What Is Hedge Fund Administration
Administration, in the context of Alternative Investment and Hedge Funds, (which I will refer to collectively as Hedge Funds in this presentation), means, in effect, the management of the Fund in virtually all aspects of the day-to-day operations of the Fund, except the actual investment of the assets, which is the responsibility of the Investment Manager. In this role, the Administrator is always answerable to the Board of Directors and does not have any actual management control.
In simple terms, an Administrator is responsible for ensuring the efficient operation of a fund, whilst at the same time relieving the Investment Manager from having to do all the boring stuff, such as:
Calculating the NAV and the NAV per share or unit, as often as may be required by the Fund or its Board. That may be daily, weekly, monthly or quarterly. Usually Hedge Funds have monthly valuations, however, as institutions become more and more involved in these markets, so does the demand for more frequent valuations;
Keeping the accounts and financial records;
Preparing the annual audit file and liaising with the Auditor;
Liaising with the Investment Manager or Advisor, the Custodian, the Brokers and other service providers;
Liaising with prospective investors and sending out the offering documentation;
Calculating, confirming and arranging payment of all subscriptions, redemptions, fees and expenses, and arranging for the payment of all dividends or other distributions, if required;
Maintaining the statutory books and records;
Usually the Administrator will also act as Registrar & Transfer Agent, handling the registration of shares and liaising with shareholders with regard to subscriptions, redemptions and transfers; and
Carry out anti-money laundering due diligence with regard to investors;
The Administrator may also act as Company Secretary - and will therefore be responsible, amongst other things, for arranging Board Meetings, calling the AGM and preparing Board Minutes.
The Administrator will maintain a copy of the Share Register at its office and, if the Administrator is not resident in the domicile of the Fund, ensure that the original Share Register is held in the Registered Office in that jurisdiction;
If the shares of the Fund are listed on a Stock Exchange, ensure that the Company and the Directors comply with the ongoing obligations of the relevant Stock Exchange;
And perhaps most important of all, the Administrator will be the interface between you, the Manager and Investors;
Depending on the terms of its agreement, the Administrator may also be responsible, for ensuring that the Fund complies with the terms of its Offering Memorandum in many ways, including the management of its investment portfolio with regard to, for instance, investment restrictions and diversification requirements.
This is not an exhaustive list of an Administrators duties but should give you a reasonable idea of what is involved.
In summary, as I said, an Administrator should be responsible for making sure everything is done to enable the fund to run efficiently in all aspects, except the management of the assets - that is the Investment Manager's task. Thus an efficient Administrator will enable the Investment Manager to sit in his ivory tower and make pots of money, without distraction.
In the Hedge Fund industry, I suggest that the main advantage that the third party Administrator brings to the table is the comfort that is provided to investors, if the administration of a Fund, and particularly the calculation of the net asset value (NAV) of that Fund, is being carried out by an independent third party (that is independent from the Funds Manager), using independent prices and transaction data sources when calculating the NAVs.
Why do I stress this Let me briefly explain - the majority of Hedge Funds, of which there are now several thousand some estimate close to 6,000 - are established in the United States as Limited Partnerships. As I have already said, General Partner is usually the Hedge Fund Manager and also, usually, handles the administration of the Fund and produces all of the partnership accounts, reports and statements. In the vast majority of cases, there is nothing wrong with that and, historically, the vast majority of US Hedge Fund accounts and reports have been spot-on.
Please remember that I am talking about Hedge Funds, which are, on average, very much smaller than the average retail fund. Very few Hedge Funds are over half a billion dollars. This is because many, indeed most, Hedge Fund strategies are capacity sensitive. The other day I heard a UK Fund Manager described as small, in the context of the European retail market, at ten billion dollars I would be surprised if you needed more than two hands to count up the number of Hedge Funds Managers with over five billion, let alone ten billion, dollars under management.
However, as those whose knowledge of this market is based on the somewhat sensationalist, and, frankly, ill-informed, articles in the press over the past couple of years (including, rather disappointingly, at least one article in The Economist) they will know, there have been a number of scandalous frauds involving US Hedge Funds. I would point out, in passing, that these frauds represent a tiny percentage of the universe of Hedge Funds and an even smaller percentage of the asset pool invested in those Hedge Funds. Unfortunately, these small percentages seem to be in inverse proportion to the column inches that the scandals apparently merit in the press.
