Hedge Fund Administration 101
HEDGE FUND ADMINISTRATION 101 INTRODUCTION
Why have hedge funds been so successful?
It probably comes a shock to many people to realize that the hedge fund industry has, in fact, been operating as an industry for over 40 years and has had a steady, if relatively unremarkable, growth for the first 30 or so years of that period. In fact, the first hedge fund was started by the now legendary Arthur Jones over sixty years ago, but the real growth has come with the interest shown by the institutional market, such as pension funds, of which the leading light has been CALPERS. In fact, the first institutions, if I can describe them as such, to invest were probably the more adventurous of the US education endowments, such as Harvard, University of Virginia and Yale.
However, without going into a detailed history of the growth of hedge funds, I think it is fair to say that the main factors that have made them so successful are:
i. Performance certainly over the long term, linked with the ability to consistently make real returns;
ii. The fact that they are not correlated with traditional markets and, therefore, can hold their heads above water during crippling market declines, like the bursting of the tech bubble in 2000/2001 and the years that followed; and
iii. The fact that the hedging techniques used means that hedge funds are, for the most part, less risky and less volatile than funds committed to long only strategies.
This last statement, of course, flies in the face of what the majority of the media would have you believe earlier this month, there was an article in one of the Sunday papers, that I read here in Dublin, which was discussing risky hedge funds and, inevitably, went into a diatribe about Long Term Capital. Obviously, some hedge funds are going to lose money or not perform as intended, but that is inevitable in all business and should not be used as a benchmark for measuring the industry as a whole.
Finally, as the industry has grown, so have the numbers of strategies employed and they have become more and more esoteric and complex. What is, I think, indisputable, is that the brightest minds in the investment industry have specialized in various hedge fund strategies, not just because it is intellectually satisfying, but also because they make a hell of a lot of money doing so.
Current Market Size and Growth Forecasts
As I have already said, in the last 5 to 7 years, we have seen a vast and rapid growth as pension funds come into the market. Why have they come into the market Because they have seen that, even if hedge funds are not today producing the 20% and 30% annual returns that they had been historically, they are still producing real returns and they can do so when the rest of the market is underperforming or is in negative territory.
It must be remembered, however, that, even though hedge funds are meant to represent somewhere between one and one and a half trillion Dollars, including Funds of Funds - so one trillion is probably more accurate this still represents less than 5% of the total of invested assets around the world. I think this could increase to nearer 10%, but, and in my view, it is unlikely that hedge funds will grow to a much larger percentage than that, if only because of the capacity problems in the strategies that the funds follow more on this later.
As I have already said, we are advised by various different data agencies that hedge funds, including Funds of Funds, amount to approximately $1.5 trillion and that, if you take away the Funds of Funds, that probably reduces down to something in the region of $1 trillion single strategy funds. It is believed that this money is invested in somewhere between 8,000 and 12,000 funds. These are not numbers that can ever be accurately stated, because quite often, hedge funds have closed, either because they have failed or because they have enough assets and have closed to new investment. In either case, they fall off the screen. It is also generally accepted that 70% of all hedge funds have less than US$100 million in assets - probably on average US$40-60 million many of which are not included on any databases.
The next topic is
The development of hedge fund administration domiciles (onshore versus offshore) and administration centers
I think that there is no doubt that, today, Dublin is the hedge fund administration center of the world, certainly with regard to Offshore Funds, but this was not always the case. Historically, hedge funds in the United States have been limited partnerships and the general partner has, for the most part, been responsible for carrying out the administration i.e. maintaining the accounts and the books and records and reporting the performance to the limited partners of the fund.
On the other hand, Offshore Funds are, for the most part, limited liability companies, issuing shares and they usually, and this is required by regulation in most jurisdictions, have to appoint an independent administrator.
The first major Offshore Fund centers were Curacao and the BVI, closely followed by the Cayman Islands and Bermuda. Inevitably, the administrators for those funds were based in the jurisdiction in which the fund was established.
Gradually, the Cayman Islands achieved popularity in the States, I suspect, probably this is my opinion because they developed a huge banking center which is now, I believe, the third or fifth largest banking center in the world. At the same time, they also introduced regulations to enable the establishment of Offshore Funds and provided a customer-friendly regulatory environment.
There is no doubt that, today, the Cayman Islands is the leading jurisdiction in terms of Offshore Funds being established I was advised by the Cayman Island regulator late last year that they were authorizing 35 new funds every week interestingly, they were also closing 8 funds per week and recently passed the 10,000 funds mark.
