Global regulation drives fund managers to strengthen operational controls and improve corporate governance
By James Williams – A recent industry survey that ranked Asian prime brokerages based on hedge fund AUM was both predictable and unexpected. Predictable in the sense that Goldman Sachs remains the leading broker in Asia. Unexpected in the sense that Morgan Stanley, ranked Number 2 in the survey, was only some USD420million ahead of Credit Suisse (with approximately USD19.2billion in AUM), with Deutsche Bank and UBS each gaining 10 per cent market share.
Since 2008, Goldmans and Morgan Stanley have seen their market share in the region halved as European players and the likes of Bank of America Merrill Lynch and Citi have moved aggressively to win clients. The ‘duopoly’ has become a stable of six or seven quality primes all battling for market share, illustrating that Hong Kong’s prime brokerage industry has become more competitive than ever.
This diversification trend is occurring throughout the service provider space in Hong Kong.
Vistra Fund Services, an independent administrator, last month rolled out its Privium Capital Fund structure; a turnkey solution aimed primarily at smaller and start-up managers, providing full fund formation and operational support.
“For mid-size or smaller fund managers they don’t get the same quality of service (from tier one providers). We’re hoping that we’ll attract some of these clients currently using bigger administrators,” says Charles Kwun, Managing Director, Vistra Fund Services Asia.
“Hopefully the experience of our team, many of whom have worked at tier one firms, will work to our advantage. As a new player you have to build up market share through word of mouth which is why we’re investing in our people, giving clients the highest quality service. As long as they’re happy, other managers will start to hear about us.”
For global firms like BNY Mellon, the focus is not only on delivering exceptional fund administration services but also in developing new products that reflect the changing dynamics of the industry. The clearest evidence of this is the firm’s Prime Custody model: a solution that allows managers to reduce counterparty risk by segregating unencumbered cash and securities.
Says Andrew Gordon, Head of BNY Mellon’s Alternative and Broker Dealer Services, Asia Pacific: “No doubt larger firms see this as the ‘new operating norm’ but there are also smaller firms using our Prime Custody solution. In many ways what they’re doing is making an investment in their business. They might not be managing big assets today but they’re mindful of the fact that in order to gather assets going forward they have to show a good operational track record.”
Outsourcing is becoming increasingly prevalent. One such firm, DragonBack Capital, provides an operational platform that handles all the regulatory and operational risk controls for managers.
Philip Tye and Rob Lance spun the platform out of their former DragonBack hedge fund and have proceeded to onboard a number of clients such as Sharp Peak Capital Management – a long volatility/long gamma strategy run by co-founders Jean-Guy Renard, Nils Razmilovic and Jonathan Hodgson.
Says Tye: “Our last big project was the transition of the Double Haven credit team, led by Daryl Flint, from the Sparx Group and four of its funds. Since then we’ve launched an Asian liquid bond strategy called the Double Haven Asia Absolute Bond fund, which launched on 19 December 2011 and was seeded largely with principals’ money. It’s had a good run performance-wise: it’s up nearly 9 per cent in 2012 and we’re delighted with that.”
Although global regulation is raising the barriers to entry, fund formation numbers haven’t exactly fallen off the cliff. Rolfe Hayden, partner at Simmons & Simmons (Hong Kong) says that overall it’s been busy: “I think there is an increase in quality of new funds; everyone knows that fund raising is difficult and there aren’t as many trying their luck, as it were. People are better prepared now and I think the quality is higher. Of the funds we’ve been working on this year, nearly all have third party money up-front,” says Hayden.
Adds George Saffayeh, partner with Ernst & Young’s Assurance practice: “Given where the market was in December, we were pleased to see the amount of regional start-up activity in the first half of the year. In addition to the number of launches, there has also been an increase in the size of launches.”
