Segregated managed accounts: Caveat emptor
The demand among institutional investors for managed account solutions continues to evolve, as they seek out new structuring solutions and vehicles to meet their investment return, liquidity, transparency and jurisdictional needs.
One of the manifestations of this evolution is the emergence of using regulated fund vehicles to optimise their hedge fund allocations, not only in UCITS funds but also Alternative Investment Funds (AIFs) under the European AIFM Directive. Lyxor Asset Management has been operating managed accounts for two decades. Over that time, it has seen, and responded to, changing market dynamics. More recently, this has meant focusing on building out a larger range of liquid, regulated alternative UCITS funds on the Lyxor Alternative UCITS platform.
Offshore commingled and dedicated funds still dominate the Lyxor MAP, in terms of AUM (approximately USD13.5 billion), but the compass bearing has changed with respect to future evolution.
As Moez Bousarsar, Co-Head of Hedge Fund Selection, Lyxor Asset Management explains: “Four years ago, the bulk of our managed accounts were a range of offshore commingled funds mainly selected for institutional investors. Over the past two years, however, the Lyxor platform has definitely changed in terms of its priorities as relate to the products and services we offer clients. The level of assets on the offshore fund platform remains strong and we still have big names but interest among our investors has focused mainly on regulated UCITS funds.”
In addition, Lyxor’s investor base has shifted to a more balanced mix between institutional and distribution. More than just a managed account-based offering, Lyxor’s MAP has, says Bousarsar, become a centre point of expertise, “providing clients with research, selection, products and infrastructure services in order to help them with fund investments across different asset classes”.
LumX Group operates its LumMap platform as an Irish ICAV and has visions to build out a suite of AIFs to give European institutional investors access to hedge funds that can closely replicate offshore strategies without any of the restrictions of the UCITS regime.
Eric Bissonnier is CIO of LumX Asset Management and a member of the LumX Group’s Executive Committee. In his view, there is still a disconnect between how much an AIF can be helpful to the end investors, and their current perception.
“We’ve seen awareness grow over the last 12 months and the AIF becoming more well-known to investors,” confirms Bissonnier. “However, the UCITS structure still remains the default option. It takes time for investors to take on board the fact that the AIF is the better option, because over the years, UCITS investing has become a habit; it’s what they are used to. It’s either an offshore Cayman fund or an onshore UCITS fund.
“They hear about the AIF but it still remains a slightly nebulous concept to them. We are doing quite a lot of work to explain how the AIF works and why it is a compelling proposition, both for asset managers and investors.
“The education part is important and continues to evolve. Investors are creatures of habit at the end of the day.”
From a supply/demand perspective, it could be argued that the supply side (i.e. hedge fund managers) is somewhat more restrictive than the demand side. Institutions have long understood and leveraged managed accounts for their long-only portfolios, and while early stage alternative investors might prefer to use commingled managed accounts, those with deeper pockets and a more sophisticated palette are opting to build their own bespoke managed account mandates.
However, this is predicated on managers wanting to accept an SMA in the first instance. Some managers are not as taken by the merits of managed account mandates as others.
“If managers have a choice, in my opinion, they don’t take managed accounts because they are potentially a bit of a headache,” remarks one London-based global macro hedge fund. “It makes everything more costly. You’ve got to book trades separately, sometimes with a different prime broker so there is more chance of making mistakes; it just makes everything more difficult.
“The manager gets more assets but everything else is a negative. There should be an overriding reason for why an investor would decide to use a managed account. It needs to be well thought out because by using one of these structures it puts an unnecessary drain on the investment manager in my opinion.”
As such, MAP providers still need to get the message out that the operational burden, or the drain on a manager’s resources, is not necessarily the case.
“We perform all of the non-investment functions,” remarks Andrew Lapkin, CEO of HedgeMark, a BNY Mellon company. “The manager is almost exclusively limited to trading within our structure; moving any collateral, handling the NAV, etc; this is all done by us, unlike some other platforms who expect the manager to perform these functions. If a manager is having to use additional third parties to handle the managed account, it adds to the cost, which investors need to be aware of.”
Knowing that the platform is fully willing and able to handle all of the operational non-investment functions is critical. This is especially so when a large institution embarks on using carve-outs of investment strategies, possibly to create a more concentrated book, or to meet ESG criteria; whatever the reason, customised demands potentially place an even more onerous burden on the manager.
LumX’s network of service providers, trading counterparties, and prime brokers ensures fully independent valuations, tight control over mandate guidelines and limits, and direct verification of asset custody and ownership for each fund on the platform. It also typically offers managers the flexibility to trade through their preferred counterparties, minimising their internal administrative burden.
“We’re providing a solution rather than just a platform,” says Bissonnier. “We approach it from an asset manager’s perspective because that’s our heritage. We’ve been investing in hedge funds for decades and therefore we understand each manager’s issues, as well as what investors are looking for in terms of types of vehicles, how they wish to monitor strategies and so on.
“We spend time understanding what the manager needs, rather than fitting them in a box and sending them a pre-specified term sheet which they can’t change. Our ability to come up with a tailored solution has been the main driver for managers wishing to join us.
“If you look at other platforms which are typically owned by service providers, they have a different incentive. For some managers who maybe have a complex strategy, it can quickly become a difficult discussion, which they might not have the bandwidth to handle.
“I believe that our flexibility and willingness to provide something that is tailored to what they need, within legal and structural boundaries, makes managers’ lives a lot easier. To them, operating on a platform is suddenly achievable rather than feeling they might get lost in the operational details.”
