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Data Warehouse Implementation | Hedge Fund IT Solutions

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.

Update on H.R. 3818 | Hedge Fund Registration Bill

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As has been reported by a number of groups the Private Fund Investment Advisors Act of 2009 was approved by the House Financial Services Committee by a vote of 67-1. The proposed bill underwent a number of significant changes during the committee meeting. The attached document shows (in redline format) the changes which were made to the bill during the committee meeting. I compiled this “new” text of H.R. 3818 by making the changes as introduced by various committee members, see markups.

The major changes include:

a provision which exempts managers from registration if the managers only provide investment advice to SBICs (introduced by Mrs. Capito and Mr. Paulsen)
a provision which exempts managers from registration if the managers have less than $150 million of AUM (introduced by Mr. Peters, Mr. Meeks, and Mr. Garrett)
a provision which directs the SEC to take into account certain factors when promulgating regulations which apply to advisers to “mid-sized” private funds (introduced by Mr. Peters, Mr. Meeks, and Mr. Garrett)

Please also see Doug Cornelius’ article on the changes to the bill.

Hedge Fund Business & Technical Issues

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Overview

In addition to providing startup and established managers with information on various hedge fund laws and regulations, we have also provided a number of articles on the general business issues that hedge fund managers need to address. These articles cover a number of areas and many of the articles below are from service providers to hedge funds. Please feel free to suggest other areas for us to explore in future articles.

Hedge Fund Technology, IT and Internet Issues

IT Issues for Hedge Fund Managers – this article, written by a technology solutions firm, details some of the IT solutions which are available to hedge fund managers who will need to register after the new hedge fund registration rules are adopted. These issues also apply for currently registered (SEC or state) hedge fund managers as well.
Data Warehouse Implementation for Hedge Funds – a summary of a panel discussion on the reasons managers should think about implementing a data warehouse system.
Hedge Fund Hotels – hedge fund hotels offer managers a whole suite of hosted services for turnkey back office implementation.
Hedge Fund Domain Names – this article discusses domain names for hedge fund managers.
Hedge Fund Managers and Blogs – this article discusses whether hedge fund managers can run a blog.

Hedge Fund Tax Issues

Proposition Q and Hedge Funds – hedge fund managers located in San Francisco should be aware of Proposition Q (a special San Francisco payroll tax) and how it will affect them and their top earners.

General Business Issues

Hedge Fund Employment Law Issues – this article, forthcoming, will discuss the issues that managers need to consider when they bring on employees for the first time. While each state will have different laws and regulations which the manager will need to follow, there are general items which a manager should be prepared for including establishing a structure to pay state and federal income taxes for employees.
IP Licensing Agreements – this article, forthcoming, will discuss the business and legal issues involved when managers license their intellectual property to a hedge fund.
Hedge Fund Management Company Insurance – this article discusses the costs of insurance for hedge fund management companies.
Hedge Funds and Rehypothication – this article discusses rehypothication as it relates to hedge funds.
Prime Brokers, Margin Lock-ups and Hedge Funds – this article discusses prime broker margin lock-ups and some of the issues which managers should understand.
Hedge Fund Operational Issues and Failures – this article discusses a press release about a white paper released from a hedge fund due diligence firm. The firm examines the reason why many hedge fund managers fail.
Hedge Fund Operations During a Pandemic – examines the issues which face managers because of the H1N1 virus.
Agreed Upon Procedures – hedge fund managers sometimes will engage auditors to provide “agreed upon procedures” especially with regard to their Level III assets. This article, written by a hedge fund due diligence firm, provides some thoughts on how investor may view these procedures in the future. Managers should be aware of how investors (or potential investors) might view these types of engagements.
Women and Hedge Funds – this article explores the world and opportunities for women in the hedge fund industry.
Naming Your Hedge Fund – this article discusses common hedge fund naming conventions.
Hedge Fund Best Practices – discussion of the President’s Working Group on Financial Markets (PWG) report on hedge fund best practices.
SIPC Customer Asset Protection – statements by FINRA and the SEC on asset protection for customers.

