Part 2
Regulation and Fund Structures
Abstract
This part starts by looking at the regulation of funds and covers the types of fund structure, which includes examining retail and alternative investment funds. Fund jurisdictions are looked at along with the key players before finally moving on to look at the fund set-ups, outsourcing, and agreements.
Keywords
fund regulation
investment funds
federal regulation
legislation
financial markets
In this part, we will consider the regulatory environment that some investment funds will fall under. Not all funds are regulated although they may need to be registered with a regulator in the jurisdiction.
The amount of change that has taken place in the regulation of funds has been a massive challenge, and a significant cost, to both promoters and administrators as well as custodians and depositaries.
Overview of regulation
Each country will have its regulatory authority or authorities that will have the responsibility for authorizing and monitoring participants, their activities, and their relationships with customers and other parties. For example, in the UK the regulatory authorities are the Financial Conduct Authority (FCA) and the Prudential Regulatory Authority (PRA). In the United States we have the Securities Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).
In the Far East we have the Monetary Authority of Singapore (MAS), in Japan we have the Financial Services Agency (FSA) and the Securities and Exchange Surveillance Commission (SESC), in Hong Kong we have the Hong Kong Monetary Authority (HKMA), and in Australia we have the Australian Securities and Investment Commission (ASIC). (Appendix 4) (http://asic.gov.au/).
In China the regulator is China Securities Regulatory Commission (CSRC). (Appendix 7)
There has been significant legislation enacted in both Europe and the United States in the years, since the market crash of 2008.
Some of the regulation is aimed at the financial markets in general and some is specific to investment and investment funds.
Regulation and directives
In the United States, a key piece of legislation introduced post 2008 was the Dodd–Frank act.
Investopedia defines the Act as:
“--a compendium of federal regulations, primarily affecting financial institutions and their customers, which the Obama administration passed in 2010 in an attempt to prevent the recurrence of events that caused the 2008 financial crisis” (http://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp).
The Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly referred to as simply “Dodd-Frank,” is designed to lower risk in various parts of the US financial system including the investment industry. It is named after US Senator Christopher J. Dodd and US Representative Barney Frank because of their significant involvement in the formulation and passage of the act.
A key part of the Act is the Volcker Rule, which restricts the ways banks can invest and regulates trading in the derivatives.
In Europe, post the crash the regulatory landscape changed as within the EU, the European Securities Market Association (ESMA) was created to oversee the European Market Infrastructure Regulation (EMIR).
A key piece of new legislation introduced in Europe was the Alternative Investment Managers Directive (AIFMD), which sets out the regulation that will be applicable to the managers of alternative investment funds (AIFs) (Appendix 6).
AIFMD and AIFMs
The following is a brief explanation of AIFs and the Alternative Investment Fund Manager (AIFMs).
The scope of the AIFMD is broad and, with a few exceptions, covers the management, administration, and marketing of AIFs. Its focus is on regulating the AIFM rather than the AIF.
The following gives the FCA definition of some of the meanings:
An AIF is a “collective investment undertaking” that is not subject to the UCITS regime, and includes hedge funds, private equity funds, retail investment funds, investment companies, and real estate funds, among others. The AIFMD establishes an EU-wide harmonized framework for monitoring and supervising risks posed by AIFMs and the AIFs they manage, and for strengthening the internal market in alternative funds. The Directive also includes new requirements for firms acting as a depositary for an AIF.
Some of the main changes are that:
• A number of fund managers in the UK hold a permission to manage investments. It is likely that some of these firms, dependent on business models, needed to be reauthorized under the AIFMD to operate as AIF managers. These included:
• MiFID firms carrying out portfolio management and/or risk management for EEA funds that are not UCITS funds or funds located offshore in third-country jurisdictions, such as the United States and Cayman Islands; and
• Operators of collective investment schemes that are not UCITS funds carrying out portfolio management and/or risk management inhouse.
• The AIFMD meant certain fund managers are being regulated for the first time. For example, investment companies that do not employ an external manager will need to be authorized or registered with the FCA under the AIFMD.
• Depositaries of AIFs have to comply with new requirements.
• The AIFMD brought in significant changes to the management/administration of AIFs in the EU and introduced new EU-wide passports for authorized full-scope AIFMs to market and manage AIFs from 22 July 2013.
