Fixed vs. Variable Hedge Fund costs

Within the Hedge Fund industry Institutional Investors are putting increasing downward pressure on the fees being charged by many funds. The erosion of Performance and Management Fees has been well documented but less so the reduction they are seeking in more generic operational fees. These include the fees to staff and run a proficient operations department as well as the software to support it.

Throughout the industry there is a push away from these fixed costs to instead mandating expert service providers to provide these services. These include outsourcing of a Hedge Fund’s traditional middle office, trade processing and software support. These services are often paid for on an asset basis - the fees changing as the Funds NAV moves up and down.

This move to variable fund costs is in turn enabling Hedge Fund Managers to offer new Hedge Funds at a lower Total Expense Ratio (TER) which should be more favourably received by Institutional Investors.

This is the very start of a trend I expect to see continuing over the next few years. The best practice line between what should be kept in-house and what should be outsourced has yet to be determined.

The trend towards Liability Caps at some Hedge Fund Administrators.

An interesting new development within the Hedge Fund industry concerns the increasing use of Liability Caps by Fund Administrators. Hedge Fund Administrators particularly are starting to follow the lead set by many auditors a number of years ago and placing a cap on their potential liability within their Administration agreements in the case of incorrect NAV calculation.

The implications for this for the Investment Manager could be quite significant. Essentially they are made far more accountable for the correct valuation of the Fund’s NAV. To ensure this is done accurately will require significant investment in adequate operational systems, resources and controls.

And this goes back to another point I’d heard recently – the increasing requirement by many institutional investors to have a full separate general ledger – independent of their administrator. This is a big change because many existing “shadow” fund accounting systems are not and where not built to have this level of functionality. This is likely to increase pressure on the industries software vendors to ramp up the accounting functionality of their software.    

The new reporting requirements under Dodd Franks

As the whole Hedge Fund Industry knows there is a tidal wave of new legislation on the way. Both AIFM in Europe and the Dodd Franks Act in the US will require most Hedge Fund Managers to register and provide detailed regular reporting.

Up until this point there has been no clear picture of what exactly this reporting would entail. This has been a concern for many Managers and Administrators especially as Dodd Franks becomes law next July and they will need time to ensure their operational area's can meet these reporting requirements.

This weeks Hedge Fund Alert had a very interesting article about the SEC for the first time quietly showing its draft reporting requirements to a number of large hedge funds (ahead of publishing the official reporting requirements in Qtr 1 next year).

Reading between the lines I think they got a bit of a shock. The level of reporting sounds very detailed and will have to be done at least twice a year - for AUMs, trading positions, Counter-Party arrangements, Valuation practices, Leverage use and details of Sidepockets and any illiquid securities. None of this information is to be made public but I imagine that won't help many Fund Managers sleep any easier at night as they live in fear of leaks to the public or competitors.

For Operational departments at Hedge Fund and Administrators it will mean a rush to get new data amd reporting  feeds in place before the July deadline. Hopefully some of it they will be producing already for internal use but I imagine the first half of next year will see a flurry of activty within these teams worldwide as they try to get their reporting capabilities in place before the new regulations start to bite.
 

Wanted! - Hedge Fund Directors with Ops Experience

There was a time when all Directors of Hedge Funds had to do to get their $5k each year was dial into an annual conference call and rubber stamp the NAV of the Fund and any material changes to it's Service Providers.

No longer.

Now all of a sudden Directors need to a have a detailed understanding of the Hedge Fund, its underlying investments and crucially how these assets are valued. In other words for the first time Directors need to understand Hedge Fund's Operations.

This most definitely hasn't always been the case. Many Directors served on numerous funds boards and it was widely regarded few of them understood how to value CDO's, CFD's, Credit Default Swaps etc correctly. Either as instruments or what they should be looking out for.

However since the financial earthquake of 2008 that has all changed. Directors must now understand how to fairly price the fund's investments, maintain a detailed record of the fund liquidity and investors situation and closely monitor any unusual breaks in cash or asset reconciliation. Directors for the first time must be proactive in understanding and investigating the operational areas of their Hedge Funds.

What this means for Hedge Funds is that (quite understandably) Directors Fees are on the way up. I have heard comments of moves to Fee's approaching $30k - especially as more detailed governance and scrutiny precludes serving on a large number of Fund's Boards. Additionally, what this means in the industry is for the first time Directors with a history in the operational end of the Alternative Investment business are in high demand.

And the word on the street is that there are not many of them out there.

Month-end mayhem at every Hedge Fund Administrator

A large part of my experience is from Hedge Fund Administration. Every month my teams of Fund Accountants would work diligently to try and prepare for that first crazy week after month end.
Funds would be reconciled. Fees would be posted. Expenses analysed. Everything would be booked until the day before month end and we would go home for an early night. On the first of the month itself we'd all troop in early, eager to get started on the previous month end valuation.

And it was always the same every time - absolute mayhem!

The reason I got married mid-month is because I simply could be out for that week after month end - not for holidays, weddings, births (well ok maybe for your first baby - just this once!). The period was too fraught with potential problems and issues that would need immediate decisions - about both funds valuation and accounting. I've often thought Managers looking to learn the art of crisis-management would do well to spend that first week of a new month at a Hedge Fund Administrators (don't get me started about the first week of January!).
 
By day two of the month the clients in London/NYC are barking down the line looking for the NAV to give to their investors. We'll all need to reconcile with each other but there is still a $2 million break in the cash we just can't find - and it goes without saying it’s our fault!

But hey you know what? Its only 12 bps on the fund. Often we could turn around and utter (besides "are you SURE you sent us all the trades?) every Fund Accountants favourite word - don't word guys its "immaterial".

I always slept like the dead the first weekend of each new month. Satisfied but exhausted.

The 2 & 20 World is Dead

Ok I think we all know the 2 & 20 world is dead and gone - but what is going to replace it?
And what will that mean for Hedge Fund Managers and their Administrators?

Hedge Fund Managers I've spoken to have said they are happy in this new world to be getting a Management Fee of 1.5% and a Performance Fee of 15%  - even as low as 10 - 12% for large Institutuonal Investors.

Part of this trend is a move towards more varied, complex Performance Fees, with complicated Hurdles in the Fund Prospectus to be reached before the Manager collects his fee. The turbulence in the Industry since 2008 has accelerated this change. Without a doubt this will present a challenge to operational staff in our industry.

In many ways Hedge Fund Ops software had only just caught up to calculating the more standard Performance Fees, Hurdles, Loss Carried Forward etc. Will these more complex Fee models mean a return to the trusty old spreadsheet? I am pretty sure no Fund Accountant wants that but it will be interesting to see over the next couple of years how the main Hedge Fund Managers and their Administrators handle far more complex fee structures - especially on Hedge Funds that may be cutting their NAVs more regularly.

I think software vendors are going to be busy updating ther applications...   

The new focus on Hedge Fund Operations

Last week I attended the second annual GAIM OPs conference in Dublin. It was an excellent conference and discussed all operational aspects of the Alternative Investment industry and the likely forthcoming future trends.  I decided to set up this blog after looking for a similar one on the web that discussed these issues and finding that there was none. Instead they all focused on front office issues, asset allocation and generating Alpha.

Ironically with the forthcoming changes in the global regulatory landscape (Dodd Franks & AIFM) as well as increased information demands from investors the focus in the Hedge Fund industry in moving squarely over to Operations - both at the Investment Manager and with their Administrator.

Going forward I'll be lookin at some of the operational trends we can expect to see - and how the industry will manage them.

All comments most welcome!