A comprehensive MiFID II solution for new managers

Starting up a hedge fund is a challenging endeavour. Hiring staff, implementing all the necessary risk controls and regulations as well as running the organisation profitably, is far from easy. Many new hedge funds fail every year. However, starting a successful new hedge fund is still possible if one takes a pragmatic approach by outsourcing as many of the operational parameters as possible, including trading and execution. 

“We have the infrastructure in place, which is a big benefit to any new hedge fund manager and effectively offer a hedge fund hotel-type model,” comments Jerry Lees (pictured), Chairman of Linear Investments. 

In today’s regulatory environment, it can be hard to make a GBP20 to GBP30 million fund operate over the long term. A start-up manager is unlikely to be charging 2/20, at least not at the outset. If their Year One performance is 10 per cent and they are charging 1.5/20 this would equate to 3.5 per cent. If the fund’s AUM is GBP20 million, GBP700,000 of total revenue would be coming in to the business. 

As Lees points out, with that a manager has got to factor in the costs of operating the fund, including annual regulatory costs, office space, salaries, and IT infrastructure costs, all of which can quickly burn a hole in the operating revenue. 

“What we do, using our MiFID compliant and FCA registered platform is package everything together. Generally, our recommendation to managers at the smaller end of the scale is to start off with a managed account. They’re not going to be making enough profit to justify setting up a standalone fund structure. 

“By doing this they only pay brokerage fees. Then, at the end of two years (for example), if the manager is ready to set up a standalone fund structure we give them an independently audited track record,” says Lees.

This option of outsourcing the compliance aspect is proving highly popular with new managers, where they join a regulatory hosted platform and act as an appointed representative. 

“By outsourcing processes such as regulatory set-up and reporting to a platform solution, you will be able to show that your fund has operational technology in place, complies with all regulations and has the necessary risk controls. 

“Managers can use desk space in our office and use our IT infrastructure, all of which is now fully compliant with MiFID II. This includes transaction reporting, best execution, voice recording mobile phones, market abuse oversight, as well as complying with General Data Protection Regulation (GDPR) which comes into effect in May 2018,” explains Lees.

All of this means that start-up managers don’t have to look at the whole process of setting up their own IT infrastructure to get operationally ‘mission ready’. Rather, they can focus on the task of running their investment strategy and building a track record while they wait to receive FCA approval. 

Linear has a significant compliance team able to offer expertise in helping managers put all of their fund documentation together to apply for their FCA license, as well as advising them on the best jurisdiction to set up their fund. It has independent relationships with all of the big law firms and fund administrators so there are no conflicts of interest. 

By using Linear’s office space in the City of London and also in the West End, it gives start-ups the opportunity to talk to and share ideas with other fund managers. 

“We have 130 trading desks and at present we have six or seven fund managers, which vary in size; One of them has a staff of 18 people. It’s a diverse mix of trading strategies. We have FX funds, global macro, a cryptocurrency fund to name a few,” confirms Lees, who further adds that by using outsourcing trading, managers immediately remove the fixed costs of hiring two of three internal traders, Bloomberg terminals, paying end-of-year bonuses, etc. It all adds up and makes a real dent in a manager’s fledgling P&L.

“A number of large funds have moved across to us recently from existing prime brokers because they only had GBP40-50 million in AUM. They were given 30 days’ notice at the end of last year and needed to set up quickly, which we facilitated. They appreciate the fact that our trading and execution team gives them far more support than they ever received with their former PB. 

“To illustrate the point, this particular manager needed to execute a large block trade without moving the market and we managed to do the whole trade in the dark. There was no market impact and we managed to keep the costs down to a minimum. That sort of thing is really important to fund managers,” remarks Lees. 

Linear’s business model performs two major functions: execution, clearing and settlement on the one side and prime brokerage and financing on the other side. Without doing both, says Lees, “it becomes problematic”. 

“Say you are a GBP150 million long-only fund. Long-only funds hardly trade at all; they don’t generate a lot of commissions and revenue. Under Basel III, a bank-owned prime broker has to allocate up to 1 per cent of their balance sheet against those positions. That’s not economically viable if the fund is only generating a couple of hundred thousand in commissions each year. 

“Alternatively, that manager can come to us where we have huge trading lines due to the fact that we pool all of our clients together into an omnibus account. When we go to one of our prime brokers they like the fact that we give them a mixture of trades. We push through a high trading volume, on aggregate, so it works well,” says Lees.

Linear has an experienced trading team that includes David Michael, head of multi product trading who has more than 25 years’ experience and who joined Linear in May 2017 from Convergex. The aim, at all times, is to seek out best of breed trade execution prices. 

This is especially beneficial to managers as they start to adjust to life under MiFID II.

Linear spends a substantial amount of capital each year on technology, including the latest transaction cost analysis software, which it runs on a real-time basis. 

“We look at trade flow going to a particular broker to determine if they are offering the best price and have the tools in place to properly analyse trades. We have access to multiple market makers, MTFs and dark pools so we can fish around and get a client’s order to multiple brokers to execute best price,” confirms Lees.

This specialist hands-on approach is being well received among new managers and those rotating out of existing prime relationships where the manager wants a more inclusive, meaningful partnership. 

The omnibus account is fully hedged back to the underlying broker meaning Linear never has risk exposure. Linear currently uses a number of executing prime brokers including many global international players. 

Moreover, as Linear has a global financing deal with its executing brokers, Lees says the fact that overall trade volume in the omnibus account is substantial means that it is able to pass on competitive commission and finance rates; something that emerging managers are only too grateful for in today’s challenging market environment. n

To find out more about Linear go to www.linearinvestment.com

 

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James Williams
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