says Jun Li, partner,  Ernst & Young’s asset management tax practice

Regulation pushes the envelope for operational excellence

Download the special report US Hedge Fund Services 2012

By James Williams – If there’s one tangible benefit to the way regulation is reshaping the hedge fund industry, it’s that service providers have to work in even closer collaboration with each other than they did previously. This is good news for investment advisers and their investors.

“There are a lot more compliance and reporting requirements in the industry,” says Jun Li (pictured), a partner in Ernst & Young’s asset management tax practice. “That places greater emphasis on law firms, tax advisers and administrators to work more collaboratively together, because if something is miscommunicated, the cost to the manager of non-compliance could be significant.”

There’s no doubt that enhanced reporting and accounting procedures are both raising the veil of secrecy surrounding hedge fund management and inculcating a culture of best practice. Unfortunately, this costs money. Small and mid-sized managers have to weigh up the positives of strengthening their operational infrastructure versus the negatives of having to hire more staff, further eating into their management fees.

One thing is clear: non-investment processes are now just as important as actual portfolio management. Says Ernst & Young’s Daniel New: “It’s part of a new client due diligence process.

“Institutional investors are asking to spend time with the chief compliance officer to get an understanding of the governance structure and of the compliance infrastructure. Have there been any regulatory issues? What systems do they have in place? The better answers you can offer, the better shot you have at getting the money.”

A clear demonstration of how the mindset of managers – both in the US and globally – has changed post-2008 is the sharp increase in hedge fund assets available for prime custody. Managers have responded to investor concerns about counterparty risk by using a multi-prime model, and now increasingly, it seems, a multi-custodian model.

Last month BNY Mellon, in conjunction with research and consulting firm Finadium, issued a report indicating that available assets for custody had shot up 40 per cent since 2010 to an estimated USD684bn. Significantly, the number of hedge funds with USD1bn or more in assets using prime custody agreements has jumped from 15 per cent in 2008 to 50 per cent today.

Michele Cottone, head of prime custody product management at BNY Mellon, says some of the larger managers were heading down the prime custody path even before the financial crash to safeguard their unencumbered assets (fully paid-for securities).

The push, she says, was coming primarily from institutional investors putting pressure on hedge fund managers to comply with the same kind of requirements they demand of traditional long-only managers in terms of transparency and full disclosure of information. “It really changed their mindset,” Cottone says. “Managers recognised that they needed to take actions similar to those of their traditional counterparts”.

One would have thought that the messy unwinding of Lehman Brothers’ London operation would have driven more European managers to reappraise their prime brokerage relationships and move more aggressively into establishing prime custody agreements.

Interestingly, the opposite has happened. “Despite the fact that Lehman was unwound in a more orderly fashion in the US, most managers there now deal with a custodian in a significant manner,” Cottone says.

As a result, BNY Mellon now holds more than USD155bn of prime custody assets, out of USD525bn in total assets under administration and custody. “We’re also seeing more encumbered assets come our way,” she says. “Unless these assets need to be used for financing purposes, they don’t need to be kept with the prime broker.

“Hedge fund investors are increasingly saying that they want an independent third party to sit in the middle between transactions. Primes realise that while the assets may not necessarily sit with them, as long as the custodian can support the model they use to conduct rehypothecation, it isn’t as a big a concern as perhaps it once was.”

Best practice is now a central issue for managers of all sizes. Even firms starting out below the threshold for SEC registration are thinking more about compliance and “structuring themselves accordingly so that when they need to register as an adviser, they’ll have everything in place”, according to Jeffrey Rosenthal, partner in charge of the financial services practice at accounting and advisory firm Anchin Block & Anchin.

“Previously it was a lot easier to start a fund,” Rosenthal says. “These days you need high-quality service providers – an independent administrator, an industry-experienced accountancy firm, a well-known attorney and a chief compliance officer in place – and to be fully prepared for when the SEC does its examination.”

Not being ready, and potentially ruining their reputation overnight because the SEC has flagged up issues, is the last thing managers want. Whereas in the past a compelling investment strategy might have been enough to secure new investors, today they also have to demonstrate their operational cutting edge.

“All things being equal, if investors are deciding between two management companies, both of which can demonstrate good performance, they’ll probably go with the one that has the better infrastructure in place,” New says.

Adds Li: “Hedge fund managers are striving toward a best-in-class model, from accounting to the customer relationship management system, risk reporting and middle office; even the office facilities and data security should be top-notch. That’s what institutional investors are asking about during their due diligence questionnaire process.”

For administrators, this requires innovation and flexibility to adapt to managers’ changing needs. Everybody needs data delivered faster, in specific ways, and in specific formats. Far from taking a cookie-cutter approach, administrators need to be more consultative.

