3rd Party Administration & Deriviative Operations

Good afternoon Ladies & Gentlemen,

As you will have seen from the programme, my talk today is to be divided into two parts.

    * The first will be on the subject of pricing hard to value investments, when calculating the NAV of a fund and
        The second will be discussing the problem in structuring and administering a multi-Manager managed account platform as a daily dealing fund and I will describe one solution that we have come up with for that problem.

So firstly:

Hard to value investments and, obviously, in this context, I am going to discuss OTC Derivatives, rather than other illiquid investments, like real estate and private equity transactions are becoming more and more common.

As the derivative markets have expanded  and they seem to produce evermore complex OTC products every month  so the subject of valuing these instruments has been one of increasing concern, not only to the traders of these derivatives, but also to the investors, the regulators and, inevitably, the auditors.  For the latter, this has become a particular problem, as they are now having to determine what is fair value, which is another problem all in itself.

In April of last year, AIMA (the Alternative Investment Management Association), of which I am Deputy Chairman, published the first of a planned series of research papers on the subject of Asset Pricing and Fund Valuation for the Hedge Fund Industry.  Furthermore, an AIMA working group is heavily involved in the IOSCO Pricing Initiative.  Indeed, this particular aspect of valuing hedge fund assets is a very hot topic today.

To my mind, two important factors emerged from the AIMA paper.

The first, and this surprised many, was that only 14% of hedge funds assets managed by those who took part in the research survey were used hard to value instruments and secondly, what were hard to price assets two or three years ago, are now routine.  This demonstrates that the knowledge base of the hedge fund industry and, particularly, the hedge fund administration community, is fluid, flexible and adaptable.

The main problem for the hedge fund administrator is getting a reasonable, independent price for these instruments.  The difficulty in pricing any asset occurs once you are no longer able to take a price from an exchange or other organized market.  The degree of difficulty, inevitably, increases with the degree of complexity of the instrument and the degree of illiquidity.

For many derivatives, it is quite simple and practical for the administrator to ring up two or three prime brokers, or other counterparties who deal in the particular derivative and obtain from them a price at the end of each day, week or month and value on a pre-agreed formula based on those prices  such as the mid or average price of the three prices collected.

The real problems arise, however, when there is a particular tailored product, in which there is only one counterparty and, therefore, it is difficult to get independent pricing if you only have the Manager of the fund and the funds counterparty to rely on.

It goes without saying that, in all these derivatives, there will be a complex pricing model that can be used and, indeed, the Manager will be using its own pricing model, as will the counterparty.

However, it is never the preferred option to rely on the Managers pricing, although, sometimes, there is no other way.  If there is no other way then, in my opinion, it is acceptable to use the Managers price, albeit somewhat reluctantly, but only, and I repeat, only, if the fact that the administrator is relying on the Managers price is clearly disclosed in the offering documentation, both in the section describing the administrator and under the Risk Factors section.  The main problem with using the Managers asset valuations is that there is a potentially huge conflict of interest  but if this is well flagged in the offering documentation, it is then up to the investor to assess this risk  and if it is deemed too great, then he can vote with his feet.

I would also strongly recommend that, where the Managers price is going to be used, then the administrator should insist that the auditor reviews the Managers pricing models, not only before the fund starts trading and during the life of the fund, but also during each annual audit, to check that the final price used on the last day of the financial year is in line with the models output.

In these circumstances, the other and, in my opinion, preferred option, which may not always be possible, particularly for small funds, because of cost, would be to outsource the pricing to a professional pricing company, such as SunGard Reech, Lombard Risk, Future Value Consultants, or other similar companies that specialize in building models to price esoteric derivatives.  As I said, this is a complex business and, therefore, it is relatively expensive to outsource the pricing function, but you can be sure that it is not as expensive as getting it wrong.


Finally, on this subject, I have a very strong opinion that administrators should not build or operate their own pricing models.  It is not, in my view, an administrators function to be proactive in this area.  The administrator is supposed to take information provided to the administrator, by a reliable independent source, check that information  to that extent they are proactive - and then produce the numbers.

