Tag Archives: hedge fund

What is a qualified client? Qualified client definition

UPDATE: the below article is based on the old “qualified client” definition. The new “qualified client” definition can be found in full here, and the SEC order increase the asset thresholds can be found here. As a gross summary, the new definition of a qualified client is:

entity or natural person with at least $1,000,000 under management of the advisor, OR
entity or natural person who has a net worth of more than $2,100,000

For the second test above, natural persons exclude the value of (and debt with respect to) their primary residence (assuming the primary residence is not under water).

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Certain hedge fund managers need to be registered as investment advisors with the SEC or with the state securities commission of the state which they reside in. For SEC-registered investment advisors, and most state registered advisors, the investors in their hedge fund will need to be “qualified clients” in addition to the requirement that such investors are also accredited investors. While many accredited investors will also be qualified clients, this might not always be the case because the qualified client defintion requires a higher net worth than the accredited investor definition. Hedge fund managers who are required to have investors who are both accredited investors and qualified clients cannot charge performance fees to those investors who do not meet the qualified client definition. Individual investors will generally need to have a $1.5 million net worth in order to be considered a “qualified client.”

The definition of “qualified client” comes from rules promulgated by the SEC under the Investment Advisors Act of 1940, specifically Rule 205-3. That rule provides:

The term qualified client means:

1. A natural person who or a company that immediately after entering into the contract has at least $750,000 under the management of the investment adviser;

2. A natural person who or a company that the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, either:

a. Has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $1,500,000 at the time the contract is entered into; or

b. Is a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 at the time the contract is entered into; or

3. A natural person who immediately prior to entering into the contract is:

a. An executive officer, director, trustee, general partner, or person serving in a similar capacity, of the investment adviser; or

b. An employee of the investment adviser (other than an employee performing solely clerical, secretarial or administrative functions with regard to the investment adviser) who, in connection with his or her regular functions or duties, participates in the investment activities of such investment adviser, provided that such employee has been performing such functions and duties for or on behalf of the investment adviser, or substantially similar functions or duties for or on behalf of another company for at least 12 months.

What is an accredited investor? Accredited investor definition

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[2017 EDITORS NOTE: this article will be updated shortly. Please note that the definition has changed and that the net worth requirement now carves out any equity or debt of a personal residence.]

Hedge fund managers can only admit certain investors into their hedge funds. Most hedge funds are structured as private placements relying on the Regulation D 506 offering rules. Under the Reg D rules, investors must generally be “accredited investors.” Many hedge funds have additional requirements.

With regard to individual investors, the most common of the below requirements is the $1 million net worth (which does include assets such as a personal residence). With regard to institutional investors, the most commonly used category is probably #3 below, an entity with at least $5 million in assets. Please note that there may be additional requirements for your individual hedge fund so you should discuss any questions you have with your attorney.

The accredited investor definition can be found in the Securities Act of 1933. The definition is:

Accredited investor shall mean any person who comes within any of the following categories, or who the issuer [the hedge fund] reasonably believes comes within any of the following categories, at the time of the sale of the securities [the interests in the hedge fund] to that person:

1. Any bank as defined in section 3(a)(2) of the [Securities] Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;

2. Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;

3. Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;

4. Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;

5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;

6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

7. Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii) and

8. Any entity in which all of the equity owners are accredited investors.

Hedge Fund and Pension Report Issued by GAO

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On Wednesday the U.S. Government Accountability Office (“GAO”) released a report examining investments by defined benefit pension plans into hedge funds. The report is titled: Defined Benefit Pension Plans: Guidance Needed to Better Inform Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity. To produce the report, the GAO talked with hedge fund instry associations, government administrative entities and both private and public pension funds. Some of the private pensions interviewed include: American Airlines, Boeing, Exxon Mobil, John Deere, Macy’s and Target. Some of the public pensions included: CalPERS, New York State Common Retirement Fund and the Washington State Investment Board.