DragonBack Capital have been active this year as they look to source new talent with Tye noting that they’ve had in excess of 40 conversations over the last couple of months. “Despite quite a large number of fund closures last year it’s quite a vibrant market for start-ups. There’s good variety in terms of talent coming through and there’s always going to be talented managers who have good ideas but who perhaps need to be nurtured,” opines Tye.
Alex Last, partner at Mourant Ozannes, says that people are looking more carefully at how they plan the start-up phase of their business: “Funds that want to raise institutional money need a solid middle and back office infrastructure which comes at a cost. As a result, start-up activity is taking longer.”
Operationally, Hong Kong’s fund management community is having to raise its game. Firms like Ernst & Young are evaluating the operating models and internal control structures of hedge funds, and providing recommendations for improvements where warranted according to Saffayeh. He says that while they are seeing improvements, “for smaller managers it’s difficult for them to have all the right people, processes and systems onboard. What we see is that they’re outsourcing a lot of these functions to make themselves more efficient.”
“What we recommend, and what institutions are increasingly looking for, is that the manager has his own processes and systems in place in order to shadow what the administrator is doing. That way they can compare their performance with their administrator’s and ensure that everything is correctly reconciled,” says Saffayeh.
One of the perceived weaknesses of Asian hedge funds in the minds of western investors is that historically they’ve not been as operationally robust as their western peers. But things are changing. BNY Mellon’s Gordon says that compared to the rest of the world Hong Kong definitely has some world-class managers, “not just in terms their investment performance, but also in terms of their operational performance.
“There are a good number of smaller managers here that look up to these firms, aspiring towards getting there themselves, and that’s really where the opportunity set lies for us,” says Gordon.
Tye says that whilst there are still sources of capital that may not need such an ‘absolute’ high standard, operationally speaking, for those who want to target global institutions they need to have an institutional control environment comparable to DragonBack’s. “We don’t do risk management, we do risk control. And it’s this independent risk control that investors require today. They want to know not only that risk management is being properly performed, but also that there is independent control over that risk management process.”
Technology vendors are also having to respond quickly to the operational demands being placed on managers. Linedata, for instance, whose Beauchamp portfolio management system is the firm’s flagship hedge fund product, is releasing version 6.1.1 in June. More importantly, the firm has been working on a major development project – Linedata Beauchamp Sigma – to make the PMS interface more user-friendly and efficient for clients. It will be released towards the end of the year, providing clients with full front- through back-office support from trade execution through to settlement and custody across multiple currencies and asset classes.
“The new GUI is completely user-centric allowing each individual to build a personalised view using simple widgets, graphs and drag and drop techniques. Whilst the underlying data remains unchanged end-users can create a set of views that reflect their particular workflow needs. In an age of increasing data, growing regulatory and investor requirements and market volatility, we think this is a key development which will help hedge funds manage their portfolios more efficiently,” says Sally Crane, Managing Director of Linedata (Hong Kong) Ltd.
Another trend emerging out of Hong Kong is an increased focus on improved corporate governance. Managers are paying more attention to the non-investment aspects of running a fund and increasingly hiring COOs. As Gordon puts it, having a strong COO is “pretty much a given these days”. It’s merely another sign of Asia’s intent to catch up with New York and London.
With the Weavering case still fresh in people’s minds, investors want to see evidence of better corporate governance and the use of truly independent directors. Saffayeh comments: “This year we’ve seen more involvement of fund boards understanding the operations and risks of the fund, and also understanding more of what we do, especially in terms of accounting, to help them round out their complete understanding of the fund before signing off on the accounts.
“Board directors increasingly want to understand where the various risks lie within the fund structure and we believe this will be a continuing trend going forward.”
Tim Wannenmacher, UBS Head of Prime Services, Asia Pacific, notes that historically investors were happy enough to deal with the CIO and portfolio manager and if they liked them they’d invest “but today they want to spend significant time with the COO and broader non-investment team.
“Investors want to know who can say ‘No’ to the portfolio manager, who supervises risk, what is the disaster recovery plan, compliance procedure etc. Since we know what is required we’re helping funds put these processes in place.”
