Having weathered the storms that have raged across the hedge fund industry since mid-2008, many funds of hedge funds and other allocators such as private banks and endowments are looking to re-establish their credibility with investors. The old model of outsourcing the governance of a hedge fund portfolio to a string of boutique management firms is being questioned and re-engineered to bring more appropriate levels of control back to the allocators.
The change in the fund of hedge funds model to enable fiduciary powers to be reclaimed on behalf of the investor has spawned much new thinking and better practice, the application of which is being embodied in the wide range of infrastructure designs known as managed account platforms.
Demand was already growing from funds of hedge funds seeking to re-engineer their business practices to protect themselves from a repeat of the liquidity problems they faced in obtaining redemptions from underlying managers, before the eruption of the Bernie Madoff scandal in December 2008 focused increased attention on the advantages of managed account investment in reducing fraud risk.
MAG Consultancy was established in early 2009 to meet demand among allocators such as funds of hedge funds for a managed account infrastructure that would resolve a number of the key operational issues that had caused such angst, such as the inability to control valuation policy, cash policy and the inappropriate use of gating.
The firm’s partners and staff, who include John Godden of IGS and Simon Hookway of MSS, have between them been closely involved in the design, building and running of more than a dozen existing managed account platforms and have been able to bring the benefit of this experience to those looking for advice and assistance in deploying a managed account strategy.
A huge dynamic shift is in prospect. Whereas historically some 3 per cent of assets allocated to funds of hedge funds has been invested via managed accounts, this is rising exponentially and could increase over the next year to as much as half of all fund of funds assets. MAG Consultancy is dealing with a broad spectrum of allocators including fund of funds managers, administrators and banks as well as hedge fund managers seeking to offer their own managed account infrastructure.
It has become apparent that much of the managed account capability has rested with product providers, which has limited the possible solutions and kept fees falsely high. MAG’s strength as the only independent adviser in the managed accounts space enables us to look at clients’ options with a completely clear eye and to provide advice on resourcing, costs, systems and legal structure.
Many allocators have rejected a fully outsourced managed account solution as carrying too many compromises, such as commingling with structured product investments or weak key service providers. But building an in-house managed account platform, with key functions outsourced but under the control of the allocator, requires careful planning if it is to be executed efficiently and effectively.
A managed account platform consists of various major components. First, the legal structure needs to be a cost-effective regime in a domicile that suits the target investors and takes account of potential regulatory measures such as the EU Directive on Alternative Investment Fund Managers. Customer views will influence whether a platform should be onshore or offshore, or in the Channel Islands as opposed to Cayman, the BVI or Bermuda. Another key consideration is the relative merits of a corporate as opposed to a trust arrangement. There are some 56 separate legal documents on an average managed account platform – making these talk to each other is the trick to an effective regime.
The second crucial component is operational infrastructure, as the allocator moves to the new position of being the de facto trading middle office between the trading advisor (via the prime broker) and the fund. Unless the allocator is already experienced in such tasks this is probably best outsourced to a bank or administrator.
Third is risk monitoring. Managed accounts throw up daily position-level data that needs to be handled (usually by specialist IT) to monitor accurately for breaches against predetermined trading mandates. Last is fiduciary management, the key decision-making tasks including selection of managers, defining trading advisory terms and taking action in the event of breaches. This also extends to responsibility for valuations and selection of all service providers. Again, allocators are increasingly looking for outsourcing in this area.
Within a managed account infrastructure, it is the ability to act on information that creates meaningful control and is central to resolving governance issues. If a manager is in material breach of any major factor, you can take back control immediately rather than being stuck behind a six-month redemption notice. Even if the liquidity of the underlying assets is limited, you can take control of the assets, either for someone else to run or to close out the positions.
Further benefits of a managed account platform include the fact that daily, highly robust data enables much more sophisticated portfolio management and risk monitoring tools to be used, while the common legal infrastructure allows a more dynamic allocation strategy to be deployed. Operational due diligence is applied on a platform-wide basis as all components and service providers are common, and scale benefits can be brought to bear to reduce service provider fees. In addition, corporate policy can be deployed effectively on behalf of investors – for instance, a view that Lehman was in trouble could have been acted upon immediately.
The scale required for a successful managed account platform used to be calculated in terms of an average minimum fund size of USD50 and total minimum assets of USD1bn. However, the advent of non-bank commingled facilities is set to reduce the minimum platform size necessary to just a few hundred million.
Another important change is the readiness of managers to meet requests for managed accounts. In recent months managers have become more accessible than ever, although increasing asset levels across the industry may see attitudes hardening over time. Managers will also, sensibly, limit the number of managed accounts they offer. As a result, there is a something of a race underway to get facilities established.
In the past creating managed account infrastructure has been expensive and time-consuming; two years and USD10m has been par for the course. Usually new platforms would be created from scratch, with no managers, infrastructure or assets. However, today clients tend to be running assets and have investments with managers already, so they are no longer building on a greenfield site. The migration of existing assets with an existing manager array will initially drive the design of the platform.
MAG Consultancy utilises its existing technology in all areas from legal documentation to risk monitoring systems to save clients time and money, and our staff resources include highly experienced lawyers, operations staff and administrators who have already been there, seen it, done it, and know where mistakes can be made or where costs can run out of control.
Having taken crucial but difficult decisions in the past, it is easier to develop solutions today. Many clients already have much of what they need and just need help to take the final step. With the right direction that can take less than six months, delivering a robust infrastructure for a tenth of what it would have cost in the past.
Richard Day is managing director with MAG Consultancy