• Marketing and management passports are not be available to non-EEA managers of AIFs or to EEA managers in respect of their non-EEA AIFs (this may be adopted from 2015 subject to ESMA reports and Commission delegated acts). Marketing of such funds to professional investors is allowed under national private placement (NPP) regimes. Note: It is envisaged that existing NPP regimes will be phased out after the non-EEA passport regime becomes operational, although not before 2018.
EEA Firms
• AIFM authorized in their EEA home Member State (“EEA AIFM”), are able to exercise management and marketing passport rights in the UK in relation to certain types of EEA AIF, on a services and/or establishment basis, from 22 July 2013 onward.
• In order to exercise these rights, the EEA AIFM’s home Member State competent authority will need to send the relevant notification forms, in accordance with the requirements of the AIFMD, to the Financial Conduct Authority, the UK’s competent authority for these purposes.
Retail funds
In Europe, retail funds are often established under the Undertaking for Collective Investments in Securities Directive (UCITS).
UCITS directive
Created as long ago as 1985, UCITS has become a global benchmark structure with popularity in the Far East and Latin America.
As a single market within the EU, UCITS allow asset managers to offer funds across the region after authorization from one of the Member States.
UCITS IV is now being superseded by UCITS V, however the new version is designed to enhance and supplement UCITS IV so that following the introduction of the AIFMD which gives greater protection to investors in AIFS, investors in UCITS funds will have a similar level of protection. For example, UCITS V aligns the rules governing asset managers’ remuneration and duties of depositaries with the corresponding provisions of AIFMD. It also strengthens the protection of UCITS investors in relation to asset managers and depositaries by focusing on three main areas. These are:
1. Rules governing remuneration of asset managers
2. The depositary’s eligibility, obligations, and liabilities
3. The sanctions regime
Other important changes cover areas such as the disclosure of information to UCITS investors and conditions for the appointment of a UCITS depositary.
In these and some other cases UCITS V rules exceed those within AIFMD, for example:
1. Specific independence requirements of the depositary from the asset manager.
2. Insolvency protection when the safekeeping has been delegated by the depositary.
The new directive was published in the Official Journal on 28 August 2014 and entered into application on 18 March 2016. Some aspects of UCITS V are dependent on information being published, for example, the Level 2 Text (due late 2015) and the ESMA recommendations on managers remuneration also due end 2015.
In the book, we will be referring many of the existing and new key UCITS requirements like diversification, salability, limited exposure to liabilities and illiquid assets as well as strategies that involve the borrowing of cash or assets and may be considered to have an unacceptable level of risk.
Money laundering
No fund wants their reputation tarnished by being found to be assisting money launderers. Antimoney laundering (AML) regulations exist in most jurisdictions and must be rigorously enforced and any suspicion reported to the relevant person. A regulated administrator may lose their authorization if they are found guilty of lax controls and non-implementing of AML processes and procedures.
Subscription and redemption applications via intermediaries are an issue as it must be clearly established that the AML checks have been done.
In the UK the Financial Conduct Authority states:
However some regulation and directives in the EU are causing issues with associations representing fund management.
For example, in an article published in Funds Europe, the investment management industry has called on Brussels to delay and change the updated Markets in Financial Instruments Directive (MiFID II), which is due to be implemented just over a year from now.
The European Fund and Asset Management Association (EFAMA), which represents national industry bodies, want a delay partly over fears the directive will be implemented unevenly between countries (http://www.funds-europe.com/home/news/16841-efama-calls-for-mifid-ii-delay).
Principles and recommendations
The regulators in many jurisdictions issue guidelines, principles, and recommendations, which funds must follow and which the administrator and custodians must be aware of.
For example, the Association of the Luxembourg Funds Industry (ALFI) published in 2013 an updated Code of Conduct for Luxembourg Funds.
ALFI stresses that these are “Principles” not Rules and are designed to establish the best practice framework for Luxembourg funds and management companies, whether listed or unlisted.
Although we have talked about the regulation of UCITS and AIFs, it is important to remember that there is a great deal of commonality between the two.
For example, AIFMD and UCITS V are similar in the following:
• Remuneration policy—UCITS V introduces remuneration provisions that are similar to AIFMD.
• Conflicts of interest—UCITS V broadly consistent with AIFMD.
• Liquidity policy—UCITS V broadly consistent with AIFMD.
• Risk management policy—UCITS V broadly consistent with AIFMD.
• Authorization and delegation—UCITS V broadly consistent with AIFMD.
• Valuation policy—UCITS V contains no explicit requirement for a valuation policy, but it remains standard industry practice in some jurisdictions.
• Calculation of leverage—UCITS V broadly consistent with AIFMD.
