The third of a six-part guide by Dermot S.L. Butler, Chairman of Custom House Administration & Corporate Services Limited (Custom House).<?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />
3. The Complexities of Administering Hedge Funds
There are a number of areas in which the administration of Hedge Funds differs from the administration of the more traditional Mutual Funds or Unit Trusts. These include: the range of investment instruments; and the strategies used to exploit these instruments; the ability to go short; leverage; fee structures, including incentive or performance fees; and equalisation.
The traditional Mutual Funds or Unit Trusts are, for the most part, retail funds with quite restrictive investment policies - which include: very broad diversification; no short selling; no leverage; and derivative trading limited to "Efficient Portfolio Management", which is a Euro euphemism for hedging, but very targeted hedging.
On the other hand, Hedge Fund strategies utilise a vast range of derivative instruments, which can introduce pricing problems.
These strategies range from the relatively straightforward exchange traded commodities, financial futures and options contracts, to highly complex derivative products, which include swaps and CFDs, which are Contracts for Differences, currency forward contracts traded on the Interbank market and a wide variety of customised instruments created by major banks and financial institutions and sold on the Over the Counter (OTC) market.
Hedge Fund portfolios, which have these exotic investments, are not inherently difficult to administer or account for, providing the Administrator is able to obtain a reliable and verifiable price for the investments, upon which that Administrator can base the NAV calculation.
Most Hedge Fund strategies are, essentially, quite simple long-short strategies, from the obvious long-short equity fund, through merger arbitrage, commodities, futures, options and bonds and none of these present a problem, if they are traded on a recognised exchange and a liquid market.
The problems come with illiquid assets and esoteric derivative products, created by and sold by just one financial institution, which is the only valuer of those assets.
What is essential is that a clear valuation policy is disclosed in the offering document and some fallback plan is in place, in case the unthinkable happens, - which it inevitably will, if you don't have any fallback plan.
Where possible, an independent price source must be used. If that isn't possible, a reasonable, practical pricing formula must be agreed between the Investment Manager, the Administrator, and - this is important - the Auditor, before the Fund is launched and, some fallback plan, in the event that market circumstances change, is also agreed.
The volatility of the Fund can be exacerbated by leverage and this can bring its own valuation problems, particularly if leverage is provided by utilising an option or other derivative instrument. The ability to go short is, itself, a form of leverage and, in some arbitrage strategies, a dramatic change in market conditions, or even just market sentiment, can decimate the relationship between the two arbitrage components, which is essentially what happened to Long Term Capital.
Management and Performance Fees
The manner in which management and performance fees for Hedge Funds are calculated, can be very complicated and is certainly never standardised, unlike Mutual Funds, which are, for the most part, charged on a standardised basis. For instance, management and/or performance fees can be charged on a monthly, quarterly, half-yearly or annual basis, but they must be accrued for at least monthly.
- They may be charged, on the opening NAV at the start of the period, the closing NAV at the end or, on the average, during the period.
- They may be charged before all other fees, or after all other fees.
- They may be subject to a benchmark, or a hurdle, which could be a market index, such as the S&P500, or a specified fixed return, or a variable rate - say three month LIBOR.
- The accrual of these fees, including the calculation of the performance fees, after allowing for the benchmark, then has to be adjusted in the event of a redemption, because, even if the rest of the Shareholders aren't due to pay their performance fee yet, the redeeming Shareholder will have to pay any performance fee due on its investment.
- All this is a relatively complicated accounting process, but can be achieved automatically, if the Administrator has the appropriate system.
The real problems occur in this area with "Equalisation", which is the term used to describe the various accounting processes designed to ensure that the performance fee due to the Investment Manager is allocated fairly between all Shareholders.
Most people assume that Equalisation is only needed in order to ensure that the Investment Manager receives the full performance fee due to him and that an investor who buys on a dip does not get a "free ride". Consider the following example:
- If a Fund starts trading at USD 100 per Share and the market rises to USD 120 at the end of an accounting period, then an incentive or performance fee will be paid, which, if it is a 20% incentive fee, would be USD 4.
- The Investment Manager would not receive any further incentive fees until the NAV per Share had reached USD 120 again - the "High Watermark".
- Let us assume that the Fund suffers a drawdown to USD 90 per Share, at which point a new investor subscribes.
- If the value of the shares now rise from USD 90 to USD 120 at the end of the fee payment period, the USD 30 profit made by that Shareholder would not incur an incentive fee, because the Investment Manager would not be entitled to claim an incentive fee, until the NAV had reached USD 120. So that Shareholder would receive a USD 6 (20% of USD 30) 'free ride'.
Equalisation eliminates this anomaly.
Most people think the 'free ride' was the main reason for bringing Equalisation in and they are correct. Undoubtedly, that is why Equalisation was introduced in the first place. However, mathematically, it can be proved that, if investors subscribe into a Fund between performance fee payment dates then, regardless of whether the price of the shares had risen or fallen in the meantime, some Shareholders will pay a proportionately lower incentive fee than they should, and so conversely, others will pay a higher incentive fee than they should. Thus, unless Equalisation is applied all the time, some Shareholders are subsidising other Shareholders, to their own detriment.
Dermot S.L. Butler is Chairman of Dublin-based Custom House Administration & Corporate Services Limited ("Custom House"), a company that specialises in assisting clients in the organisation, establishment and administration of alternative investment and hedge funds. Custom House is regulated by the Irish Financial Services Regulatory Authority ("IFSRA"), and authorised under Section 10 of the Irish Investment Intermediaries Act, 1995.