The Responsibilities Of A Hedge Fund Administrator
Good afternoon ladies and gentlemen.
It was some months ago that I agreed not only to speak, but also agreed the subject I was to speak on today.
It was several weeks later that I received a copy of the Conference Programme, which confirmed that I was supposed to be talking about
Establishing a Fully-Fledged Off-Shore Hedge Fund
However, that subject had been divided into five not entirely related sub-topics.
Furthermore, when I reviewed the full programme, it appeared to me that most of what I was going to say would be covered in presentations to be made by other speakers.
I am therefore, in somewhat of a quandary.
Should I bore you by speaking to you strictly in accordance with the programme, in the hope that I will provide you with the same wise advice that you have already heard, or will hear, from the other three speakers,
Or should I scratch around like a barnyard hen trying to find some other grains of wisdom on these subjects to offer you
Or should I speak on a totally different subject all together
Well, you may or may not be pleased to hear that I have decided on the latter course, and will therefore be talking predominantly about four topics, largely unrelated to the subject I was supposed to talk about, under the broad title of:
The Responsibilities of a Hedge Fund Administrator
The first topic 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, SICAV, UCITS or Mutual Fund.
That will, surprising as that may seem, lead in to the second subject - Equalization,
by which I mean both the equitable allocation
and the accounting of the equitable allocation
of incentive fees between Shareholders in a Hedge Fund.
I will also touch on a third subject, which relates to some of the problems relating to the valuation of Hedge Funds.
Finally, I will briefly try to answer a question that I was asked about recently, concerning where the loyalties of the administrator lie
Is the Administrator responsible to the Fund Manager
or to the Shareholders the investors in the Fund
So, on to the first topic
What is the Difference Between Administering Alternative Investment and Hedge Funds and Administering Traditional or Conventional Unit Trusts, SICAVS, 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 investment funds such as Mutual Funds, Unit Trusts, SICAVS, and UCITS, which are predominantly retail funds).
In fact, there are some very definite differences, which substantially affect the Administrators task.
First of all, 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 more esoteric instruments,
including for example,
unlisted securities and derivatives, the valuation of which can sometimes present problems.
By the way UCITS are permitted to use futures or derivative products for Efficient Portfolio Management
which is Eurospeak for Hedging
but there are tight restrictions on the type of derivative or futures that can be used
for example, I know of specialist equity fund that was not allowed to even partially hedge using the S&P500
that 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.
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.
On the other hand, of course, for Hedge Funds, where there are short sales, there will be financing arrangements with the Prime Broker that have to be accounted for by the Administrator. This is not a problem that the Traditional Administrator has.
Thirdly, Traditional Funds will usually, by their very nature, have many small Shareholders. This requires the Administrator of Traditional Funds to maintain a very much larger shareholder register system than would be needed for 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 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 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 Traditional Fund Administrator is used to.
For instance, the management fees of a Hedge Fund can be charged on the basis of the 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 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 Managers fees, as a special arrangement between the Fund Manager 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 Funds 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, predominantly 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, along side 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 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, 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.
Let me give a simple example the famous 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 Investor A - 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.
This 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 Investor B - comes in and buys one share at US$100.00.
Without Equalisation, the Fund Manager would not be able to charge any incentive fees until the NAV per share had risen back up to US$110. And if that happens,
Investor B gets a Free Ride on his profit of US$10 per share, because Investor B will not be paying any incentive fee on that profit.
Equalisation eliminates this.
I would 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.
So how is Equalisation achieved How are these anomalies eliminated
The equalisation process is an accounting methodology, whereby one investor (or group of investors who invest at the same time) are individually assessed for their own incentive fee liability and charged accordingly, thus eliminating the anomalies I have just described.
There are, basically, two commonly used methods:
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 of Share.
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.
This may be quarterly, or half-yearly or annually.
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 can be cumbersome, especially for an active fund, subject to an annual incentive fee, attracting new subscribers each month, because you end up with twelve different Series in issue, before consolidation.
and that assumes a profit at the end of the period not a universal situation at 31st December 2000.
This obviously also causes problems with reporting performance.
The major advantage is that it is relatively simple to explain to investors.
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.
The advantage of The Equalisation Method is that you can publish one NAV per share for all investors.
But this is a very complex process and the main disadvantage is that it is, in fact, very investor unfriendly and administratively complicated.
I have seen the most sophisticated fund accountants, whose eyes have glazed over at the mere mention of the word Equalisation.
As I have said, there are a number of variations on the Equalisation Method and
the only consistent factor is that they are all indescribably complex,
therefore I am not going to attempt to describe them to you in detail now
otherwise I really will bore you to tears
Suffice it to say that an investor who purchases shares at a time when the Fund is in profit, and an incentive fee is due or accrued to the Fund Manager,
will pay the gross NAV (i.e. excluding any accrual for incentive fees),
but will receive what is called an Equalization Credit for that portion of the NAV which represents the incentive fee accrual, which the investor has actually paid on the gross NAV.
If, at the end of the year the shares are still showing a profit, then the investor will be paid his Equalization Credit by way of an allocation of additional shares in the Fund.
On the other hand, if the investor buys when the Fund is in a drawdown period, then he will pay an Equalization Deposit,
which will be equal to the amount of the performance fee that would be payable if the Funds price rose from the subscription level to the previous high-water mark.
In my opinion, few of these Equalization Methods are perfect,
whereas I believe that you do get an entirely accurate allocation from the Series of Shares method
but course, as I have already stated, that is cumbersome and if the Fund under-performs in one year, you could have 24 Series of Shares in issue or more,
if you have to wait until the third incentive payment date.
By the way equalisation does not present any problem in the US where almost all, if not all, funds are partnerships and, therefore, use partnership or capital accounting.
Whereas, of course, offshore Hedge Funds are, for the most part, investment companies which issue shares and publish NAVs of the Fund company and per share.
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 we havent got the time, nevertheless, I hope I have made two things clear:
Firstly, I hope I have made it clear 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.
Secondly, I believe 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.
There are still many funds on offer - both new and established funds,- which ignore equalization,
just because it is a hard sell many European and Middle Eastern investors do not feel comfortable with any form of equalization and particularly the Equalization Method.
However, I do believe quite strongly that some form of equalization is essential so that one shareholder is not penalized to the benefit of another.
I would now like to go back to
The Valuation of Hedge Funds,
another topic I feel quite strongly about.