Be that as it may be, the reports of these scandals have honed investors senses and, because the majority of these frauds involved self-administered US Funds, those Investors now want to see that the Funds they invest in are administered by an independent third party Administrator. Therefore, I believe that the appointment of a third party Administrator can add immeasurable value to a Fund, if it means that it will retain investors in the Fund or, indeed, attract new investors to the Fund.
For a small or emerging Hedge Fund Manager, setting up his first fund, the cost advantages of appointing a third party Administrator can be easily demonstrated, but it is not just a matter of pure dollars and cents.
Until the Fund grows in size to, at least fifty, or even one hundred million dollars, which is above the average size, the actual cost of setting up an administration facility - (which involves renting more space, employing qualified staff, acquiring the specialised technology and providing the managerial resources required to ensure the efficient self-administration of the Fund).
These costs can be almost prohibitive and are unlikely to compare favorably with the fees charged by many of the specialist Hedge Fund Administrators or at any rate those Administrators who will accept the smaller start up Hedge Funds.
Obviously, once the Fund has reached a critical mass, the cost ratios change and the attraction of a third party Administrator may decline. However, it is also likely that, as the Fund grows, the fees charged by the Administrator will also be volume sensitive.
So, it can be seen that the decision to use a third party Administrator is not necessarily cost driven and can be swayed by other considerations, such as the perception of independence that I have already mentioned, and risk transfer.
By this I mean transferring the risk, and resulting liability, represented by, for instance, the possibility of expensive administrative errors, from the Fund Manager to the third party Administrator or that Administrators insurance company.
One area where dollar costs can be a serious factor is when a Fund Manager, who has hitherto administered the Fund that he manages, decides, perhaps because of investor pressure, to appoint a third party Administrator. In these circumstances, the Manager will already presumably have made a substantial capital investment into his own administration department and that department and the technology purchased, may have proved very efficient.
In choosing to outsource the administration, the Manager may, on top of paying the new administration fees, have to decide to write off the capital investment and let some staff go. And, as we all know, in Europe at any rate, that can be a very expensive way to cut costs.
Often in these circumstances and in order to avoid these write-offs, the Fund Manager may decide to continue preparing the Funds accounts and calculating the NAV.
At the same time, the Manager will try and appoint a third party Administrator to fulfill the function of verifying the figures produced by the Fund Manager and, of course, to do that for a nominal cost. This is what is known in Hedge Fund circles as NAV Lite. Obviously, this is, potentially, a very dangerous area for an Administrator and any Administrator who agrees to verify such numbers and be described as The Administrator in the Funds documentation, should, in my view, still replicate the whole accounting process, in-house, using independently sourced data, which, of course, cannot be done for a nominal cost.
Having said all that, in many jurisdictions, it is now a requirement that an independent Administrator is appointed for most Funds, obviously excluding those managed by the larger Fund Managers who have their own separate administration company Fidelity, Citigroup, Barings all spring to mind and, of course, many such huge companies also act for both their own in-house funds and outside funds.
COMPARISON WITH MUTUAL FUNDS
There are a number of areas in which the administration of Hedge Funds differs from the administration of the more traditional Mutual Funds or Unit Trusts. These include: the range of investment instruments; and the strategies used to exploit these instruments; the ability to go short; leverage; fee structures, including incentive or performance fees; and equalisation.
The traditional Mutual Funds or Unit Trusts are, for the most part, retail funds with quite restrictive investment policies which include: very broad diversification; no short selling; no leverage; and 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, which can introduce pricing problems.
These instruments range from the relatively straightforward exchange traded commodities, financial futures and options contracts, to highly complex derivative products, which include swaps and swaptions, as well as CFDs, currency forward contracts traded on the Interbank market and a wide variety of customised instruments created by major banks and financial institutions and sold on the Over the Counter or 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 the NAV calculation.
Most Hedge Fund strategies are, essentially, quite simple long-short strategies, from the obvious long-short equity fund, through merger arbitrage, commodities, futures, options and bonds and none of these present a problem, if they are traded on a recognised exchange and a liquid market.
The problems come with illiquid assets and esoteric derivative products, created by and sold by just one financial institution, which is the only valuer of those assets. Again, no problem in liquid high volume markets, but if markets fall dramatically and volumes shrink, God help you, if you expect the institutions to look after Number Two you.
They will inevitably look after Number One - themselves.