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

House Committee Votes for Hedge Fund Registration

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Bart Mallon, Esq. (http://www.hedgefundlawblog.com)

Private Equity Funds Not Excluded

Today the House Financial Services Committee voted to require hedge fund managers to register with the Securities and Exchange Commission. While private equity firms are also required to register under the proposed bill, managers to venture capital funds are excluded from this registration requirement.

The bill will next be presented to the House of Representatives and if it passes there it will move onto the Senate and eventually to President Obama to sign into law. The name of the bill is the Private Fund Investment Advisers Registration Act of 2009. For the full text please see H.R. 3818.

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For Immediate Release: October 27, 2009

Committee Approves Private Advisor Registration Bill with Bipartisan Support

Washington, DC – Today, the House Financial Services Committee passed H.R. 3818, the Private Fund Investment Advisers Registration Act, introduced by Congressman Paul E. Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises. The Committee passed H.R. 3818 with extensive bipartisan support by a vote of 67-1. Tomorrow, the Committee is expected to vote on Chairman Kanjorski’s H.R. 3817, the Investor Protection Act and H.R. 3890, the Accountability and Transparency in Rating Agencies Act.

“The Private Fund Investment Advisers Registration Act, which passed today with wide-ranging bipartisanship support, will force many more financial providers to register with the Securities and Exchange Commission,” said Chairman Kanjorski. “The past year has shown that the deregulation or in many cases, lack of regulation, of financial firms is an idea of the past. Advisors to financial firms must receive government oversight and we must understand the assets of financial firms, including for hedge funds, private equity firms, and other private pools of capital. Under this legislation, private investment funds would become subject to more scrutiny by the SEC and take more responsibility for their actions. I look forward to moving this legislation to the House floor for a vote.”

A summary of H.R. 3818 follows:

Everyone Registers. Sunlight is the best disinfectant. By mandating the registration of private advisers to private pools of capital regulators will better understand exactly how those entities operate and whether their actions pose a threat to the financial system as a whole.
Better Regulatory Information. New recordkeeping and disclosure requirements for private advisers will give regulators the information needed to evaluate both individual firms and entire market segments that have until this time largely escaped any meaningful regulation, without posing undue burdens on those industries.
Level the Playing Field. The advisers to hedge funds, private equity firms, single-family offices, and other private pools of capital will have to obey some basic ground rules in order to continue to play in our capital markets. Regulators will have authority to examine the records of these previously secretive investment advisers.

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Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

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

H.R. 3818 | Hedge Fund Registration

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Bart Mallon, Esq. (http://www.hedgefundlawblog.com)

Private Fund Investment Advisers Registration Act of 2009 (text of act)

Below is the final text of the hedge fund registration bill as passed by the House Financial Services Commission.

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111th CONGRESS

1st Session

H. R. 3818

To amend the Investment Advisers Act of 1940 to require advisers of certain unregistered investment companies to register with and provide information to the Securities and Exchange Commission, and for other purposes.

IN THE HOUSE OF REPRESENTATIVES

October 15, 2009

Mr. KANJORSKI introduced the following bill; which was referred to the Committee on Financial Services

A BILL

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. SHORT TITLE.

This Act may be cited as the `Private Fund Investment Advisers Registration Act of 2009′.

SEC. 2. DEFINITIONS.

Section 202(a) of the Investment Advisers Act of 1934 (15 U.S.C. 80b-2(a)) is amended by adding at the end the following new paragraphs:

`(29) PRIVATE FUND- The term `private fund’ means an investment fund that–

`(A) would be an investment company under section 3(a) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(a)) but for the exception provided from that definition by either section 3(c)(1) or section 3(c)(7) of such Act; and

`(B) either–

`(i) is organized or otherwise created under the laws of the United States or of a State; or

`(ii) has 10 percent or more of its outstanding securities by value owned by United States persons.

