The Administration of Hedge Funds
Good afternoon ladies and gentlemen.
My name is Dermot Butler and I am Chairman of Custom House Administration and Corporate Services. We are based in Dublin and, although we do help clients set up their own customised offshore fund, our primary business is acting as administrator of alternative investment and hedge funds.
If you look at your programme, you will see that there are three topics that I am to discuss this afternoon, that clearly relate to the administration of hedge funds.
The first topic is
Acting as an Administrator of Hedge Fund Strategies.
Before discussing hedge fund strategies, in particular, I think it is important to explain that there are a number of areas in which the administration of hedge funds in general differ from the administration of the more traditional Mutual Funds or Unit Trusts. These differences include: the range of investment instruments; and, of course, the strategies used to exploit these instruments; the ability to go short; leverage; fee structures; incentive or performance fees; and equalisation. The first three points are strategy related, whereas the second three points are, I suggest, more structurally related, but nonetheless important.
Traditional Mutual Funds or Unit Trusts are, for the most part, retail funds with quite restrictive investment policies, requiring very broad diversification, no short selling, no leverage, derivative trading limited to Efficient Portfolio Management, which is a Euro euphemism for hedging, but very targeted hedging. On the other hand, hedge fund strategies utilise a vast range of derivative instruments, ranging from the relatively straightforward exchange traded commodities, financial futures and options contracts to highly complex derivative products, which include swaps and swaptions, CFDs, which are contracts for differences, currency forward contracts traded on the Interbank market and a wide variety of customised instruments, created by major banks and financial institutions and sold over the counter, on what is known as the OTC market.
Hedge fund portfolios, which have these exotic investments, are not inherently difficult to administer or account for, providing, and this is a big providing, the administrator is able to obtain a reliable and verifiable price for the investments, upon which that administrator can base his NAV calculation.
Most hedge fund strategies are essentially quite simple long-short strategies, ranging from the obvious long-short equity fund, through merger arbitrage, commodities, futures, options and bonds, but none of these present a problem if they are traded on a recognised exchange and liquid market.
The problems come with illiquid assets and esoteric derivative products, created by and sold by one financial institution, which is the only valuer of those assets. Again, no problem in liquid high volume markets, but as markets fall and volumes shrink, God help you, if you expect the institution to look after Number Two you.
They will inevitably look after Number One.
What is essential is that a clear valuation policy is disclosed in the offering memorandum or prospectus, and some fallback plan is in place, in case the unthinkable happens - which it inevitably will, if you dont have any fallback plan.
Where possible, an independent price source must be used. If that isnt possible, a reasonable, practical pricing formula must be agreed between the investment manager, the administrator, and - this is important - the auditor, before the fund is launched and, as I say, some fallback plan, in the event that market circumstances change is also agreed.
Of course, the volatility of the fund can be exacerbated by leverage and this can bring its own valuation problems, particularly if leverage is provided by utilising an option or other derivative instrument. Of course, the ability to go short is, itself, a form of leverage and, in some arbitrage strategies, a dramatic change in market conditions, or even just market sentiment, can decimate the relationship between the two arbitrage components, which is essentially what happened to Long Term Capital.
Just a quick word here on the complexities of hedge fund fees, and particularly management fees, performance fees and equalisation.
Basically, all I am going to say about this subject is that the amount of the management fees, the manner in which they are charged, as well as the manner in which performance fees are calculated, can be very complicated. For instance, performance fees can be charged on a monthly, quarterly, half-yearly or annual basis, but they must be accrued for monthly. They may be charged on the opening NAV or the closing NAV; before all other fees or after all other fees; they may be subject to a benchmark or a hurdle, which could be a market index, such as the S&P500, or a specified fixed interest rate of, say, 10%, or a variable interest rate say a three month LIBOR. The accrual of these fees, including the calculation of the performance fees, after allowing for the benchmark, then has to be adjusted in the event of a redemption, because, even if the rest of the shareholders arent due to pay their performance fee yet, the redeeming shareholder will have to pay any performance fee due. All this is a relatively complicated accounting process, but can be achieved automatically, if the administrator has the appropriate system.
The real problems occur in this area with Equalisation, which is the term used to describe various accounting processes designed to ensure that the performance fee due to the investment manager is allocated fairly between all shareholders.
Most people assume that Equalisation is only needed in order to ensure that the Investment Manager receives the full performance fee due to him and that an investor who buys on a dip does not get a free ride. Let me briefly explain:
- If a fund starts trading at $100 per Share and the market rises to $120 at the end of an accounting period, then an incentive fee will be paid, which, if it is a 20% incentive fee would be $4
- The investment manager would not receive any further incentive fees until the NAV per Share had reached $120 again.
- Let us assume that the fund suffers a drawdown to US$90 per Share, at which point a new investor subscribes.
- If the value of the shares now rise from $90 to $120, the $30 profit made by that shareholder would not incur an incentive fee because the investment manager would not be entitled to claim an incentive fee, until the NAV had breached $120, so that shareholder would have received a $6 20% of $30 free ride.
Equalisation eliminates this anomaly.
As I said, most people think the free ride was the main reason for bringing Equalisation in and, undoubtedly, that is why Equalisation was introduced in the first place. However, mathematically, it can be proved that, if investors subscribe into a fund at dates in between performance fee calculation periods, then, regardless of whether the price of the shares had risen or fallen, in the meantime, some of the shareholders will pay a proportionately lower incentive fee than they should, and so conversely, others will pay a higher incentive fee than they should. Thus, unless Equalisation is applied all the time, some shareholders are subsidising other shareholders at their own cost.
