Tag Archives: hedge fund operations

Hedge Fund State and Local Business Requirements

Compliance Guide for New Hedge Fund Managers

Like any new business a hedge fund manager must comply with state and local ordinances, and make local business filings.  However, when launching a hedge fund, a manager may become so consumed with preparing launch documents, opening prime brokerage accounts and, most importantly, meeting with potential investors that these formalities might be overlooked.  In response to numerous questions from our clients, we prepared this guide for managers located in New York, San Francisco, and Chicago.  Please contact your attorney if you have questions about these or any other locations.

Because most manager entities are formed in Delaware, but are operating in another state, it is necessary to register them in their home state; this process is also known as qualifying the entity to conduct business, or applying for authority to conduct business, in the state where they are located.  Additional requirements typically include state and local taxes, payroll and other employment matters and city business licenses.

A checklist and quick reference table are provided as links at the bottom of this post.  All forms, procedures, fees, taxes or other requirements discussed below are subject to change by the state and local authorities; this guide is not intended to be an exhaustive list of all possible requirements in these locations.   Please confirm any requirements with your attorney or the authority in question before making any filings.

New York, New York

New York State Authority to Conduct Business.  Delaware limited liability companies (“LLCs”) and limited partnerships (“LPs”) must apply for authority to conduct business in New York State by filing an Application for Authority (“NY Application”) with the Department of State – Division of Corporations, along with a Certificate of Existence (called a Certificate of Good Standing in Delaware) from the state of formation (“COE”).   New York requires that the COE is dated within one year of the date the NY Application will be filed.

New York State Certificate of Publication.  Once the NY Application has been certified by the Department of State, the manager must publish in two newspapers a copy of the application for authority or a notice related to the qualification of the entity.  Publication must be done in the specific newspapers designated by the clerk of the county in which the manager is located.  After publication, the printer or publisher of each newspaper will provide an affidavit of publication.  A Certificate of Publication with the affidavits of publication of the newspapers attached must be submitted to the Department of State – Division of Corporations.  The publication process must be completed within 120 days after the filing of the NY Application.

Please also see our post on the New York Publication Requirement.

New York State Workers’ Compensation.  Any business operating in New York State must have workers’ compensation coverage for all employees.  Employers can obtain a workers’ compensation insurance policy with a private carrier, with the New York State Insurance fund or through self-insurance.  Failure to carry workers’ compensation insurance constitutes a misdemeanor or a felony punishable by a fine of $1,000 up to $50,000.  The level of offense depends upon whether an employer has five or more employees and whether the violation is a first or a repeated offense.  The Workers’ Compensation Board may also issue a stop work order to any business that fails to obtain a policy or owes a fine to the Board.  Failure to keep the required records is punishable by fines of $5,000 to $10,000 for a first-time violation.

New York State Disability Coverage.  Any business operating in New York State with employees must also provide disability benefits coverage.  The law provides for the payment of cash benefits to employees who have become disabled because of injuries or illnesses that have no connection to their employment, and for disabilities arising from pregnancies.  The law allows, but does not require, an employer to collect contributions from its employees to offset the cost to provide this benefit.  Employers may obtain coverage through a private carrier, the New York State Insurance fund or through self-insurance.  Failure to obtain disability benefits coverage constitutes a misdemeanor, punishable by a fine of $100 to $500 and/or imprisonment for not more than one year.  Additionally, an employer without coverage will be liable for any benefits due to an injured employee.

New York State Unemployment Insurance.  Employers must file a Quarterly Combined Withholding, Wage Reporting and Unemployment Insurance Return with the New York State Department of Labor.  Generally, all employment performed for an employer is covered whether it is on a part-time, full-time, temporary, seasonal, or casual basis.  If all required parts of the return are not received by the due date, the return is considered delinquent.  The penalty for failure to file is the greater of $1,000 or $50 per employee listed on the latest quarterly return, up to a maximum fine of $10,000.

New York City Unincorporated Business Income Tax.  The Unincorporated Business Tax (the “UBT”) is imposed on partnerships and limited liability companies, which would include most hedge funds and investment managers.  The UBT is equal to four percent of taxable income allocable to New York City, but the net effective tax rate for hedge fund managers could be near two percent after tax credits and deductions.  This stems from the deductibility of local business tax payments on federal taxes, and a twenty-three percent credit for UBT taxes against New York City personal income liability.  At present, the New York City Administrative Code taxes fees earned by managers, but carried interest may be exempt.  To obtain some relief from this tax, managers located in New York City typically form a separate entity to serve as the general partner of their onshore funds, rather than having the manager serve as general partner.

New York City Commercial Rent Tax.  A business must file a Commercial Rent Tax Return if the occupied premises are located in Manhattan, south of 96th Street, and the annual or annualized gross rent paid for such location is at least $250,000.  This tax also applies to: (i) those who occupy space in buildings they themselves own, individually or jointly with another person other than a spouse; (ii) those who occupy space in buildings owned by corporations where they are an officer or holder of all or part of the corporation stock; (iii) a corporation, occupying space in a building that is owned by a subsidiary corporation or by a parent corporation; and (iv) a corporation, occupying a space in building owned by an officer or stockholder of the corporation.