For some reason, the Cayman Islands also, with Bermuda, became the main centers for Offshore Fund administration the BVI lagged behind and I have never quite understood why, except for the fact that the BVI has a much smaller infrastructure than the other two. By the way, the Bahamas has always been a junior member of the club and there have been many funds established there and they have had administration capacity available for those funds. The Bermudan, Cayman and Curacao administrators became international names, within the hedge fund industry including, inter alia, Citco, Fortis, Bank of Bermuda and Hemisphere and thats the way it remained until the early 90s, when Dublin raised its flag.
In the late 1980s, legislation was passed in Ireland to authorize the establishment of the International Financial Services Center (IFSC), which was to be based in the Custom House docks. The objective of the IFSC was to attract foreign financial services companies to carry on their business in the IFSC and create a new export business from Ireland and, of course, generate jobs. There were a number of incentives offered, but the main one was a corporation tax rate of 10%. Because of the various double taxation treaties that Ireland had with numerous jurisdictions throughout Europe and the rest of the world, the 10% corporate tax rate, combined with favorable double taxation treaties provided a huge advantage for many organizations and the IFSC has been a remarkable success.
The first customers who were attracted to the IFSC were the treasury arms of major corporations who ran all their non-domestic cash management and currency management programmes through Dublin. For those of you who can remember, these were the days of 10% and higher interest rates, so the attraction becomes obvious if your domestic tax rate is 50%. For a corporation like Volvo, for instance, who would net, say, 5% after tax and costs on any cash balances they have invested in the money markets out of their Swedish office, could net 9% on their Dublin business, through their Irish subsidiary and that 9% could be repatriated to Sweden without any further tax liability. That effectively converts their lending operations to junk bonds rates 9% net equals a virtual gross 18% yield to the home office, if the transaction had been carried out in the home office.
So there were attractions for opening up in Dublin and, as the European hedge fund industry grew, so many hedge fund administrators opened offices in Ireland. Over the years, these have included IFS, IFA, DCM, Bank of Bermuda, Citco and Hemisphere all of whom have now been acquired by major traditional mutual fund administration companies.
During most of this period, Luxembourg missed out because they only started taking hedge funds seriously two or three years ago.
There is also the factor that, for the most part, hedge funds are an English language product and Ireland, of course, speaks English, albeit with a certain poetic brogue.
I also have no doubt that Dublin also proved attractive to many American hedge fund managers, for historical reasons you must remember that every American thinks he is Irish I understand that even Colin Powell has been discovered to be of Irish decent in some form or another but, in all honesty, I cant claim that that would be a major influence.
What was a major influence, in my opinion, is the fact that, in 1995, the Irish Government introduced the Investment Intermediaries Act, which required all financial services companies, including administrators, to be regulated and the regulatory environment in Ireland is very strong fair, but strong. Although you may have to be authorised to be an administrator in other jurisdictions, including the Caribbean, the actual regulation is not as aggressive or proactive as it is in Ireland. This has given a lot of investors in Irish administered funds comfort, as the markets demand for independent administration has increased. In the context of onshore administration (the word onshore predominantly refers to the United States), there have been a number of administrators operating in the United States for many years, but, with the exception of some of the larger domestic partnerships, the majority of hedge funds in the United States are self-administered by the general partner. However this is changing.
You will have read about various scandals in the United States in the hedge fund industry over the past few years and, again, I would again criticize the media for trying to represent these few frauds as being the standard by which to judge hedge funds. When you consider the size of the market and the fact that it has been, until recently, virtually unregulated in the United States, it is to me surprising how little fraud has occurred. Nevertheless, the fraud that has occurred has been high profile and investors have become very much more cautious in their selection of funds and very much more demanding in the context of independent valuations and, indeed, independent administration of funds they invest in. As a result, many more US funds are now administered by third party administrators and the majority of those administrators are based in the United States, unless they have an Offshore Fund as well, in which case, they will probably utilise a Master Feeder Fund Structure.
I should explain this. It goes without saying that hedge fund managers would much prefer to manage one account indeed, this is why they set up funds in the first place. Also, although some investors do prefer the managed accounts that have full transparency, others prefer funds because the limited liability protection that gives them.
The problem comes with the fact that US taxpaying investors require a limited partnership in order to comply with their tax requirements, which are that they should pay tax on the annual return of the fund, whether or not that return is distributed. Therefore, the books and records of the partnership have to be maintained in such a fashion that the information can be provided to enable the US taxpayer to complete his K1, which is a tax reporting form. This is not a major problem, but it is difficult to do if you have corporate accounting.
Furthermore, most offshore investors and, indeed, US tax-exempt investors prefer to invest in a company issuing shares precisely because that investment will not have the look through provisions of a limited partnership.
