By Simon Gray – Legislators, financial regulators and investors in alternative funds are examining how the informational deficiencies that did much to exacerbate the industry’s problems over the past few years can best be remedied. Their efforts to address the problems have already resulted in substantial changes in approach and working practices not only for hedge fund managers but for the firms that provide services to the sector.
The need for greater transparency is resulting in new requirements for more frequent and more detailed reporting to regulators and to investors. It is also prompting the use of structures of which transparency is an inherent characteristic, notably Ucits funds, as opposed to classic offshore vehicles, not least because more highly regulated funds in general benefit from a correspondingly greater scope in terms of distribution.
At the same time, investors are seeking – and in many cases receiving – the benefits of oversight and control offered by managed accounts and single investor funds. Although the bespoke quality inherent to a lesser or greater extent in such structures is liable to entail additional costs by comparison with traditional pooled funds, for many institutional investors in particular this is a price worth paying for peace of mind and protection against the unpleasant surprises that some experienced in 2007 and 2008.
This brings new challenges – but also opportunities – to industry players such as prime brokers, whose sector has been transformed by the disappearance or sale in 2008 of industry heavy hitters Bear Stearns and Lehman Brothers, and the emergence of others. “A few prime brokers have exited the business or merged, and the US in particular has seen the phenomenon of mini-primes emerge,” says Andrew Dollery, who is responsible for origination and structuring at Newedge.
“That has been driven to some extent because the US market is homogenous, and there’s a very large asset base. In Europe, by contrast, we have not really seen the development of mini-primes, but a greater dispersion of market share among a group of eight or 10 large prime brokers. It is no longer the duopoly, relatively speaking, that you could say existed up to 2006 and 2007, but a much broader and more competitive market environment.”
Dollery says prime brokerage businesses have responded in different ways to the emergence of Ucits structures as an avenue to access both institutional and affluent investors in Europe. “Some have taken the platform approach,” he says. “They not only provide prime brokerage but offer their own legal structures to clients.”
Newedge, by contrast, has opted for an agency-only conflict-free business model. “We consciously decided not to move into the asset management space by offering clients our own structures for them to sub-advise, which set us apart a bit,” he says. “We remain a prime broker to Ucits funds as opposed to entering into what is almost a joint venture. There are obviously arguments for both approaches, but we believe that from a cost, flexibility and branding standpoint, having managers keep control of the structure is optimal in the long term.”
Setting up a Ucits fund is not something to be undertaken lightly, Dollery cautions. “A lot of work goes into it,” he says. “Whether managers join a platform or choose to do it on their own has an impact on a lot of things, notably the total expense ratio.” Platforms may not be the cheaper solution over the longer term, he says: “For maybe EUR50,000 you can have your own Irish or Luxembourg structure and avoid paying anywhere from 20 to 80 basis points to a banking group every year of the fund’s existence.
“Investment banking platforms may offer advantages in terms of time to market, but the manager is to some extent stuck with the jurisdiction and service providers that the bank has chosen. From a branding point of view it’s effectively a joint venture that you can’t get out of without basically shutting the fund.
“By contrast, when we went live with Aspect Capital in December 2010, they set up their own Ucits-compliant CTA strategy in Ireland to which we are the swap counterparty. It allows them to be masters of their own destiny to a large extent, as they would be in the case of a Cayman fund. It’s been tremendously successful in terms of fund raising, with USD250 in the first four months. Investors seem to like a clean structure where the manager sets up its own structure and there aren’t multiple layers or fees.”
Dollery also notes that some platform providers charge fees on all assets raised for their Ucits funds, even if the manager’s own sales team has won the business. “If you do it yourself, our cap intro team will support the launch as a value-added service,” he says. “These are all debates that we have with clients when they’re looking at which structure to use. There is no single right answer – platforms will argue, for instance, that they take away the regulatory burden. But it’s an importance decision for managers when they come to launch their first fund.”
Managed accounts offer an alternative for investors with larger amounts of capital to invest, but Dollery argues that they represent the other side of the same coin to Ucits funds. “Many institutions prefer to ask for a managed account if they have enough capital to allocate to a particular manager or strategy, say USD20m, and if the manager can accommodate that,” he says.
“Both Ucits and managed accounts are currently seeing strong demand. Although they offer slightly different propositions – Ucits is more about distribution – they also answer some of the same questions regarding security, liquidity and transparency. A managed account holder legally owns and controls the assets; they can hire and fire the trading advisor as they wish, and redeem their money when they please. Although a Ucits fund is a commingled vehicle, it is a regulated product that offers frequent liquidity.”
Dollery says that most of Newedge’s hedge fund clients can comply with the Ucits framework without too much modification of their portfolios. “If you’re relatively well diversified and trading liquid instruments, or at least the majority of the portfolio is liquid, the exposures can be structured sin a Ucits-compliant manner with relative ease,” he says. “My only caveat is that as a broker, Newedge tends to focus on relatively liquid strategies. We’ve never been involved with funds that invest in illiquid loans and credit strategies, so our book of business probably complements Ucits quite well.”
