Do's and Don'ts of Setting up a Fund
I have been asked to speak to you today on the topic of the Dos and Donts of setting up a Fund and propose to concentrate on Funds of Funds and only briefly discuss the basic dos and donts, which most people will know. This is because I want to discuss some of the problems (and their solutions, or potential solutions) related to Funds of Funds that have come out of the recent financial debacle, whose shadow still overhangs us.
I have said that I am going to concentrate on Funds of Funds, but, inevitably, several of the points that I make will apply to ordinary single strategy hedge funds as well.
The first decision that has to be made, when considering establishing any fund, is the domicile of the fund that is the jurisdiction where the fund will be established. This is important for a number of reasons, including reputation, tax efficiency and cost.
Historically, any tax efficient jurisdiction would do, but, gradually, over the past 20 years, the strength and reputation of the jurisdiction has become much more important, for two reasons. Firstly, investors are increasingly concerned as to reputational risk of being involved in a fund which has been established in a dubious jurisdiction and, secondly, the regulators of the world particularly the regulators of the Western world have taken a much more proactive, or rather pro-negative, approach to what they call tax havens.
There has been much debate as to whether the Caribbean Islands are tax havens the Bahamas, for example, would not consider itself to be a tax haven, because the tax levels they charge to outside non-Bahamian investors into Bahamian funds is the same as the tax level they charge on Bahamian residents which happens, in both cases, to be zero.
That, however has now become academic, because most countries in the Western world the United States and Europe, at any rate are now short of tax dollars and will, therefore, be flexing their muscles to try and recoup any tax revenue that they believe is being hidden in these jurisdictions and to close any loopholes which facilitates any tax avoidance programs.
Not only have we seen the United States attacking tax havens, in general, but specifically we have seen Alastair Darling, in the UK, threaten the Isle of Man and Germanys finance minister attack both Switzerland and Lichtenstein.
Of course, these sort of hysterical attacks tend to come out whenever there is an economic downturn, but this downturn has been so dramatic that the mud may stick. If that happens, then investors in funds established in these demonised centres may encounter problems and, of course, they may come under the media spotlight, which is anathema to most investors.
Therefore, when setting up a fund, you should consider the jurisdiction carefully and maybe in a different light today to the way you would have considered it two or three years ago.
Normally the jurisdiction is decided upon on the basis of a combination of familiarity and investor demand, or comfort. Since the late 70s, the Caymans have established an extremely strong foothold and are, or have been up to now, the jurisdiction of choice for most US hedge fund managers and, indeed, most Asian managers, purely because of that familiarity. However, this could change.
Before the Cayman Islands established their dominance in this area, the Bahamas was the offshore financial centre of choice. However, they lost that position because of a mixture of inefficiency and corruption. If the regulators in Europe and the US do put considerable pressure on the Caribbean, and other perceived tax havens, then I think it is likely that investors will look to funds that are established in Europe.
For hedge funds today, this basically means Ireland, Luxembourg and Malta. Ireland is very expensive to set up and, although Luxembourg is making great efforts to introduce the SIF fund, Malta appears to have stolen a march, in terms of a new jurisdiction, for a number of reasons. These include:
- It is a full member of the EU;
- Flexibility;
- Costs both set-up and ongoing;
- Adequate resources (professional personnel); and
- Strong, but proactive/pro-business regulation.
I should also mention in passing that the Netherlands have recently introduced the Netherlands Exempted Fund (NEF) or Vriefstelde Beleggings Instelling (VBI) to show off my Dutch! - as direct competition to the Luxembourg SIF and other similar funds.
So much for jurisdictions.
The other matters that I propose to discuss are, for the most part, fairly straightforward and obvious. For example, you should provide as much transparency as will not affect the strategy. By transparency, I mean full disclosure of structure, fee arrangements and risk management. I do not mean disclosure of the positions, because I think that is a dangerous precedent to set in the hedge fund market, or at least for portfolios with short positions or positions that can be squeezed or manipulated if they are exposed to outside scrutiny.
It is essential to follow good corporate governance, which means, among other things, appointing Directors and holding regular Board Meetings. In the present political and regulatory environment, it is important that the Directors of the funds, who are ultimately responsible for the management of the funds, are experienced and seen to be experienced.
We would recommend that one of the Directors should be a representative of the Investment Manager, because that gives investors some comfort that someone from the Investment Manager has put their head on the block.
If that happens, then we at Custom House are prepared to provide a Director, although many service providers now refuse to do so, because of the perceived risk indeed, not just perceived, but the actual risk.
I am often asked why I am prepared to act as a Director of the funds that we administer, but also do so for a pretty derisory fee am I not frightened of the risk My response is that we accept directorships of funds because we believe that whilst, as the Administrator, Custom House is well positioned to identify many of the risks as well as existing or potential problems that a fund may have, we are not necessarily able to take any action to resolve those situations. As a Director, one is empowered to call and hold Board Meetings and to raise and discuss topics that you consider important. As an Administrator, you are a mere servant and any queries you raise can be dismissed by the Board as being of no relevance.