This problem is resolved by establishing a Master Feeder structure, which means that you establish a US limited partnership and the Offshore Fund as Feeder Funds. The subscriptions into those two vehicles are fed down into a third entity, which is the Master Fund, usually established offshore in the jurisdiction of the Offshore Fund. This Master Fund is usually a limited liability company issuing shares, but maintains its books and records as if it was a partnership and follows a procedure, which is known as checking the box, so that it applies for recognition by the US Inland Revenue service. The administrator can then maintain all of the books and records as if the company (Master Fund) was a partnership. The manager, therefore, gets his desire to handle one pool of assets those of the Master Fund - and the US investors get their requirements with regard to tax reporting, whilst the offshore investors remain offshore.
As I have already mentioned, Dublin and now Ireland, is probably the prime hedge fund administration center in the world. I have already explained the reasons why it has become so popular and that is, primarily, professionalism, regulation and, more recently, the involvement in the hedge fund industry by the major institutional administrators, who have been playing Pac Man all round the market.
What are the challenges for hedge fund administrators
Firstly, there are substantial differences between the administration of a classic vanilla long only mutual fund, or unit trust and the administration of hedge funds, which may use a variety of different strategies, or, for that matter, Funds of Funds that invest in those hedge funds. I am not going to go into the full explanation of the differences now, but suffice it to say that, just the calculation of fees is very much more difficult in hedge funds than it is for the traditional funds, therefore, the skill sets required for administering a hedge fund are greater than the skill sets required for a mutual fund. This, of course, is one of the reasons why the large mutual fund players purchased their hedge fund expertise, rather than developing it in-house.
Of course, another reason for purchasing was to acquire market share, however, most of the major traditional administrators were acquiring hedge fund expertise so as to be sure that they could service their existing client base, as that client base turned towards the hedge fund market from long only equity and bond markets. I venture to suggest that, if the traditional administrators had been able to administer their own clients hedge fund vehicles, they would not have been so keen to purchase outside companies, bearing in mind all the cultural problems that appear when you are trying to integrate two different companies with different procedures, systems and even attitudes to the market place.
Having said that, one of the challenges that Dublin faces is the very fact that the market is expanding whilst costs are rising and, once more, staff is becoming scarce.
To a large extent, the problems caused by staff shortages have been mitigated by enormous technological improvements, but however far one may go down the road to super-technology, you still need human beings to check and authorize transactions and entries into computers. There is no doubt the costs of operating in Ireland have risen hugely, not only labour, but we all know about property and living expenses, therefore, it is no surprise that the major Irish administrators have opened up offices in Galway, Cork, Naas, Drogheda and Waterford. We, in fact, opened up in Chicago, but then most of the other administrators already have US offices. What came as a surprise was that the operating costs in Chicago are noticeably lower than the operating costs in Dublin.
One of the other problems that administrators in Dublin have faced over the past few years has been the decline of the Dollar. The majority of hedge funds are designated in Dollars and, for many administrators, their fees are paid in Dollars, whereas, of course, the overhead is in Euros. This has meant an effective decline of more than 30% in Euro revenues for many administrators, on the basis of exchange rates some four or five years ago versus the exchange rates today. In fact, that was one of our considerations when opening in Chicago at least we had a Dollar overhead versus Dollar revenues.
Impact of Technology
Enormous. Think back five or ten years. Could you have imagined carrying around a little box no bigger than a packet of Rothmans and being able to communicate, both verbally and by the written word, with anybody, anywhere in the world, at any time of the day or night. The Blackberry age has revolutionized the way that many people in the financial industry (and other industries, for that matter) communicate with each other and keep up to date. The same revolutionary changes have occurred in all walks of the financial industry, including hedge fund administration and this has been largely on the back of Microsoft, Cisco and other similar technological geniuses.
One of the effects of technology has been to increase the speed and efficiency that hedge funds can enjoy. It used to be that a hedge fund administrator would take three or four weeks to produce a valuation for a fairly simple, straightforward long/short hedge fund. We are now producing weekly and daily valuations and some administrators are producing real-time online valuations and, presumably, that is the way of the future. Of course, daily valuations do not necessarily mean daily liquidity, but it certainly enables risk management of a greater quality than used to exist.
Of course, the main problem with technology is that it costs a lot of money, although, in the long run, it is less expensive than the staff it replaces.
I would just briefly like to describe the system that we use and I am sure there are other administrators that you can speak to at this conference that will have similar stories.
We installed a system called PFS PAXUS three to five years ago I say three to five years, because it took us approximately two years to complete the installation.
