Monthly Archives: September 2008

SEC Charges Investment Adviser with Cherry-Picking

Blue sky laws and filings for hedge funds

The term “blue sky laws” refers, generically, to any of the securities laws of the individual states. Each state has a set of laws on its books dealing with securities. These laws have many similarities to the securities laws at the federal level (the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Investment Advisers Act of 1940); in fact, many of the state blue sky laws are based on the laws at the federal level. The state blue sky laws are enforced by the state securities administrator which is the state’s enforcement agency – it serves a similar function as the SEC does at the federal level. Additionally, the state securities administrator may work in conjunction with the SEC in certain matters.

There are two distinct instances when, in virtually all of the states, blue sky laws become applicable to hedge fund managers (even unregistered hedge fund managers).

Blue Sky Anti-Fraud Authority

The first instance is when the state administrator pursues an action (i.e. request information, etc.) against a hedge fund manager (even if the hedge fund manager is unregistered) pursuant to its anti-fraud authority. While each state’s anti-fraud statutes will differ, they are all drafted very broadly to give the state administrator wide lattitude for going after potential hedge fund frauds. However, under this authority, the state administrator can also go after honest hedge fund managers. While uncommon, it may happen in certain instances. If it does, you should contact an experienced attorney immediately. For most all unregistered hedge fund managers, this should not be something to worry about.

Blue Sky Filing Requirements

The second and more common instance when blue sky laws are implicated is when a fund will need to make a “blue sky filing.” As a general statement, a hedge fund will need to make a “blue sky filing” in each state where one of its investors resides. The filing will generally need to be made within 15 days of the date of the investment into the hedge fund and the investment manager will need to pay a fee which will usually range anywhere from $75-$300 or more. (Please note: for investors from New York a manager will need to make the blue sky filing prior to an initial investment into the fund. The New York filing fee is going to be approzimately $1,400.)

To make a blue sky filing, you will first need to provide your hedge fund attorney or your compliance consultant with a few items of information including:

1. state where the investor resides
2. amount of the investment (including the amount of all previous investments)
3. the minimum investment amount (can be found in the hedge fund offering documents)
4. the management fee (can be found in the hedge fund offering documents)

After recieving this information your lawyer will complete a Form D and a Form U-2 and will help coordinate the filing of these documents with the appropriate state administrator. The lawyer will also send a copy of Form D to the SEC for filing. Form D filings are searchable through the SEC Edgar search engine.

Blue Sky Questions

Question: Does the fund or the management company pay the blue sky filing fees?

Answer: Most all offering documents which I have seen specifically name blue sky filing fees as an expense of the fund. However, if this is not specifically named as a fund expense in your fund’s offering documents, it will likely still be a fund expense as most fund’s have a general catch-all for expenses like these. If you have any specific questions, it is best to get clarity from your attorney.

Question: Does a manager have to pay the blue sky filing fee to each state on a yearly basis?

Answer: This is a good question. As with many blue sky questions, it will depend on the specific state. Some states only require a one-time filing fee, other states require that the filing fee be paid on an annual basis. New York is a combination of these two as its filing fee is good for four years. Your attorney or compliance professional should be able to discuss this with you on a state by state basis.

Hedge fund institutional investor due diligence

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The goal of many hedge funds is to reach a point where they can start attracting investments from institutional investors. Many hedge funds (especially those with pedigreed managers) are able to start with backing from institutional investors while others (including many start up hedge funds) will need to develop a track record before seriously courting these types of investors. This article describes institutional investors and details some of the hedge fund due diligence procedures which institutional investors will put a fund through prior to investing.

What is an institutional investor?

Institutional hedge fund investors include state and corporate retirement and pension plans, endowments (non-profit and educational), banks, insurance companies and other types of corporations and companies. Sometimes there are very large hedge funds which will themselves invest in small and start up hedge funds – in such instances the large hedge fund will be acting as an institutional investor and will require many of the same due diligence materials. Institutional investors are important for the hedge fund community because they provide a very large potential base for investments.

What is hedge fund due diligence?

Hedge fund due diligence is the process that an investor goes through in order to vet a potnetial investment in a hedge fund. Due diligence will include the following:

background checks on all of the managers and employees of the management company
thorough review of all of the hedge fund offering documents
review of the management company’s risk management procedures

Due diligence document request

The timeline for an investment by an institutional investor is likely to be much longer than the time an individual investor will take to invest in your fund. Typically an investment will need to be approved by the managing director in charge of investments or alternatives; then the institutional investor’s compliance department will typically make a request for certain documents and/or other information. A sample list of the documents requested might look like the following:

Please provide the following information:

Brokerage Agreement with [name of hedge fund broker]
Copies of the executed partnership agreement(s)
Copy of executed opinion of legal counsel relating to the legality of the interests [HFLB note: this is not a legal requirement and many funds do not receive an opinion of counsel with regard to these matters]
Copy of executed opinion of legal counsel with respect to U.S. Federal Income Tax Consequences [HFLB note: this is not a legal requirement and many funds do not receive an opinion of counsel with regard to these matters]
Any other legal opinions rendered in connection with the Partnership
Reference name, title and telephone number for each auditor, legal counsel, clearing broker, custodian, consultant, administrator engaged by the Partnership of General Partner for the past two years
A description of valuation policies and procedures [HFLB note: this may not be applicable to a fund; will depend on the investment strategy and the potential investments]

Depending on the nature of the institutional investor, you will see different levels of analysis of the actual trading style and returns of the fund. A sample reqest for information might include the following:

A detailed information on the trading program including:

list of investments
execution
frequency
diversification
liquidity

A detailed examination of historical returns including:

weekly/monthly/annual returns (best/worst/average)
sharpe ratio
sortino ratio
standard deviation
VaR
drawdown analysis

While I have hit upon most of the high points, any one institutional investor may have requests which are completely different from the items requested above. If you have any questions on the due diligence process or an investment into your fund from institutional investors, please don’t hesitate to contact me directly.

Offshore hedge funds – structure and considerations

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Many people don’t understand what an offshore hedge fund is or the purpose of the offshore hedge fund. An offshore hedge fund is simply a structure used by hedge fund managers as a way to attract offshore investors (non-U.S. citizens) or U.S. tax-exempt investors (explained later in this article). The offshore hedge fund will generally be established in various jurisdictions through a variety of structures (that is, as a single entity structure, a side by side structure or a master-feeder structure).

I provided the information in the article below to inform you about the various jurisdictions in which offshore hedge funds will be established. Please note that the driving considerations for establishing an offshore hedge fund will be tax efficiency (both the structure and jurisdiction should be discussed with your attorney), preference and perception of manager and prospective investors and the cost of establishing the fund in the various jurisdictions. Your attorney should discuss these items with you when you consider in which jurisdiction to establish your hedge fund.

Offshore Hedge Fund Jurisdictions

The offshore hedge fund can be established in a variety of different jurisdictions and the driving force for the jurisdiction of choice will be tax considerations. A vast majority of the hedge funds are established in low or zero tax jurisdictions. This means that there is no corporate level tax for the offshore hedge fund – this does not, however, necessarily mean that there are no taxes for the investors in the fund. Instead the investors in the fund will generally be taxed in their country of residence on the income from the fund. Another consideration will be the regulatory laws in place in the jurisdiction.

