While researching our team has come up with an intresting article about offshore fund administration which was published in the risk and reward magazine.
As the hedge fund industry has grown, and recently it has grown very rapidly in Europe, it has been offering all kinds of new opportunities and challenges for the industry’s main service providers, especially the fund administrators. Neil Wilson reports.
Fund administrators fulfil various key functions for the industry, not least in terms of providing independent fund valuation and net asset value (NAV) calculations. In addition to these core functions, many also provide all manner of additional services, ranging from fund establishment to registrar and shareholder record services, accounting, performance measurement, legal support and help with tax assessment.
It can be a complicated business. As Dermot Butler, chairman of Custom House Group in Dublin, puts it: “The administration of a hedge fund is technically much more difficult than with a unit trust or mutual fund.”
Most obviously, hedge funds usually have a more complex fee structure, including both a management fee and an incentive fee based on performance. How these fees are calculated and when they are paid, however, varies manager by manager and fund by fund. As Butler points out: “There is not a standard format, and are not any regulations governing how they should be structured. It depends on the manager.”
Even the calculation of the fees can vary. Sometimes it is done at the beginning of the month; sometimes at the end of the month. Then there are the questions of whether the management fees should be calculated before or after other fees and whether interest income should be included. As Butler points out: “It tends to become quite a manual job, and can be very time consuming.”
As the industry has grown so dramatically, and especially in an environment of rapid economic growth generally, this has caused logistical difficulties for many in the industry - especially given the need to find trained and skilled personnel. Since hedge funds are usually administered from offshore jurisdictions, where it is often difficult or impossible to simply draft in the right personnel, the problem has become acute in some places.
“Currently, there are staff problems - and not only for administrators - all over the world,” Butler says. This has increased the pressure to develop ever more sophisticated systems to automate as much of the process as possible.
Perhaps the trickiest task facing an administrator is the arcane issue of equalisation - the process by which an administrator tries to ensure that investors who invest in a fund at different times (and hence at different levels of NAV) are treated equally and fairly.
It can often happen, for instance, that investors who come in at inception are obliged to pay fees when the NAV has risen from 100 to say 120 at the end of an accounting period. But what if, for the sake of argument, the NAV then falls back as low as 90? If, at this point, new investors come in, who pays what and when?
Under the process of equalisation, these new investors should pay incentive fees when the NAV rises 20% from the level of 90, ie to a level of 108, at the end of the next accounting period. But the old investors, if they are still in the fund, should not be paying fees again until the fund goes back above 120. And so on. Hence, in cases where there are multiple investors in a fund who have all come in at different times, one can see how the process becomes so complicated.
Butler says that Custom House is in the process of implementing a system to automate the process of equalisation. Others are also thought to be testing or implementing similar systems.
Custom House started as a fund administrator in 1993 and administers a variety of types of business, including many US clients, long/short equity funds (of the type that have become very popular in Europe), plus some futures funds, currency funds and funds of funds. In line with the growth of the industry, its growth over the past year has been dramatic, with the number of funds it handles rising from about 90 to 145, according to Butler. The total amount managed by these funds is about $2 billion at present, he says.
Among the other biggest players is Bank of Bermuda, which also operates from a number of different jurisdictions, including Hong Kong, Luxembourg, Guernsey and Ireland. According to Dave Shastri at the bank’s representative office in London, Bank of Bermuda administers about $80bn in all, about 60% of which is in alternative investments of all types and $25-30bn is reckoned to be in hedge funds.
Bank of Bermuda has developed a particular niche in handling funds that deal in exotic markets and products. “We specialise in all things that cannot be easily commoditised,” says Shastri. The bank has some 500 staff in Hong Kong, and claims to handle about 70% of all hedge funds operating in Asia.
The blacklist
Other recent developments of concern to all offshore administrators have involved the issue of jurisdiction - ever since the OECD produced a ‘blacklist’ of offshore locations that it claims are not co-operating in the fight against money laundering. While nearly all the centres involved have now reacted to take corrective steps, nobody really knows yet how important this blacklist will be or what effect it will ultimately have. It also remains to be seen how these centres will tackle further steps by the OECD to limit their use as so-called tax havens - which looks like a much more intractable issue.
Of course, there are those in the financial industry, including many institutional investors, who remain sceptical about offshore centres in general and the intermediaries that serve them. But the administrators themselves are generally indignant in their defence.
As Butler points out, most of the major financial scandals of recent years - such as those involving Barings, Daiwa Bank, Sumitomo and Morgan Grenfell - have occurred in heavily-regulated jurisdictions. “It’s not regulation that people should be looking at, but at who is involved [in a hedge fund], and if there is independence [among the service providers],” he says.
As Shastri also points out, some of the blacklisted centres impose supervision requirements on funds that are not applied in places that are excluded. In Guernsey, for instance, there is a requirement for non-domiciled funds to go through a promoter review, he says.
Other centres impose requirements intended to provide comfort in other ways. Luxembourg, for instance, tends to be geared towards larger firms as a result of the relatively more onerous capital requirements for conducting business there.
As administrators are usually not slow to point out, most of the major scandals in the industry this year have occurred in the US - where most of the funds involved, with the notable exception of Manhattan Capital Management, did not use an independent administrator. In theory at least, the administrator should provide investors with a greater degree of comfort that a hedge fund is in fact doing what it claims.
Standardisation ahead?
Nevertheless, there does seem to be increasing pressure on the industry to standardise the main functions of fund administration. This trend can probably be traced to the dramatic impact of August 1998 and the near-collapse of Long-Term Capital Management, the big hedge fund set up by John Meriwether.
In efforts to stave off the unwelcome prospect of invasive new regulations, various industry groups have since proposed measures to enhance transparency and disclosure by hedge funds. There have also been moves by the regulators, including a report from the Financial Stability Forum in the US and a warning to hedge funds from Financial Services Authority (FSA) chairman Howard Davies in the UK. The recent further spate of scandals involving frauds in the US has added a further stimulus to the process.
According to Shastri, much of the pressure that originated from investors in the US has now spread globally, and is impacting funds in Europe. In the past, European managers had tended to take a more laissez-faire approach, he says, using shorter and simpler disclosure documents - as opposed to the US, where the industry is older and has developed more codified methods of conducting business.
Managers in Europe as well as the US certainly seem to have become more sensitive to the increasing demands of investors. An increasing number now want to offer not only weekly but daily NAVs, and in some cases statements of their risk profiles as well. Many of these are delivered via the Internet.
Where all this will lead is not yet clear. While there is pressure for more standardisation, the industry remains highly heterodox, with managers not only implementing widely divergent trading strategies but also preferring to interact with their investors in varying ways.
It seems that the fund administrators will have to keep expanding - and automating - if they are to keep pace.
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