• Calculation of AUM—Explicit AIFMD obligation but no equivalent in UCITS V.
• Minimum capital—UCITS V ongoing obligations broadly consistent with AIFMD.
• Regulatory report—New Annex IV requirement in AIFMD.
• Annual financial report—UCITS and AIFMD ongoing obligations broadly consistent.
• Disclosure to investors—Similarly to AIFMD, UCITS V requires disclosure to investors in relation to management remuneration and conflicts of interest.
• Depositary operations—A single depositary must be appointed for each UCITS and AIF (unless acting as depo-lite). AIFMs of non-EEA AIFs do not need to comply with AIFMD Article 21 (Depositaries). However, if a non-EEA AIF is marketed to European investors via “National Private Placement” rules, as opposed to reliance on passive marketing/reverse solicitation, an AIFM needs to comply with Article 36. This requires the AIFM to “ensure that one or more entities are appointed to carry out” the depositary duties of (1) safe custody; (2) cash flow monitoring; and (3) oversight. Strict liability does not apply. This has therefore been dubbed the “depositary lite” model. Source: http://www.thehedgefundjournal.com/node/8459#sthash.TnSUwiNh.dpuf.
• Asset safekeeping—Assets to be entrusted to the depositary for safekeeping, with new requirements on delegate and reuse of assets.
• Cash monitoring—Depositary must monitor cash flows and ensure cash booked to the correct account (delegation of oversight and cash).
• Investment compliance—UCITS V broadly consistent with AIFMD.
• Depositary oversight—UCITS V broadly consistent with AIFMD.
• Insolvency protection—New to UCITS V, assets held in custody are not available to general creditors on the insolvency of the depositary or its delegate if they are located in the EU.
• Location—A depositary must have its registered office or established in the home state of the UCITS.
• Discharge of liability—No option for depositary to discharge liability under UCITS V.
Source: Northern Trust—readers should access the Convergence Checklist at – https://www.northerntrust.coml
We can now look at different fund structures:
Fund Structures—Companies, Trusts, Partnerships, Common Funds
In the Introduction and Part 1, we looked at the possible structures we can find in funds. Let us now continue this. A general structure of a fund is shown in diagram 2.1.
The management company deals with the day-to-day process of the fund operation.
Investment management is done by managers and/or advisers in conjunction with investment management agreement, investment committee etc. and through brokers, the prime broker for securities, commodities and derivatives, agents for property, advisers/agents/directors of private equity firms for opportunities for PE funds etc.
The administrator manages the day-to-day processing of the activity of the fund and the custodian holds the assets and deals with settlement of the asset transaction (Diagram 2.1).
Diagram 2.1 (Source: The DSC Portfolio Ltd.)
There are many different types of funds and the way in which the fund is structured and operate will determine the work, the administrator and custodian will be involved in.
As we have already seen specific structures can apply to some funds.
Fund of funds
Fund of funds are a structure where the fund invests in the shares or units of other funds rather than in assets directly. The investment management process is to research and select the best performing funds in a sector and then to allocate the funds to the portfolio on the basis of the asset allocation (Diagram 2.2).
Diagram 2.2
As shown, the XYZ Equity Arbitrage Fund may be 10% of the total portfolio.
For the administrator the main issue is the valuation of the portfolio as they will be using the NAV of the funds in the portfolio rather than valuing assets.
Multimanager funds
Multimanager funds are structures where the investment management process is outsourced to other investment managers under a mandate or an agreement (Diagram 2.3).
Diagram 2.3
In the example, it is shown that Hermes will manage the property asset class and M & G the bond asset class. The administration could also be outsourced but if not, the administrator will receive details of the assets held by each manager and will then value the portfolio as well as reconciling to the custody accounts.
Other structures
Other structures include master/feeder funds where funds are set up to meet regulatory and investor requirements but all the subscription capital is then passed to (invested in) a master fund where the portfolio will be managed. Each feeder fund will have an administrator as will the master fund (Diagram 2.4).
Diagram 2.4
The structure of a fund like a master feeder can be used to manage the potential investor base. For example, as shown in the diagram, Fund A is set up under European regulation and Fund B is set up under US regulation. Fund A will have Euros as the base currency and Fund B will have US dollars as the base currency.
The fund promoter has created a structure that appeals to different investor domiciles but has an efficient single investment process.
Retail funds
We have already mentioned that retail funds is a generic term for funds that can be marketed and sold to a wide audience of investors who do not need to have any particular knowledge of finance or risks associated with investment.
