which substantially affect the Administrators task.

 

First of all, for the most part, Traditional Funds invest in listed securities, which are easily priced. 

 

Of course, many Hedge Funds invest in listed securities, but unlike Traditional Funds, they also invest in many esoteric instruments, including derivatives, the valuation of which can sometimes present problems. 

 

I will be discussing valuation of Hedge Funds later. 

 

Secondly, few Traditional Funds sell short of anything indeed, UCITS which is euro-speak for cross-border European retail funds are specifically prohibited from making short sales, and, of course, where there are short sales, there will be financing arrangements with the Prime Broker that have to be accounted for and administered.

 

Thirdly, Traditional Funds will usually, by their very nature, have many smaller shareholders than a Hedge Fund. This requires the Administrator of Traditional Funds to maintain a very much larger and very efficient shareholder register system that he would need for a Hedge Fund. This is because Hedge Funds are generally targeted at the sophisticated high net worth, professional, or intuitional investor

 

with minimum investments of anything from US$100,000 to US$10 million

 

although the majority of larger Hedge Funds have minimums of between a quarter of a million and a million dollars. 

 

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 that I mean that, to all intents and purposes, all Sicavs will be same, all Unit Trusts will be the same and all Mutual Funds will be the same, so the administration task is relatively boiler-plate. This is largely because of the invasive regulation that applies to the 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 in quite a fundamental way, particularly with regard to management and incentive fees.

 

For instance, a Hedge Fund Managers management fees can be charged in advance on the basis of the NAV (Net Asset Value) at the beginning of the month, or in arrears, at the end of the month.

 

But it is much more complicated with incentive fees: are they paid monthly, quarterly, half yearly, or annually; 

 

are they calculated on the gross profit, before charging other fees and expenses, or on the profit, net of all other expenses; 

 

does the profit include, or exclude, 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 was 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 and it would be an accounting nightmare. Therefore, these rebates are paid by the Investment Manager out of the Investment Managers fees, as a special arrangement between the Investment Manager and the investor. 

 

And, of course, such rebates are quite likely to vary between investors. Needless to say, it is the Administrator who is required to calculate those rebates and often pay them, by way of issuing new shares, which are funded by the reinvestment into the fund of a portion of the fees payable by the fund to the Investment Manager.

 

One other difference between Traditional Funds and offshore Hedge Funds, with regard to management and incentive fees, is the requirement that many American Hedge Fund Managers want to defer payment of their management fees, for tax planning purposes. This required 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, along side the shareholders assets and participates, on a pro-rated basis, in the performance of the fund, lie a quasi-shareholder.

 

But I have to say all of this pales into absolute insignificance when we come to the complex subject of Equalisation. 

 

I assume that most of you know what Equalisation means in the context of incentive fees, but for those who dont, I will explain briefly.

 

Equalisation, in simple terms, is 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.

 

Let me give a simple example The Free Ride - which was the original reason and justification for the introduction of Equalisation in the first place. (This example is shown in Table 1 in your papers):

 

Let us assume that a fund starts trading at US$100 per share and we have an initial investor who buys one share at US$100;

 

Let us now assume that, at the end of the first quarter, the gross NAV per share has risen to US$110, which will result in an NAV of US$108, net of the incentive fee of US$2 (20% of US$10 profit), which has been paid;

 

One month later, the NAV per share has fallen to US$100 again and a second investor comes in and buys one share at US$100.00.

 

 

 

I should point out that the necessity for Equalisation is not entirely, as some people believe, in order to avoid The Free Ride. It can be shown mathematically that, without some form of Equalisation being applied, when investors subscribe at different NAV levels, one shareholder will always be subsidizing another shareholder to some extent or another. (Although this is shown by way of example in Table II, I will still run through that table with you now).

 

Again, let us assume that Investor 1 buys 1 share at $100 when the fund is launched. We again assume the market rises in the second month to 110 NAV per share.

 

The NAV per share is published at 108, net of 20% incentive fee accrual.

 

Let us now assume that, at quarter end, the gross NAV per share has risen to 120.

 

This results in gross profits of $32 based on the following:

 

Investor 1 invested $100 and Investor 2 invested $108. Thus, the total invested was $208.

 

The gross NAV at the end of the quarter was $240, which shows a gross profit of $32, which would normally be allocated as $20 to the first investor and $12 to the second investor.

 

However, let us look at how the incentive fee is calculated.

 

The incentive fee should be 20% of $32, which is $646.4, which, in turn, will be allocated at $3.2 per share. As there are only 2 shares, if you take the NAV per share, that will be the gross NAV of $240 less the incentive fee of $6.4, which equals $116.8 per share.

 

On this basis, Investor 1 effectively pays 3.2 incentive fee on a profit of $20, which equals 16.4% of the profit made by Investor 1, whereas Investor 2 also effectively pays 3.2 incentive fee, but on a profit of $12, which equals 26.66% of the profit made by Investor 2.

 

 

The equalisation process is an accounting methodology where one investor (or group of investors who invest at the same time) are individually assessed for their own incentive fee liability and charged accordingly. This eliminates these two anomalies.

 

There are, basically, tow commonly used methods:                                              

 

(i) The first that I will discuss is the Series of Shares and Consolidation Method. This involves issuing a new series of shares each time that there is a subscription and calculating the NAV per share including incentive fee accruals for each series. These series are consolidated into the Lead Series, which is usually the first series to be issued, when a new High Watermark is achieved and an incentive fee is paid. The major disadvantage of the series methodology is that it is not possible to publish one NAV per share because there may be many different series of shares outstanding. This causes problems with reporting performance. The major advantage is that it is relatively simple to explain to investors.

 

(ii) The other method of which there are various versions - is generically called The Equalisation Method and involves issuing or redeeming shares to accommodate the incentive fee adjustments. This is a very complex process and the main disadvantage is that it is, in fact, very investor unfriendly and administratively complicated, but it is essential with funds that issue shares or units. Conversely, the advantage of The Equalisation Method is that you can publish one NAV per share for all investors. 

 

By the way equalisation does not present any problem in the US where almost all, if not all, funds are, in fact, partnerships and, therefore, use capital accounting. US investors just look at the change in the value of their partnership interest each month and are not, therefore, confused by inconsistent NAVs or changes in their shareholdings.

 

I could go on for hours about this but I am sure you will be pleased to hear that I havent got the time but I hope I have made two things clear: Firstly, that some form of Equalisation is essential for funds that charge incentive fees and issue shares, or units, valued on the basis of the NAV of the fund. The second point that I hope I have made clear is that, regardless of everything else I have discussed all the other differences between Traditional and Hedge Funds - the subject of Equalisation alone will explain why administrators of Hedge Funds need different skills and perhaps greater flexibility than Administrators of the more Traditional investment products.

 

The second topic today is Assisting in the Organisation of Customised Offshore Funds.

 

Believe it or not, some Administrators appear to take no interest in the organisation of their clients funds, until the fund has been established and the final offering document has been handed to them. They then take on the administration on the basis of that document and proceed from there. I think that is, at best, irresponsible and, frankly, potentially dangerous. However, other Administrators get very much more involved in the structure of the fund from the beginning. Indeed, some, including my own company, have legal set-up departments, which specialise in helping new Hedge Fund Managers establish their own customized offshore funds. 

 

There are three points I always make to new Hedge Fund Managers when deciding who is going to help them set up their fund. These are that, whoever they decide to retain to set up their fund, whether it is a consultant, an administrator or their attorney, they must: firstly, check out what other funds the consultant, administrator, or attorney have set up and speak to those fund managers; secondly, get a firm quotation; and thirdly, only appoint one advisor.