Evan Katz is a Managing Director at Crawford Ventures, the New York City-based hedge fund fundraising firm. He believes that there are two principal advantages to using managed accounts. The first is that it removes some of the operational risks that investors face, especially if they are investing in small or emerging managers. Because the platform will typically provide robust infrastructure and operational oversight, often far greater than these managers are able to afford or provide at that stage of their lifecycle.
“Secondly, if the platform is respected and well-known, there may be a ‘halo effect’ in that if the platform is very particular about whom they let on, in terms of fund performance and the pedigree of the portfolio management team, this can benefit managers and present their funds in a more positive light.
“Furthermore, there is also the possibility of increased capital inflows from being on a prominent platform, especially if the platform also offers fundraising and cap intro services. Although in some cases this may be more hope than expectation, it definitely does occur,” suggests Katz.
Managed accounts are becoming an easier concept for managers to consider given technology advances, compared to a decade ago. As a rule of thumb, says Katz, if an allocator wants to do a managed account typically “they will need to invest the equivalent of at least 20 per cent of the manager’s AUM.
“That is, if an emerging manager has USD100 million in the fund, many would consider accepting a managed account for about USD20 million or more. But there are some investors, including some endowments, foundations and pensions, that often don’t want managed accounts, because they don’t want to be doing their own account setup, ISDAs and so on.
“It is also worth noting that regulators are looking closely at these structures in order to verify and ensure that all of the fund’s trading orders are being executed accurately and pari passu among the onshore fund, the offshore fund, and any and all platforms and SMA’s, and that all of the orders are being executed simultaneously. This is to ensure that the none of the fund’s investors are benefiting from better execution and prices than any of its other investors,” explains Katz.
This is a key point as any hedge fund manager must always consider how taking on a managed account mandate might potentially impact existing investors in their offshore fund(s).
“If an investor wanted to appoint us to a private mandate we would want to clearly determine what terms they were asking for, for liquidity, structure and fees, such that it would not disadvantage our existing clients,” comments Susannah de Jager, Partner and COO, SW Mitchell Capital, a European equities investment manager. “Our level of comfort, on the whole, is greater if someone is setting up an SMA with longer liquidity terms, to avoid skewing anything in the flagship strategy.”
She says that, conceptually, SW Mitchell is comfortable with taking on managed accounts but stresses that each potential mandate would need to be assessed on its own merits, so as to ensure that it would work harmoniously within the overall investment strategy.
“In our experience, the smallest least institutional accounts you take on tend to become the most burdensome, just by the nature of the way these things work. Those investors with the least experience of using managed accounts need more handholding,” adds de Jager.
Taking on a managed account is an easier concept if it is an asset owner of size and they are a long-term asset owner. In such a situation, using such a structure make sense. It ensures all parties are correctly aligned, it gives the investor greater transparency, and it should lead to reciprocity for the manager if they know this is a long-term commitment.
“Our long-term experience of using managed accounts has been very positive,” says one hedge fund manager, who asks to remain anonymous. “As a general rule we’ve had very good relationships with people, they’ve set up everything the way they wanted, received reporting when they needed it, they’ve been able to do currency hedging and so on, in order to meet their specific investment requirements.
“On the flip side, if you have an asset owner who is going into it for lack of a suitable commingled fund, I would say it can have a more negative effect. We’ve had situations in the past where there has been promise of further growth in the mandate by the investor, it fails to happen and it then leads to a mismatch in terms of the effort it takes to set up the SMA and the fees taken.”
Investors therefore need to be wary about unnecessarily introducing complexity if it doesn’t match the reward: this benefits neither party. There is plenty of appeal to using a managed account to improve one’s customisation to hedge fund investing, but it is not without risks and requires substantial planning and a clear vision.
“I would say the minimum amount for taking on a managed account mandate is USD50 to USD100 million before it even starts to make any sense for the manager,” suggests the global macro manager.
Katz relays an anecdote that highlights an issue in terms of how some institutions really use managed accounts. Much is made of the added real-time transparency and control, but what, if anything, do investors really do with all that data? Do they really analyse it on a daily basis, to track their portfolio of potentially dozens of hedge fund managers?
“One manager I met with recently told me that he was curious just how many of his hedge fund’s investors were actually checking on the daily numbers and positions, using the fund’s real-time investor portal. To test this, at the start of the month, the PM changed everybody’s passwords and waited to see how many investors called him to say, ‘Hey, we’re having trouble accessing the portal’.
“He waited two weeks and the percentage of investors who called was roughly only 10 per cent,” recalls Katz. “That is, some 90 per cent of the fund’s investors were not even bothering to use the fund’s full-transparency portal.”
Does an SMA, therefore, give investors a false sense of security perhaps?
“You certainly need to make sure that things are automated to effectively monitor investment guidelines, risk controls, etc,” continues Katz. “If a manager isn’t abiding by position or sector limits, for example, or leverage limits, this should get automatically flagged and immediately brought to the investor’s attention.
“It’s very hard to effectively monitor many managed accounts manually. Investors need that system automation set up on their end. Otherwise I think it is a bit of a false sense of security.”
Bissonnier says that the liquidity argument for using fund platforms is somewhat of a red herring. In the current market environment, institutional investors are all too aware that they need to diversify into more illiquid investments – hence why private equity and real estate funds have attracted so much capital.
“Some of the most interesting investments are illiquid in nature, so to solve the liquidity conundrum (and avoid becoming a forced seller) the best option is to have your own structure. One where you can make sure that someone is checking that the pricing is done independently and to make sure the manager is doing what they should be doing, which is the premise of using managed account platforms,” concludes Bissonnier.