I do not intend to go into the mathematics of Equalisation today, because it is a subject that could take up a session on its own, if not a morning, but if anybody would like to know more about this, then please give me your name afterwards and I will send you a copy of a paper I have written on the subject.
The next bullet point on your programme refers to
Technology and the Administrator.
Technology is, of course the buzzword of the day and so it should be. Until fairly recently, I think it was fair to say that most hedge fund administrators utilised what I describe as a multiplex administration system. This was a system that consisted of several different sub-systems or modules. There could be a shareholder services module, a securities trading module, a general fee module, a performance fee calculation module and an Equalisation module. The last three would, almost certainly be worked out on spreadsheets.
It doesnt take an Einstein to realise that, where you have to transfer information from one module to another, in order to carry out the overall administrative process and particularly the calculation of the NAV, you are at risk of error every time that the data is transferred from one module to another what I call an error zone. When it comes to spreadsheets, there is, of course, a huge risk of error, as the information is transported from one side of the spreadsheet to the other. These error zones are exaggerated, if there has to be a change in the calculation, because, for example, someone calls you up to say that the price of some exotic emerging market bond was, in fact, 97.4 and not 94.7 that you had been told a week before. The administrator would then have to unwind all of the calculations in all of the spreadsheets and go back to the original securities transaction, put in the new price and redo everything. The potential for error will increase with the aggravation and the only way to eliminate those errors, or try to eliminate those errors, is to instigate a high degree of checking, which involves a high degree of manual labour and staff cost.
Frankly, this explains why may offshore hedge fund administrators have been unable to get NAVs out on certain funds until the end of the month and even sometimes not until the following month.
Recently, there have been various systems designed, which fully automate this process. We have installed one called PFS PAXUS, which has transformed our life. The great advantage of an automatic system is that, once you have programmed the fund onto the system on its first day of trading and assuming, of course, that you have put in the right numbers and rules and regulations for the fund, the actual calculation of the NAV and various other administrative functions are carried out extremely quickly, extremely efficiently and without error. Changing the price of your emerging market bond would still be aggravating, but it would take a matter of seconds to enter the price and then recalculate the whole shebang.
It goes without saying, therefore, that technology, in terms of advanced computer systems, for the administrator, is an extremely high priority.
But that is only the guts of the system.
Other areas in which technology can benefit the administrator and, indeed, the investor, is the ability for the system to draw down data electronically before processing it. If the administrator can link electronically to the prime broker and can draw down all the information it needs with regard to the trading history of the fund, then the administrator will be able to show that they have obtained that information from an independent source namely the broker, rather than the investment manager - and this will, of course, avoid the Manhattan Syndrome.
We are in the latter stages of linking to all of the major prime brokers and all major banks that we use and, when we have all of those linked, we should be in the position to value funds on a real time basis, although few, if any, hedge fund managers would appreciate that but that is a totally different subject.
The third area of where technology comes into play in this market, is the ability to disseminate information electronically using the Web and the Internet. This means that the hedge fund manager, the investors and anybody else, who may wish and is authorised to know information about the fund, can be fed that information electronically and, providing suitable password controls are in place, the amount of information that is available will depend upon the status of the person dialing in. Thus, all of the information could be available to the fund manager, but an investor may only be allowed see the value of its investment, without having access to the portfolio details.
As we all know, every silver lining has its cloud. The advantages of technology are, of course, enormous, but they bring with them substantial additional risks, including risks of hackers, viruses and a systemic collapse of the system. People have forgotten how to calculate even using a calculator nowadays and if there is a problem with their computer systems, they walk around in a daze, lost to the world.
Therefore, what is essential when considering an administrators technological expertise is to also consider what their history is with regard to avoiding or handling viruses and what they have in the form of a disaster recovery or business continuity plan.
This whole area has, of course, come to the forefront following the awful events in New York last month, but, as was seen, those who were well prepared were up and running in a matter of hours, whereas it took some other institutions upwards of a week to return to any semblance of normality, because their business continuity plan was not as effective as it could have been.
Having said that, the expression There but for the Grace of God came to mind when I read about the company that operated on one of the higher floors in one Tower and had established their disaster recovery site and kept all their back-up in the basement of the other Tower. They, of course, were decimated, but nobody could claim that they were being imprudent after all, only one of the Towers was insured, because of the actuarial improbability that both would collapse.
The next bullet point is:
Who is the Administrator Responsible to the Shareholder or the Fund Manager
The answer is, of course, Both, but only so long as the fund manager is fulfilling its responsibilities to the shareholders. Ultimately, although the administrator may have been selected by the fund manager, the administrators contract is with the fund. Thus, the administrator has been retained by the Board of Directors of the fund to act for the fund and, as such, the administrator has a fiduciary responsibility to look after the interests of the shareholders.
When it comes down to it, the administrator has a variety of responsibilities, including, for example, seeing that the fund complies with its investment restrictions and seeing that one shareholder is not treated differently to another. The administrator, of course, has a conflict of interest here because he gets paid by the fund and, if he takes a drastic step that may upset the fund manager, then he could lose the contract.
But it is better to lose the contract than to lose your reputation.
We have, in the past, been instrumental in closing funds where we thought that the investment strategy had got out of hand or, on a couple of occasions, where the Net Asset Value of the fund had been decimated by unfortunate another euphemism trading, with the result that the operating costs of the fund were untenable. We, therefore, took steps to persuade the investment manager to close the fund. I am glad to say this is a very rare occurrence and, for the most part, the administrators responsibilities and duties lie with the shareholder, as do the fund managers and, because most fund managers are honest, regardless of what you may read in the press, the administrator and the fund manager are almost always able to work together in the interest of the shareholders.
Thank you.