`(30) FOREIGN PRIVATE FUND ADVISER- The term `foreign private fund adviser’ means an investment adviser who–

`(A) has no place of business in the United States;

`(B) during the preceding 12 months has had–

`(i) fewer than 15 clients in the United States; and

`(ii) assets under management attributable to clients in the United States of less than $25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in the public interest or for the protection of investors; and

`(C) neither holds itself out generally to the public in the United States as an investment adviser, nor acts as an investment adviser to any investment company registered under the Investment Company Act of 1940, or a company which has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940 (15 U.S.C. 80a-53) and has not withdrawn such election.’.

SEC. 3. ELIMINATION OF PRIVATE ADVISER EXEMPTION; LIMITED EXEMPTION FOR FOREIGN PRIVATE FUND ADVISERS; LIMITED INTRASTATE EXEMPTION.

Section 203(b) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(b)) is amended–

(1) in paragraph (1), by inserting `, except an investment adviser who acts as an investment adviser to any private fund,’ after `any investment adviser’;

(2) by amending paragraph (3) to read as follows:

`(3) any investment adviser that is a foreign private fund adviser;’;

(3) in paragraph (5), by striking `or’ at the end; and

(4) in paragraph (6)–

(A) in subparagraph (A), by striking `or’;

(B) in subparagraph (B), by striking the period at the end and adding `; or’; and

`(C) a private fund.’.

SEC. 4. COLLECTION OF SYSTEMIC RISK DATA.

Section 204 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-4) is amended–

(1) by redesignating subsections (b) and (c) as subsections (c) and (d), respectively; and

(2) by inserting after subsection (a) the following new subsection:

`(b) Records and Reports of Private Funds-

`(1) IN GENERAL- The Commission is authorized to require any investment adviser registered under this Act to maintain such records of and file with the Commission such reports regarding private funds advised by the investment adviser as are necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk as the Commission determines in consultation with the Board of Governors of the Federal Reserve System. The Commission is authorized to provide or make available to the Board of Governors of the Federal Reserve System, and to any other entity that the Commission identifies as having systemic risk responsibility, those reports or records or the information contained therein. The records and reports of any private fund, to which any such investment adviser provides investment advice, maintained or filed by an investment adviser registered under this Act, shall be deemed to be the records and reports of the investment adviser.

`(2) REQUIRED INFORMATION- The records and reports required to be maintained or filed with the Commission under this subsection shall include, for each private fund advised by the investment adviser–

`(A) the amount of assets under management;

`(B) the use of leverage (including off-balance sheet leverage);

`(C) counterparty credit risk exposures;

`(D) trading and investment positions;

`(E) trading practices; and

`(F) such other information as the Commission, in consultation with the Board of Governors of the Federal Reserve System, determines necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

`(3) OPTIONAL INFORMATION- The Commission may require the reporting of such additional information from private fund advisers as the Commission determines necessary. In making such determination, the Commission may set different reporting requirements for different classes of private fund advisers, based on the particular types or sizes of private funds advised by such advisers.

`(4) MAINTENANCE OF RECORDS- An investment adviser registered under this Act is required to maintain and keep such records of private funds advised by the investment adviser for such period or periods as the Commission, by rule or regulation, may prescribe as necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

`(5) EXAMINATION OF RECORDS-

`(A) PERIODIC AND SPECIAL EXAMINATIONS- All records of a private fund maintained by an investment adviser registered under this Act shall be subject at any time and from time to time to such periodic, special, and other examinations by the Commission, or any member or representative thereof, as the Commission may prescribe.

`(B) AVAILABILITY OF RECORDS- An investment adviser registered under this Act shall make available to the Commission or its representatives any copies or extracts from such records as may be prepared without undue effort, expense, or delay as the Commission or its representatives may reasonably request.

`(6) INFORMATION SHARING- The Commission shall make available to the Board of Governors of the Federal Reserve System, and to any other entity that the Commission identifies as having systemic risk responsibility, copies of all reports, documents, records, and information filed with or provided to the Commission by an investment adviser under this subsection as the Board, or such other entity, may consider necessary for the purpose of assessing the systemic risk of a private fund. All such reports, documents, records, and information obtained by the Board, or such other entity, from the Commission under this subsection shall be kept confidential.