The two most prevalent offshore jurisdictions are the Cayman Islands and the British Virgin Islands (BVI). In both the Caymans and the BVI there are strong regulatory structures in place in order to assure investors that the managers of the offshore funds are legitimate. Other offshore hedge fund jurisdictions include: Bahamas, Bermuda, Nevis, Guernsey, Jersey, Dubai, among many others.

Structure

There are three main offshore hedge fund structures: single, side by side and master-feeder. The structure will be dictated in large part by the intent of the sponsor of the offshore fund.

Single fund structure – this is a structure which is geared primarily towards non-U.S. investors, and also potentially to U.S. based non-taxable investors (such as pensions and endowments). The sponsor and management company can be either U.S. based or offshore based, but most offshore stand alone fund structures are managed by offshore individuals.

Side by Side structure – in this structure a U.S. based (typical) investment manager will run two completely separate funds in the exact same manner. This means that the manager will form both a domestic and offshore hedge fund. This structure is often good for certain strategies such as a fund of funds strategy. It is not as good for other, trading intensive strategies simply because trade tickets are typically split between the domestic and offshore fund which creates administrative hassles.

Master-feeder structure – this is a very common structure which will have a domestic hedge fund “feeder,” an offshore hedge fund “feeder” and an offshore hedge fund “master.” In many cases the master-feeder structure is the preferable structure from an ease of administration point of view. However, please be aware that there are some accounting considerations which you should be aware of when establishing a master-feeder structure. In many instances this structure can be used to minimize tax impact on the investment manager – our firm has substantial experience with this structure and would be happy to help you think through the issues involved. Other law firms should also be able to help you use this structure to minimize tax impact to the manger.

Cayman Island hedge funds

Cayman is probably the most popular offshore jurisdiction and is viewed to be the pre-eminent offshore hedge fund jurisdiction. The Cayman Islands regulatory body is named the Cayman Islands Monetary Authority or CIMA. There are two types of offshore funds which can be structured in the Caymans: a registered or non-registered fund.

Registration

A Cayman hedge fund is required to register with CIMA if:

The fund is open-ended and has more than 15 investors, OR
The fund has 15 or less investors and those investors do not have the right to appoint or remove a director.

A fund would not need to be registered with CIMA if neither of the above items were applicable. Generally this will be the case for private equity funds and for offshore incubator hedge funds.

Requirements

If the Cayman offshore fund is registered with CIMA, it will need to comply with the following requirements:

payment of an up front and recurring annual fee of US$3048 to CIMA
at least 2 directors who must be individuals (the directors do not need to be resident in the Caymans)
an auditor who is situated in Cayman
a minimum initial investment of US$100,000 or higher

If the fund is not CIMA registered, the fund will only need to have 2 directors.

Other

It was recently released that Cayman Islands has over 10,000 offshore hedge funds registered with CIMA.

BVI hedge funds
[Information on the BVI will be coming soon!]

Tax Considerations
[Information on tax considerations will be coming soon!]

Hedge fund high watermark

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Question: What is the hedge fund high watermark?

Answer: The hedge fund high watermark is a mechanism that is implemented to make sure that managers do not take a performance fee when the fund has had negative performance over previous performance fee periods. The high watermark is the colloquial term for the mechanical application of a “cumulative loss account.” A cumulative loss account is a memorandum account which calculates any losses to an investor during a performance fee period (it does not matter whether the performance fee period is monthly, quarterly, or yearly); the cumulative loss account starts out with a zero balance and it is increased only if there are losses during the performance fee period. The cumulative loss account will increase by the amount of any loss any time there is a loss during a performance fee period. The cumulative loss account will decrease by the amount of any gain during a performance fee period, but the cumlulative loss account will never go below zero. So if a hedge fund has gains over three performance fee periods, then the cumulative loss account will be zero. An example of the mechanical application of the cumulative loss account and high watermark calculations are below:

Hedge fund NAV 01/01/04 1,000,000

Hedge fund NAV 12/31/04 1,200,000 (total after expenses, including the management fee expense)
Gain 200,000
Less Performance fee 40,000 [20% of 200,000]
Cumulative loss account 0

Hedge fund NAV 01/01/05 1,160,000

Hedge fund NAV 12/31/05 1,000,000 (total after expenses, including the management fee expense)
Gain (160,000)
Less Performance fee 0
Cumulative Loss Account 160,000

Hedge fund NAV 01/01/06 1,000,000

Hedge fund NAV 12/31/06 1,100,000 (total after expenses, including the management fee expense)
Gain 100,000
Less Performance fee 0
Cumulative Loss Account 60,000

Hedge fund NAV 01/01/07 1,100,000

Hedge fund NAV 12/31/07 1,300,000 (total after expenses, including the management fee expense)
Gain 200,000
Less Performance fee 24,000 [20% of 140,000]
Cumulative Loss Account 0

The concept of the high watermark is theoretically similar to the “claw-back” provision found in many private equity funds in that its purpose is to make sure that the manager is not overcompensated for underperformance. But the high watermark is distinctly different in the fact that it is a prospective in nature (whereas the claw-back is retrospective in nature); that is, the high watermark is applied on a going forward basis so that a manager will not be penalized for profits which were previously taken. The manager however, will need to get the fund’s account back up to the highwatermark before he can again take a performance fee.

Paulson announces conservatorship of Fannie and Freddie

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In an unprecedent move today, Treasury Secretary Henry Paulson announced that Fannie Mae and Freddie Mac will be placed under Federal Housing Finance Agency conservatorship.

I expect that this will be huge news tomorrow and I look forward to any comments on how this will affect the hedge fund industry.

For questions and answers on the conservatorship, please see: fhfa_consrv_faq_090708hp1128

From the Treasury website:

September 7, 2008
hp-1129

Statement by Secretary Henry M. Paulson, Jr. on Treasury and Federal Housing Finance Agency Action to Protect Financial Markets and Taxpayers

Washington, DC– Good morning. I’m joined here by Jim Lockhart, Director of the new independent regulator, the Federal Housing Finance Agency, FHFA.

In July, Congress granted the Treasury, the Federal Reserve and FHFA new authorities with respect to the GSEs, Fannie Mae and Freddie Mac. Since that time, we have closely monitored financial market and business conditions and have analyzed in great detail the current financial condition of the GSEs – including the ability of the GSEs to weather a variety of market conditions going forward. As a result of this work, we have determined that it is necessary to take action.

Since this difficult period for the GSEs began, I have clearly stated three critical objectives: providing stability to financial markets, supporting the availability of mortgage finance, and protecting taxpayers – both by minimizing the near term costs to the taxpayer and by setting policymakers on a course to resolve the systemic risk created by the inherent conflict in the GSE structure.

Based on what we have learned about these institutions over the last four weeks – including what we learned about their capital requirements – and given the condition of financial markets today, I concluded that it would not have been in the best interest of the taxpayers for Treasury to simply make an equity investment in these enterprises in their current form.

The four steps we are announcing today are the result of detailed and thorough collaboration between FHFA, the U.S. Treasury, and the Federal Reserve.

We examined all options available, and determined that this comprehensive and complementary set of actions best meets our three objectives of market stability, mortgage availability and taxpayer protection.

