23 Dec 2010, Bill Henderson, Butterfield Fulcrum, Hedge Funds Review
When setting up a hedge fund, the fund manager must first consider who and where the prospective investors will be and then choose the appropriate structure to accommodate them. There is a multitude of structuring and domiciliation options available to a hedge fund looking to raise capital from international or offshore investors. For example, a fund aiming to attract investment from within the European Union (EU) may be established as a Ucits fund in Ireland or Luxembourg, while a vehicle targeting Japanese investors could be formed as a unit trust in the Cayman Islands.
But for many hedge fund managers, the first stop on the fund-raising journey will be the US. Ever since the formation of the first hedge fund in the US in 1949, American investors have demonstrated an appetite for the ‘higher risk/higher reward’ ethos of alternative investment strategies and have been instrumental in the rapid evolution of the asset class.
Today, there is an enormous pool of onshore capital available for investment into hedge funds. Wealthy individuals, family offices, pensions, universities, charities and endowments in the US have been steadily increasing their allocations to hedge funds over the past two decades. This trend shows no sign of abating. In order to tap into this sizeable investor base, the hedge fund manager will need to open a domestic US fund vehicle.
Most US hedge funds are structured as either limited partnerships (LPs) or limited liability companies (LLCs). Both of these structures facilitate investment by US persons and limit each investor’s financial liability for the debts of the fund to the value of his/her investment.
LPs and LLCs are also effective from a US tax perspective, since they allow a fund to pass on income, capital gains and expenses to its investors with full tax transparency, in accordance with the Internal Revenue Service’s (IRS) rules.
Hedge fund managers, whether they sit in New York, London or Hong Kong, are likely to establish a US-based LP or LLC as a means to access domestic investor capital. The fund may be a stand-alone trading fund or it may be part of a multi-entity structure such as a master-feeder vehicle that combines US investors’ money received through an onshore feeder fund, with capital from non-US and US tax-exempt investors received through an offshore feeder fund in a master fund which is the main trading vehicle.
With the formation of the fund in whatever form or structure, then comes the consideration of service providers. The right service providers can provide invaluable support to a manager who is launching a new investment product in today’s complex and dynamic hedge fund world.
Virtually all funds engage a law firm to co-ordinate the legal set-up of the entity and to draft the organisational documents. Most funds will also hire an audit firm whose responsibility will be to review the financial statements of the fund on a regular (usually annual) basis and give assurance to investors that those financials are accurate, complete and fairly presented. Legal and audit services have long been viewed as specialized functions that can only be provided by third parties.
When it comes to employing someone to calculate a US fund’s net asset value (NAV) and communicate with/report to investors, some managers do not feel the need to appoint an external service provider. While funds set up in offshore jurisdictions are required by their local regulators to engage an independent administrator to keep the official books and records, there is no such requirement for US-domiciled funds. They can be administered by their own investment manager/general partner/managing member.
Self-administration was historically the norm for US managers running onshore hedge funds. From the 1950s to the 1980s, when the alternative fund administration profession was in its infancy, managers had no choice but to build and maintain their own back office, hiring the necessary personnel to fulfil bookkeeping duties, maintain the investor registry, perform various processing, reconciliation and valuation tasks, and prepare and issue investor statements. There were perceived advantages to self-administration. Chief among them was that the manager had a greater degree of control over the core processes in the back office, especially with regards to investor relations.
Investors felt comfortable dealing directly with the manager and generally had no issues with the lack of independence between the trading unit that generated the fund’s performance and the administration unit that reported it.
As the number of hedge funds and the sophistication of their investment styles increased, so too did the complexity of the back office activities required to support them. Strategies such as capital structure arbitrage, event driven and distressed debt, which require constant monitoring and focused investment management, needed to be reinforced by robust administrative capabilities coupled with effective technology.
Operational workflows in the areas of reconciliation and fund-level accounting became more onerous with the addition of side pockets for illiquid investments, more complicated incentive fee arrangements, and the movement from a single prime broker trading environment to one involving multiple primes as well as over the counter (OTC) counterparties.
Over time, some managers who were not willing or able to build these capabilities or invest in the required infrastructure began to realize that outsourcing the back office functions to a fund administrator was a viable option.
Since the 1990s administrators have evolved from basic bookkeepers to become experts in complex fund accounting and valuation, registrar and transfer agency, investor relations and corporate governance. They have invested heavily in technology and people to support their businesses.
An administrator and an investment manager should view each other as partners. In essence the administrator is truly an extension of its client’s middle and back office. Appointing an independent administrator allows the manager to focus on its primary objective – generating positive returns.
The self-administration model is still being used by some managers of US hedge funds, primarily for funds that have been in existence for many years and are closed to new investors. The vast majority of US funds now engage a third-party administrator either on a fully outsourced basis or to run parallel with the manager’s internal back office. In either case the administrator produces the official books and records. There are several factors driving this flight to independent administration for onshore funds.
One key dynamic is the increased influence of the investor over the manager’s activities. After several high profile hedge fund fraud cases that resulted in the loss of billions of dollars, the uproar from the investor community led to changes in industry best practices. One such development was that alternative investment managers should hire a reputable administrator to provide core back office services like calculating the NAV and holding an independent set of books and records.
The concept of self-administration has fallen swiftly out of favour. Nowadays, before allocating money to any hedge fund or fund-of-funds, an investor will often do a detailed review of the manager’s operational infrastructure including the administration provider and may even perform a site visit to the administrator’s office to evaluate its capabilities.
If the investor is not confident that the manager will preserve investors’ capital and satisfy fiduciary obligations in line with industry best practices, then their investment dollars will be withheld or directed elsewhere.
Regulatory developments are also forcing a trend away from self-administration for US managers. In 2004-05, the Securities and Exchange Commission (SEC) proposed that all hedge fund managers should become registered investment advisors, making them subject to regular inspection and examination by the SEC, requiring them to disclose information on their operations, valuation techniques and risk management procedures regularly. The rule did not pass but was an indication of where the industry was headed. There are and will continue to be similar proposed regulation and legislation aimed at enforcing stricter oversight.
Managers can prepare themselves by adopting an attitude that self-regulation – including the use of robust and transparent administrative procedures – is the best way to remain beyond reproach. To achieve this goal onshore fund administration should not be handled by the manager’s own back office but by an outsourced administrator.
Managers of US funds should seek an administrator with a long history of servicing alternative investments as well as a skilled, dedicated staff with the expertise and knowledge to support the requirements of funds utilising various strategies.
A good administrator will also be able to leverage its technology to deliver customised service solutions to the client on any desired frequency.