`(7) DISCLOSURES OF CERTAIN PRIVATE FUND INFORMATION- An investment adviser registered under this Act shall provide such reports, records, and other documents to investors, prospective investors, counterparties, and creditors, of any private fund advised by the investment adviser as the Commission, by rule or regulation, may prescribe as necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

`(8) CONFIDENTIALITY OF REPORTS- Notwithstanding any other provision of law, the Commission shall not be compelled to disclose any report or information contained therein required to be filed with the Commission under this subsection. Nothing in this paragraph shall authorize the Commission to withhold information from the Congress or prevent the Commission from complying with a request for information from any other Federal department or agency or any self-regulatory organization requesting the report or information for purposes within the scope of its jurisdiction, or complying with an order of a court of the United States in an action brought by the United States or the Commission. For purposes of section 552 of title 5, United States Code, this paragraph shall be considered a statute described in subsection (b)(3)(B) of such section.’.

SEC. 5. ELIMINATION OF DISCLOSURE PROVISION.

Section 210 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-10) is amended by striking subsection (c).

SEC. 6. EXEMPTION OF AND REPORTING BY VENTURE CAPITAL FUND ADVISERS.

Section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3) is amended by adding at the end the following new subsection:

`(l) Exemption of and Reporting by Venture Capital Fund Advisers- The Commission shall identify and define the term `venture capital fund’ and shall provide an adviser to such a fund an exemption from the registration requirements under this section. The Commission shall require such advisers to maintain such records and provide to the Commission such annual or other reports as the Commission determines necessary or appropriate in the public interest or for the protection of investors.’.

SEC. 7. CLARIFICATION OF RULEMAKING AUTHORITY.

Section 211 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-11) is amended–

(1) by amending subsection (a) to read as follows:

`(a) The Commission shall have authority from time to time to make, issue, amend, and rescind such rules and regulations and such orders as are necessary or appropriate to the exercise of the functions and powers conferred upon the Commission elsewhere in this title, including rules and regulations defining technical, trade, and other terms used in this title. For the purposes of its rules and regulations, the Commission may–

`(1) classify persons and matters within its jurisdiction based upon, but not limited to–

`(A) size;

`(B) scope;

`(C) business model;

`(D) compensation scheme; or

`(E) potential to create or increase systemic risk;

`(2) prescribe different requirements for different classes of persons or matters; and

`(3) ascribe different meanings to terms (including the term `client’) used in different sections of this title as the Commission determines necessary to effect the purposes of this title.’; and

(2) by adding at the end the following new subsection:

`(e) The Commission and the Commodity Futures Trading Commission shall, after consultation with the Board of Governors of the Federal Reserve System, within 6 months after the date of enactment of the Private Fund Investment Advisers Registration Act of 2009, jointly promulgate rules to establish the form and content of the reports required to be filed with the Commission under sections 203(i) and 204(b) and with the Commodity Futures Trading Commission by investment advisers that are registered both under the Investment Advisers Act of 1940 (15 U.S.C. 80b-1 et seq.) and the Commodity Exchange Act (7 U.S.C. 1 et seq.).’.

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Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs hedge fund law blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. Cole-Frieman & Mallon LLP helps hedge fund managers to register as investment advisors with the SEC or the state securities divisions. If you are a hedge fund manager who is looking to start a hedge fund or register as an investment advisor, please contact us or call Mr. Mallon directly at 415-868-5345.

Hedge Fund Audit Firms and Agreed Upon Procedures

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Hedge Fund Due Diligence Firm Discusses “Agreed Upon Procedures”

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 Operational Issues and Failures). Today we are publishing a piece by Chris which discusses hard to value hedge fund assets (so called Level III assets). In certain situations hedge fund audit firms will be engaged to perform an “Agreed Upon Procedures” review of the pricing of these assets. As discussed in the article below, agreed upon procedures engagements do not provide hedge fund investors with a great deal of comfort with regard to the pricing of these assets. It is unclear whether in the future investors will push back with regard to such engagements and require more robust pricing audits. The problem with more robust procedures, obviously, is increased cost (because of increased liability for the audit firms).