New York City Waste Removal and Recycling.  A commercial business is required to dispose of its waste, including recyclable materials, through a private disposal company.  All businesses are required to recycle office paper, corrugated cardboard, magazines, catalogs, and newspapers.  Businesses must post signs notifying employees, and customers where relevant, about what and how to recycle and must place labeled recycling containers where waste is routinely discarded.  Usually the building management makes arrangements with a disposal company for removal of recycling and waste for the entire building.  Regardless of a building's recycling arrangements, every company is required by law to maintain separate labeled recycling bins for paper.  Fines will be levied for violations.

San Francisco, California

California Business Registration.  LLCs and LPs must qualify to transact business in California by filing an Application for Registration  (“CA Application”) and a COE with the California Secretary of State.   In addition, within 90 days after the CA Application has been filed, an LLC must file a Statement of Information (“SOI”) with the California Secretary of State.  Thereafter, the SOI is due every other year on or before the anniversary of the initial SOI filing. LPs are not subject to the SOI filing requirements.

California Franchise Tax Board.  Registered LLCs and LPs are subject to an $800 annual tax even if they conduct no business in California.  They may also be subject to an annual fee based upon total income from all sources derived or attributable to California.  Additionally, an entity that has members or partners who are not residents of California must file consents signed by the nonresident individuals and foreign entity members to show their consent to California’s jurisdiction to tax their distributive share of income attributable to California sources.  The LLC or LP must pay the tax for every nonresident member or partner who does not sign the consent.

California Withholding on Distributions.  LPs and LLCs must withhold 7% on distributions of California source income made to nonresident partners or members when distributions to a particular partner or member exceed $1,500 for the calendar year.  LPs and LLCs must withhold on allocations of California source income to foreign partners and members (payees) at the maximum applicable California tax rate.

California Payroll Taxes.  A business becomes subject to state payroll taxes upon paying wages over $100 in a calendar quarter to one or more employees.  Wages include cash payments, commissions, bonuses, and the reasonable cash value of noncash payments (such as meals or lodging) for services performed.  Once subject, an employer must complete and submit a registration form to the Employment Development Department (“EDD”) within 15 days.  After registering, a business will receive a State Employment Identification Number.  Employers must report wages paid, taxes withheld and pay unemployment insurance, state disability insurance and employment training tax on employee wages.

California Workers’ Compensation.  California Labor Code requires employers with at least one employee to carry workers’ compensation insurance.  Employers may finance liability for workers’ compensation through self-insurance, private insurance or through the California State Compensation Insurance Fund.  Failure to carry workers’ compensation coverage is a misdemeanor punishable by a fine up to $10,000 and/or one year in jail.  The Division of Labor Standards Enforcement can issue a stop order preventing an employer from using employee labor until coverage is obtained.

San Francisco Business Registration and Renewal.  Every person or entity doing business in the City and County of San Francisco must have a valid Business Registration Certificate (“SF Certificate”).  A certificate is required for businesses located outside of San Francisco that transact business or perform services within San Francisco.  The registration fee varies based on a business’s estimated annual payroll tax expense.

The SF Certificate is issued annually and must be renewed by February 28th of each year.  All businesses must report their taxable payroll tax expense, even if it was zero, as part of the Business Registration Renewal process.   Businesses meeting a specified payroll threshold (which may be adjusted each year) are required to submit an additional Payroll Expense Tax Statement.

San Francisco Payroll Expense Tax.  The tax amount is equal to 1.5% of a business’ annual San Francisco payroll expense.  The recently-passed Proposition Q raised the payroll tax exemption for small businesses whose payroll expense for the year is $250,000 or less and extended the applicability of payroll expense tax to include compensation for personal services paid to owners of LPs, LLCs and other entities.  If a business has at least four W-2 employees based in San Francisco, the amount of payroll included for each individual owner of a pass-through entity may be calculated under the “safe harbor provision” by adding to his or her base salary an amount equal to 200% of the average annual compensation paid to the W-2 employees of the pass-through entity whose compensation is in the top 25% of that entity's employees based in San Francisco.

Please also see our post on San Francisco Proposition Q.

San Francisco Assessor Tax.  A business entity’s property is reappraised annually.  This includes all property owned or leased by a business except licensed vehicles, business inventory, intangible assets or application software.  Businesses that receive a property statement from the Assessor’s Office or that own taxable property with a total cost of $100,000 or more must file a 571-L business property statement each year by April 1st.  The filing must detail the costs of all supplies, equipment, and fixtures, improvements, land improvements, and land and include other information requested on the form at each location.  The 2010 tax rate for business property was 1.159% of the value of assessable property.  Such value is determined based upon cost, tax, freight, installation and depreciation.