I had a chance to read through the 65 page report and found it to be very well written and researched. The report also accurately and succinctly summarizes the applicable laws and regulations which apply to pensions investing in hedge fund and private equity funds. Overall I think that the report contains a good deal of very useful information. For start up hedge fund managers looking to eventually raise money from institutional investors, the report should be required reading. Some of the more salient points raised in the report include:

pension plans investments into hedge funds is expect to continue to increase
pension plans are aware of the risks of investing in hedge funds including: liquidity risk, transparency risk, valuation risk (potentially), high fees, and leverage
pension plans are not afraid to pull money from non-performing hedge funds; however, hedge fund managers should not focus on investment ideas at the expense of operational considerations
due diligence will become more important as time goes on (and as more frauds are caught)

Below I have produced (what I view are) the most useful or intersting parts of the report. The headings and the emphasis in the text below, along with all information in brackets, are my own. Any footnotes have been omitted. The entire report can be found here.

Background and purpose of the report

Millions of retired Americans rely on defined benefit pension plans for their financial well-being. Recent reports have noted that some plans are investing in ‘alternative’ investments such as hedge funds and private equity funds. This has raised concerns, given that these two types of investments have qualified for exemptions from federal regulations, and could present more risk to retirement assets than traditional investments.

To better understand this trend and its implications, GAO was asked to examine (1) the extent to which plans invest in hedge funds and private equity; (2) the potential benefits and challenges of hedge fund investments; (3) the potential benefits and challenges of private equity investments; and (4) what mechanisms regulate and monitor pension plan investments in hedge funds and private equity.
GAO recommends that the Secretary of Labor provide guidance on investing in hedge funds and private equity that describes steps plans should take to address the challenges and risks of these investments. Labor generally agreed with our findings and recommendation.

Hedge fund definition

While there is no statutory definition of hedge funds, the phrase “hedge fund” is commonly used to refer to a pooled investment vehicle that is privately organized and administered by professional managers, and that often engages in active trading of various types of securities and commodity futures and options contracts. Similarly, private equity funds are not statutorily defined, but are generally considered privately managed investment pools administered by professional managers, who typically make long-term investments in private companies, taking a controlling interest with the aim of increasing the value of these companies through such strategies as improved operations or developing new products. Both hedge funds and private equity funds may be managed so as to be exempt from certain aspects of federal securities law and regulation that apply to other investment pools such as mutual funds.

Description of pension plan investment into hedge funds

Pension plans invest in hedge funds to obtain various benefits, but some characteristics of hedge funds also pose challenges that demand greater expertise and effort than more traditional investments, which some plans may not be able to fully address. Pension plans told us that they invest in hedge funds in order to achieve one or more of several goals, including steadier, less volatile returns, obtaining returns greater than those expected in the stock market, or diversification of portfolio investments. Pension plan officials we spoke with about hedge fund investments all said these investments had generally met or exceeded expectations. However, at the time of our contact in 2007, several plan officials noted that their hedge fund investments had not yet been tested under stressful economic conditions, such as a significant stock market decline. Further, some indicated mixed experiences with hedge fund investments. At the time of our discussions, however, officials of each plan interviewed indicated that they expected to maintain or increase the share of assets invested in hedge funds.

Nonetheless, hedge fund investments pose investment challenges beyond those posed by traditional investments in stocks and bonds. These additional challenges include: (1) the inherent risks of relying on the skill and techniques of the hedge fund manager; (2) limited information on a hedge fund’s underlying assets and valuation (limited transparency); (3) contract provisions which limit an investor’s ability to redeem an investment in a hedge fund for a defined period of time (limited liquidity); and 4) the possibility that a hedge fund’s active or risky trading activity will result in losses due to operational failure such as trading errors or outright fraud (operational risk). Although there are challenges of hedge fund investing, plan officials and others described steps to address these and other challenges. For example, plan officials and others told us that it is important to negotiate key investment terms and conduct a thorough “due diligence” review of prospective hedge funds, including review of a hedge fund’s operational structure. Further, pension plans can invest in funds of hedge funds, which charge additional fees but provide diversification and the additional skill of the fund of funds manager. According to plan officials and others, some of these steps require considerably greater effort and expertise from fiduciaries than is required for more traditional investments, and such steps may be beyond the capabilities of some pension plans, particularly smaller ones.