Managers who are engaging audit firms pursuant to agreed upon procedures should be aware that they may face tougher questions from investors going forward.

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Agreed Upon Procedures

A number of our recent posts have focused on the challenges of the hedge fund administrator‘s role in relation to security valuation. We will, of course, return to this topic – but, in the meantime, wanted to focus on some of the alternatives to administrator pricing.

One of the more common comments from today’s administrators is that, while an admin may be able to price Level I and Level II securities, they do not necessarily have information to price Level III instruments. (To recap, the US accounting standard FAS 157 divides portfolios into three levels, being Level I, liquid instruments readily priced from a pricing feed (typically exchange traded); Level II, instruments priced using inputs from “comparable” securities (essentially mark to model, albeit with mainstream models); and Level III, everything else.)

This leaves investors with a challenge – if administrators cannot price Level III instruments, who can? Moreover, to repeat one of our frequent comments, it is self evident that if a hedge fund manager wishes to deliberately mismark securities, they would most likely misprice a Level III instrument. It is, of course, very hard to fake the price of IBM common stock, but much easier to mismark emerging market private loans.

Two of the most common tools available to hedge fund managers looking for third party oversight over pricing for Level III instruments – assuming the administrator has washed their hands of the problem – are third party pricing agents and auditor agreed upon procedures, or “AUP”. We will return to the strengths and weaknesses of third party pricing agents in a subsequent post, but wanted to focus this discussion on AUP.

In an Agreed Upon Procedures engagement, the auditor completes specific procedures which have been dictated by the client. The procedures are specified and the auditor then prepares a report outlining the findings of that specific work.

We have two comments here: the first is to take a high level view as to the adequacy of these procedures, and the second is to dig a little more deeply into the actual audit guidance that covers this type of work.

Our first comment is, unfortunately, an Emporer Has No Clothes observation. The significant majority of hedge fund AUP engagements we have seen require the auditor to test a fund’s pricing on a quarterly basis. This usually involves (i) obtaining a portfolio list from the investment manager and (ii) testing the pricing support for those positions.

There are, however, generally two snags. Firstly, many AUP only test a sample of prices, not the whole portfolio. Sample testing clearly provides much less assurance than a price review of all positions: the administrator, for example, is usually expected to price the entire book (would any investor accept a NAV which has been priced on a “sample” basis???)

The bigger problem, however, is the type of testing completed by the auditor. In way, way too many cases, the auditor tests security prices back to the manager’s own pricing support and makes no attempt to obtain independent pricing information.

This type of work is, clearly, somewhere between minimal and absolutely no value for investors. If the auditor receives a spreadsheet from the manager showing the matrix of broker quotes received, how does the auditor know that the manager has not adjusted that spreadsheet to exclude quotes which were uncomfortably low? Even more importantly, if all the auditor does is to check prices back to pieces of paper in the manager’s own pricing file, how does the auditor know that those pieces of paper are genuine? As we have said before, and will keep on saying, it only costs $500 to buy a copy of Adobe Photoshop if you are of a mind to alter documentation.

When discussing this type of work, the manager typically notes that, if the auditor was to complete a full, independent pricing review, it would be too costly and too time consuming to be practical on a quarterly basis. A full, GAAP audit review is, of course, performed at year end – this does include independent pricing (although – investor fyi – auditors will still only sample test many portfolios.)

While these are fair points, it remains the case that this type of AUP provides minimal protection against pricing fraud. In the meantime, the manager gets the marketing benefit of being able to claim enhanced scrutiny and oversight from a Big 4 firm each quarter.

Which leads to our second point. Why would an auditor accept to complete agreed upon procedures when any reasonable accountant would rapidly conclude that the typical scope of these AUP provide pretty much nil controls assurance? Why does the auditor not insist that, if their name is to be associated to this work, then the procedures must be meaningful and sufficient to meet an actual control standard?