San Francisco Labor Laws.  Three San Francisco labor laws generally apply to all employers with employees performing work within the City of San Francisco.  First, the Health Care Security Ordinance requires for-profit businesses with twenty or more employees to spend a minimum amount on health care for each employee working eight or more hours per week in San Francisco.  The Paid Sick Leave Ordinance entitles all employees (no minimum) working in San Francisco to paid time off when they or family members are sick or need medical care.  It also sets a minimum rate of accrual for sick leave of 1 hour for every 30 hours worked; fractional accruals are not permitted.  Finally, San Francisco has a minimum wage of $9.79 per hour for all employees who work in San Francisco more than two hours per week.

Exemptions for Businesses Located within the Presidio.  The Presidio is an area in the city that is owned by the federal government.  The Presidio Trust Act explicitly gives the Presidio Trust immunity from state and local taxes, which extends to property interests of third parties under “leases, concessions, permits and other agreements associated with Trust properties.”  Under federal law only income and use taxes can be levied on federal enclaves.  Because the business registration fees and payroll taxes discussed above are not income or use taxes, businesses located in the Presidio are exempt from these requirements imposed on businesses located elsewhere in San Francisco.

Chicago, Illinois

Illinois Admission to Conduct Business.  An LLC must submit an Application for Admission to Transact Business and a COE authenticated within the last 60 days to the Illinois Secretary of State.  An LP must submit a similar “Application for Certificate of Authority” along with a COE authenticated within the last 30 days (either, the “IL Application”).

Illinois Department of Revenue Registration.  A business must register with the Illinois Department of Revenue to receive a Certificate of Registration and Illinois Business Tax number.  Registration must be completed before a business makes sales, or when it hires employees.  This certificate must be displayed in a prominent location

Illinois Unemployment Insurance.  If a business hires employees to work in Illinois, it must register with the Department of Employment Security (“IDES”) within 30 days of the date it starts doing business in the state to receive an Illinois Unemployment Account number.  On a quarterly basis, employers must file an “Employer’s Contribution and Wage Report” and pay contributions to IDES.  The penalty for failure to file the report is the lesser of $5 for each $10,000 or fraction thereof of the total wages for insured work during the period, or $2,500 for each month or part thereof of such failure to file the report.  The amount of the total fine is capped at the lesser of $5,000 or $10 for each $10,000 or fraction thereof of the total wages for insured work during the period.

Illinois Workers’ Compensation.  All employers must obtain workers’ compensation insurance, post a notice in the workplace listing the insurance carrier and workers’ rights, and keep records of work-related injuries.  Accidents involving more than three lost workdays must be reported to the Workers’ Compensation Commission.  Employers may be fined up to $500 for each day without insurance, with a minimum fine of $10,000.  The commission may issue a stop-work order for a knowing failure to carry insurance.  Corporate officers may be held personally liable and/or sent to prison.

City of Chicago Business License.  All persons who “conduct, engage in, maintain, operate, carry on or manage a business” in the City of Chicago must obtain a business license from the Department of Business Affairs and Consumer Protection (the “BACP”), unless exempted by state law or regulated by another license category.  Applicants must complete a Business Information Sheet listing the business name, a detailed business description,

square footage, address, ownership information, and Illinois and federal tax numbers.  Businesses operating in a properly zoned area will be automatically approved when applying; these businesses need only file a tax registration form with the city.

The business license must be posted in a conspicuous place.  In the event of a violation, the BACP may issue a notice, a cease and desist order and depending on the type of business, the BACP may also confiscate personal property or make an arrest.  Additionally, fines may be imposed ranging from $200 to $10,000 per day.

Chicago Employers’ Expense Tax.  Businesses that employ fifty or more full-time employees who perform 50% or more of their work per calendar quarter in the City of Chicago and who earn more than $900 in a calendar quarter must pay the Employers’ Expense Tax.  The tax is equal to $4.00 per employee per month.  In determining the number of employees, employees of a “unitary business group” will be combined, i.e., a group of people under common ownership or control, whose business activities are in the same general line and whose members are functionally integrated through centralized management.

To help managers keep track of the filings that they should complete we have created a checklist, please see Checklist for State and Local Business Filings.  For information on division contact persons that can help with information on how to complete the above filings, please see our Quick Reference and Contact Information guide.  If you have questions on any of the items in this post, please feel free to contact us.

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Cole-Frieman & Mallon LLP provides a variety of legal services to hedge fund managers including entity formation, general business issues, legal advice with respect to hedge fund seeding, employment matters and matters related to hedge fund formation.  Karl Cole-Frieman can be reached at 415-352-2300; Bart Mallon can be reached directly at 415-868-5345.