We saw earlier in this part of the book that in the EU these funds are often UCITS compliant funds.
The main characteristics of retail funds are:
• Authorized and regulated.
• Open-ended to allow constant subscription and redemption.
• Promoters are usually Investment Management/Asset Management Companies.
• Designed to provide income or growth and some funds will have two classes of shares, one growth and one income.
• Established as either companies or unit trusts.
• Minimum subscription is usually 1 share or unit.
• Net Asset Value is calculated and published.
• Marketed and sold via third parties like financial advisers, banks etc.
• Mainly securities funds but some property funds like Real Estate Investment Trusts (REITs).
• Funds can focus investment on domestic or international assets (or both).
• Many are “passive” funds, that is, ETFs or benchmark/tracker funds.
• Most are long only funds.
Alternative Investment Funds
Although there are potentially many types of AIFs and the term alternative investments can mean nontraditional assets such as wine, antiques, vintage cars etc. However in many types of context AIFs means “nonretail” structures such as hedge funds, private equity and property funds.
We can look at some of the features of these funds here.
Private Equity (Often referred to as the “waterfall”)—drawdown capital, growth, and then distribution periods, fund has a projected life (5–10 years). Distribution pays off in order:
a. The initial capital of the investors.
b. The preference return to the investors.
c. The carried interest of the general partner.
d. Remaining return distributed across investors/general partner.
e. Fund is charged fees throughout the life of the fund so initially investors have a negative situation.
The basic structure of a private equity fund is shown in Diagrams 2.5 and 2.6:
Diagram 2.5
Diagram 2.6 (Source: The DSC Portfolio Ltd and Onestudy Training.)
Hedge funds
Hedge funds have their origins back in the 1950s, in the United States, there are many types of hedge funds including long-short funds but very wide range of hedge fund strategies including distressed stocks.
Widely considered as AIFs, hedge funds are also popular investment for other funds including some retail funds that are permitted to invest part of their portfolio in other funds.
Fund of hedge funds are often the vehicle for this type of investment.
Let us look at one of the common hedge fund strategies, long-short.
The basic concept is shown in (Diagram 2.7)
Diagram 2.7 (Source: The DSC Portfolio Ltd.)
We can see the idea is that by correctly selecting undervalued or strong performers and buying these assets and offsetting these by selling short, selling something we do not own, overvalued or weak performers, the portfolio should make gains irrespective of which way the market moves.
The following two diagrams show (Diagram 2.8):
Diagram 2.8
Here the undervalued/strong assets move ahead strongly if the market rises while the offsetting short positions rise less strongly. As we are short of these assets, the portfolio makes a loss but it will be offset by a much greater profit on the long position (Diagram 2.9).
Diagram 2.9
When the market falls the loss on the long position should be more than offset by the profit on the short sales, which have dropped sharply and the short position can now be bought back for a much lower cost and therefore large profit.
Whichever way the market moves, if the manager’s selections are right the profit will outweigh the losses.
For the administrator and custodian, the key issues in a long-short fund are the short sale of assets, which means the fund will need to borrow securities to enable the settlement of the transaction. The fund records will need to reflect the cost of borrowing these securities and the liability (borrowed shares will have to be returned) plus any collateral that is required by the prime broker or securities lender (see Part 3 of the book).
If the short position is being achieved through the use of derivatives like index futures, by exchange-traded funds, contracts for difference or other nondeliverable products, there will be no borrowing of assets involved.
Open Ended and Closed Funds
As we have already mentioned the open-ended fund is a structure that has variable capital and can therefore issue and cancel shares or units in the fund in response to supply and demand.
A closed fund on the other hand is a fund that has a fixed capital and issues a finite number of shares or units based on the fixed amount of capital.
Open-ended funds are common in retail funds because if you remember retail funds are usually required by the regulator to allow an investor to exit the fund at any time, however they are also found in AIFs like hedge funds and property funds, although there may be dealing periods rather than constant subscription and redemption associated with these funds.
The closed structure is common in funds like private equity and some property and hedge funds.
For the administrator the major difference is the amount of workflow for the transfer agent dealing with the subscriptions and redemptions (see Part 3 of the book).
Fund Jurisdictions
There are numerous jurisdictions that are home to funds, administrators, custodians, and other service providers.