ERISA considerations

Under the Employee Retirement and Income Security Act (ERISA), plan fiduciaries are expected to meet general standards of prudent investing and no specific restrictions on investments in hedge funds or private equity have been established. Labor [the DOL] is tasked with helping to ensure plan sponsors meet their fiduciary duties; however, it does not currently provide any guidance specific to pension plan investments in hedge funds or private equity. Conversely, some states do specifically regulate and monitor public sector pension investment in hedge funds and private equity, but these approaches vary from state to state. While states generally have adopted a “prudent man” standard similar to that in ERISA, some states also explicitly restrict or prohibit pension plan investment in hedge funds or private equity. For instance, in Massachusetts, the agency overseeing public plans will not permit plans with less than $250 million in total assets to invest directly in hedge funds. Some states have detailed lists of authorized investments that exclude hedge funds and/or private equity. Other states may limit investment in certain investment vehicles or trading strategies employed by hedge fund or private equity fund managers. While some guidance exists for hedge fund investors, specific guidance aimed at pension plans could serve as an additional tool for plan fiduciaries when assessing whether and to what degree hedge funds would be a prudent investment.

… all [the pension plans] said that their hedge fund investments had generally met or exceeded expectations, although some noted mixed experiences. For example, one plan explained that it had dropped some hedge fund investments because they had not performed at or above the S&P 500 benchmark. Also, this plan redeemed its investment from other funds because they began to deviate from their initial trading strategy.

Challenges and risks of hedge fund investments

While any plan investment may fail to deliver expected returns over time, hedge fund investments pose investment challenges beyond those posed by traditional investments. These include (1) reliance on the skill of hedge fund managers, who often have broad latitude to engage in complex investment techniques that can involve various financial instruments in various financial markets; (2) use of leverage, which amplifies both potential gains and losses; and (3) higher fees, which require a plan to earn a higher gross return to achieve a higher net return.

Hedge Fund Fees

Several pension plans cited the costly fee structure fees as a major drawback to hedge fund investing. For example, representatives of one plan that had not invested in hedge funds said that they are focused on minimizing transaction costs of their investment program, and the hedge fund fee structure would likely not be worth the expense. On the other hand, an official of another plan noted that, as long as hedge funds add value net of fees, they found the higher fees acceptable.

Operational Risk

Pension plans investing in hedge funds are also exposed to operational risk—that is, the risk of investment loss due not to a faulty investment strategy, but from inadequate or failed internal processes, people, and systems, or problems with external service providers. Operational problems can arise from a number of sources, including inexperienced operations personnel, inadequate internal controls, lack of compliance standards and enforcement, errors in analyzing, trading, or recording positions, or outright fraud. According to a report by an investment consulting firm, because many hedge funds engage in active, complex, and sometimes heavily leveraged trading, a failure of operational functions such as processing or clearing one or more trades may have grave consequences for the overall position of the hedge fund. Concerns about some operational issues were noted by SEC in a 2003 report on the implications of the growth of hedge funds. For example, the 2003 report noted that SEC had instituted a significant and growing number of enforcement actions involving hedge fund fraud in the preceding 5 years. Further, SEC noted that while some hedge funds had adopted sound internal controls and compliance practices, in many other cases, controls may be very informal, and may not be adequate for the amount of assets under management. Similarly, a recent Bank of New York paper noted that the type and quality of operational environments can vary widely among hedge funds, and investors cannot simply assume that a hedge fund has an operational infrastructure sufficient to protect shareholder assets.

Several pension plans we contacted also expressed concerns about operational risk. For example, one plan official noted that the consequences of operational failure are larger in hedge fund investing than in conventional investing. For example, the official said a failed long trade in conventional investing has relatively limited consequences, but a failed trade that is leveraged five times is much more consequential. Representatives of another plan noted that back office and operational issues became deal breakers in some cases. For example, they said one fund of funds looked like a very good investment, but concerns were raised during the due diligence process. These officials noted, for example, the importance of a clear separation of the investment functions and the operations and compliance functions of the fund. One official added that some hedge funds and funds of funds are focused on investment ideas at the expense of important operations components of the fund.