Throughout this process we have been in close communication with the GSEs themselves. I have also consulted with Members of Congress from both parties and I appreciate their support as FHFA, the Federal Reserve and the Treasury have moved to address this difficult issue.

Before I turn to Jim to discuss the action he is taking today, let me make clear that these two institutions are unique. They operate solely in the mortgage market and are therefore more exposed than other financial institutions to the housing correction. Their statutory capital requirements are thin and poorly defined as compared to other institutions. Nothing about our actions today in any way reflects a changed view of the housing correction or of the strength of other U.S. financial institutions.

***

I support the Director’s decision as necessary and appropriate and had advised him that conservatorship was the only form in which I would commit taxpayer money to the GSEs.

I appreciate the productive cooperation we have received from the boards and the management of both GSEs. I attribute the need for today’s action primarily to the inherent conflict and flawed business model embedded in the GSE structure, and to the ongoing housing correction. GSE managements and their Boards are responsible for neither. New CEOs supported by new non-executive Chairmen have taken over management of the enterprises, and we hope and expect that the vast majority of key professionals will remain in their jobs. I am particularly pleased that the departing CEOs, Dan Mudd and Dick Syron, have agreed to stay on for a period to help with the transition.

I have long said that the housing correction poses the biggest risk to our economy. It is a drag on our economic growth, and at the heart of the turmoil and stress for our financial markets and financial institutions. Our economy and our markets will not recover until the bulk of this housing correction is behind us. Fannie Mae and Freddie Mac are critical to turning the corner on housing. Therefore, the primary mission of these enterprises now will be to proactively work to increase the availability of mortgage finance, including by examining the guaranty fee structure with an eye toward mortgage affordability.

To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size.

Treasury has taken three additional steps to complement FHFA’s decision to place both enterprises in conservatorship. First, Treasury and FHFA have established Preferred Stock Purchase Agreements, contractual agreements between the Treasury and the conserved entities. Under these agreements, Treasury will ensure that each company maintains a positive net worth. These agreements support market stability by providing additional security and clarity to GSE debt holders – senior and subordinated – and support mortgage availability by providing additional confidence to investors in GSE mortgage backed securities. This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations. It is more efficient than a one-time equity injection, because it will be used only as needed and on terms that Treasury has set. With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers. Additionally, under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares.

These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS.

Market discipline is best served when shareholders bear both the risk and the reward of their investment. While conservatorship does not eliminate the common stock, it does place common shareholders last in terms of claims on the assets of the enterprise.

Similarly, conservatorship does not eliminate the outstanding preferred stock, but does place preferred shareholders second, after the common shareholders, in absorbing losses. The federal banking agencies are assessing the exposures of banks and thrifts to Fannie Mae and Freddie Mac. The agencies believe that, while many institutions hold common or preferred shares of these two GSEs, only a limited number of smaller institutions have holdings that are significant compared to their capital.

The agencies encourage depository institutions to contact their primary federal regulator if they believe that losses on their holdings of Fannie Mae or Freddie Mac common or preferred shares, whether realized or unrealized, are likely to reduce their regulatory capital below “well capitalized.” The banking agencies are prepared to work with the affected institutions to develop capital restoration plans consistent with the capital regulations.

Preferred stock investors should recognize that the GSEs are unlike any other financial institutions and consequently GSE preferred stocks are not a good proxy for financial institution preferred stock more broadly. By stabilizing the GSEs so they can better perform their mission, today’s action should accelerate stabilization in the housing market, ultimately benefiting financial institutions. The broader market for preferred stock issuance should continue to remain available for well-capitalized institutions.

The second step Treasury is taking today is the establishment of a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Given the combination of actions we are taking, including the Preferred Share Purchase Agreements, we expect the GSEs to be in a stronger position to fund their regular business activities in the capital markets. This facility is intended to serve as an ultimate liquidity backstop, in essence, implementing the temporary liquidity backstop authority granted by Congress in July, and will be available until those authorities expire in December 2009.

Finally, to further support the availability of mortgage financing for millions of Americans, Treasury is initiating a temporary program to purchase GSE MBS. During this ongoing housing correction, the GSE portfolios have been constrained, both by their own capital situation and by regulatory efforts to address systemic risk. As the GSEs have grappled with their difficulties, we’ve seen mortgage rate spreads to Treasuries widen, making mortgages less affordable for homebuyers. While the GSEs are expected to moderately increase the size of their portfolios over the next 15 months through prudent mortgage purchases, complementary government efforts can aid mortgage affordability. Treasury will begin this new program later this month, investing in new GSE MBS. Additional purchases will be made as deemed appropriate. Given that Treasury can hold these securities to maturity, the spreads between Treasury issuances and GSE MBS indicate that there is no reason to expect taxpayer losses from this program, and, in fact, it could produce gains. This program will also expire with the Treasury’s temporary authorities in December 2009.

Together, this four part program is the best means of protecting our markets and the taxpayers from the systemic risk posed by the current financial condition of the GSEs. Because the GSEs are in conservatorship, they will no longer be managed with a strategy to maximize common shareholder returns, a strategy which historically encouraged risk-taking. The Preferred Stock Purchase Agreements minimize current cash outlays, and give taxpayers a large stake in the future value of these entities. In the end, the ultimate cost to the taxpayer will depend on the business results of the GSEs going forward. To that end, the steps we have taken to support the GSE debt and to support the mortgage market will together improve the housing market, the US economy and the GSEs’ business outlook.

Through the four actions we have taken today, FHFA and Treasury have acted on the responsibilities we have to protect the stability of the financial markets, including the mortgage market, and to protect the taxpayer to the maximum extent possible.

And let me make clear what today’s actions mean for Americans and their families. Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe. This turmoil would directly and negatively impact household wealth: from family budgets, to home values, to savings for college and retirement. A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance. And a failure would be harmful to economic growth and job creation. That is why we have taken these actions today.

While we expect these four steps to provide greater stability and certainty to market participants and provide long-term clarity to investors in GSE debt and MBS securities, our collective work is not complete. At the end of next year, the Treasury temporary authorities will expire, the GSE portfolios will begin to gradually run off, and the GSEs will begin to pay the government a fee to compensate taxpayers for the on-going support provided by the Preferred Stock Purchase Agreements. Together, these factors should give momentum and urgency to the reform cause. Policymakers must view this next period as a “time out” where we have stabilized the GSEs while we decide their future role and structure.

Because the GSEs are Congressionally-chartered, only Congress can address the inherent conflict of attempting to serve both shareholders and a public mission. The new Congress and the next Administration must decide what role government in general, and these entities in particular, should play in the housing market. There is a consensus today that these enterprises pose a systemic risk and they cannot continue in their current form. Government support needs to be either explicit or non-existent, and structured to resolve the conflict between public and private purposes. And policymakers must address the issue of systemic risk. I recognize that there are strong differences of opinion over the role of government in supporting housing, but under any course policymakers choose, there are ways to structure these entities in order to address market stability in the transition and limit systemic risk and conflict of purposes for the long-term. We will make a grave error if we don’t use this time out to permanently address the structural issues presented by the GSEs.

In the weeks to come, I will describe my views on long term reform. I look forward to engaging in that timely and necessary debate.

