The Administration And Structure Of Hedge Funds

?Good morning Ladies and Gentlemen, I have been asked to talk on the broad subject of:  ?The Administration and Structure of Hedge Funds? and to break the presentation down into five, very specific, sub-topics, as outlined in your programme. 

 

Frankly, each one of these topics could take all the time that I have been allocated to speak to you ? so please forgive me if this presentation is more of a brief introduction to each of the subjects, rather than an in-depth discussion.  The first topic is:

 

?Acting as an Administrator of Funds Using Hedge Fund Strategies?

 

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 retail investment funds such as Mutual Funds, Unit Trusts, UCITS and Sicavs.)  In fact, there are some very definite differences, which substantially affect the Administrator?s task.

 

First of all, for the most part, 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 esoteric instruments, including derivatives, the valuation of which can sometimes present problems.  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 ? specifically prohibit short sales, and, of course, where there are short sales, there will be financing arrangements with the Prime Broker that have to be accounted for and administered.

 

Thirdly, Traditional Funds will usually, by their very nature, have many smaller shareholders than a Hedge Fund, which requires the Administrator of Traditional Funds to maintain a very much larger and very efficient shareholder register system.  On the other hand, Hedge Funds are generally targeted at the sophisticated high net worth, professional, or intuitional investor with minimum investments of anything from US$100,000 to US$10 million ? although the majority of larger Hedge Funds have minimums of between a quarter of a million and a million dollars.  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?.  Whereas I think it is equally fair to say that the structure of Hedge Funds can vary from fund to fund in quite a fundamental way, particularly with regard to management and incentive fees.

 

For instance, a Hedge Fund Manager?s management fees can be charged in advance on the basis of the NAV (Net Asset Value) at the beginning of the month, or in arrears, at the end of the month. But it is much more complicated with incentive fees: are they paid monthly, quarterly, half yearly, or annually?;  are they calculated on the gross profit, before charging other fees and expenses, or on the profit, net of all other expenses?;  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 was 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 it would be an accounting nightmare and there is a basic legal requirement to treat all shareholders the same.  Therefore, these rebates are paid by the Investment Manager out of the Investment Manager?s fees, as a special arrangement between the Investment Manager and the investor.  And, of course, such rebates are quite likely to vary between investors.  Needless to say, it is the Administrator who is required to calculate those rebates and often pay them, by way of issuing new shares, which are funded by the reimbursement of the fees payable by the fund to the Investment Manager.

One other difference between Traditional Funds and offshore Hedge Funds, with regard to management and incentive fees, is the requirement that many American Hedge Fund Managers want to defer payment of their management fees, for tax planning purposes.  This involves the Administrator in calculating 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.

 

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 don?t, I will explain briefly. ?Equalisation?, in simple terms, is 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 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 below): Let us assume that a fund starts trading at US$100 per share and we have an initial investor 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, which 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 comes in and buys one share at US$100.00.

 

Without Equalisation the Investment Manager would not be able to charge any new incentive fees until the NAV per share had risen back up to US$110.  And if that happens, the second investor gets a ?Free Ride? of US$10 per share, before paying any incentive fee on that profit.  Equalisation eliminates this.

 

Table 1:                                                                 THE ?FREE RIDE?
i)	Investor One buys one Share at US$100, at launch.
ii)	End of first quarter gross NAV per Share has risen to US$110.
iii)	NAV per Share published at US$108 ? (US$110 ? US$2) i.e. net of 20% incentive fee paid on US$10 profit.
iv)	New High Watermark ? US$110.
v)	At the end of the following month, the NAV per Share has dropped back to US$100.
vi)	Investor Two buys one Share at US$100.
vii)	NAV per Share will have to rise above US$110 before the Manager can charge any more incentive fees.
viii)	If that happens, Investor Two will have a ?Free Ride? on his profits from US$100 to US$110.