Importance of hedge fund due diligence

Pension plans take steps to mitigate the challenges of hedge fund investing through an in-depth due diligence and ongoing monitoring process. While plans conduct due diligence reviews of other investments as well, such reviews are especially important when making hedge fund investments, because of hedge funds’ complex investment strategies, the often small size of hedge funds, and their more lightly regulated nature, among other reasons. Due diligence can be a wide-ranging process that includes a review and study of the hedge fund’s investment process, valuation, and risk management. The due diligence process can also include a review of back office operations, including a review of key staff roles and responsibilities, the background of operations staff, the adequacy of computer and telecommunications systems, and a review of compliance policies and procedures.

Smaller pension plans are not as active hedge fund investors

Available data indicate that pension plans have increasingly invested in hedge funds and have continued to invest in private equity to complement their traditional investments in stocks and bonds. Further, these data indicate that individual plans’ hedge fund or private equity investments typically comprise a small share of total plan assets. However, data are generally not available on the extent to which smaller pension plans have made such investments. Because such investments require a degree of fiduciary effort well beyond that required by more traditional investments, this can be a difficult challenge for plans, especially smaller plans. Smaller plans may not have the expertise or financial resources to be fully aware of these challenges, or have the ability to address them through negotiations, due diligence, and monitoring. In light of this, such investments may not be appropriate for some pension plans.

Conclusions

The importance of educating investors [pension plans] about the special challenges presented by hedge funds has been recognized by a number of organizations. For example, in 2006, the ERISA Advisory Council recommended that Labor publish guidance about the unique features of hedge funds and matters for consideration in their use by qualified plans. To date, EBSA [Employee Benefits Security Administration] has not acted on this recommendation. More recently, in April 2008, the Investors’ Committee formed by the President’s Working Group on Financial Markets published draft best practices for investors in hedge funds. This guidance will be applicable to a broad range of investors, such as public and private pension plans, endowments, foundations, and wealthy individuals. EBSA can further enhance the usefulness of this document by ensuring that the guidance is interpreted in

GAO Recommendation

To ensure that all plan fiduciaries can better assess their ability to invest in hedge funds and private equity, and to ensure that those that choose to make such investments are better prepared to meet these challenges, we recommend that the Secretary of Labor provide guidance specifically designed for qualified plans under ERISA. This guidance should include such things as (1) an outline of the unique challenges of investing in hedge funds and private equity; (2) a description of steps that plans should take to address these challenges and help meet ERISA requirements; and (3) an explanation of the implications of these challenges and steps for smaller plans. In doing so, the Secretary may be able to draw extensively from existing sources, such as the finalized best practices document that will be published in 2008 by the Investors’ Committee formed by the President’s Working Group on Financial Markets.

DOL Response to GAO Recommendation

With regard to our recommendation, Labor stated that providing more specific guidance on investments in hedge funds and private equity may present challenges. Specifically, Labor noted that given the lack of uniformity among hedge funds, private equity funds, and their underlying investments, it may prove difficult to develop comprehensive and useful guidance for plan fiduciaries. Nonetheless, Labor agreed to consider the feasibility of developing such guidance.

GAO’s Response to the DOL’s Response

Indeed, the lack of uniformity among hedge funds and private equity funds is itself an important issue to convey to fiduciaries, and highlights the need for an extensive due diligence process preceding any investment.

Investment Advisor faces fine and injuction for unauthorized leverage

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As a hedge fund lawyer one of my most important jobs is to help keep the client out of any trouble and to help the manager deal with any potential issues before they become issues.

Below is a classic example of an investment manager who did not adequately describe his investment program (and the risks). One of the more important parts of the hedge fund start up process is to create an investment program which accurately describes the trading which the fund will engage in. While many offering documents include very broad language allowing a manager to make changes to the investment program, gross or wholesale changes should be communicated to the investor (potentially with the right to redeem the interests, depending on the hedge fund’s terms and structure). The highlighted language below emphasizes the point that descriptions of a hedge fund’s investment program should be accurate, as well as the point that hedge fund managers should never lie or intentionally mislead their clients.