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Hedge Fund Operations During a Pandemic

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Thoughts on Business Continuity Planning

Over the past week, I have attended a couple of interesting panel discussions on the hedge fund industry.  At these events, one of the common themes was that the investment management industry is changing and hedge fund management companies need to make sure that operations are tight – this means that a management company should have developed and robust procedures for disasters including, as the article below indicates, pandemics.  It is expected that this topic will become even more important if the impact of the H1N1 virus does not abate.

The article below was provided by Lisa Smith of Eze Castle Integration, an IT solutions firm for hedge fund management companies. This article is part of our guide to Hedge Fund Business & Technical Issues.

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Business Continuity: A Look at Pandemic Response Planning
By: Lisa Smith, Certified Business Continuity Planner, Eze Castle Integration

As the last several months have unfolded, one thing has become clear: the influenza A (H1N1) virus is not going away.  After the initial panic subsided, fear and concern seemed to diminish even though the World Health Organization and U.S. Centers for Disease Control insist that the threat is not over.  Now, nearly five months since the first case of H1N1 was reported in Mexico, a pandemic has emerged as predicted.

As of November 1, 2009, 199+ countries have reported laboratory confirmed cases of pandemic influenza H1N1 2009, including over 482,000 cases and 6,000 deaths (World Health Organization).  U.S. health officials estimate that the virus could directly and indirectly affect up to 40 percent of the nationwide workforce over the next two years (Centers for Disease Control).

What does this mean for hedge funds?  It is more important than ever to ensure a firm can and will remain functional if you are affected by a pandemic. Particularly, hedge funds must be mindful of the repercussions of the virus, as a decrease in staff could cause potential downtime.

Below are six essential pandemic response steps that firms need to undertake to ensure their businesses remain at peak performance, even if an outbreak occurs in the office.

Begin response procedures BEFORE a disaster strikes.

Organizational resiliency starts by strengthening your organization during normal business operations prior to a disaster such as a pandemic.  It should not take a disaster to compel your firm to evaluate its business continuity and response processes.  One should be in place long before disasters strike.

Identify who will serve as crisis leaders and be in charge of handling situational changes that may occur, including communication to other employees about response procedures and alternative site locations.  An ideal crisis leader is someone who demonstrates good leadership skills during normal business operations and has experience dealing with crises.  Typical crisis leaders are members of the senior management team (i.e. COO, CFO or Portfolio Manager).  Firms must also ensure all employees are mentally and physically able to respond to changes, especially if they are telecommuting.

Also, certify that all employees are cross-trained within the organization; if there is a staff shortage as a result of a pandemic, employees will need to fill additional roles and responsibilities.  Non-critical employees, including business development, accounting and research analysts, may be able to take larger roles and assist during a pandemic response phase.

Develop disaster / pandemic procedures based on a variety of scenarios.

Be proactive.  As part of the planning process, create a list of potential scenarios and define your firm’s response strategies.  Impact scenarios should include both potential internal and external occurrences.

For instance, what is your response if access to your office building is restricted due to extensive H1N1 exposure?  How will you access your email, market data and portfolio management systems?  Where will employees work and how will they communicate with colleagues and counterparties?

Externally, how will you operate if your prime broker or fund administrator contacts are unavailable?  Being prepared will ensure your business operations continue seamlessly and without interruption.

Thoroughly review and modify your business’ Employee Assistance Program (EAP).

An EAP provides assistance and access to counseling services for issues in and out of the workplace.  In the event of a disaster, employees may wish to speak with a professional counselor to deal with any stress or negative emotions that have resulted from the event.  If you cannot provide a physical counseling presence, provide a list of area clinics that offer comparable services.  In advance, consider preparing educational materials that inform employees of the various stress indicators and reactions they may experience as a result of a disaster.  If employees know that support is available prior to a disaster, it will mitigate panic and stress, and they will be better able to adapt to changes in their environment.

You should also inform employees about current sick leave and family support policies in the event that someone is forced to take an extended leave of absence.

In addition to developing and strengthening your EAP, you might also consider having upper management and emergency response team leaders partake in Critical Incident Stress Management (CISM) training, which will provide advanced preparation for responding to critical situations.

Test alternate site and remote access capabilities.

If a crisis situation is directly affecting your physical workspace or your employees, you must be prepared to provide alternatives.  You may choose to move business operations to an alternate site where employees can go without risk.  An alternate site would make sense for crisis situations that are confined to specific areas, such as natural disasters, outages or other situations.

In a pandemic situation – particularly if you have had any outbreaks of illness amongst your employees – you may choose to allow employees to work remotely.  If this is a viable alternative, ensure ahead of time that you have adequate capacity and infrastructure to support multiple virtual private networks (VPN) and remote access capabilities.  Confirm the number of Citrix licenses you have available; if there are not enough to support your complete staff, you may need to consolidate responsibilities.

Review your business response plan and procedures with team members and leaders.