 

I should 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.  (This is shown in the example in Table II).                                              

 

Table II:                           INEQUITABLE INCENTIVE FEES IN A RISING MARKET
1.	Again, assume Investor One buys one Share at US$100.
2.	Assume the market rises in the second month to US$110 NAV per Share.
3.	NAV per Share published at US$108, net of 20% incentive fee accrual.
4.	Investor Two buys one Share at US$108.
5.	Let us now assume that at quarter-end, the gross NAV per Share has risen to US$120.
6.	Gross profit in US$32 based on the following: a) Investor One invested                                US$100 b) Investor Two invested                               US$108     Total invested                                             US$208 c) Gross NAV at end Qt:                                US$240     Gross profit                                                 US$ 32
7.	Incentive fee at 20% of US$32 = US$6.4, or US$3.2 per Share (only two Shares in issue)
8.	NAV per Share = (US$240 ? US$6.4) ? 2 = US$116.8 per Share
9.	Therefore: a) Investor One effectively pays US$3.2 incentive fee on a profit of US$20, which equals 16.4% of the profit                         made by Investor One; whereas,                  b)Investor Two effectively pays US$3.2 incentive fee on a profit of US$12, which equals 26.66% of the profit                       made by Investor Two.

 

The Equalisation process is one where each investor (or group of investors who invest at the same time) are individually assessed for their own incentive fee liability and charged accordingly and eliminates these two anomalies.  There are, basically, two commonly used methods:

 

(i) Firstly, 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.  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.  The major disadvantage of the series methodology is that it is not possible to

     publish one NAV per share because here may be many different series of shares outstanding.  This causes problems with

     reporting performance.  The major advantage is that it is relatively simple to explain to investors.

 

(ii) 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.  This is a very complex process and the

      main disadvantage is that it is, in fact, very investor unfriendly and administratively complicated, but it is essential with

      funds that issue shares or units.  Conversely, the advantage of ?The Equalisation Method? is that you can publish one

      NAV per share for all investors. 

 

By the way equalisation does not present any problem in the US where almost all, if not all, funds are, in fact, partnerships and, therefore, use capital accounting.  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 I haven?t got the time but I hope I have made two things clear: Firstly, 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.  The second point that I hope I have made clear is 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.

 

The second topic today is ?Assisting in the Organisation of Customised Offshore Funds?.

 

Believe it or not, some Administrators appear to take no interest in the organisation of their client?s funds, until the fund has been established and the final offering document has been handed to them.  They then take on the administration on the basis of that document and proceed from there.  I think that is, at best, irresponsible and, frankly, potentially dangerous.  However, other Administrators get very much more involved in the structure of the fund from the beginning.  Indeed, some, including my own company, have legal set-up departments, which specialise in helping new Hedge Fund Managers establish their own customized offshore funds. 

 

There are three points I always make to new Hedge Fund Managers when deciding who is going to help them set up their fund.  These are that, whoever they decide to retain to set up their fund, whether it is a consultant, an administrator or their attorney, they must: firstly, check out what other funds the consultant, administrator, or attorney have set up and speak to those fund managers; secondly, get a firm quotation; and thirdly, only appoint one advisor. 

 

If one of our clients appoints an attorney to set up their fund, we always try to stand aside and, in effect, decline to act in the setting up process, because two advisers on the same project inevitably leads to conflict, let alone additional unnecessary expense.  And  frankly, if an attorney has been appointed, we are unlikely to add much value.  We are, of course, quite happy if we can secure the administration contract.  But even if the Administrator is not directly involved in setting up the fund, I still believe that the Administrator should review the offering document and have some input, not only with regard to any statements about the Administrator itself and the service it will provide, but also, the Administrator should review the whole document, particularly, with regard to the sections relating to the valuation of the assets and the calculation of the NAV.

 

For some funds with illiquid, or potentially illiquid, investments, or very esoteric derivative products, the valuation of the assets can be extremely difficult.  and it is not just that the method may be difficult, there may be two or three very different valuation methods to choose from.  I believe it is essential that the method of valuation to be used is clarified between the Administrator and the Hedge Fund Manager at the outset and is clearly explained in the Offering Memorandum.  Also, if there is any room for dispute, it must be approved by the Auditor before the fund starts trading.  Can you imagine the chaos, let alone the cost that could be involved in revaluing the monthly NAV of a fund after a year?s trading, because the Auditor decided not to approve the agreed valuation method used from day one?  And it is not only the method, but the risks involved in some esoteric valuations that should be fully explained in the offering memorandum and some alternatives included, in case of a dramatic change in circumstances.

 

I was on the board of a Russian fund (as an Independent Director ? not involved in the Administration) that was hit by the Rouble collapse and suffering the extraordinary spreads that appeared on the markets for what had been previously reasonably liquid shares.  We had one holding that was quoted US$11 bid, US$23 offered.  The offering memorandum specified that the portfolio was to be valued at the mid-price which, in this case, would have been US$17 per share. 