Important compliance information for registered investment advisors

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Many registered investment advisors are happy once a registration has gone through. The individual, or firm, has gone through all of the following:

Receiving entitlement to the IARD system
Passing the Series 65 exam (tips on the series 65 exam)
Completing both the investment advisory firm’s Form ADV and Form ADV Part II (the investment advisor brochure)
Filing Form ADV through the IARD system
Notice filing in the state of the firm’s principal place of business

Once a firm has become registered as an investment advisor with the SEC, however, the important work is not over. The firm and the principals of the firm must make sure that all of the investment advisor rules are followed. Below is an overview of the laws a SEC registered investment advisor must follow; it was prepared by the SEC and serves as a good guide for the newly registered investment advisor. In addition to the following guide for newly registered investment advisors, it is also recommended that you thoroughly review your investment advisor compliance manual with your lawyer or your compliance professional.
Full article can be found here.

For the presentation below, I have changed the SEC’s spelling of “investment adviser” to “investment advisor” as appropriate. Which begs the question: What is the difference between an “investment adviser” and an “investment advisor”?

There is no difference between the term “investment adviser” and “investment advisor” despite the incongruent spellings. The term “investment advisor” is most commonly used within the securities industry, however the SEC uses spelling “investment adviser”. It is likely that the reason the SEC uses this spelling is because the laws passed by congress specifically use the term.

Please feel free to contact us if you have any questions regarding any of the items below. We will try to answer all questions in another blog post. Also, we can provide you with help if you need assistance with an SEC mock examination and help with your compliance manual or code of ethics.

Information for Newly-Registered Investment Advisors

Prepared by the Staff of the Securities and Exchange Commission’s Division of Investment Management and Office of Compliance Inspections and Examinations

This information sheet contains general information about certain provisions of the Investment Advisers Act of 1940 (also called the “Advisers Act”) and selected rules under the Advisers Act. It is intended to assist newly-registered investment advisors in understanding their compliance obligations with respect to these provisions. This information sheet also provides information about the resources available to investment advisors from the SEC to help advisers understand and comply with these laws and rules.

As an adviser registered with the SEC, you have an obligation to comply with all of the applicable provisions of the Advisers Act and the rules that have been adopted by the SEC. This information sheet does not provide a complete description of all of the obligations of SEC-registered advisers under the law. To access the Advisers Act and rules and other information, visit the SEC’s website at www.sec.gov (the Advisers Act and rules are available at http://www.sec.gov/divisions/investment.shtml).

Investment advisors Are Fiduciaries

As an investment advisor, you are a “fiduciary” to your advisory clients. This means that you have a fundamental obligation to act in the best interests of your clients and to provide investment advice in your clients’ best interests. You owe your clients a duty of undivided loyalty and utmost good faith. You should not engage in any activity in conflict with the interest of any client, and you should take steps reasonably necessary to fulfill your obligations. You must employ reasonable care to avoid misleading clients and you must provide full and fair disclosure of all material facts to your clients and prospective clients. Generally, facts are “material” if a reasonable investor would consider them to be important. You must eliminate, or at least disclose, all conflicts of interest that might incline you — consciously or unconsciously — to render advice that is not disinterested. If you do not avoid a conflict of interest that could impact the impartiality of your advice, you must make full and frank disclosure of the conflict. You cannot use your clients’ assets for your own benefit or the benefit of other clients, at least without client consent. Departure from this fiduciary standard may constitute “fraud” upon your clients (under Section 206 of the Advisers Act).

Investment Advisors Must Have Compliance Programs

As a registered investment advisor, you are required to adopt and implement written policies and procedures that are reasonably designed to prevent violations of the Advisers Act. The Commission has said that it expects that these policies and procedures would be designed to prevent, detect, and correct violations of the Advisers Act. You must review those policies and procedures at least annually for their adequacy and the effectiveness of their implementation, and designate a chief compliance officer (“CCO”) to be responsible for administering your policies and procedures (under the “Compliance Rule” — Rule 206(4)-7).

We note that your policies and procedures are not required to contain specific elements. Rather, you should analyze your individual operations and identify conflicts and other compliance factors that create risks for your firm and then design policies and procedures that address those risks. The Commission has stated that it expects your policies and procedures, at a minimum, to address the following issues to the extent that they are relevant to your business:

Portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with clients’ investment objectives, your disclosures to clients, and applicable regulatory restrictions;
The accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements;
Proprietary trading by you and the personal trading activities of your supervised persons;
Safeguarding of client assets from conversion or inappropriate use by your personnel;
The accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;
Safeguards for the privacy protection of client records and information;
Trading practices, including procedures by which you satisfy your best execution obligation, use client brokerage to obtain research and other services (referred to as “soft dollar arrangements”), and allocate aggregated trades among clients;
Marketing advisory services, including the use of solicitors;
Processes to value client holdings and assess fees based on those valuations; and
Business continuity plans.

Investment Advisers Are Required to Prepare Certain Reports and to File Certain Reports with the SEC

As a registered investment advisor, you are required to file an annual update of Part 1A of your registration form (Form ADV) through the Investment Advisers Registration Depository (IARD). You must file an annual updating amendment to your Form ADV within 90 days after the end of your fiscal year. In addition to making annual filings, you must promptly file an amendment to your Form ADV whenever certain information contained in your Form ADV becomes inaccurate (the Form ADV filing requirements are contained in Rule 204-1 of the Advisers Act, and in the instructions to the Form).

Make sure your Form ADV is complete and current. Inaccurate, misleading, or omitted Form ADV disclosure is the most frequently cited finding from our examinations of investment advisors.
Please keep the e-mail address of your contact person current (Form ADV, Part 1A, Item 1J). We use this e-mail address to keep you apprised of important developments (including when it’s time to file an amendment to your Form ADV).
Accurately report the amount of assets that you have under management (Form ADV, Part 1A, Item 5F(2)). Advisers who have less than $25 million of assets under management, who are not otherwise eligible to maintain their registration with the SEC, or who stop doing business as an investment advisor, should file a Form ADV-W through IARD to withdraw their registration.

With respect to Part II of your Form ADV, you are not required to file it through IARD at this time. Rather, it is considered to be ‘filed’ with the SEC when you update the form and place a copy in your files. As with Part 1A, you must update Part II annually within 90 days of the end of your fiscal year and whenever it becomes materially inaccurate.

You may also be subject to other reporting obligations. For example, an adviser that exercises investment discretion (or that shares investment discretion with others) over certain equity securities (including convertible debt and options), which have a fair market value in the aggregate of $100 million or more, must file a Form 13F each quarter that discloses these holdings. “Discretionary authority” means that you have the authority to decide which securities to purchase, sell, and/or retain for your clients.

You should also be aware that it is unlawful to make any untrue statement or omit any material facts in an application or a report filed with the SEC (under Section 207 of the Advisers Act), including in Form ADV and Form ADV-W.

Investment Advisors Must Provide Clients and Prospective Clients with a Written Disclosure Statement

Registered investment advisors are required to provide their advisory clients and prospective clients with a written disclosure document (these requirements, and a few exceptions, are set forth in Rule 204-3 under the Advisers Act). As a registered adviser, you may comply with this requirement either by providing advisory clients and prospective clients with Part II of your Form ADV or with another document that contains, at a minimum, the information that is required to be disclosed in Form ADV, Part II. This written disclosure document should be delivered to your prospective clients at least 48 hours before entering into an advisory contract or, if it is delivered at the time the client enters into the contract, the client should be given five business days after entering into the advisory contract to terminate the contract without penalty (under certain conditions, you may comply with the delivery requirements through electronic media).