We have, although albeit very rarely, instigated the closure of funds which have, for example declined in NAV, to such an extent that the cost of continued operation was a very high percentage, or even more than the fund could be expected to generate on an annual basis.
On the other hand, one of the advantages of being on the Board is that you find out what is going on, which otherwise you might not find out, as an Administrator, and that is critical, both from the point of view of our own risk management and our ability to ensure that, ultimately, shareholders are treated correctly.
I should stress here that these represent extreme cases and I would not expect one fund in a hundred to suffer these sort of problems. However, most funds, at some time in their life, have an issue where a proactive Board of Directors is useful and having a representative of the Administrator on that Board is also very useful.
We then recommend that there should be at least a third Director and that all three Directors should be resident, for tax purposes, in different jurisdictions, so that it cannot be claimed that the Directors, resident in any one of the jurisdictions, are managing and controlling the fund, which, certainly in the case of Ireland or the UK, could make it vulnerable to tax in that jurisdiction. There are other fairly straightforward rules that Boards should follow but I wont go into this here.
Finally, with regard to the number of Directors, I would always recommend that there be an odd number of Directors so that you do not have a stalemate. That means, if you want more than three, you go for five rather than four. I prefer this to giving the Chairman a casting vote, unless the Chairman is independent.
As I say, the fund should hold regular Board Meetings, which means at least three each year, but preferably four, or one per quarter. Board Meetings are relatively costly, so where and when they are held somewhat depends upon the size of the fund. A fund of US$200 million or more should hold at least two, but preferably three, face-to-face Board Meetings per annum and one or, if necessary, two telephone Board Meetings. All of those meetings should be held in, or originate in, a neutral territory, and preferably one should be held in the jurisdiction where the fund is domiciled. AIMA has produced a very good guide for Directors of offshore funds, which is an excellent must-read document.
Obviously, it is important to appoint good quality and financially stable service providers, as after the Investment Manager, it is these entities that investors will be most concerned with.
Ironically, in the context of administrators, we have found, at Custom House, that the attitude to administrators has changed with some investors. Recently, the Equity Fund Services division of Equity Trust merged into Custom House, which took us up to above US$40 billion assets under administration, which is an acceptable size for many institutions. Nevertheless, as a private company, not associated with a major financial institution, we always had the counterparty risk bridge to cross. Recently, we have found that many managers and, indeed, investors look upon Custom House more favourably than they used to, just because we are not associated with a major financial institution or bank and, therefore, not vulnerable to the collapse of that bank. Of course, all this will be discovered by investors and, hopefully, the manager when carrying out their proper due diligence.
And so what about due diligence It is important, when you set up a fund, that the manager, and indeed the investors, carry out in depth due diligence on the service providers. When I was Deputy Chairman of AIMA, we regularly updated the Due Diligence Questionnaires, which were started many years ago and have produced Due Diligence Questionnaires relating to Administrators, Prime Brokers and Custodians, as well as CTAs and Investment Managers.
These Questionnaires are, in my opinion, an elimination tool rather than a selection tool. By that, I mean that if you get all prospective administrators to complete the Questionnaire, or supply you with their own for example, we have a completed Due Diligence Questionnaire based on the AIMA model then you can review them and should be able to decide which are worth further investigation and which should be eliminated immediately.
At that point, you should commence a program of really in depth due diligence, which means visiting the offices, taking out references, reviewing systems, checking status with regulators, if any, etc. etc. This due diligence is very important, not only to make sure you are getting a good service provider, but also to be able to demonstrate that you have acted prudently, should there be any problems in the future.
Another area that has become more important in the last few years has been the introduction of a Pricing Policy. It used to be the case that a very vague description of how prices of the underlying assets of the fund would be valued, was inserted into the Offering Memorandum. As the problems with pricing complex derivatives have grown, so has the requirement to have a much more detailed functional Pricing Policy. We now recommend that this should be an agreement between the Investment Manager and the Administrator, which is approved by the Board and would be one of the material contracts. This will outline the types of securities that the fund will invest in and how those securities will be valued.
Moving on to the donts
Dont think that the worst cannot happen. You should provide for every contingency and ideally, as we have recently experienced, that should include contingencies that we have, in the past, been told could never possibly happen and ideally, even those that you cannot imagine.
Of course, that is a ridiculous suggestion, however I would counsel all people setting up a fund to ensure that, in the Offering Memorandum and the Memorandum and Articles of Association, or Statutory Documentation for the fund company, the Board is permitted to implement certain programmes - Disaster Recovery Plans - if you like, such as, inter alia, gates, side-pockets, suspension of redemptions and payment of redemptions in specie.
Today, none of these suggestions are particularly unusual, but there are many funds out there that have had to spend a lot of money on legal advice, to find out how they can implement some of these requirements without infringing on shareholders rights. It is an unfortunate fact that, when times are hard, many investors automatically believe that managers are trying to take advantage of them and tend to vote against propositions that, in fact, can be in their best interest, such as, for example, side-pockets. This can be avoided if the provision to create side pockets is included in the OM on day one.