“If we can help managers look at their portfolios more effectively through a tailored solution, it’s far more helpful than a one-size-fits-all approach to analytical and risk reporting,” says Toni Pinkerton, global head of fund services at Maples Fund Services. “We’re telling our clients that if two months down the line their requirements change, we can adapt our solution and evolve with their business needs.”

It seems to be working. MaplesFS has enjoyed revenue growth in double digits in 2012, while assets under administration have grown from USD28bn to USD36bn. It’s a similar story at UMB Fund Services, where assets have grown from USD16bn three years to approximately USD26bn, but Lonnie Macdonald, president of the group’s hedge fund administration business JD Clark, is well aware of the challenges that service providers face.

The first, unsurprisingly, is the global economy. Although the S&P 500 index is up 13.5 per cent this year, Macdonald says much of that gain is down to the “morphine drip” of Federal Reserve chairman Ben Bernanke’s programme of quantitative easing.

“Second, and more importantly, fund administration is a fee-based business and everyone is under pressure, including fund managers,” he says. “It’s pretty tough delivering first-class technology solutions when your fees are being cut, but you’re still expected to deliver. Prime brokerage revenues are down big-time, yet they’re still expected to stay right on top of their business, just like we are. That’s probably the industry’s biggest challenge.”

The demands that administrators themselves are placing on technology vendors to innovate is a good thing for the industry. “If it were only one or two firms pressuring them, you wouldn’t get the same level of innovation and change,” Macdonald says. “It’s a good thing we’re all pushing in the same direction.”

Managers have to be even more competitive in all aspects of the business to stand out from the crowd, and the fact that billion-dollar managers are increasingly using prime custody is having a trickle-down effect. Says Cottone: “Smaller firms are following suit because they realise their bigger counterparts have gotten to that milestone by adopting best practices to stay ahead of their investors’ needs. They’re becoming more proactive.”

Whereas previously BNY Mellon received few if any RFPs from hedge fund managers, the number is now increasing. “They want to show they’re doing the same due diligence as traditional asset managers do for their institutional investors,” Cottone says.

The next major challenge for most US fund managers will be preparing their first Form PF filing. An SEC staffer offers two pieces to advice to the next wave of managers preparing to file: “First, pay attention to the form now. We’ve heard from first-time filers that it takes time to prepare for the questions, so don’t leave it to the last minute.

“Secondly, we understand that this is the first filing and that it’s not going to be perfect. The adviser registration form [Form ADV] has existed for over 10 years and been refined numerous times. Likewise, Form PF will be amended as we become more familiar with the data. I would refer managers to Item 4 in the filing: if in doubt, just explain. Don’t over-analyse and worry about putting together perfect answers.”

Taxation is another potential headache for managers. Regardless of the election outcome, all unearned income – capital gains, interest dividends – will be subject to an additional 3.8 per cent Medicare Tax from January 1.

“This will affect anyone earning more than USD200,000, which basically includes everyone that invests in hedge funds,” Rosenthal says. “People must decide whether it makes sense to take some realised gains before year-end.

He notes that the difference between economic income and taxable income coming from a hedge fund is primarily a result of unrealised gains and losses: if a gain is unrealised, it is still economic income and not subject to taxation until it becomes realised. Rarely do investors complain when economic income is higher than taxable income because of a large build-up of unrealised gains, but they do when the opposite is true.

“More managers are looking closely at their portfolios from a tax perspective than probably did in the past,” Rosenthal adds. “If you recognise income earned for 2012, it can escape the new Medicare Tax and any potential increase in capital gains taxes.”

A side effect of regulatory change in the industry is likely to be consolidation, both between service providers and between fund managers. This is already well underway in Europe, with Man Group having recently acquired London-based Financial Risk Management with its USD8bn in assets to take the group’s total fund of hedge funds assets to USD19bn.

Meanwhile, family offices that have expanded into the business of managing external money have started to revert to type to avoid the new regulatory burden. Says Rosenthal: “I’ve seen consolidation among the many family offices we work with. I would estimate that the majority of them have returned all their external investor capital as a result of registration.”

As for administrators (and prime brokers), Macdonald thinks the industry will continue to see firms deciding that they have taken their business as far they can on their own and that they now need the backing of a larger organisation.

“Look at GlobeOp and SS&C, or Goldman Sachs selling its business to State Street – that’s a big deal,” he says. “Even with USD200bn in assets under administration, Goldman decided it wasn’t a big enough scalable business for them!

“When we bought JD Clark three years ago, I kept my eye out for other deals, and continue to do so. There’s going to be more consolidation. I think it’s positive, certainly for the managers, to be working with stronger, more stable institutions.”

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