Each year, you must also deliver or offer (in writing) to deliver a disclosure document to each client, without charge. You are required to maintain a copy of each disclosure document and each amendment or revision to it that was given or sent to clients or prospective clients, along with a record reflecting the dates on which such disclosure was given or offered to be given to any client or prospective client who subsequently became a client (under Rule 204-2(a)(14)).

Investment Advisors Must Have a Code of Ethics Governing Their Employees and Enforce Certain Insider Trading Procedures

As a registered investment advisor, you are required to adopt a code of ethics (under the “Code of Ethics Rule” — Rule 204A-1 under the Advisers Act). Your code of ethics should set forth the standards of business conduct expected of your “supervised persons” (i.e., your employees, officers, directors and other people that you are required to supervise), and it must address personal securities trading by these people.
We note that you are not required to adopt a particular standard of business ethics. Rather, the standard that you choose should reflect your fiduciary obligations to your advisory clients and the fiduciary obligations of the people you supervise, and require compliance with the federal securities laws. In adopting a code of ethics, investment advisors may set higher ethical standards than the requirements under the law.
In order to prevent unlawful trading and promote ethical conduct by advisory employees, advisers’ codes of ethics should include certain provisions relating to personal securities trading by advisory personnel. Your code of ethics must include the following requirements:

Your “access persons” must report their personal securities transactions to your CCO or to another designated person each quarter. “Access persons” are any of your supervised persons who have access to non-public information regarding client transactions or holdings, make securities recommendations to clients or have access to such recommendations, and, for most advisers, all officers, directors and partners.
Your access persons must submit a complete report of the securities that they hold at the time they first become an access person, and then at least once each year after that.3 Your code of ethics must also require that your access persons obtain your approval prior to investing in initial public offerings or private placements or other limited offerings, including pooled investment vehicles (except if your firm has only one access person).
Your CCO or another person you designate in addition to your CCO must review these personal securities transaction reports.
Your supervised persons must promptly report violations of your code of ethics (i.e., including the federal securities laws) to the CCO or to another person you designate (provided your CCO also receives a report on such issues). You must also maintain a record of these breaches.

Also, as a registered investment advisor, you are required to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the misuse of material non-public information (under Section 204A of the Advisers Act). These policies and procedures must encompass your activities and those of your supervised persons. Advisers often include this prohibition on insider trading in their code of ethics.

Provide each of the people that you supervise with a copy of your code of ethics (and any amendments that you subsequently make to it), and also obtain a written acknowledgement from the supervised person that he/she has received it. In addition, you must describe your code of ethics in your Form ADV, Part II, Item 9 and provide a copy to your advisory clients, if they request it.

Investment Advisors are Required to Maintain Certain Books and Records

As a registered adviser, you must make and keep true, accurate and current certain books and records relating to your investment advisory business (under “the Books and Records Rule” — Rule 204-2). The books and records that you must make and keep are quite specific, and are described below in part:

Advisory business financial and accounting records, including: cash receipts and disbursements journals; income and expense account ledgers; checkbooks; bank account statements; advisory business bills; and financial statements.
Records that pertain to providing investment advice and transactions in client accounts with respect to such advice, including: orders to trade in client accounts (referred to as “order memoranda”); trade confirmation statements received from broker-dealers; documentation of proxy vote decisions; written requests for withdrawals or documentation of deposits received from clients; and written correspondence you sent to or received from clients or potential clients discussing your recommendations or suggestions.
Records that document your authority to conduct business in client accounts, including: a list of accounts in which you have discretionary authority; documentation granting you discretionary authority; and written agreements with clients, such as advisory contracts.
Advertising and performance records, including: newsletters; articles; and computational worksheets demonstrating performance returns.
Records related to the Code of Ethics Rule, including those addressing personal securities transaction reporting by access persons.
Records regarding the maintenance and delivery of your written disclosure document and disclosure documents provided by certain solicitors who seek clients on your behalf.
Policies and procedures adopted and implemented under the Compliance Rule, including any documentation prepared in the course of your annual review.

Some advisers are required to maintain additional records. For example, advisers that have custody and possession of clients’ funds and/or securities must make and keep additional records that are described in the Books and Records Rule (Rule 204-2, paragraph (b)), and advisers who provide investment supervisory or management services to any client must also make and keep specific additional records (which are described in Rule 204-2, paragraph (c)).

You must keep these records for specified periods of time. Generally, most books and records must be kept for five years from the last day of the fiscal year in which the last entry was made on the document or the document was disseminated. You may be required to keep certain records for longer periods, such as records that support performance calculations used in advertisements (as described in Rule 204-2, paragraph (e)).

You are required to keep your records in an easily accessible location. In addition, for the first two of these years, you must keep your records in your office(s). If you maintain some of your original books and records somewhere other than your principal office and place of business, you must note this practice and identify the alternative location on your Form ADV (in Section 1K of Schedule D). Many advisers store duplicate copies of their advisory records in a location separate from their principal office in order to ensure the continuity of their business in the case of a disaster.

You may store your original books and records by using either micrographic media or electronic media. These media generally include microfilm or digital formats (e.g., electronic text, digital images, proprietary and off-the-shelf software, and email). If you use email or instant messaging to make and keep the records that are required under the Advisers Act, you should keep the email, including all attachments that are required records, as examiners may request a copy of the complete record. In dealing with electronic records, you must also take precautions to ensure that they are secure from unauthorized access and theft or unintended destruction (similar safeguarding provisions regarding client information obtained by you is required by Regulation S-P under the Gramm-Leach-Bliley Act). In general, you should be able to promptly (generally within 24 hours) produce required electronic records that may be requested by the SEC staff, including email. In order to do so, the Advisers Act requires that you arrange and index required electronic records in a way that permits easy location, access, and retrieval of any particular electronic record.

Investment Advisors Must Seek to Obtain the Best Price and Execution for Their Clients’ Securities Transactions

As a fiduciary, you are required to act in the best interests of your advisory clients, and to seek to obtain the best price and execution for their securities transactions. The term “best execution” means seeking the best price for a security in the marketplace as well as ensuring that, in executing client transactions, clients do not incur unnecessary brokerage costs and charges. You are not obligated to get the lowest possible commission cost, but rather, you should determine whether the transaction represents the best qualitative execution for your clients. In addition, whenever trading may create a conflicting interest between you and your clients, you have an obligation, before engaging in the activity, to obtain the informed consent from your clients after providing full and fair disclosure of all material facts. The Commission has described the requirement for advisers to seek best execution in various situations.

In selecting a broker-dealer, you should consider the full range and quality of the services offered by the broker-dealer, including the value of the research provided, the execution capability, the commission rate charged, the broker-dealer’s financial responsibility, and its responsiveness to you. To seek to ensure that you are obtaining the best execution for your clients’ securities trades, you must periodically evaluate the execution performance of the broker-dealers you use to execute clients’ transactions.