The full release can be found here.

Release:

U.S. SECURITIES AND EXCHANGE COMMISSION
Litigation Release No. 20713 / September 11, 2008
SEC v. Mark D. Lay and MDL Capital Management, Inc., Civil Action No. 08-CV-1269 (DSC) (W.D. Pa.)
SEC Charges Mark D. Lay and MDL Capital Management, Inc. With Defrauding Ohio Bureau of Workers’ Compensation

The Securities and Exchange Commission announced that today it filed securities fraud charges in the United States District Court for the Western District of Pennsylvania against Mark D. Lay of Aliquippa, Pennsylvania, and MDL Capital Management, Inc. (“MDL Capital”), an investment adviser registered with the Commission and located in Pittsburgh, Pennsylvania. Lay was the Chairman, CEO and Chief Investment Strategist of MDL Capital and part-owner of MDL Capital. Without admitting or denying the allegations of the Complaint, Lay and MDL Capital have consented to the entry of a final judgment permanently enjoining them from engaging in the violations set forth below, and ordering other relief

The Commission’s Complaint alleges that, between February 2004 and November 2004, Lay and MDL Capital defrauded their advisory client, the Ohio Bureau of Workers’ Compensation, in connection with the Bureau’s investment of public money in the MDL Active Duration Fund, Ltd., a hedge fund affiliated with and managed by Lay and MDL Capital. The Bureau transferred approximately $200 million from its advisory account managed by MDL Capital and Lay to the hedge fund pursuant to an agreement that those assets would be conservatively leveraged.

The Complaint further alleges that MDL Capital and Lay exposed Bureau funds to unauthorized and undisclosed risk by substantially exceeding a 150% leverage guideline, at one point using leverage of over 21,000% in the hedge fund. As a result, the Bureau incurred losses of approximately $160 million. During the course of the fraud, Lay repeatedly lied to and misled the Bureau as to the reasons for and amount of the losses as well as the excessive leverage Lay was using.

In October 2007, based on these same facts, Lay was convicted in the Northern District of Ohio of criminal mail fraud, wire fraud and investment adviser fraud. Lay is currently serving a 12 year prison sentence.

The Complaint alleges that Lay and MDL Capital violated Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 206(1) and 206(2) of the Investment Advisers Act of 1940. Subject to the Court’s approval, the final judgment imposes permanent injunctions against MDL Capital and Lay and orders them to pay $1,544,195 in disgorgement and prejudgment interest, but waives payment of these amounts, and does not impose civil penalties, based on the defendants’ sworn statements of financial condition.

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.

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.

Offshore hedge fund director requirements

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Two of the most popular offshore hedge fund jurisdictions are the Cayman Islands and the British Virgin Islands. In another post I will detail the requirements for registration or recognition with these jurisdictions, but for the purposes of this article it is enough to point out that both jurisdictions will generaly require each hedge fund entity (in the case of a master feeder structure there would normally be two offshore entities) to have two directors.

Cayman Islands Director Requirements

In the Cayman there are two types of funds – (i) Cayman Islands Monetary Authority (“CIMA”) registered funds and CIMA non-registered funds. CIMA registration is required if a hedge fund is open-ended (allows investors the option to redeem) and has 16 or more investors. CIMA registration is not required if a hedge fund is closed-edned (does not allow investor the option to redeem) or if a hedge fund has 15 or fewer investors who have the right to appoint or remove directors.

For CIMA registered funds, there must be at least 2 directors who must be individuals. For non-CIMA registered funds, there must be at least 1 director who must be an individual. The individual directors do need not to be a Cayman resident.

BVI “four eyes” policy

In the BVI most hedge funds are deemed to be mutual funds. Because they are mutual funds, they will need to be “recognized” as such with the BVI’s Financial Services Comission (“FSC”).

Pursuant to BVI laws and statutes all companies (including hedge funds) are only required to have 1 director. However the FSC has just recently instituted a new “four eyes” policy which effectively requires that all funds have two directors (the “four eyes” policy has been applied for some time in relation to BVI-incorporated investment managers; however, its application to BVI based funds is a new development). This policy is not codified and it seems to be enforced only on a case by case basis. We are recommending to our clients that they name 2 directors because the liklihood of the FSC requiring 2 directors prior to recognition is quite high.