Popular fund centers include:
• The Channel Islands and Isle of Man
• Cayman
• British Virgin Isles
• Bermuda
• Turks and Caicos
• Dublin
• Luxembourg
• Switzerland
• Gibraltar
• Malta
• Singapore
• Hong Kong
• Malaysia
This is only a small sample of fund centers and, as each center is unique in terms of the funds they support and the services available including many more readers should research them all by using journals like Funds Europe as well the Useful Website List at the end of the book.
Key Players in the Operation of a Fund
There are many people and entities involved with most types of fund from promoters, through the managing of investments, the fund administration and custody process, and the fund secretary.
Fund promoters, like the issuers of securities, bring funds to the “market” so that investors can invest their capital. Most investment funds are collective investment schemes where investor monies are pooled together. Promoters can set up large retails funds with a wide base of investors (often run by investment management companies that are part of large banks, or more specialized and sometimes smaller funds with a restricted investor base which can be owned by companies or by individuals.
The fund owners have a fiduciary responsibility to the investors in the fund and whether they are companies or individuals they must ensure the fund is set up and operates correctly. The governance responsibility has been reinforced in regulations’ introduced after the market crash of 2008, which includes more transparency and more reporting to the regulators.
The reputation or track record of the fund promoter can also be a key factor, particularly where the owner/promoter is also the investment manager.
The owner/promoter will make money out of the management fees they apply to the fund and which are paid by the investors minus the business expenses that are not rechargeable to the fund itself, for example, premises. Some types of fund like the AIFs will often have a structure where the owner/promoter has a stake in the fund through investing their own capital, sometimes called founders shares and some key investors may provide seed capital to the fund in return for shares that have some rights or advantages over the ordinary investor shares or units. We have seen that a term used in some funds like private equity to describe this type of participation is “carried interest.”
The fund promoter will need to decide which investment and support processes to set up internally and which to outsource, although in some cases regulation may be a determining factor.
Prime brokers (PBs) and their services started to appear in the latter part of the last century to service hedge funds. Today PBs provide services to a wide range of fund clients. The PB is often a large investment bank with a wide range of capabilities and services. It forms an integral part of the fund operations sitting between the investment process and the administration process.
The range of services offered can be extensive and may include:
• Executing portfolio trades but will “accept” trades executed elsewhere for settlement.
• Selling shares/units in the fund and possibly direct investment—using the PBs extensive client base and market position.
• Research—providing information and opinion on possible investments.
• Financing leverage—lending the fund capital over and above its subscription capital and against collateral (assets of the fund), for example, for strategies that involve “trading on margin.”
• Lending securities—to facilitate strategies like short selling.
• Custody Services—holding physical assets and electronic records of assets of the fund.
The relationship between the fund and the PB is a key one that must be established and operated properly and professionally. It will be covered by:
• Service Provision—Covered by a Prime Broker Agreement.
• Other agreements—Needed, for example, for OTC derivative transactions and any other intermediaries. OTC transactions are mainly transacted under the International Swaps and Derivatives Association documentation even when the OTC transaction is centrally cleared.
• Risk—Fund has a counterparty risk with the PB.
The prime broker may offer custody services.
The role of the custodian is essential in investment funds as they are both the safekeeper of assets that belong to the fund as well as providing key services related to the settlement of asset trades and collection of benefits and entitlements due to the fund on the assets in its portfolio.
The use of a custodian brings potential benefits to the fund operation. By centralizing the settlement and safekeeping processes there are both potential risk management benefits and cost savings.
In addition the fund can benefit from the expertise and market knowledge of the custodian including areas like short selling and securities lending opportunities and regulations.
Post 2008, the independent safekeeping of the fund’s assets is of prime importance for investor. Remember the earlier case study on Madoff’s Ponzi scheme.
Although the custodian is holding the assets in their name, a concept sometimes called the nominee process, the assets belong beneficially to the custodian’s client.
In the financial markets, a custodian is any business entity that holds its customer’s investment assets for protection. As we have seen typically, a custodian also offers trade settlements, foreign exchange transactions, and tax services. The custody service industry has grown significantly since 1980s and yet its profit margins have been under significant pressure. Smaller companies have, it appears, adapted to the challenge through technological innovation.
Retail/mutual fund custodian
Banks often provide custody services to many types of customers, including retail/mutual funds, alternative investment managers, retirement plans, insurance companies, foundations, and agency accounts. A custodian that takes care of its customer’s retail, mutual, AIF, hedge fund, property fund, or private equity funds is simply called a “custodian.”
A fund custodian can either be a bank or a trust. The fund’s assets, for example, its underlying securities, are kept with the third party to reduce the risk of manipulation, fraud, or unauthorized use of the fund assets. The custodian may also keep records for the fund or collate and provide other information as needed.