The firm has refined and to some extent built new service offerings to meet the demands of Ucits hedge funds, particularly for the CTA and systematic macro managers that currently make up the largest segment of the European industry. He says: “We have done some structuring work, because Ucits funds are unable to hold commodity futures directly. They can take synthetic exposure to a financial index which itself consists of a range of underlying instruments including commodities contracts.
“Once the client receives regulatory approval for its index, it can then systematically trade the index constituents through a hedge account at Newedge. The P&L of the hedge account flows through to the index, and Newedge transfers the exposure to the Ucits fund through a total return swap.
“These three components – the hedge account at Newedge, the Ucits-compliant index and the swap – allow you to trade a CTA or systematic macro strategy in a Ucits-compliant manner. In the equity long/short space you may need to take the exposures synthetically through swaps and contracts for difference to gain long and short exposure, because you’re not allowed to leverage your positions directly.
“Newedge’s role includes strategy-specific prime brokerage work, whether through index swaps or CFDs, but also other areas such as capital introduction. Ucits funds offer the ability to access an additional investor base, and we have worked hard through our cap intro team to reach out to wealth management platforms and other investors who have become interested in alternative Ucits funds over the past year or two.”
Paul Farrell, a Dublin-based partner in Walkers’ global investment funds group, says that in the wake of the crisis regulatory scrutiny of Ucits funds has increased in Ireland. “The Central Bank undertakes a full review of the documentation for Ucits vehicles, whereas Qualifying Investor Funds designed for sophisticated investors normally receive next-day authorisation,” he says. “The review of a fund’s management and investment policies is more involved.”
The volume of new Irish-domiciled funds following alternative strategies has increased significantly since the beginning of 2010, he says. “Investors, particularly in the European Union, are pushing for regulated products, and more alternative managers are seeking to determine whether their products are suitable for the Ucits regime. Often they are setting up parallel Irish structures to their existing offshore vehicles, designed to meet the requirements of European investors who no longer feel comfortable investing through Cayman funds.”
In an interesting counterpoint, however, UK-based managers of offshore funds are examining whether having an offshore management company structure might enable them to escape the increased constraints – and costs – once the EU’s Alternative Investment Fund Managers Directive takes effect in two years’ time, according to Farrell’s London-based colleague Deborah Poole.
“London-based managers are looking very closely at potential arbitrage opportunities where they could act as investment adviser to an offshore manager,” she says. “They are hoping that when the directive’s Level 2 measures are drawn up, the offshore company will be treated as the fund’s investment manager, rather than the regulated entity in London. The aim is to minimise the impact of the directive, at least for the transition period over the next four or five years until all funds that want to market into Europe have to comply with the directive in full.”
Another relatively new development, Poole says, is moves by managers to clarify the liquidity rules for their offshore funds, reflecting the difficulties that arose at the peak of the crisis when funds imposed liquidity restrictions on the basis of terms and conditions that were sometimes unclear and in most cases had not been previously tested.
“Amid the fallout from the global financial crisis, we expected significant changes to Cayman structures to make liquidity rules rather more bespoke than they had been previously,” she says. “The typical boilerplate wording was tested by measures such as suspension of redemptions, gating and side-pockets. However, it is only relatively recently, with the resumption of start-up activity, that Cayman platform providers have moved to address these issues and tailor liquidity rules to a fund’s strategy and investor base, and to what the product is intended to achieve.”
There have been changes in other areas to the documentation drawn up for Cayman, she adds, notably affecting redemption proceeds paid in kind rather than in cash. “We now see more clarity in the documentation as to when and how ‘in kind’ assets are valued, for example where it has been defined how much investors are to be paid on the redemption day, but the assets decline in value before they are paid out,” Poole says.
“Disclosures in the offering documentation will often now address whether the obligation to pay the redemption proceeds will be satisfied by delivering those assets, or whether it requires delivery of something else that brings the cash value to the defined level on the redemption date.”
Uncertainties over redemption issues have resulted in a number of Cayman court cases over the past year. “They have involved the redemption process itself, when the redemption actually happens, and whether or not you can impose a suspension after the redemption date but before the proceeds have been paid,” she says. “It has made managers more conscious about ensuring transparency in the documentation about what they want to, or even can, achieve.”
However, Poole argues that other recent cases in which investors have sought to have an external liquidator appointed rather than allowing the fund’s manager to complete an orderly wind-down of the fund most likely reflect failures in communication with investors as much as uncertainty in the fund documentation.
“It’s a signal to the managers that they simply can’t neglect communication with their investors,” she says. “In many cases it appears that the problem has been not that investors were unable to get their cash out, but that the investment managers had gone underground. Some managers have taken their eye off the ball and gone on to other things. They may not have seen the process through to the end and kept their investors informed. These cases are symptomatic of investors at the end of their tether. A little more communication and transparency might have resolved these issues without going to court.”
In other cases investors in funds with distressed assets have been satisfied with innovative solutions designed to make the most of an unattractive economic environment. “We are seeing some rollover funds where investors are being partly cashed out and partly rolling over into a new structure,” Poole says. “Often there is a new investment manager providing a different skill set that may be particularly appropriate to the illiquid assets previously held in side-pockets. New seed capital is used in part to pay out investors in the existing structure, but they keep a certain proportion of their investment in the new structure they have been