In the BVI a hedge fund can name a company to be a director.

Offshore Nominee Directors

Not all hedge funds will not have two persons who wish to serve as directors of the fund. The reasons may vary from unwanted perceptions to unwanted responsibilities. For whatever reason in these instances the hedge fund will need to name another person (or a company, for the BVI) which will serve as a director for the fund.

In such cases an offshore hedge fund manager may want to think about using a “nominee” director. There are companies in both the BVI and the Cayman Islands which can provide nominee director services, usually on an annual basis, for a fee. While these fees will depend on a number of factors, including the percieved risk of the fund and the manager, you will probably be looking at anywhere from US $5,000-$10,000 per year.

When searching for a nominee director we recommend shopping around as there are going to be groups which naturally feel more and less comfortable with your program. Some nominees will require some sort of involvement in the high-level affairs of the fund. Some nominees will also ask to be at least be co-signatories on any bank accounts opened in the name of the fund. These precautions are understandable as the nominee services are typically provided by services companies (registered office, registered agent, etc) who could potentially lose their license if something happens with the fund.

Directors from non-US jurisdictions

Please note with all directors the issue of perception. There have been recent instances of large brokerage firms refusing to establish brokerage accounts for some hedge funds because the directors (or even a director) were from states known to support terrorism. It will be a good idea to think about selecting a director who is from country which supports or sponsors terrorism. I do not think that this is a wide-spread practice; however, if a brokerage firm does not allow for the account formation because a new director will need to be appointed, you are going to end up delaying your launch.

Confidentiallity of Director information

In the BVI, the details of directors and shareholders of BVI funds is strictly confidential and not a matter of public record. Funds can if they wish elect to file a register or a document which details directors &/or shareholders but this is not common practice. Obviously the details of directors and shareholders may come into the public domian when they are distributed to third parties (e.g. administrators or auditors) but many times these third parties have previously agreed to keep also such information strictly confidential. Any information held by a fund’s registered agent, likewise, will be kept confidential unless required to be disclosed by order of the FSC (believing it to be in the best interests of the jurisdiction – this is not common and generally requires substantial proof of criminal activity), or a BVI Court.

Offshore Director due diligence requirements

Becoming a director of a company which acts as a hedge fund is not difficult but there are many due diligence requirements for all directors of these companies. While all jurisdictions will differ, the BVI and the Caymans will typically require the following documents from each director:

List of director details – name, address, etc
Copy of director utility bill – can include: gas, power, electric, water, television/cable, phone/internet; showing home address; notarized
Copy of director passport – showing a clear picture of the director, notarized
Director bank reference – should include length of relationship; may need to include average amount of assets
Director professional reference – should be from a lawyer or accountant who has had a previous professional relationship with the director
List of owners/shareholders of director (if an entity)
Copy of director formation documents (if an entity)
Other items as requested by the registered agent

Please contact us if you have any questions on any of the above or would like to inquire about a nominee director or establishing an offshore hedge fund.

DOL tells ERISA plan to monitor hedge fund valuation practices

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I came across this ERISA hedge fund article last night and found it to be very interesting. This article highlights an issue that is plaguing the hedge fund industry – how to value illiquid and other hard to value assets. This issue has come to the forefront over the last year as the bank and large hedge funds have posted huge losses due to improper valuation of assets. More to come on this issue. The orginal article can be found here: www.castlehallalternatives.com.

ERISA vs. the Hedge Fund Industry

According to Pensions and Investment, the Boston office of the US Department of Labor (the “DOL”) recently issued a letter to an (unidentified) US Pension Plan subject to ERISA (the Employee Retirement Income Security Act) stating that the plan was in violation of ERISA regulations. The DOL is responsible for monitoring – and sanctioning – ERISA plans and, in their letter, threatened legal action if the plan in question did not remedy the noted violations.

The problem?