If an administrator takes on the responsibility of actually valuing any asset in-house, then they are taking on a risk that they can ill-afford.  If an administrator wishes to get into this business, then I suggest that they establish their own separate pricing company and thus take it out of the actual administrators purview.  Personally, I think that there is as big a conflict of interest in administrators actually determining the price of a funds assets, utilizing their own models and then calculating the NAV, as there is when an audit firm establishes its own fund administrator and then audits the funds numbers produced by that administrator.

The second half of my talk is on the subject of multi-managed account platforms restructured as a daily dealing fund.

We are all familiar with the ongoing battle between fund of funds and multi-strategy funds and the arguments that have been presented in favour of one and against the other.  In my opinion, to date, both have had their uses.  For example, although some funds of funds are now huge institutions, there comes a time when a large investor with several billion Dollars under management may be better off establishing their own portfolio of single strategy funds, which becomes, de facto, their own fund of funds, rather than investing in someone elses.

One of the attractions of a fund of funds, to my mind, is, for the smaller investor who wishes to have a diversified portfolio of hedge funds but cannot afford to establish its own management and research department and the fee paid to the Manager of the fund of funds will be less than it would cost them to do the work themselves.

The advantage of the multi-strategy fund, on the other hand, has usually been stressed on this matter of cost i.e. the overlay fee paid to the fund of funds Manager and that is a valid argument.  However, one of the risks of a multi-strategy fund is the fact that one Manager can blow up, thereby decimating the assets of the whole fund and this was amply demonstrated earlier this year by the Amaranth debacle.

The third vehicle, which has its detractors, is the managed account platform.  This obviously requires the same level of management as a fund of funds, but greater oversight, because the Manager of the platform will have full transparency and, therefore, must be capable of assessing the risks within each managed account.  The advantage of the managed account platform is, of course, flexibility and liquidity and the very fact that you have that transparency, which enables a competent Manager to assess and manage the risk in each component account within the overall portfolio.  However, this structure does not remove the cross collateral risk that can occur if one of the Managers blows up.

Last year, we were asked by a North American institution that wished to move its managed account platform off its balance sheet, whether we could structure the platform as a fund product, whilst still providing the advantages of a managed account platform.  We looked at this and came up with a solution that answers all the questions in your conference programme.

Now we come to the tricky bit.  Speakers at conferences like this, such as myself, are invited to speak on the understanding that they do not blatantly try and puff their own company.  My problem is that I dont know anyone else who has come up with the same solution to this problem as we did  and so please excuse the fact that I will be explaining how we, at Custom House, dealt with this problem and, inevitably, I will do so in reasonably flattering terms!

The solution that we came up with was a daily dealing fund structure that provides transparency and liquidity and avoids cross collateral risk between each managed account.

There is one other question asked in your programme  Is it all more trouble than its worth, which I will address in a minute.

What we did for this client was to establish a master feeder fund in Malta.  The feeder fund has monthly liquidity and also has several sub-funds to provide flexibility with regard to the composition of the portfolios.

The master fund was structured as a Maltese SICAV with over 30 segregated cells.  Each managed account was encapsulated into one of these segregated cells, so that there was no cross collateral risk between each cell and, therefore, each managed account.

The sub-funds of the feeder funds were allocated to meet different investment objectives.  For example, the institution itself, which had created the managed account platform, obviously wished to invest in all of the Managers and did so through sub-fund 1.

A client of the institution, however, wished to invest in all of the Managers, except CTAs, because it already had made its own arrangements with regard to the CTA market.  Thus, it only invested in 80% or so of the managed accounts.  Other sub-funds were offered to clients of the institution who wanted variations on the theme, in terms of the underlying managed accounts.

What is the advantage of this structure

One of the advantages is that we can calculate the NAV for each of the sub-funds of the master fund and for each of the feeder funds on a daily basis.  This enables the institution to maintain a tight control on performance and also to carry out a thorough risk management process, also on a daily basis.  I should point out that, although the Manager has a daily NAV for each of the Master funds sub funds and for the Feeder Funds sub-funds, it only offers the investor monthly liquidity, whilst the Manager can deal in each segregated sub-fund of the Master on a daily basis.

