As institutional investment in alternative assets increases, concern is mounting about operational risk and regulated entities.
According to Julian Korek, founding member of consultants Kinetic Partners, many institutional investors do not realise that in the UK, only the hedge fund manager is regulated by the Financial Services Authority (FSA). Other associated entities which might reside offshore, such as the fund itself, the fund’s directors, prime broker, custodian and administrator, fall outside the regulatory ambit of the FSA and therefore pose a potential risk to the investor.
Contending that investors do not perform enough due diligence on prospective hedge fund managers, Mr Korek says there is a lot of focus on strategy and performance at the expense of the operational side of the business.
“You really do have to drill down into the relationships between the manager, the board of directors, the administrators and the prime brokers because often these people have legal agreements around pricing and net asset value (NAV). We have seen instances where the manager said to the administrator that they want to price certain instruments in the fund and these instruments have been mispriced by a huge amount, so effectively the fund becomes overvalued and at some point the balloon bursts,” he says.
Over the last 15 years, all the big hedge fund blow ups have been caused by false valuations, says Mr Korek, adding that legal documentation relating to the pricing of underlying securities is not always clear enough. Also, investors often do not understand who is ultimately responsible – the fund’s board of directors, the manager or the administrator – for the integrity of the pricing.
“The fund will appoint a board of directors who will have responsibility for all other service providers. I don’t think investors have thought through what this actually means if things go wrong. Because you tend to deal with different jurisdictions with all their different legal and regulatory requirements.”
 | Raymond O’Neill, another founding member of Kinetic Partners, maintains that hedge fund managers do not spend enough time studying the systems and processes used by an administrator. He believes too much emphasis is placed on driving down the price charged by the administrator. |
“You can only go so far with this. For instance, you cannot run a business on a 1 per cent fee. We would say to managers: spend more time with the administrator and make sure they can handle your particular strategies. There should be an agreement up-front; if an administrator cannot price a particular security themselves, this should be agreed with the manager and signed off by the fund’s board of directors,” he advises.
The need for independent pricing is paramount, adds Mr O’Neill. If independent pricing is not possible for some reason and the hedge fund manager is pricing the assets, that fact should be disclosed to the investor.
“We also appreciate that you cannot always get precision in pricing. In the case of pricing estimates, hedge funds should be setting de minimus levels of pricing. It should be stated that the estimate must be within a certain percentage of the actual price,” he says.
Fund pricing
As more institutional money comes into hedge funds, administrators are being asked to provide NAV calculations, not only monthly but weekly and even daily.
Could this pressure for more frequent reporting drive up the rate of pricing errors? Mr Korek does not think so.
He says: “There is an argument that if you have a pricing error in one of the weekly valuations, what is the impact? Does that influence the investor to buy in or sell out of the fund?
But he adds that typically hedge funds price once a month and also have lock-in periods, which inhibit investors who want to redeem.
“The standard is monthly dealing or on a less regular basis, quarterly dealing. But a lot of managers want to produce a weekly price for indicative purposes so they can show their investors the trends in the market. I think there will be pressure for greater liquidity and that will drive more frequent NAV calculation.”
 | According to Bhagesh Malde, global head of the hedge fund services group at JPMorgan Worldwide Securities, the likelihood of pricing errors happening increases as hedge |
Fund managers use evermore complex
trading strategies and instruments that are hard to value. He contends that a small hedge fund service-provider in particular, which might lack the technology and the linkages to all the various pricing sources, would be prone to error.
A recent report by investment management consultancy Investit, found that both asset managers and third-party fund administrators encounter problems when handling over-the-counter (OTC) derivatives. While administrators and outsourcing companies have different systems in place for tracking OTC derivatives, they cannot yet provide a single platform to meet all their clients’ requirements.
The report noted that while good systems are available for OTC derivatives, exchange-traded derivatives and physical assets, as yet there is no integrated platform that is good for all instruments.
Mr Malde concurs that technology deficit is a big issue for the fund management and servicing industry and one that will drive more outsourcing of middle office functions by hedge fund managers.
He claims: “Most hedge funds will want to outsource and the quantum jump required by an administrator from just doing accounting to performing a full middle-office service is going to challenge them.”
Mr Malde maintains that institutional investors are already asking hedge fund managers more searching questions about their operations and the administrators they use.
This quest for greater transparency, he claims, will lead to a flight “towards substance and quality” as institutional investors look to have the same recognised, brand-name asset managers which run their long-only funds also managing their hedge funds.
It is true to say that investors stand a better chance of recovering their money should a hedge fund managed by the subsidiary of a large global investment bank go bust. Such organisations will be backed up by far more regulatory capital than a boutique-sized hedge fund operation.
Mr Malde says the bigger hedge fund administrators that are owned by banks “cannot escape control” by the FSA or the US Securities and Exchange Commission. “It would not be the same for a smaller hedge fund service provider.”
He adds that every time a hedge fund suffers an operational scare, the trend towards people asking questions about the administrators used is accelerated. And, this is going to force improvements in standards of service.
Consolidation
The greater demands being imposed by institutional investors on hedge funds will fuel consolidation of administrators.
“I see evidence of that; a lot of smaller service providers are offering themselves up for bigger players to buy them. And smaller operators might combine with each other,” says Mr Malde.
Another factor driving consolidation is the onerous cost of maintaining and investing in the technology needed to service hedge funds.
But with 10,000 hedge funds today managing assets of $14,000bn and about 1000 net new funds opening every year, the administration sector is also experiencing capacity constraints which are allowing new administrators into the marketplace.
Mr Korek says: “There has been consolidation over the last seven years with a lot of independent administrators being bought by the big traditional players. The top five hedge fund service providers now account for 65 per cent of assets under administration. Where will the next wave of administrator consolidation come from when you have so few independent players left? It may be that some administrators may decide it is not economically viable to continue because not everyone is making super profits; they cannot on current fee levels. So we may not have further consolidation until the next layer of new entrants come through into the market and establish themselves.”
Mr Malde maintains that there will always be room for the smaller administrators because their larger counterparts tend to favour bigger hedge funds, those above $100m in size. The constant stream of new start-up hedge funds will gravitate to the smaller, niche service-providers.
Capacity contraints in the hedge fund servicing arena are exacerbated by skills shortage in the main servicing centres of New York, Boston, Cayman Islands, Ireland and Luxembourg. The cost of recruiting and retaining qualified people has led to talk about the possible offshoring of certain fund administration functions to lower-cost locations such as India.
Services such as reconciliations and NAV calculation could easily be carried out in India, says Mr Korek of Kinetic Partners. He predicts a globalisation of the hedge fund servicing sector going forward as international players seek cost efficiencies and economies of scale.
Gary Enos, head of alternative investment servicing at State Street, argues that while fundamental services such as reconciliations and ledger accounting will be farmed out to new locations, it is less likely that NAV calculation will be offshored, due to the complexity of the function and the importance of being close to the hedge fund market.