You may determine that it is reasonable for your clients to pay commission rates that are higher than the lowest commission rate available in order to obtain certain products or services from a broker-dealer (i.e., soft dollar arrangement). To qualify for a “safe harbor” from possible charges that you have breached your fiduciary duty by causing your clients to pay more than the lowest commission rate, you must use clients’ brokerage commissions to pay for certain defined “brokerage or research” products and services, use such products and services in making investment decisions, make a good faith determination that the commissions that clients will pay are reasonable in relation to the value of the products and services received, and disclose these arrangements.

The SEC staff has stated that, in directing orders for the purchase or sale of securities, you may aggregate or “bunch” orders on behalf of two or more client accounts, so long as the bunching is done for the purpose of achieving best execution, and no client is systematically advantaged or disadvantaged by the bunching. The SEC staff has also said that, if you decide not to aggregate orders for client accounts, you should disclose to your clients that you will not aggregate and the potential consequences of not aggregating orders.

If your clients impose limitations on how you will execute securities transactions on their behalf, such as by directing you to exclusively use a specific broker-dealer to execute their securities transactions, you have an obligation to fully disclose the effects of these limitations to the client. For example, if you negotiate volume commission discounts on bunched orders, a client that has directed you to use a specific broker should be informed that he/she will forego any benefit from savings on execution costs that you might obtain for your other clients through this practice.

You should also seek to obtain the best price and execution when you enter into transactions for clients on a “principal” or “agency cross” basis. If you have acted as a principal for your own account by buying securities from, or selling securities to, a client, you must disclose the arrangement and the conflicts of interest in this practice (in writing) and also obtain the client’s consent for each transaction prior to the time that the trade settles. There are also explicit conditions under which you may cross your advisory clients’ transactions in securities with securities transactions of others on an agency basis (under Rule 206(3)-2). For example, you must obtain advance written authorization from the client to execute such transactions, and also provide clients with specific written disclosures. Compliance with Rule 206(3)-2 is generally not required for transactions internally crossed or effected between two or more clients you advise and for which you receive no additional compensation (i.e., commissions or transaction-based compensation); however, full disclosure regarding this practice should be made to your clients.

Requirements for Investment Advisors’ Contracts with Clients

As a registered investment advisor, your contracts with your advisory clients must include some specific provisions (which are set forth in Section 205 of the Advisers Act). Your advisory contracts (whether oral or written) must convey that the advisory services that you provide to the client may not be assigned by you to any other person without the prior consent of the client. With limited exceptions, contracts cannot include provisions providing for your compensation to be based on the performance of the client’s account. In addition, the SEC staff has stated that an adviser should not enter into contracts with clients, except with certain sophisticated clients, that contain terms or clauses commonly referred to as a “hedge clause” because such clauses or provisions are likely to lead other clients to believe that they have waived their rights of legal action, whether under the federal securities laws or common law.

Investment Advisors May be Examined by the SEC Staff

As a registered investment advisor, your books and records are subject to compliance examinations by the SEC staff (under Section 204 of the Advisers Act). The purpose of SEC examinations is to protect investors by determining whether registered firms are complying with the law, adhering to the disclosures that they have provided to their clients, and maintaining appropriate compliance programs to ensure compliance with the law. If you are examined, you are required to provide examiners with access to all requested advisory records that you maintain (under certain conditions, documents may remain private under the attorney-client privilege).

More information about examinations by the SEC and the examination process is provided in the brochure, “Examination Information for Broker-Dealers, Transfer Agents, Clearing Agencies, Investment Advisers and Investment Companies,” which is available on the SEC’s website at http://www.sec.gov/info/cco/ccons2006exambrochure.pdf.

Requirements for Investment Advisors that Vote Proxies of Clients’ Securities

As a registered investment advisor, if you have voting authority over proxies for clients’ securities, you must adopt policies and procedures reasonably designed to ensure that you: vote proxies in the best interests of clients; disclose information to clients about those policies and procedures; and describe to clients how they may obtain information about how you have voted their proxies (these requirements are in Rule 206(4)-6 under the Advisers Act).

If you vote proxies on behalf of your clients, you must also retain certain records. You must keep: your proxy voting policies and procedures; the proxy statements you received regarding your client’s securities (the Rule provides some alternative arrangements); records of the votes you cast on behalf of your clients; records of client requests for proxy voting information; and any documents that you prepared that were material to making a decision as to how to vote or that memorialized the basis for your decision (these requirements are described in Advisers Act Rule 204-2(c)(2)).

Requirements for Investment Advisors that Advertise their Services

To protect investors, the SEC prohibits certain types of advertising practices by advisers. An “advertisement” includes any communication addressed to more than one person that offers any investment advisory service with regard to securities (under “the Advertising Rule” — Rule 206(4)-1). An advertisement could include both a written publication (such as a website, newsletter or marketing brochure) as well as oral communications (such as an announcement made on radio or television).

Advertising must not be false or misleading and must not contain any untrue statement of a material fact. Advertising, like all statements made to advisory clients and prospective clients, is subject to the general prohibition on fraud (Section 206 as well as other anti-fraud provisions under the federal securities laws). Specifically prohibited are: testimonials; the use of past specific recommendations that were profitable, unless the adviser includes a list of all recommendations made during the past year; a representation that any graph, chart, or formula can in and of itself be used to determine which securities to buy or sell; and advertisements stating that any report, analysis, or service is free, unless it really is free.

The SEC staff has said that, if you advertise your past investment performance record, you should disclose all material facts necessary to avoid any unwarranted inference. For example, SEC staff has indicated that it may view performance data to be misleading if it:

does not disclose prominently that the results portrayed relate only to a select group of the adviser’s clients, the basis on which the selection was made, and the effect of this practice on the results portrayed, if material;
does not disclose the effect of material market or economic conditions on the results portrayed (e.g., an advertisement stating that the accounts of the adviser’s clients appreciated in value 25% without disclosing that the market generally appreciated 40% during the same period);
does not reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that accounts would have or actually paid;
does not disclose whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings;
suggests or makes claims about the potential for profit without also disclosing the possibility of loss;
compares model or actual results to an index without disclosing all material facts relevant to the comparison (e.g., an advertisement that compares model results to an index without disclosing that the volatility of the index is materially different from that of the model portfolio); and
does not disclose any material conditions, objectives, or investment strategies used to obtain the results portrayed (e.g., the model portfolio contains equity stocks that are managed with a view towards capital appreciation).

In addition, as a registered adviser, you may not imply that the SEC or another agency has sponsored, recommended or approved you, based upon your registration (under Section 208 of the Advisers Act). You should not use the term “registered investment advisor” unless you are registered, and you should not use this term to imply that as a registered adviser, you have a level of professional competence, education or special training. For example, the SEC staff has stated that advisers should not use the term “RIA” after a person’s name because using initials after a name usually indicates a degree or a licensed professional position for which there are certain qualifications; however, there are no federal qualifications for becoming an SEC-registered adviser.

Requirements for Investment Advisors that Pay Others to Solicit New Clients

Registered investment advisors may pay cash compensation to others to seek out new clients on their behalf, commonly called “solicitors” or “finders,” if they meet certain conditions (under Rule 206(4)-3 of the Advisers Act):

The solicitor is not subject to certain disciplinary actions.
The fee is paid pursuant to a written agreement to which you are a party and (with limited exceptions) the agreement must: describe the solicitor’s activities and compensation arrangement; require that the solicitor perform the duties you assign and in compliance with the Advisers Act; require the solicitor to provide clients with a current copy of your disclosure document; and, if seeking clients for personalized advisory services, require the solicitor to provide clients with a separate written disclosure document containing specific information.
You receive from the solicited client, prior to or at the time you enter into an agreement, a signed and dated notice confirming that he/she was provided with your disclosure document and, if required, the solicitor’s disclosure document.
You have a reasonable basis for believing that the solicitor has complied with the terms of your agreement.