In simple terms the Manager truly can maintain transparency, liquidity and flexibility, combined with the elimination of cross collateral risk.

What more could he ask for.

It goes without saying that the actual day-to-day administration of this structure is, to say the least, quite complex.

The institution requires two things from Custom House:

    * Firstly, Custom House provides a trade capture and reconciliation blotter each morning.  This is a report that captures and reconciles all trades carried out on behalf of each of the sub funds of the Master Fund on the previous day.  We established a team of about 10 people, who capture and reconcile all the transactions carried out by the various trading Managers each morning.  These amount to between 1,500  2,000 trades per day, which are executed through several different prime brokers and, indeed, with some trading Managers, through three, four, or more such prime brokers.

The trade capture report is delivered to the Manager of the fund between 10.30 a.m. and 11.00 a.m. each day (Dublin time), which means that it hits the desk of the Manager very early in his day - before 5.00am each morning.  The reconciliation is completed by lunchtime in Dublin, which is still 7.00am in Chicago.  These reports, which are fed electronically into the Managers systems, enables the Manager to carry out all of the risk analysis, such as, producing the VAR (Value at Risk) reports, and he can also feed the data into any other risk management tools that they wish to use.

    * Secondly, once we have completed and despatched the trade capture and reconciliation reports, we can start working on the production of the NAVs of each of the segregated Sub-Funds of the Master Fund, and each of the Sub-Funds of the Feeder Fund.  We aim to have all of these NAVs delivered to the Manager, out of our Chicago office by 5.00 p.m. Chicago time, on the same day.


The reconciliation is, at present, all done in Dublin and I have already shown the time advantage we have by carrying out this work whilst the client in North America is asleep.  The NAV calculations, which were partially done in Dublin and partially in Chicago, are now calculated in Chicago  although that may change, as I will explain in a moment.

It goes without saying, that providing such a service is expensive, and therefore to achieve economies of scale, a fund structure such as this one must start with substantial assets  in this case the Master Feeder Fund was launched with total assets of circa US$1.8 billion.

It must be admitted that taking on this account presented several major challenges for Custom House and it took quite a long time  for example, we ran in parallel for almost four months - before we were comfortable with the process.  There were also some potential pricing problems with some esoteric derivates, but these problems have been solved, as they always are, as I discussed a short while ago, with the pricing policy being clearly defined in the offering document.

It can readily be understood that taking on such a client as this one has dramatically changed Custom Houses image in the Hedge Fund Administration market, as indeed I would suggest that it has also established Malta in the Hedge Fund market, but we have not become complacent.  We are constantly trying to improve our service.  This may be by automating tasks and functions that had hitherto been manual, or outsourcing hard to value pricing problems.

A couple of years ago, we introduced CHARIOT, our password protected web-reporting platform, which has been very well received by our clients.

Currently, we are in the process of setting up an office in Singapore.  On the face of it, you might imagine that this move is designed purely to enable us to target Hedge Funds run by investment Managers based in South East Asia and, indeed, that was the original concept.  However, as we have developed our product offering for the multi-Manager, daily dealing, Hedge Fund platform, we have realised that, by opening an office in Singapore, we can extend and improve this offering substantially.  What we expect to happen will be that, for North American managed account funds, such as the one I have been discussing, the initial operations in Singapore will be the trade capture and reconciliation function.  Because of the time differences, we would expect that most of the transactions carried out by the trading Managers will be captured and reconciled by our Singapore office before we get into the office in Dublin in the morning.  Singapore will then send the files to both ourselves and to the Manager of the Funds in United States by 2:00 or 3:00 oclock in the morning, his time.

Our Dublin office will then be in the position to calculate and issue all of the NAVs for both the Master and Feeder fund by 12:00 noon in the US, which will be a very satisfactory result for our clients.

That is why we opened in Chicago and will open in Singapore  whereas most of our competitors in Dublin have opened satellite offices in Galway, Cork, Waterford and other pleasant Irish cities.

Thank you.