When valuing hedge funds and other alternative assets for purposes of the Plan’s annual filing, the pension investor had apparently relied upon valuations provided by the underlying funds’ general partners and, in some cases, on audited financial statements for those funds.

This is, of course, standard practice for many hedge fund investors. It appears, however, that this approach could create a major roadblock for ERISA plans.

According to the DOL, “it is incumbent on the Plan Administrator to establish a process to evaluate the fair market value of any hard to value assets held by the Plan. Such a process would include a complete understanding of the underlying investments and the fund’s investment strategy. In addition, the Plan Administrator must have a thorough knowledge of the general partner’s valuation methodology to ensure that it comports with the fund’s written valuation provisions and reflects fair market value. A process which merely uses the general partner’s established value for all funds without additional analysis may not insure that the alternative investments are valued at fair market value.”

In other words, the entity which has to value all assets – and especially hard to value assets – is the pension investor subject to ERISA. There is no way of dodging this poison chalice – the ERISA investor cannot simply rely on the hedge fund’s own valuation.

This is an enormously challenging obligation, particularly in the context of the severe fiduciary standards set by ERISA. Indeed, the DOL position raises a broad question – is it even possible for ERISA plans (or indeed any hedge fund investor) to meet this duty of care?

We have three observations.

Firstly, very few hedge funds provide position level transparency. However, it is stating the obvious to say that, without position level transparency, it is impossible for an ERISA investor (or any other investor for that matter) to have a “complete” understanding of the underlying investments and the fund’s investment strategy. Moreover, even if managers do provide position information, how can investors ensure that it is timely and accurate? The best solution to the transparency issue is a managed account – as such, would one outcome of the DOL’s position, if enforced, be for ERISA plans to only invest through managed account structures?

Secondly, the DOL states that ERISA plans must have a “thorough knowledge of the general partner’s valuation methodology”. However, in practice, most hedge fund offering documents have deliberately vague and unspecific clauses as to valuation and calculation of the net asset value, especially in relation to hard to value instruments. To add salt to the wound, every prospectus we have ever read includes a final caveat along the lines of “notwithstanding the above policies, the general partner (or the Board of directors in “consultation” with the investment manager for an offshore fund) may elect any “alternative method” of fair valuation. “ There is hence very limited specificity as to valuation procedures in virtually all hedge fund offering materials, and certainly insufficient information to provide a “thorough knowledge” of the valuation methodology which will be applied.

If the prospectus gives an inadequate description of the valuation process, investors need to turn to supplementary information from the hedge fund manager. At this point, however, things get worse – many hedge fund managers have not developed any internal, written valuation policy at all. For those funds which do have a valuation document, there is no standardization, and many valuation policies remain uncomfortably vague and unspecific (although, in fairness, we congratulate the minority of managers who have some stepped up and do furnish investors with comprehensive valuation information.)

The worst case is when a manager does have a valuation document, but will not provide it to the investor. Ironically, the worst culprits in this situation are some of the industry’s largest and most well known hedge fund managers. The issue is liability: hedge fund lawyers now appear to advise managers that the more information provided to investors, the more the potential liability. (As an aside, we recently spoke with the CFO of a large hedge fund: he noted that the sight of the Bear Stearns hedge fund managers being led away in ‘cuffs had resulted in urgent calls from the firm’s lawyers, advising the manager to reduce the amount of information it provided to investors.)

The third area of concern is the ongoing assumption by many investors, including many ERISA plans, that third party administrators assume responsibility for valuing hedge fund portfolios. As such, the administrator, it is perceived, can provide the necessary independence in the valuation process.

Not so fast. As we have noted before, much of today’s administration industry is now emphatic that they perform only the services of a “calculation agent” not a “valuation agent”. This is a relatively mute point when dealing with exchange traded securities, but it is an enormous issue when looking at a hedge fund which trades hard to value instruments (it goes without saying that we need help to value exotic CDOs, not IBM stock).

As a “calculation agent”, many administrators have amended their legal contracts to retain the right to “consult with” the manager and, indeed, accept prices from the hedge fund manager without further verification. Again, we hate to make an “emperor has no clothes” comment, but this is obviously nonsense: taking prices from the manager is like a police officer issuing speeding tickets on the basis of asking drivers how fast they were going.