Requirements for Investment Advisors that have Custody or Possession of Clients’ Funds or Securities

Registered investment advisors that have “custody” or “possession” of client assets must take specific measures to protect client assets from loss or theft (under “the Custody Rule” — Rule 206(4)-2(c)(1) under the Advisers Act).

The first step is to determine whether you have custody or possession of client assets. “Custody” is defined as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.” This includes situations in which you:

have physical possession of client funds or securities, even temporarily;
enter into arrangements (including a general power of attorney) authorizing you to withdraw funds or securities from the client’s account (note that if you are authorized to deduct your advisory fees or other expenses directly from clients’ accounts, you have custody); and
serve in a capacity that gives you or a supervised person legal ownership or access to client funds or securities (note that if you are a general partner to a privately-offered pooled investment vehicle, you have custody).

If you have custody, with limited exceptions, you must maintain these client funds and securities at a “qualified custodian.” Generally, qualified custodians include most banks and insured savings associations, SEC-registered broker-dealers, Commodity Exchange Act-registered futures commission merchants, and certain foreign financial institutions. With a limited exception, for client accounts over which you have custody, you must have a reasonable basis for believing that the client (or a designated representative) receives periodic reports directly from the custodian that contain specific information with respect to the funds and securities in custody. With respect to pooled investment vehicles over which you have custody, the qualified custodian must send account statements for the pooled vehicle directly to each investor.
If you, rather than a qualified custodian, send account statements directly to your clients, you must have a “surprise verification” by an independent public accountant. The independent public accountant must verify the funds and securities in your custody or possession at least once each calendar year, and must then promptly file a “certificate of examination” with Form ADV-E with the SEC.4

Requirements for Investment Advisors to Disclose Certain Financial and Disciplinary Information

Registered investment advisors may be required to disclose certain financial and disciplinary information (under Rule 206(4)-4 under the Advisers Act). These requirements are described below.
Registered advisers that have custody or discretionary authority over client funds or securities, or that require prepayment six months or more in advance of more than $500 in advisory fees, must promptly disclose to clients and any prospective clients any financial conditions that are reasonably likely to impair their ability to meet their contractual commitments to their clients.

All registered advisers must also promptly disclose any legal or disciplinary events that would be material to a client’s or a prospective client’s evaluation of the adviser’s integrity or its ability to meet its commitments to clients (regardless of whether the adviser has custody or requires prepayment of fees). The types of legal and disciplinary events that may be material include:

Criminal or civil actions, where the adviser or a management person of the adviser was convicted, pleaded guilty or “no contest,” or was subject to certain disciplinary actions with respect to conduct involving investment-related businesses, statutes, regulations, or activities; fraud, false statements, or omissions; wrongful taking of property; or bribery, forgery, counterfeiting, or extortion.
Administrative proceedings before the SEC, other federal regulatory agencies, or any state agency where the adviser’s or a management person’s activities were found to have caused an investment-related business to lose its authorization to do business or where such person was involved in a violation of an investment-related statute or regulation and was the subject of specific disciplinary actions taken by the agency.
Self-regulatory organization (SRO) proceedings in which the adviser or a management person was found to have caused an investment-related business to lose its authorization to do business; or was found to have been involved in a violation of the SRO’s rules and was the subject of specific disciplinary actions taken by the organization.

Informational Resources Available From the SEC

The SEC provides a great deal of helpful information about the compliance obligations of investment advisors on the SEC’s website at http://www.sec.gov/divisions/investment.shtml. This information includes links to relevant laws and rules, staff guidance and studies, enforcement cases, and staff no-action and interpretive letters (generally from 2001 — present). In addition, the SEC’s website contains a list of the source materials that were used in preparing this information sheet.

To assist chief compliance officers of investment advisors and investment companies in meeting their compliance responsibilities and to help enhance compliance in the securities industry, the SEC has established the “CCOutreach Program.” This program includes regional and national seminars on compliance issues of concern to CCOs. Information about CCOutreach and any scheduled events is available at http://www.sec.gov/info/ccoutreach.htm.

Finally, the SEC staff regularly receive calls and correspondence concerning the application of the federal securities laws, and advisers and other registrants are encouraged to communicate any questions or issues to SEC staff. To ensure that you reach the right person at the SEC, the SEC’s website lists the names and contact information for SEC staff in the Division of Investment Management who are responsible for responding to communication from the public about specific topics (http://www.sec.gov/divisions/investment/imcontact.htm).

With respect to issues or questions that arise in the context of a compliance examination by the SEC, advisers are encouraged to raise any questions or issues directly with the SEC examination team, or with examination supervisors in their local SEC office (contact information for senior examination staff is available at http://www.sec.gov/about/offices/ocie/ocie_org.htm).

Survey of hedge fund administrators

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As a hedge fund attorney I am often asked for referrals to hedge fund administrators. There are many very good administration firms that I have worked with in the past – for both small and large clients. The administration firms I would recommend for a larger client are not necessarily the same firms I would recommend for smaller clients. For either small or large hedge fund clients I will usually give the client two or three different administrators to talk with. Ultimately a start up hedge fund manager must be comfortable with the contact person at his administration firm and must also be comfortable with the fees that the administrators will charge – after the hedge fund launch most hedge fund managers will be communicating more with the administrator than the lawyer so it is important that the manager has a good relationship with the administrator.

Below is a press release which details a recent survey of hedge fund administrators. The survey comes from the Global Custodian website and can be found here.

Uncertain Markets Fail To Dent Appreciation of Hedge Fund Administrators

LONDON (2 September 2008) – Despite industry-wide anxiety about market conditions, more hedge fund administrators than ever took part in the annual Global Custodian survey of client perceptions of service quality and value. Nearly 1,200 responses were received from clients of 56 hedge fund administrators.

“Despite the consolidation which has taken place in the industry, and difficult investment and financing markets, we still attracted responses for well over 50 hedge fund administrators this year,” says Dominic Hobson, editor in chief of Global Custodian. “This is only one measure among many of the buoyant conditions in the alternative investment administration industry. Our survey also picked up signs of capacity constraints, limits on client size, high rates of staff turnover and expansion into new territories. These are all problems of success. The industry is clearly in a rude state of health.”

Despite the challenges they face, the average scores awarded by clients to their administrators are also up across the board, fuelled by a response rate that surged 25% this year.

“However, the headline scores are not the sole measure of success in the survey,” adds Dominic Hobson. “There are also large differences between providers in terms of the number, size and types of client they seek to service, which is why we divided the providers into separate peer groups this year.” The new peer group rating category facilitates comparisons between providers of similar size and structure.

In the first peer group, consisting of the largest and most international administrators, Citco Fund Services continues to top the annual survey. On the biggest turnout of any provider, Citco raised its scores in all but one question, further cementing the company’s long-held domination of the top spot in the survey.