Develop communication notification and escalation procedures for response team leaders and assign internal notification tasks to each leader.  Identify if there are external business partners who need to be notified as well (i.e. investors, service providers, etc.).  Assign a primary and secondary spokesperson in case the public needs to be notified, and ensure the spokesperson(s) has training and experience dealing with the media.  If your spokesperson does not have training, now is the time to arrange for crisis communications training.

Test your pandemic response plan.

It is important to test your company’s response plan with leaders and response team members to ensure there are no glitches or obstacles in the event of a real disaster.  Test internal communication strategies – from response team leaders to staff members.  This can be done manually or through an automatic notification system.  You can also send employees to work at the alternate site or to work remotely to ensure there are no technical issues that can affect productivity.  It is imperative that the teams and employees are able to work together and build trusting relationships today.  A strong foundation that includes good performance and trusting relationships will enable your business to recover from any kind of crisis.

Business Continuity Professionals say that “planning” helps mitigate panic and downtime.  It takes work and resources to develop a resilient organization prior to an interruption or disaster, but it is imperative if businesses want to stay operational.  Businesses cannot function without employees that maintain knowledge and expertise to operate the business, and those employees need to know what to do during an interruption or disaster.  Without a plan, you will spend the entire time chasing the incident instead of recovering from it.

For more information, please see http://www.eci.com.

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Other related hedge fund law articles include:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog and the forex registration website.  He can be reached directly at 415-868-5345.

Data Warehouse Implementation | Hedge Fund IT Solutions

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Deloitte & Netik Conference – Asset Management: Managing and scaling your reference, market and portfolio data

This article is part of our guide to Hedge Fund Business & Technical Issues.

On October 29, 2009 I attended an event at San Francisco’s Omni Hotel put on by Deloitte and Netik.  The event featured a panel discussion with the following panelists:

  • Brian Lott – Executive Vice President, Operations, Netik
  • Michael Smith – Senior Manager, Deloitte & Touche LLP
  • Joseph Clark – Market Data Manager, MSCI Barra
  • James Wu – Product Manager, MSCI Barra
  • Moderated by Ray Iler – Northwest Pacific Hedge Fund Leader, Deloitte & Touche LLP

The discussion was quite interesting and was most appropriate for hedge fund managers who have a need for transparency into their positions and who also need the ability to quickly manipulate large amounts of data.  Coming into this discussion I was not aware of any of the issues involved with data warehouse implementation.  I am sure that much of this discussion went over my head, but I did the best I could to summarize the points made by the various panelists.  As always, any errors or confusion found below is likely attributable to me solely.  [HFLB note: I have not checked with any of the panelists regarding my summary of their comments.]

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Data Warehouse Hedge Fund Discussion

[Moderator questions in italics.]

Ray Iler started the panel discussion by stating that investors and regulators want more information, generally for risk management purposes.

Michael Smith – pending investment adviser registration will mean that managers need to make sure their data systems are ready to handle SEC requests for information, SEC audits and most importantly investor requests for data.  Data warehouses help asset managers to reconcile their various data inputs (especially with regard to multi-custodial relationships).

Brian Lott – regulation is going to drive what “transparency” means.  Old systems were not designed for the way that business is now done – data warehouses now allow managers to bring all information into a central repository and helps the manager to have a holistic view of their portfolios.  These data warehouses can also help ease the regulatory burden by speeding up the time it takes to search and categorize data.

James Wu – data warehouses give managers the ability to see and analyze portfolio and asset level risk characteristics.  These solutions allow managers to run robust reports and ad hoc queries fast.

Ray Iler asked how data warehouses can help managers such as fund of funds or hybrid funds.  [Or something to that effect.]

Brian Lott – legacy apps have not evolved quickly over time.  Data warehousing goes beyond position level down to the data below.  Prior to data warehouses there were systems which were modified to try to function like current data warehouses.  The current data warehouse system is equivalent to a hub and spoke system where the data warehouse is the hub and the various data inputs (information or fees) are the spokes.  The advantage of this hub and spoke system is the ability for managers to centralize data and then be able to analyze it.

Michael Smith – it is one thing for a manager to understand the economics of an investment at the beginning of the deal, then then understanding what is going on with that deal on an ongoing basis becomes harder.  Data warehouses allow managers with a common platform to understand their deal on a continuous basis.  One application for managers is that they could understand how their portfolio composition would change based on an investment.  Such information helps a manager to understand the investment on a continual basis.

Joseph (Joe) Clark – another thing about clients without a data warehouse is that they have a hard time trying to find the data.  A data warehouse makes finding certain data much easier.

James Wu – one of the great things about a data warehouse is that allows you to have more spokes – legacy systems which have been modified (shoehorned) to try to meet current demands often are not able to seemlessly integrate new feeds.

Michael Smith – [made a statement about Microsoft sharepoint and other solutions which make technology easier.]  Managers moving into new asset classes (say a private equity fund moving into real estate investments) should think about how cash flows and reporting are going to change from current systems.  How will this change the formatting?