What is essential is that a clear valuation policy is disclosed in the offering document 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, for some reason, 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 fees and, particularly, performance fees and equalisation.
Basically, all I am going to say about this subject is that the manner in which management and performance fees for Hedge Funds are calculated, can be very complicated and is certainly never standardised, unlike Mutual Funds, which are, for the most part, charged on a standardised basis. For instance, management and/or performance fees for a Hedge Fund can be charged on a monthly, quarterly, half-yearly or annual basis, but they must be accrued for at least monthly.
- They may be charged, on the opening NAV at the start of the period, the closing NAV at the end or, on the average, during the period;
- They may be charged 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 return, or a variable rate say 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 on its investment.
- 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 the 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 or performance 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 the High Watermark.
- 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 subsequently rise from $90 to $120 at the end of the fee payment period, the $30 profit made by the new Shareholder would not incur an incentive fee, because the Investment Manager would not be entitled to claim an incentive fee, until the NAV had reached $120. So that Shareholder would receive 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 they are correct. Undoubtedly, that is why Equalisation was introduced in the first place. However, mathematically, it can be proved that, if investors subscribe into a Fund between performance fee payment dates then, regardless of whether the price of the shares had risen or fallen in the meantime, some 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, to their own detriment.
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 see the paper on Equalisation on our Website.
How to go About Selecting an Administrator Due Diligence or What to Look For, What to Ask
Before you can select an Administrator, you must have an absolutely clear understanding of your requirements what you want, or, perhaps more to the point, what you need. This comes down to What to Look For and What to Ask. Before you can make any decision on these, you must carry out your own due diligence.
It is extraordinary to me that, whereas almost all Investment Managers would expect any sophisticated investor to carry out serious in depth due diligence, on the Manager, on the Manger's trading techniques, past performance, checking references, reviewing systems, in fact delving into everything, yet those same Investment Managers, when acting as promoters of funds, often do not carry out even the simplest due diligence when selecting an Administrator, other than getting a fee quote.
Let me be quite categoric due diligence is essential when choosing an Administrator.
To do this, you need to ask the candidate Administrator to complete a detailed Questionnaire but I will come back to that later.
If, having received and reviewed the Questionnaire, you decide that this candidate is still in the running, you then need to carry out further checks and assessments including:
Get references and be clear about what the references say - and what they dont say.
I have told this story before, but I think it bears repeating. When I first moved to Ireland, I was looking for someone to work at my home. My lawyer at the time, who was a canny old bird, told me to look out for what was missing from a reference - what was written may not be quite so relevant as what was not.
For example, if the reference didn't say that the person I was considering employing was sober and honest, then that probably meant that he was a drunken thief.
You should look for similar clues.
Sadly I have to say that almost every reference you get, will probably say that the referee does not accept responsibility for what the reference says, but occasionally you may get a reference from somebody saying, directly, or between the lines:
"I wouldnt touch this company with a barge pole" and that is quite useful.
In fact I believe that when getting a reference, it is often better to call the referee, after you have received his written reference, because he may say something "off the record" that he would not commit to writing.
Next, as a trader, you would normally "check your market". Do the same when selecting an administrator.
That is to say, look at more than one Administrator - hold a beauty parade - find out what they offer.
You should, if practical, which is not always the case, visit their offices and see what they do and how they do it.
You should, quite soon, have a pretty clear idea whether they are able to offer a personal service and whether you are going to be allocated one named person as your account executive (always backed up by another named person), or whether you will be an anonymous account. Remember, if you have a query, you need know you only have to ring up "Joe" to get a quick answer - and not find yourself floating around the ethernet, wandering from extension to extension, ending up with someone saying "I can't help you, because the person who did that last week has gone fishing".
Basically you have got to find out if you are going to be treated as a person or as a number.
Ask the Administrator how many clients they have in total and, more importantly, how many clients do they have that invest in the same asset classes, sectors or disciplines as you do.
If you are dealing in an exotic instrument, and the Administrator has never handled that instrument, then you must ensure that it is capable of doing so. The fact that it hasnt handled the instrument doesnt mean it can't, although it would be added comfort if you know, from day one, that the Administrator has other accounts that deal in the same instruments as you do.
Review the Administrators standard agreement and get a detailed procedures manual - a term sheet if you like - to explain exactly what the Administrator is going to do and (and this is very important) who is responsible, in which office, for each specific task.