These issues, in our mind, share a common theme. In recent years, with an ever-accelerating pace, we have watched the legal pendulum which defines how investors and hedge fund managers transact drift ever further in favor of the manager at the expense of the investor. It is trite, but uncomfortably accurate, to say that, in today’s hedge fund industry, no-one wants to be responsible for anything. Everyone is instead seeking to be indemnified to the point of invulnerability.

And this is the disconnect between the hedge fund industry and DOL. ERISA establishes onerous standards of fiduciary responsibility, deliberately designed to make those responsible for ERISA plans accountable, responsible and liable for their actions. Today’s hedge funds, however, are increasingly structured to ensure the lowest possible degree of accountability and liability on the part of pretty much everyone involved.

Against this background, we will watch with great interest ongoing developments as the DOL monitors ERISA plans with material hedge fund portfolios. The question, of course, is whether investing in opaque, uncommunicative hedge funds (even when they are some of the largest in the world) is too close to pushing a square peg in a round hole for investors who do operate within a strict fiduciary framework.

Cayman notches 10,000th hedge fund

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In a press release statement from Walkers, the Cayman law firm announces that the Cayman Islands have over 10,000 registered hedge funds as of the end of June 2008. Please see release below:

Cayman Islands Sets Milestone with 10,000 Registered Funds
28-Jul-2008

Recent second quarter figures from the Cayman Islands Monetary Authority (CIMA), have confirmed the achievement of a key milestone by the Cayman Islands financial services industry, with over 10,000 investment funds currently registered in the jurisdiction.

At the end of June 2008 there were 10,037 funds on CIMA’s register, compared with 9,681 at the end of the previous quarter and 8,972 at the mid point of 2007. The current annual growth rate of 12% in net new hedge funds, which takes cancellations into account, is particularly striking in the context of the deterioration in global markets following the sub-prime meltdown and associated credit crunch.

“This is yet another round of impressive statistics from CIMA,” said Mark Lewis, senior investment funds partner at Walkers. “The 10,000 barrier has been breached as hedge funds continue to be formed in the Cayman Islands, which remains the clear jurisdiction of choice for investment managers and their advisers around the world.

“Business remains active and the volatility which has impacted world markets as a result of the credit crisis, and the relatively weak valuations of many securities, has provided hedge fund managers with great opportunities to create alpha after a number of years of relatively flat returns”, Lewis added. “Hedge funds have also provided the market with much needed liquidity, which has been especially beneficial amid the current tight lending conditions.”

The continued growth in net hedge fund registrations is also partly explained by the absence of a significant spike in fund terminations. While there has certainly been a slight increase in terminations over the past 12 months, funds are not being closed at an unprecedented rate.

“There have been some forced closures, but in the cases where funds are struggling, the managers we work with are being pro-active by placing hard-to-value securities in side pockets, suspending redemptions and imposing gates. Such measures may enable a fund in distress to ride out the storm or to wind down its affairs in an orderly manner,” said Walkers investment funds partner Nick Rogers. “In the Cayman Islands the key drivers behind the actions being taken are the need to treat all investors equitably and to act in the best interests of the fund, and this provides a firm foundation for protecting market participants and preserving value.”

Among the new funds that have been established in the Cayman Islands, strategies such as distressed debt and special opportunities presented by the widespread markdown in asset prices have continued to feature strongly.

“There has also been significant ongoing activity in emerging markets and commodities,” Rogers added. “The convergence of these two hot asset classes has been particularly interesting.”

There are a number of factors behind the Cayman Islands’ attractiveness as a domicile for hedge funds, in particular the stable economic and political climate, the close relationship between the public and private sector and the presence of the world’s leading professional services firms. The regulatory regime in the Cayman Islands has been recognised internationally, notably by the International Monetary Fund (IMF) and the Caribbean Financial Action Task Force (CFATF) for its high standards. In the area of transparency and “know-your-client” regulations, these standards surpass many of the world’s top international financial centres.

Cox testifys to Congress: discusses hedge funds

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