Joe Clark – data from different vendors and from groups in different jurisidictions do present an issue for some managers.

Ray Iler – that is good point – what about licensing issues for the feeds into the data warehouse?

Joe Clark – It is an interesting issue that centers on the question of who owns the underlying data.  Questions arise as to how many deriviations of the data are needed before the feed provider no longer “owns” it.  It will really depend on each individual relationship.

Brian Lott – it is not standardized from vendor to vendor and the issue needs to be negotiated at each data provider.

Ray Iler – what are the costs and ROI by putting a data warehouse in place?

Brian Lott – the question becomes, how do I pitch this to the board?  It is often hard to quantify the return but recent market events have shown why it is so important for managers to understand total counterparty risk.  For instance, after the Lehman collapse a client had to go through 72 different relationships with Lehman to understand what the total exposure was – this took 3 months to complete.  Generally not until a catastropic event do you see the value at the most basic level like this.

Ray Iler – although we understand that each project is unique, are there some common implementation costs?

Brian Lott – on the data warehouse implementation, for a medium buy-side manager, you are looking at 3 months depending on complexity.  Costs will be all over the board and will depend on the licenses involved and the services requested.  It could be anywhere from $200,000 to $2 million.  On the data servicing side, it will really depend on the size and complexity of the services requested.  There is a big difference in costs with a firm with 2,000 positions versus a firm with 2 million positions.

Michael Smith – we have advised on system implementation for managers with a few hundered million to half a trillion.  Most of the time these can be straightforward implementations but sometimes they cannot and that will affect cost.  The point of the systems are to minimize trade failures, make sure accounting is properly completed, 13Fs and 13Gs are not filed incorrectly and that understanding the various risks of the business.  These factors (along with reputation risk if something goes wrong) are weighed against the cost of implementation – for each manager it will be different in terms of ROI.

James Wu – after Lehman and AIG groups don’t realize how much exposure they have to a counterparty that is failing or about to fail.  Having that information is crucial for managers.

Ray Iler – yes, investors want to see that managers have thought about these issues and right now, in this tough fundraising environment, managers have to do what investors want.  If investors want full transparency, managers need to provide it.  Now, what about in-house technology solutions versus outsourcing.  Can managers do both?

Brian Lott – it is not a one size fits all solution.  It will depend on the risk profile of the manager.  What will happen many times is a sort of hybrid between the in-house team and our outsourced solution.  While the whole data warehouse will be a good solution, the in-house compliance manager or risk manager will usually want to have some kind of final sign off and control over the system.  Accordingly, many firms have their in-house team working directly with the data warehouse in a number of ways.

Joe Clark – the hybrid system is part of the philosophy that the system should match a manager’s specific needs.

[Some thoughts from James Wu and Michael Smith which I did not catch.]

Brian Lott – because each solution is tailored to each manager it is very important that stystem integration firms and the managers understand the scope of the work to be performed.  To do this the manager really needs to understand what the end goal is.  From the end goal the provider will be able to provide dates, an implementation plan, a description of the scope of work to be performed as well as a timeline of the phases of the project implementation.  It is very important for the manager and the provider to define the exact scope of the project.

At this point the floor was opened to questions.

Question from audience

  • What are some of the general needs of some of these managers (such as insurance companies, pension funds and family office managers)?
  • In light of the recent Galleon hedge fund insider trading case, do data warehouse solutions work to help  compliance personnel search emails to detect possible illegal activity.

Networking After Discussion

After the event we had the opportunity to do some networking.  I had to run fairly quickly, but I did have a chance to talk briefly with the following people:

  • Maital S. Rasmussen who works with small and start up hedge fund managers on their marketing materials and presentations.  Specifically I talked with Maital about presentation coaching which is becoming more important for managers who are presenting in front of institutional investors.
  • Erin Brodie who is the Senior Business Development Manager of Global Accounts at Advent Software.
  • Mason Snyder of Catalina Partners, which providers business risk advisory for institutional investments.
  • Maria Hall of M.D. Hall & Company Inc., a hedge fund audit firm.

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Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs Hedge Fund Law Blog and can be reached directly at 415-868-5345.

Hedge Fund Operational Issues and Failures

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Hedge Fund Due Diligence Firm Releases White Paper

We’ve published a number of thoughtful pieces on this blog from Chris Addy, president and CEO of Castle Hall Alternatives (see, for example, article on Hedge Fund Auditors).  Today we are publishing a press release which announces a new white paper from Castle Hall detailing the various reasons which hedge funds fail.  The press release also describes a new web database called HedgeEvent which was created by Castle Hall and details a number of hedge fund operational failures over the last few years.

I found the white paper to be interesting.  I would imagine that some fund of funds and other types of hedge fund investors would find the information useful.  A couple of interesting facts from the whitepaper:

  • The most common causes of operational failure in hedge funds are (i) theft and misappropriation and (ii) existence of assets (i.e. Ponzi schemes).
  • Long/short equity and managed futures are the strategies which are most likely to be subject to operational failure.