To this point, the actual audit standard applicable to AUP is available here. The standard states:

An agreed-upon procedures engagement is one in which a practitioner is engaged by a client to issue a report of findings based on specific procedures performed on subject matter. The client engages the practitioner to assist specified parties in evaluating subject matter or an assertion as a result of a need or needs of the specified parties. Because the specified parties require that findings be independently derived, the services of a practitioner are obtained to perform procedures and report his or her findings. The specified parties and the practitioner agree upon the procedures to be performed by the practitioner that the specified parties believe are appropriate. Because the needs of the specified parties may vary widely, the nature, timing, and extent of the agreed upon procedures may vary as well; consequently, the specified parties assume responsibility for the sufficiency of the procedures since they best understand their own needs. In an engagement performed under this section, the practitioner does not perform an examination or a review, as discussed in section 101, and does not provide an opinion or negative assurance. Instead, the practitioner’s report on agreed-upon procedures should be in the form of procedures and findings.

In practice, this all gets horribly circular. Per the standard, a client requests an auditor to complete AUP to assist “specified parties” to “evaluate subject matter or an assertion”. In our case, the assertion would be “are hard to value securities valued correctly at quarter end.”

However, the specified party is usually the manager itself, making the client and specified party the same person. The particular trick applied, in many cases, is for the auditor to seek to prevent the investor from actually seeing the AUP in the first place! However, if the investor is to have access to the AUP, the auditor universally requires the investor to sign a Catch 22 document which requires the investor to acknowledge that the AUP are “sufficient for their needs”. So, even if the investor believes that the AUP are not “sufficient for their needs” – which is hardly a long stretch – the investor has to sign that the procedures are sufficient if they are to even see the auditor’s work. With this magic piece of paper, the auditor has met its requirements and can sleep easy. Meanwhile, the auditor will send a bill to – guess who – the fund, meaning that investors have, once more, had to foot the bill.

As always, Caveat Emptor.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

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Hedge Fund Manager Charged with Insider Trading

OTC Derivatives Markets Act of 2009 Passes House Committee Vote

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CFTC Chairman Gensler Applauds “Historic Progress”

In a first step towards increased regulation of the over-the-counter derivatives markets, the House Financial Services Committee approved the Over-the-Counter Derivatives Markets Act of 2009. The act is one of several initiatives to increase regulatory oversight of the financial markets and if passed by Congress would be signed into law by President Obama. Among other things the act would require Swap dealers and major swap participants to register with either the CFTC or the SEC.

Below I have reprinted press releases from both the House Financial Services Committee and the CFTC.

UPDATE: The Securities Industry Financial and Markets Association (SIFMA) just issued a press release reposted below as well.

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Financial Services Committee Approves Legislation to Regulate Derivatives

Committee completes work on a key element of President Obama’s plan to bring accountability and responsibility to Wall Street

Washington, DC – {The House Financial Services Committee today approved legislation that would, for the first time ever, require the comprehensive regulation of the over-the-counter (OTC) derivatives marketplace. Today’s bill, which was approved by a vote of 43-26, represents a key part of a broader effort by Congress and President Obama to modernize America’s financial regulatory system in response to last year’s financial crisis.

Under the bill, all standardized swap transactions between dealers and large market participants, referred to as “major swap participants,” would have to be cleared and must be traded on an exchange or electronic platform. A major swap participant is defined as anyone that maintains a substantial net position in swaps, exclusive of hedging for commercial risk, or whose positions creates such significant exposure to others that it requires monitoring. OTC derivatives include swaps, which are contracts that call for an exchange of cash between two counterparties based on an underlying rate, index, credit event or the performance of an asset.

The legislation then sets out parallel regulatory frameworks for the regulation of swap markets, dealers, and major swap participants. Rulemaking authority is held jointly by the Commodity Futures Trading Commission (CFTC), which has jurisdiction over swaps, and the Securities and Exchange Commission (SEC), which has jurisdiction over security-based swaps. The Treasury Department is given the authority to issue final rules if the CFTC and SEC cannot decide on a joint approach within 180 days. Subsequent interpretations of rules must be agreed to jointly by the Commissions.