Custodians act on the instructions from their client and so communicating data between the client and the custodian is critically important.
There are several ways this can happen including proprietary systems operated by the custodian and in many cases via SWIFT messages. The Society for Worldwide Interbank Financial Telecommunication (SWIFT) provides a network that enables financial institutions worldwide to send and receive information about financial transactions in a secure, standardized, and reliable environment. SWIFT also sells software and services to financial institutions, much of it for use on the SWIFTNet Network, and ISO 9362. Business Identifier Codes are popularly known as “SWIFT codes”. www.swift.com
The importance for the administrator is to be aware of the custodian’s deadlines for receipt of an instruction. These deadlines are partially set by the deadlines imposed by the securities and payment settlement systems in the jurisdiction of the asset trades as well as the settlement conventions for the instruments. For example, in early October 2014, in many jurisdictions the settlement convention for equities became T + 2 and so any asset trades by the fund would have the expected finality of settlement two days after the trade date. The fund must ensure that any instructions related to the settlement are conveyed to the custodian in time for them to meet the obligation on settlement day.
The custodian is dealing primarily with the securities depositaries (where applicable), for example, Euroclear, Clearstream, or DTC and the payment systems, for example, Target 2, Fedwire, BACS as well as the brokers used by the client to settle the transactions in the assets.
They will monitor the situation through the clearing and settlement process for the instrument and update the client account as the finality of the settlement takes place. They will provide status updates to the fund administrator so that the primary reconciliation process can be performed between the fund record and the administrators record taken from the investment managers detail.
Custodians usually divide their services into what are called “core” and “added value” services.
Core services are those related to the safekeeping of assets both physical and the “book entry” electronic record of dematerialized assets plus the settlement, income collection like dividends and interest and managing of corporate action events like rights issues.
The fund administrator needs access to the custodian’s records in order to first make sure that the fund records agree with those of the custodian and then to ensure the accounting records of the fund are complete so that NAV, statutory accounts, and reporting can be produced.
In many jurisdictions custodians need to be authorized and are regulated, for example:
Custodians in the United States of America.
The Investment Company Act of 1940 regulates the custody of mutual fund assets. Under the Act, mutual funds and custodians both need to register with the Securities and Exchange Commission.
Fund administration
Another key player is of course the fund administrator.
Let us look at the high view of fund administration:
1. Fund administration—a service based product that has developed from the independent provision of pricing and valuations of assets and portfolios into a broad based product covering:
a. Fund operations—asset trade capture and inputs to records, validation and verification of positions (exposure limits/mandate), assets (settlement status and location, eg, custodian), and reconciliations.
b. Fund accounting and valuations—statutory accounts, general ledger, pricing of assets, posting of actual and accrued income (from assets, eg, dividends, interest from debt instruments, and cash deposits), and expenses (from transactions, eg, broker commissions, services, eg, custody fees, audit fees, licences and registrations, bank charges etc.).
c. Transfer agency—managing subscriptions and redemptions, client due diligence, AML checks, the fund register, communication with clients.
d. Secretarial services, risk and compliance management, fund set-ups.
2. Change to the service requirement—driven by the need for funds to show higher degree of control and management over the day-to-day operation of the fund including risk management and compliance—key issue is quality and professionalism.
3. Product characteristics—essential that the administrator understands the structure and characteristics of different products the fund may have in the portfolio, for example, the process of accrued interest on bonds, margin, and collateral associated with derivatives, for example, and the possibility of corporate action events. Also the valuation issues surrounding “easy to value” assets like listed equities and “difficult to value” like property and illiquid assets.
4. Workflow—the ability for the administrator to manage the workflow associated with the process of subscription and redemption, through cash forecast update, asset trades, postings, reconciliation, and finally the pricing and valuation process.
5. Identifying problems—data quality crucial as is the timings and cut offs associated with key processes, for example, asset trade capture from investment manager, receipt of subscription/redemption requests etc. managing situations in a practical way.
6. NAV calculations—pricing policy, tolerances and parameters, exception management, initial reasonableness checks, for example, portfolio change versus a benchmark, correct accruals.
7. Private equity—drawdown capital, growth and then distribution periods, fund has a projected life (5–10 years). Distribution pays off in order:
a. The initial capital of the investors.
b. The preference return to the investors.
c. The carried interest of the general partner.
d. Remaining return distributed across investors/general partner.
e. Fund is charged fees throughout the life of the fund so initially investors have a negative situation.