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Castle Hall Alternatives Publishes White Paper on Hedge Fund Operational Failures: Launches “HedgeEvent” Database

MONTREAL–(BUSINESS WIRE)–Castle Hall Alternatives, the hedge fund industry’s leading provider of operational due diligence, today published its latest White Paper, ‘From Manhattan to Madoff: the Causes and Lessons of Hedge Fund Operational Failure.’ The Paper’s analysis and findings are based on HedgeEvent, a comprehensive, web-based database of more than 300 operational events, now available to Castle Hall’s due diligence clients. HedgeEvent supplements HedgeDiligence, the firm’s existing client web portal.

The White Paper may be downloaded from www.castlehallalternatives.com/publications.php

Chris Addy, Castle Hall’s CEO, said “the colossal fraud perpetrated by Bernie Madoff, together with a number of other recent cases, has made investors acutely concerned by the risk of operational ‘blow ups’. However, there has been little systematic study of operational failure, meaning that investors have limited guidance as to the extent of this problem.”

“The creation of HedgeEvent, which has taken more than two years to compile, has enabled us to summarize key metrics related to hedge fund operational failure” said Addy. “From Manhattan to Madoff analyzes operational events by number, estimated loss, causal factor and by the strategy of the funds involved.”

HedgeEvent contains 327 cases of hedge fund operational failure through June 30, 2009. Madoff, with an estimated financial impact of $64 billion, is by far the largest; the remaining cases have an aggregate estimated financial impact of approximately $15 billion. Of the 327 operational events, 121 have an estimated impact of $10 million or more, and 31 of at least $100 million.

“While operational failures are material – Madoff spectacularly so – it does not seem that fraud is pervasive in the hedge fund industry” said Addy. “Investors should, however, be very focused on the lessons which can be learned from those hedge funds which did generate large losses. Many of these were well established firms which attracted capital from reputable investors.”

Across all Events, the most common causes of operational failure are theft and misappropriation followed by existence of assets (the manager claimed to own fake securities or operated a Ponzi scheme where reported assets did not exist). The most common strategies subject to operational failure are long / short equity followed by managed futures. It is notable that investors have traditionally viewed these strategies, holding largely exchange-traded securities, as straightforward with low operational risk.

“HedgeEvent is an invaluable tool for both Castle Hall and our clients” said Addy. “A lot can be learned from historical events: better knowledge can help investors avoid the losses, both monetary and reputational, of hedge fund operational failure.”

About Castle Hall Alternatives

Castle Hall Alternatives helps leading institutional investors, fund of funds, family offices and endowments identify and manage hedge fund operational risk. Castle Hall’s team draws on more than 30 years of direct due diligence experience and is the industry’s largest, dedicated provider of operational due diligence. More information is available at www.castlehallalternatives.com

Contacts

Castle Hall Alternatives
Chris Addy, President and CEO, +1 450 465 8880
[email protected]

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Other related hedge fund law and start up articles include:

For more information, please call Bart Mallon, Esq. at 415-296-8510

Hedge Funds and OTC Products

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Some hedge funds use OTC products as part of their main investment strategy, or as a supplement to their main strategy.  In either event, there are a number of issues which hedge fund managers should consider when they decide to utilize OTC products within an investment strategy.  First and foremost, the OTC investment strategy should be adequately described in the hedge fund’s offering documents.  Secondly, the manager should consider the “back office” requirements for processing the OTC investments.  The following article gives a good background of the OTC processing requirements and issues.

Please contact us if you have any questions or you are interested in starting a hedge fund.

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The 5 Pillars of OTC Processing
Ron Tannenbaum, co-founder, GlobeOp Financial Services

As the OTC derivatives market expands in volume, complexity and sector interest, many funds face equally complex post-trade processing challenges in terms of operational processes & efficiencies. Can the key elements of a successful operational infrastructure to support a competitive OTC strategy be defined?

As a significant opportunity for alpha, the growing attraction of OTC derivatives is confirmed both at the industry level and on the “production floor”.  Supplementing Morse’s recent focus group confirmation that 64% of firms increased derivative contracts volume in the last 6 months, new trades by GlobeOp’s OTC clients in the same period increased 100%; monthly open positions increased 18%.

GlobeOp: Daily Average OTC Trade Volume

GlobeOp Monthly OTC open positions by Product Type, August 2008

In addition to traditional hedge fund activity, mutual funds liberated by the UCITS III directive are also increasingly including OTC derivatives in their trading strategies.  Exponential OTC volume growth, combined with the current market turbulence, is challenging in-house operational systems as never before. Legacy and “bolt-on” software systems struggle to communicate with each other. Spreadsheets strain to handle volumes and complexity they were never designed for, increasing the risk of error with each update. In parallel with portfolios becoming more complex, funds are facing increased investor pressure to demonstrate enhanced operational control, independent valuation, higher levels of disclosure and more transparent performance reporting. For many funds, processing derivatives internally quickly becomes cumbersome, inefficient and error-prone, increasing operational risk instead of delivering competitive advantage.