Last confirms that managers are interested in adding greater substance to their offshore structures and believes there are two drivers for better corporate governance: “Firstly, demand from investors; secondly, from a tax perspective, managers want to strengthen the tax integrity of their fund and management structures. For example, tax authorities in the region are looking more closely at transfer pricing issues in the context of offshore investment management and onshore investment advisory arrangements.”
Aside from corporate governance, Nicholas Plowman, partner at law firm Ogier (Hong Kong), says that this year has seen a number of hybrid fund structures being launched in the city, whose structure shares elements of a hedge fund and a private equity fund. “You may have highly liquid investments, amalgamated alongside a side pocket of discrete illiquid PIPE investments, for example in a hybrid fund structure. The economics and structuring of the side pocket and the liquid investments will often be entirely different,” says Plowman.
Global regulatory developments are keeping Hong Kong’s service providers busy. Hayden says that Hong Kong clients are less concerned with the European AIFM Directive. The US, however, is another story because of SEC registration and the CFTC exemption repeal. Says Hayden: “That’s a particular burden for some of our local clients who face compliance and cost addition simply for the pleasure of raising US assets.
“I think there are some Asian managers who will choose to decide not to accept US assets into their fund. That’s a luxury some of our clients have that many others can’t afford.”
With Form PF, the fact that few Asian funds exceed USD1.5billion means that for the majority they have until the end of the year (15 December) to commence filing. “As a smaller manager with USD250million AUM on the platform we still have time but we have some significant work to do on our systems to get that reporting in place,” adds Tye.
Nevertheless, with FATCA also on the horizon, the breadth of compliance now facing any potential start-up, let alone existing funds, is worryingly large. This ties back in to the issue of operational control. Managers have to be realistic that launching a fund today is 10 times harder than it was five years ago. “For smaller managers they’re increasingly turning to their service providers to assist them,” says Saffayeh.
In Hong Kong, there have been two notable regulatory developments, one of which is yet to be legally resolved. This is the case between Tiger Asia Management, a New York-based hedge fund, and Hong Kong’s financial regulator, the SFC.
The SFC wants to ban the fund from trading Hong Kong securities and freeze more than USD30million in assets, alleging that it was involved in insider trading in shares of China Construction Bank and Bank of China in 2009. In February this year the SFC won its appeal to have the case be heard in the Civil Court rather than through a market misconduct tribunal (MMT).
Paul Li, partner at Simmons & Simmons explains: “The SFC maintains that the present action is all about obtaining compensation for those disadvantaged by the insider dealing. It’s far from clear that it will be able to do so.
“The same is achievable through the MMT. The only difference is that by using the Civil Court in this way, it preserves the ability for the SFC to bring a criminal prosecution against the individuals one day. The case itself has comparatively little significance but what it does represent is part of the continuum of the SFC getting tough on insider dealing and signals that managers based outside Hong Kong are not immune,” says Li.
The second development is the SFC’s decision to tighten its short selling regime. The market capitalisation of securities eligible for short selling is to be increased from HKD1billion to HKD3billion and managers holding either 0.02 per cent of share capital or HKD30million will be required to report weekly to the SFC. Although not exactly onerous for managers, it will present a couple of niggly challenges according to Hayden:
“You have to provide the details of all the partners in the filing meaning every time a partner changes you will have to apply for a new Short Position Reporting ID, which could become a burdensome process for overseas managers.
“Also, the SFC has indicated it will produce a list of reportable stocks but they’ve also said they accept no responsibility for it so it will be up to the manager to effectively cross-check, for example, the Hang Seng Index against the list. As the list changes, not all designated stocks will need to comply with the reporting rules.
“Inevitably there are going to be teething problems but the short selling reporting rules impose criminal liability on the owner. So it’s not only an administrative burden; if you get it wrong it could lead to serious consequences.”
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