Prime broker/brokers
Most investment funds are not members of exchanges and the central securities depositories but instead access markets and assets via agents. These agents are often brokers or banks and the fund pays a commission to the brokers for the transactions they undertake on behalf of the fund.
PB services were originally designed for hedge fund managers but are today widely available to other types of funds.
The PB sits in the overall fund operational structure as shown (Diagram 2.10):
Diagram 2.10 (Source: The DSC Portfolio Ltd.)
As can be seen, the link from the PB to the administrator is a crucial one in enabling the administrator to carry out primary control reconciliation of the activity by the manager against the records of the broker and custodian.
We will look at these and other key relationships more in Part 3.
Setting up a Fund
The fund administrator may be involved in helping the promoter of a fund to establish the fund in the jurisdiction.
This is very often the case for offshore funds where the expertise that the administrator has of the regulatory environment and available service providers can be highly beneficial.
Detailed below is the kind of questions that need to be addressed in respect of the setting up of a hedge fund.
1. Confirm precise name of the fund.
2. Confirm precise name of overseas management company/distributor if such a structure is to be used. If the structure is just to be a fund with a direct contract down to a UK investment management company, then please confirm this.
3. Confirm full name, registered office address, and date of incorporation of investment manager. Also, confirm whether the investment manager is regulated. If the investment manager is located in the UK, it will normally need to be regulated which can take 3–4 months.
4. Confirm initial minimum subscription for shares and minimum incremental subscription thereafter. Confirm currency of share capital and whether there is one or more currency share classes.
5. Confirm provisional target date for launch of prospectus.
6. Describe the principal investment objectives of the fund and the target rate of return of the fund (this should be in the region of 10–15 lines to enable this wording to be inserted in the “Summary” section of the prospectus).
7. Describe the investment restrictions that will apply with reference to leverage, investment of assets in particular securities or strategies, etc.
8. Confirm identity of the Administrator for the fund and location of that Administrator. Also confirm that they will act as company secretary and whether there will be a Custodian and PB or whether nobody will hold the position of Custodian/PB and a number of brokers will be used.
9. Confirm procedure as to subscriptions and redemptions. It is presumed that subscriptions will be accepted monthly but will redemptions also be accepted monthly or perhaps quarterly? What will be the notice period required for redemptions?
10. Confirm the fees of the fund including the fixed fee based on the net asset value of the fund together with the performance fee and whether or not the performance fee will be charged above a hurdle?
11. Confirm whether US investors will be allowed to participate in the fund and, if so, whether this will just be what are known as US tax exempt investors or whether US retail investors will also be allowed to participate. If US individuals are allowed to participate, one must ascertain the minimum wealth level for such investors to allow for the appropriate wording to be added to the prospectus. Often, US taxable investors will be catered for in another parallel limited partnership structure or will be dealt with through what is known as a master/feeder structure.
12. Confirm the identity of the directors of the fund and provide a couple of descriptive paragraphs (ie, academic background and work experience on each person).
13. Confirm the auditors to the fund.
14. Confirm whether or not there will just be a single share class in the fund with all shareholders having the right to vote, receive dividends, receive distributions in a winding up on a “pari passu” basis or whether there is any advantage in having a second class of shares (often known as “founders shares” or “management shares”) which would be held by the promoters/offshore management company and would hold the votes on various key issues such as the appointment and removal of the investment manager and possibly changes to the memorandum and articles of association of the fund.
15. Confirm the appropriate “valuation point” for valuations of the fund. Often this will be the close of business in relevant markets that the fund is active in on the last business day of the month or sometimes the first business day.
16. Provide a fairly detailed description of the investment objective and policies of the fund (perhaps 1–2 pages) together with the investment restrictions (if any) that will apply to the fund and any specific investment risks that need to be referred to.
17. Confirm the identity of the directors of the overseas management company/distributor (if there is to be one) and provide one or two paragraphs on each person.