Is a water-tight process for OTC trade processing possible and if so what would it look like?
Eight years of daily OTC processing has provided GlobeOp with a crystallized perspective of the elements essential to a fund’s requirement for effective OTC derivative post-trade processing. Five core, integrated processes are needed to manage, track and report on trades end–to-end throughout their lifecycle:

  • Trade capture
  • Operations
  • Valuations
  • Collateral management
  • Documentation

Rigorous, reliable, daily reconciliation underpins much of the process, while scalability in terms of people and technology is needed to respond nimbly and promptly to trade volume growth, new products or unexpected market events.

The 5 Pillars

Trade capture – real-time, cross-product

Trade data entry sounds such a basic process that it is often underestimated as the cause of many issues further along the process. Incomplete and/or inaccurate detail risks being created when data is aggregated into an internal system from disparate silos or when bolt-on software is unable to communicate completely with front office configurations or legacy systems.

Also, due to their bilateral nature, derivative instruments do not always have established identifier codes, making them more difficult to process than securities with their standard ISIN, CUSIP or Bloomberg reference codes.

A real-time, cross-product, electronic trade capture environment can support the trading desk in developing and trading new OTC products.  Trades should only ever be recorded once, to eliminate the risk of errors associated with manual entry and spreadsheets.

Operations – the litmus test

Trade operations are the ‘litmus test’ of the entire process, encompassing the settlement of trades and reconciliation of cash and securities positions associated with individual derivatives transactions. Having cash and securities obligations in position at the time of settlement are essential to efficiently transferring ownership and moving funds.

Valuations – transparency, independence

The challenge of accurate, independent valuation can be addressed by pricing models that can adapt to new and complex instruments, and that are tolerance-checked against counterparty prices and other external industry and data sources.

Depending only on counterparty prices due to either insufficient valuation expertise or technology can increase the risk of a domino of delays to timely and reliable trade reconciliation, NAVs and investor reporting or returns.

Mutual funds face an additional regulatory dimension to their valuation challenges. In exchange for reducing mutual fund barriers to OTC derivative trading, the February 2007 UCITS III directive placed a high premium on transparent and independent valuation and risk management.

The requirement for mutual funds to demonstrate their ability to provide fully independent daily valuations and risk analytics can affect both mutual funds and their custodian bank. A mutual fund’s back office is often well-equipped to manage the long-only investments the fund traditionally makes. Operational knowledge, systems, models and capacity for complex derivatives is, however, either absent or insufficient. This is compounded when, as we have seen repeatedly, most mutual funds also initially tend to significantly underestimate their derivative trading volume,

Thus challenged, and to meet the UCITS lll independence criteria, the mutual fund turns to its custodian bank, its historic provider of a wide range of support services. While willing in spirit, most custodian banks quickly recognize that complex OTC trade processing, valuation and risk analytics exceed both their expertise and spreadsheet-based systems.

Collateral management – exposure management

Current market turbulence has sharpened the spotlight on the value of real-time, online collateral management to accurate trading and exposure management. What collateral is on the books, with whom, at what rate, for how long? What pledges are held vs. outstanding? Accurate, transparent collateral reporting will remain vital to the front office for months to come.

Effective collateral management usually includes ensuring the fund is net present value collateralised with each of its counterparties on a daily basis. In addition, an integrated facility should ensure appropriate movement of cash and securities to support revaluations and margin calls.

Documentation – integrated STP

According to recent ISDA statistics, approximately 60% of the hedge fund industry’s OTC instruments are still confirmed manually. This is not only time-consuming, but it also increases the incidence of error and leaves funds vulnerable to compliance risk, due to the high level of positions which remain based on verbal agreements. Integrated, straight-through-processing (STP) for managing, exchanging and storing trade documentation better enables both trade partners to reconcile economic terms with counterparties and meet auditor and regulatory compliance obligations.

Conclusion

A successful OTC trading strategy requires underpinning by an integrated platform of people, processes and technology that deliver post-trade processing and reporting that enables the fund to focus on its core objective of generating investor returns and expanding the capital base.

Informal industry estimates indicate that building an internal OTC processing infrastructure involves significant fund investment in cost and time — up to $50 million and five years of testing and development. Often unspoken are the risks that continued market and fund strategy evolution may result in a design neither suitable or scalable for long-term requirements, or able to deliver sufficient economy of scale.

The attraction of OTC derivative instrument strategies remains robust. As funds consider their future strategies, recent market events have only served to reinforce the need for post-trade processing and infrastructures whose key deliverables are:

  • Data and document management across the lifecycle of the trade that is timely, transparent, accurate, reconciled and real-time
  • Robust, scalable, online support
  • Independent, risk-based valuation that is tolerance-checked within well defined limits.