This we have found to be particularly important with regard to Funds of Funds, whose portfolios have included several funds that have, themselves, suspended redemptions. This can only be handled fairly by introducing a side-pocket to hold those illiquid assets.
You dont need me to tell you that, if it is not possible to side-pocket the illiquid portion of a portfolio then, when redemptions are paid, the monies can only be taken out of the more liquid assets, and that results in an unbalanced portfolio for the remaining shareholders. This is obviously unfair and unreasonable, but without a side-pocket, there is very little that can be done.
Another thought it is arguable that the inability to liquidate an asset at any price or even at a price which is more than, say, 25% or 50% below the market price is a form of Force Majeur. Perhaps this term could be defined more clearly in the offering memorandum and specifically in the context of the funds valuation policy, et ergo the redemption/side pocket policy.
This leads on to a comment on the basic strategy of some Funds of Funds, where there is a potential for a liquidity mismatch between the dealing frequency permitted for the Fund of Funds itself, and the dealing frequency of the underlying funds in which it has invested.
There has been a tendency for managers of Funds of Funds to insist on monthly liquidity, for marketing reasons it is easier to sell a monthly liquidity fund than a quarterly liquidity fund. Nevertheless, that manager will not follow the same investment principles and will, quite often, invest money in quarterly liquidity funds, or sometimes funds with even less frequent liquidity. This has, for years, caused little or no problem but, when there is a severe downturn in the market, combined with a liquidity squeeze, such a mismatch can cause its own liquidity problems which, in turn, leads to suspensions, side pockets, settlement, etc.
The other thing that has become a standard practice, which I, personally, feel is questionable, is the ability for investors in Funds of Funds, which have long notice periods, to issue redemption notices on a rolling basis. By that, I mean that they issue a redemption notice in January, for the end of March dealing date, and another one in February and another one in March and then, when it comes to mid-March, they make a decision as to whether they wish to get out or not, and that will depend on the market. If the market is looking good and the fund has gone up, then they may cancel their redemption notice for March and issue another one for June, and so on.
This is, obviously, a very prudent way to manage the portfolio for the investor, but it is disruptive for the Fund of Funds, and for the underlying investors in those Funds of Funds, because the manager of the fund often has to liquidate a part of the portfolio ahead of the redemption notice being cancelled and, as a result, once again, the portfolio is mismatched. Indeed, in some cases, the fund may have a surplus of un-invested cash, which dilutes the performance.
I have to say, I have never persuaded anyone to do this, but my own suggested solution would be to charge a cancellation fee, for investors that make a practice of this. For example, they may issue a redemption notice and cancel it once, but if they do it again, they are charged a meaningful Early Redemption Fee, which is paid into the Fund to compensate for any disruption that may have been caused.
Finally, on the donts, I would stress that you should not set up a fund, unless you are comfortable that you will have sufficient assets or subscriptions to enable the fund to operate economically. The basic cost of operating an offshore fund is at least US$100,000 a year. This makes the establishment of a US$1 million fund absolutely impractical indeed, the costs are pretty penal for anything below US$10 million a year.
Most service providers that take on smaller funds will consider an initial discount, subject to certain terms. These could be a limitation on the amount of time a discount will be offered and a requirement that the fund remain with the service provider for a minimum period of, say, three years.
Nevertheless, many new money managers come to the market with money from Aunt Ethel, Cousin Joshua and a couple of people from their last prop desk and manage to get together, with their own capital, say, US$3 million. This is still not sufficient, because the annual operating cost will be, approximately, 3% per annum which, unless you are making a huge return, is likely to be crippling. We recommend, in these cases, that, as the manager is invariably endeavouring to establish a track record before going out to raise third party capital, they should establish a trading company in which the friends and family can purchase shares. That company will not need a full Administrator and the maintenance of books and records will be a fairly simple function. The main cost will be the Auditor, but certainly overall costs could be reduced to something below US$20,000.
Once the manager has established a track record and feels comfortable that he can go out and sell the product, then we recommend that he push the button on setting up the fund which, once established and funded, will then acquire the trading company from the existing shareholder, in exchange for shares in the fund at the current NAV per share.
This not only makes the transaction relatively simple, but transfers the track record quite legally and honourably up to the fund.
Another alternative might be to take up the red herring option. This means that an Offering Document will be written, but the fund company will not be formed. That document will be circulated to prospective investors and, once sufficient investors have signed up to the concept, the button is pushed and the fund created in a couple of weeks.
There is nothing so debilitating as failing to raise money and having to jog along on negligible revenues and, inevitably, inhibited performance. This, you should avoid.
Those are some of my thoughts on dos and donts when setting up a hedge fund or a Fund of Funds. If anybody has got any questions or comments, I would be happy to try and answer them.
Wed 12.Nov