Administering assets

While hedge fund reporting is a difficult task in and of itself, funds of hedge funds add another layer of complexity to the process again

While funds of hedge funds have proved a helpful conduit to investor inflows, they can produce some headaches for unprepared fund administrators.

Funds of hedge funds (FoHFs) have been a booming region in the industry, not only stand-alone FoHFs, but also in the form of managed account platforms - Lyxor, PlusFunds, HFR spring to mind - allowing managers to select platform managers, or buy into them via ready-made investable indices.

However, such platforms impose heavy burdens on administrators - daily NAVs for the daily liquidity. Beyond the platform, says Gary Enos, executive vice-president and head of alternative investment services for State Street Corporation, ever-quicker provision of more frequent NAVs is demanded.

When State Street first entered hedge fund administration, Enos says, monthly liquidity was the standard in terms of redemptions and, therefore, also in terms of valuations administrators needed to produce.

Those days, however, are over.

"You're getting towards weekly valuations and I would say five to 10 business days turnaround of the past (for an NAV) is probably more like three to five days now. The investors are clamouring for transparency."

With platforms such as Lyxor and PlusFunds offering weekly or even daily liquidity via managed accounts, the pressure on their administrators for a daily value is great. T+5, now T+1 for a valuation, is effectively becoming T+0.

"The FoHF managers are having more pressure put on them, but with the extent to which they're in illiquid strategies, such as distressed, it can still take a while to get pricing for them." For less liquid strategies, administrators may use third-party pricing as well as in-house models, and Enos says distressed debt as a strategy may represent around 5%-8% of the funds to whom State Street administers.

He notes it is not only the distressed debt strategy that sometimes makes valuations tricky, although this strategy may catch the media's eye most often when hard-to-value investments come up. "You can also have thinly traded securities in company reorganisations, and when someone is covering them with interest rate swaps, it can get pretty complicated in a hurry," Enos says.

Any potential problem could be further complicated by some hedge funds' moves into private equity - not necessarily a pure alpha strategy, but one that can generate some handy returns. In this strategy, an investment is entered into for many years, with no necessary revaluation for portfolio NAV purposes until, in the case of closed-ended private equity funds, the deal is exited.

Timothy Spangler, a partner at lawyers Berwin Leighton Paisner, notes in A Practitioner's Guide to Alternative Investment Funds, that keeping such investments at book value for NAV purposes is a "very conservative opinion," and "without the proactivity of mark-to-market, funds are left with a naïve presentation of asset values at cost."

FOHF DEMANDS

David Aldrich, head of securities industry banking at the Bank of New York, notes the demanding FoHF community can produce some labour-intensive work for administrators asked for ever-more frequent reports.

"There is a perception that administration for FoHFs is easy compared to hedge funds," he says, "whereas the reality is that the processing of the investments for FoHFs is a complex and manual process."

"Net asset value (NAV) calculations (for FoHFs) are relatively easy, but with long and often inaccurate settlement periods the job can be labour intensive. It takes a significant capital investment to build the data warehouse and internet web tools to automate the process."

(On the IT front, Tony Swei, managing director of hedge fund IT firm Tradar, says the hedge fund industry is becoming ever more demanding on how reporting is conducted by IT packages as well, not just for assessing portfolio values, but also for measuring and monitoring FoHF portfolio risks. Investors are seeking to aggregate data across their various hedge fund holdings, he says, to assess their risk exposure to sectors or asset classes or to given events occurring.)

cherry-picking

Aldrich notes hedge fund administration reporting is becoming more prime broker-like as funds increasingly demand more for their money, and at the same time increased competition among hedge funds allows investors in them to cherry-pick the most transparent or competitive on offer. This, in turn, puts the pressure on administrators to provide the best service possible.

However once hedge funds find a good administrator, the relationship can be long-standing, he notes. He says funds do not change their administrator lightly, and the reason if ever they do normally comes down to one of three points: their shareholder servicing is inadequate, their technology is deficient, or there is a lack of documented controls, which can give rise to a loss in confidence in the NAV process.

key points

Investors are applying ever more pressure on hedge funds and fund of hedge funds to produce net asset values more often and more rapidly.

While strategies such as distressed debt may be most difficult to price quickly, other complex trade structures with more straightforward instruments can also cause problems.

Increased competition among hedge funds allows investors in them to cherry-pick the most transparent or competitive on offer.