At the time that we decided to implement PAXUS, we were, in common with most other hedge fund administrators, operating a modular administration system. This meant that we had a series of different administration modules one, a Securities Trading Module, which would track the portfolio. Secondly, we had a Shareholder Register Module, which tracked shareholders and their shareholding. The next two modules would consist of the fee calculation module, which would normally be a spreadsheet and then the Equalisation module, which is another of the great differences between traditional mutual funds and hedge funds but which is also calculated on a spreadsheet. The problem with spreadsheets and modular systems is that, every time that you have to transfer information from one module to another, you create a potential error zone and spreadsheets, of course, offer the opportunity of multiple error zones.
PFS PAXUS was designed by somebody who used to run the back office of a major Fund of Funds and who was so appalled by the problems that he inherited from hedge fund administrators in the late 90s, that he decided to design his own system. I think that one of the reasons why PAXUS has proved so effective is that it was designed by somebody who knew the industry. Be that as it may, PAXUS is a fully automated, fully integrated system.
By fully automated, I mean that, if you can import the information required electronically, you can then process that information and spew it out electronically.
By fully integrated, I mean that each of the modules are, in fact, a component of one single system, so that everything flows freely and smoothly through that system. Thus, if you have to change the price of a security, which has been quoted as, say $94.7, when it should have been $97.4, then you can do so quite simply and it will filter its way through the system without any further problems.
With the modular system, you would have to unwind every single spreadsheet and every single module until you got back to the original point, enter the new price and then reprocess everything with the same potential for multiple error zones. Thus, you can see that the improved technology does reduce labour costs, because the old modular system required multiple human and, therefore, expensive, checking. The PAXUS system still needs checking and authorization, but the number of funds that can be administered by each administrator increases dramatically and, therefore, the operating costs decline accordingly.
The other great technological leap, of course, has been web reporting, which has increased the speed of the dissemination of information and simultaneously reduced the time and cost of sending out that information.
Typical Fee Structures
The first thing I should say about this is that fees are always negotiated and, therefore, the use of the word typical is, perhaps, a little ingenuous. Having said that, most administrators charge on the basis of:
i. An ad valorem fee i.e. a fee based on the value of the fund. This will normally start in the region of 10 to 15 basis points (0.10% to 0.15% of the NAV) per annum, calculated and payable, usually, monthly in arrears.
It is common for administrators to agree to a reduction in the ad valorem fee on a volume basis. Thus, there will be trigger points say, $50 million/$100 million, when the ad valorem fee will dip, reducing further so that, after, say, $500 million, it would be down into the mid to low single figure basis points.
ii. These fees will be subject to a minimum monthly, weekly or daily fee, depending on whether the fund is monthly, weekly or daily liquidity and, of course the administrator will be reimbursed for out of pocket expenses.
Depending on the structure of the fund, there may also be charges levied for:
i. Registrar and transfer agency services this will usually be a transaction cost.
ii. Corporate secretarial services.
iii. Provision of Directors.
iv. Initial signing on of the account.
v. Cost of writing customized software.
vi. Other incidentals, such as preparation of financial statements (if auditor doesnt do it), travel and other expenses, attending Board meetings, etc.
Future Industry Outlook
Very positive - for all members.
The recent acquisition of most of the larger hedge fund administrators by huge mutual fund administrators has led to, what is, in effect, a two-tier hedge fund administration market. It is a fact of life that the large institutional administrators do not like small accounts and are only looking to take on hedge fund clients of US$100 million, at a very minimum, on day one and, indeed, some look for a minimum of US$200 million. This is an admirable policy, if you can afford it and, of course, for the big mutual fund administrators who went into the hedge fund business to service their big mutual fund clients who are entering the hedge fund business, they do have the large market to address. Nevertheless, as I have already said, the vast majority of hedge funds circa 70% - are smaller than US$100 million, with the average probably being US$50 million.
This has led to a two-tier market, with the giants on the one hand and the few remaining independents who can still afford and are interested in looking after the smaller hedge fund clients, on the other hand.
I have already said that I think it is unlikely that institutions will, excluding educational endowments, will invest more than 5% or, perhaps, at a maximum, 10% of their assets into hedge funds. Nevertheless, as the overall market grows, so that 5% to 10% will be a larger sum. You only have to consider the capacity constraints of many of the hedge fund strategies to realize that many of those strategies limit the size of the fund probably less than US$500 million or even US$300 million. Thus, as the market grows to US$2 trillion or US$3 trillion, which is to be expected, so the number of hedge funds will also grow and I believe that it wont just be a matter of an increase in the Dollar size of the fund, but more a matter of the increase in the actual number of funds.
If I am right, then the future of the hedge fund industry and, therefore, the future of the hedge fund administration industry, is one of growing strength and the future of the smaller specialist independent hedge fund administrator remains rosy.