 

This was all very well for notional valuation purposes, but patently unfair as a trading price, because both new investors and redeeming shareholders would benefit at the expense of other existing shareholders.  This is because investors would be buying into the fund at a price that was very much below the actual cost of buying the additional shares necessary to maintain the portfolio weightings, and accommodate the new subscriptions and redeemers would be selling their shares at a price that was very much higher than the actual liquidation value of their portion of the funds? portfolio.  And both of these would be at the expense of existing shareholders.

 

As the ?spread? syndrome was symptomatic of the whole portfolio and, indeed, the whole market, we - that is the Board - in agreement with the Administrator, the Investment Manager and the Auditor, decided to suspend both dealing in the shares and the calculation of the NAV, until some stability returned to the market.  I believe that the possibility that such circumstance might occur and such decisions might have to be made should be specified in the Offering Memorandum under ?Risk Factors?.

 

The third topic is: -  ?What Type of Structure Should You Choose?.

 

In this case, I have assumed that ?structure? includes, not only the corporate entity, but also the jurisdiction.  Frankly, this could be the largest part of my presentation, but I am not going to develop this topic very far today, because the question itself begs so many other questions that have to be answered before you can give a definitive reply ? such as: what is the targeted market?; who are the investors going to be?; will there be any US investors?; What is the investment strategy?; what is the Manager?s experience in managing third party money?

 

The list is almost endless and although the answers won?t necessarily change the fundamental structure, they may well influence the choice of jurisdiction and affect the detail of the structure.  In fact, we ask potential fund managers to complete a questionnaire, which has around 125 questions, before we recommend a specific structure or jurisdiction.  However, having said that, in broad terms, I think it is fair to say that many offshore funds are structured as limited liability investment companies, often with different classes of shares that provide the flexibility to add additional sub-funds at a later date, in order to create an Umbrella Fund type of structure.  But even then you have to consider: whether it is going to be a Closed-End Fund, or a Guaranteed Fund?; or whether it is going to be listed on any exchange? 

 

You can see that, to do justice to this topic, I would have to pose each question to you today and explain how the structure might differ, depending on each answer and we just don?t have the time.

 

The fourth topic is: - ?Technology and the Administrator?.

 

Where do I start, other than to say that it is obviously very important and is becoming more and more important day by day?  I should explain that my own expertise on the subject of technology is less than negligible, but I can tell you what we, as a company, decided to do. 

 

Two years ago, we decided that we needed a very efficient system in order to improve productivity.  This was because we could see, looming on the horizon, the staffing problems that have hit our industry - and by the way this is an international problem, not just Ireland.  We decided that we need a system that would go a long way towards eliminating the drudgery of Administration, and increase efficiency and as a result increase productivity.  So we spent a lot of time, money and human resources in identifying a new system and we now believe we have the ?State of the Art? Hedge Fund administration system.  We are now in the process of transferring all of the funds and sub-funds that we administer, which is close to 175, on to that system and I can assure you that is a major logistical task. 

 

You can imagine that we looked at a lot of systems - But how did we make the choice?  And what have we chosen?

The system that we have taken on, which is called PFS-PAXUS, has been designed by an independent software house, ?Pacific Fund Systems?.  One of the main attractions for us was that the designer had industry experience.  He was not a programmer sitting in an ivory tower who knew nothing about Hedge Funds.  This fellow had previously tried to find an Administrator to act for a substantial US$2 Billion Fund of Funds.  He visited 17 Administration offices (not ours by the way!) and had come to the conclusion that there was nothing out there: no system that did the job properly.  So, two years ago, he decided to design one himself.  Serendipitously we met and agreed to provide our expertise, as an Administrator, and to help in the development with our ?wish list? and by carrying out the Alpha and Beta testing.  This we have done over the past eighteen months and, as I say, we now have what we believe is a ?State of the Art? system.  But, of course, that might not mean much.  We all know that a week is a long time in politics and is certainly that maxim applies to software technology.

 

You may think that I am promoting PFS-PAXUS and, I suppose, I am because I do not know of any other administration system available that does the same job.  But I would like to make it absolutely clear that neither I, nor Custom House, have any financial interest in Pacific Fund Systems or PFS-PAXUS.  Why do I believe this is the best system available today?

 

The main advantage that the new system has over our previous system (and any other administration system that we have seen) is that it is a fully integrated and a fully automatic system.  Why is that important?

 

The problem that most, if not all, hedge fund administrators face today is that their administration systems are not fully integrated systems ? they are, what you might describe as ?MWed 18.Oct