“This survey is recognized as the most important, comprehensive annual survey of our industry,” says William Keunan, Citco’s director, fund services. “We are delighted with the top rated accolade, in particular as it comes directly from so many of our clients.”

In the same peer group, scores also rose significantly at Citi, Fortis Prime Fund Solutions and PNC Global Investment Servicing.

Peer Group 1 – Overall Scores

Provider (Total Scores)

Citco Fund Services 6.36
Goldman Sachs Administrative Services 6.23
IFS, A State Street Company 6.11
PNC Global Investment Servicing 6.03
HSBC Securities Services 6.03
CACEIS 5.96
Citi 5.76
UBS GAM -Fund Services 5.75
GlobeOp Financial Services 5.65
Fortis Prime Fund Solutions 5.51
JPMorgan Hedge Fund Services 5.14

Peer Group Overall 5.93

Administrators were divided into peer groups based on similar size and structure to facilitate comparisons among administrators

In the second peer group, which consists of smaller and often new providers with a limited international presence, scores rose significantly for AIS Fund Administration, CIBC Bank and Trust Company, Equity Fund Services and Fulcrum Fund Services, which recently agreed a merger with Butterfield Fund Services.

But it was Kaufman Rossin Fund Services that dominated the second peer group, with an impressive debut in the 13th consecutive annual survey. The company grew out of a Florida accounting firm, allowing it to grow without taking in third party investors or taking on acquisitions, and it is now larger than the average small provider, with more than $18 billion in AuA.

“These survey results clearly reflect that our strategy of controlled growth, hiring ahead of the curve and leveraging technology enables us to exceed the expectations of our clients and the industry,” says Jorge DeCardenas, a co-founding director at Kaufman Rossin.

“Our outstanding service professionals and increasing institutional client base means that KRFS is very well positioned to continue this growth while maintaining our reputation for service,” adds Keith Sharkey, a co-founding director at Kaufman Rossin.

In addition to Kaufman Rossin, several other firms made their debut in the survey as rated providers for the first time this year, including the publicly listed GlobeOp Financial Services and Quintillion (Ireland).

Peer Group 2 – Overall Scores

Provider (Total Scores)

Kaufman Rossin Fund Services 6.59
ATC Fund Services 6.59
AIS Fund Administration 6.49
Pinnacle Fund Administration LLC 6.44
Fulcrum Fund Services 6.42
Quintillion [Ireland] 6.31
Equity Fund Services 6.28
Kingsway Taitz 6.25
Trinity Fund Administration Ltd 6.23
CIBC Bank and Trust Company Ltd 6.08
LaCrosse Global Fund Services 5.98
Circle Partners 5.95
OpHedge Investment Services 5.82
Daiwa Securities Global Asset Services 5.64
Spectrum Global Fund Administration 5.43

Peer Group Overall 6.15

Administrators were divided into peer groups based on similar size and structure to facilitate comparisons among administrators

Even as several firms featured in the survey in the past have consolidated, the number of rated providers rose from 20 to 26. Of the 56 providers for which responses were received, 39 received enough responses to be either rated or mentioned in the survey.

Responses increased 25% over last year to a total of 1,160 that could be fully authenticated.

In recent years, the custodian banks that have acquired hedge fund administrators have sought to adjust client lists in favor of larger and more profitable hedge fund and fund of funds groups interested in a broader array of services. At the same time, prime brokers have recognized that providing administration services can help attract and retain clients and counter the shift among hedge fund managers towards multiple prime brokerage.

“It would be surprising if the hedge fund administration industry continues to support such a large number of providers, and there is now evidence that a renewed round of consolidation is in the offing,” says Dominic Hobson. “However, the appetite to sell may be offset as well as encouraged by the depressed prices available. In any event, the buyers are likely to be different from the banks which dominated the acquisition process in the early years of this century.”

Despite the slowdown in merger and acquisition activity, the hedge fund administration industry also continues to spawn new and smaller providers through a mixture of back office spin-offs by fund management and trading houses and start-ups that aim to service the smaller funds that are being jettisoned by the major providers, or which reckon they can use expertise acquired elsewhere to support particular investment strategies.

“It is worth reiterating that, in spite of the testing conditions in the marketplace, more hedge fund managers than ever responded to the survey this year, and we were able to rate more service providers than ever before,” says Dominic Hobson. “This reflects not only the growing maturity of the survey, but also the larger role and increased importance of administrators as the hedge fund industry has attracted institutional investors.”

Although many administrators are controlled by banks, and there is demonstrable appetite among hedge funds for financing services, the number of hedge fund administrators interested in providing credit, leverage and securities lending services to clients remains small. Only six administrators were rated for credit and leverage in the survey.

However, the inclusion in the survey for the first time this year of questions on middle office services is a measure of the expanding role of hedge fund administrators. The middle office is a term open to various definitions, but the survey measures the performance of providers in terms of the usefulness of P&L reporting, efficiency of cash market trade confirmations, efficiency of OTC derivative trade confirmations, resolution of breaks unrelated to NAV calculations, ability to support multiple prime brokers, efficiency of OTC derivative processing (e.g. documentation management, expirations, re-sets etc.) and the sophistication of collateral management.

IFS, A State Street Company topped the first peer group in middle office services while Kaufman Rossin came out first among the second peer group.

“Five years ago the idea that hedge fund administrators would get involved in functions such as leverage, OTC derivative processing and collateral management was unthinkable at most firms, and controversial where it was not,” says Dominic Hobson. “But consolidation, more imaginative business strategies, a growing willingness on the part of commercial banks to challenge investment banks, and market circumstances are gradually eroding the barriers that once separated prime brokers, fund administrators and custodian banks. Chief among the factors at work is the anxiety of institutional investors in hedge fund strategies about exposure to the credit risk of the investment banks.”

The full results of the 2008 Global Custodian Hedge Fund Administration Survey appear in the Summer Plus issue of Global Custodian magazine. They are also available online (to paying subscribers only) at www.globalcustodian.com.

Contact:

Dominic Hobson, Editor-in-Chief, at [email protected] or +44 (0) 207 148 4280

Allison Cayse, Surveys Editor, at [email protected] or +1 513 574 0220

Muzaffar Karabaev, Survey Reprints/Research Enquiries, at [email protected] or +44 (0) 207 148 4289

Notes:

1. The Global Custodian Hedge Fund Administration Survey has been published annually since 1996.

2. A full list of revisions to the 2007 questionnaire can be found online in the surveys section at www.globalcustodian.com.

3. Providers were rated on a total of 71 questions divided into 12 service areas: client service and relationship management, value, fund accounting and valuation, investor services, reporting to investors, reporting to fund managers, compliance and taxation, corporate administration, fund structures, credit/leverage, middle office services and technology. Respondents graded their administrators on quality of service using a scale of 1 to 7, where 7 is excellent; 6, very good; 5, good; 4, satisfactory; 3, weak; 2, very weak; and 1, unacceptable. Scores were then weighted for the size and sophistication of the respondent and for performance on questions named as important in each service area by all respondents.

4. Global Custodian is the leading specialist magazine covering operational, administrative and distribution aspects of the securities, derivatives, fund management and institutional investment industries. The magazine is supported in each of its chosen areas of expertise by industry-leading surveys of the global custody, sub-custody, hedge fund administration, mutual fund administration, prime brokerage and securities financing businesses.

The different “types” of activist hedge funds

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