18. Confirm the identity of the directors of the investment manager and provide one or two paragraphs on each person.
19. Confirm the basis on which the performance fees will work. In outline, there are a number of ways of charging performance fees once agreed, whether the fee will be chargeable on perhaps an annual or quarterly basis. The first of these is just to apply a performance fee (which may be 20%) to the growth in the NAV of the fund itself adjusted for subscriptions and redemptions. This is straightforward but it has the drawback of allowing what is known as a “free ride” to investors who enter the fund at a time when it is below a previous high. The second approach is to use what is known as “equalization accounting” whereby the administrator follows a procedure so that all the investors end up paying a fair performance fee based upon their own individual profits on their shares. The difficulty with this approach is that it is complex and it means the company maintaining what is known as an “equalization reserve.” The third approach is the so called “series” approach whereby each investor who subscribes for shares receives a different series of shares. Therefore, if one has in the first year investors entering the fund on six different month ends, then one would have series 1–6 issued. Each of these series would have their own individual NAV per share with the result that there would not be a common NAV for the fund itself. Therefore, this third approach really replicates partnership accounting. Although alternatives two and three both prevent the “free ride” issue, both do give rise to complexity both with reference to stating a global NAV per share for the fund and with reference to investor perception.
20. Will there be a sales charge on subscriptions made to the fund and what will this be?
21. Will there be a redemption fee on redemptions from the fund within say the first 12 months from subscription and if so, what will this be?
22. Will there be a minimum holding period for shares in the fund?
23. A limit is normally stated for the payment of the directors fee from the fund and this needs to be agreed.
24. A limit is also normally stated for the establishment and organizational expenses of the fund with these costs being amortized over perhaps a three year period in the NAV of the fund. Again, this limit needs to be stated.
25. Will the fund publish its NAV in journals such as the Financial Times or the Wall Street Journal? Will the fund or the overseas management company have its own website which investors will be able to access for pricing and reports?
26. It is presumed that the fund will not have any stated distribution policy and its objective will be to maximize capital appreciation without paying dividends on a regular basis. Please confirm this.
27. Please confirm what the appropriate reporting will be to shareholders? It is presumed that the shareholders will be sent annual audited accounts together with unaudited half yearly accounts prepared by the administrator. This is required if the fund is Irish listed but only annual accounts are required, if not. Would it also be reasonable for them to receive a report from the offshore manager on a monthly or quarterly basis?
28. Sometimes, provisions may be included limiting the percentage of the fund which can be redeemed in any one month. Commonly, this could be something like 20% of the total fund NAV with redemption requests in excess of this figure being carried over to the next month. Whether or not a client thinks this is necessary and tends to depend on how liquid their portfolio is.
29. Confirm any special pricing provisions—many hedge funds use mid or last traded price whereas some use bid/ask. This can have reasonably material implications, particularly if leverage is used on both longs and shorts.
30. Confirm whether or not the fund should have a listing on a stock exchange such as the Irish Stock Exchange.
31. In a master/feeder structure, the feeder for US taxable investors is normally a Delaware partnership. Such an entity requires a general partner which again is normally an overseas company. Details again should be provided for such a structure including the name of the partnership and the name of the general partner.
Source: The DSC Portfolio Ltd
These are some of the primary issues to be considered in formulating an offering memorandum for a new fund and once discussed and agreed with the promoter, the administrator will formulate the draft structure providing where necessary the names of potential parties, for example, legal firms secretary and directors.
Finally, the administrator will assist with completing any regulatory applications that are needed as well as compiling the draft offering documents for agreement. These will be needed for the regulatory application for the authorization and licensing of the fund.
Another area of importance in setting up the fund is to complete the agreements with the key counterparties, for example, Custody Agreement, Fund Administration Agreement, Prime Broker Agreement etc. and also Service Level Agreements. (See Part 3)
Outsourcing
The fund will in all probability outsource some or even all of the activities.
In general terms we are talking in principle about:
• The investment process
• Administration
• Custody
Outsourcing represents an operational risk for the fund mainly because of the loss of control over the process and the reliance on the skills and performance of the insourcer.
Sometimes the decision to outsource is done for financial reasons or operational reasons, for example, the cost of technology or human resource with the right skill sets. However in some cases, the fund will have no option but to outsource as it may be a requirement of the regulator in the jurisdiction.
Any outsource arrangement must be covered by an agreement.
Documentation and agreements
Funds are likely to be involved in several agreements including those covering the key counterparties already mentioned.
The purpose of the agreement is to establish the terms of the relationship, the legal basis and if a SLA, the workflow, data provision etc. and responsibilities of both parties.
In addition, the fund may have to sign other agreements related to securities financing, derivatives use, collateral etc. and these are mentioned elsewhere in the book.
Examples of agreements can be found in the appendices.
Summary
In this part, we have looked at regulation, fund structures, roles of parties associated with the fund, and some important areas like outsourcing and agreements.
In Part 3, we look at fund operations and the work that various parties in a fund undertake.
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