Description of the Over-the-Counter Derivatives Markets Act of 2009

Clearing

The legislation provides a mechanism to determine which swap transactions are sufficiently standardized that they must be submitted to a clearinghouse. For transactions that are clearable, clearing is a requirement when both counterparties are either dealers or major swap participants. Clearing organizations must seek approval from the appropriate regulator—either the CFTC or the SEC—before a swap or class of swaps can be accepted for clearing.

Transactions in standardized swaps that involve end-users are not required to be cleared. Such customized transactions must, however, be reported to a trade repository.

Mandatory Trading on Exchange or Swap Execution Facility

A standardized and cleared swap transaction where both counterparties are either dealers or major swap participants must either be executed on a board of trade, a national securities exchange or a “swap execution facility”—as defined in the legislation. If none of these venues makes a clearable swap available for trading, the trading requirement would not apply. Counterparties would, however, have to comply with transaction reporting requirements established by the appropriate regulator. The legislation also directs the regulators to eliminate unnecessary obstacles to trading on a board of trade or a national securities exchange.

Registration and Regulation of Swap Dealers and Major Swap Participants

Swap dealers and major swap participants must register with the appropriate Commission and dual registration is required in applicable cases. Capital requirements for swap dealers’ and major swap participants’ positions in cleared swaps must be set at greater than zero. Capital for non-cleared transaction must be set higher than for cleared transactions. The prudential regulators will set capital for banks, while the Commissions will set capital for non-banks at a level that is “as strict or stricter” than that set by the prudential regulators.

The regulators are directed to set margin levels for counterparties in transactions that are not cleared. The regulators are not required to set margin in transaction where one of the counterparties is not a dealer or major swap participant. In cases where an end user is a counterparty to a transaction, any margin requirements must permit the use of non-cash collateral.

Reporting and Public Disclosure of Swap Transactions

Reporting and recordkeeping is required for all over-the-counter derivative transactions. Clearing organizations must provide transaction information to the relevant Commission and a designated trade repository. Swap transactions that are not cleared and for which no trade repository exists, must be reported directly to the relevant Commission. The legislation also provides for public disclosure of aggregate data on swap trading volumes and positions—in a manner that does not disclose the business transactions or market position of any person. Large positions in swaps must also be reported directly to regulators.

Swap Execution Facilities

Swap execution facilities, or facility for the trading of swaps that are not Boards of Trade or National Securities Exchanges, must register with the relevant regulator as a swap execution facility (SEF). SEFs must also adhere to core regulatory principles relating to enforcement, anti-manipulation, monitoring, information collection and conflicts of interest, among others. The CFTC and SEC are required to prescribe joint rules governing the regulation of swap execution facilities. A Commission may exempt a SEF from registration if it is subject to comparable, comprehensive supervision and regulation by another regulator.

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Statement of Chairman Gary Gensler on House Financial Services Committee Passage of OTC Derivatives Regulatory Reform Legislation

October 15, 2009

Washington, DC – U.S. Commodity Futures Trading Commission Chairman Gary Gensler today commented on the OTC Derivatives Markets Act of 2009, passed this morning by the House of Representatives Committee on Financial Services.

Chairman Gensler said:

“Today’s vote by the House Financial Services Committee represents historic progress toward comprehensive regulatory reform of the over-the-counter derivatives marketplace. The Committee’s bill is a significant step toward lowering risk and promoting transparency. Substantive challenges remain. I look forward to building on this Committee’s hard work with Chairman Frank, Chairman Peterson and others in the House and Senate to complete legislation that covers the entire marketplace without exception and to ensure that regulators have appropriate authorities to protect the public.”

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Release Date: October 15, 2009

Contact: Andrew DeSouza, (202) 962-7390, [email protected]

SIFMA’s Bentsen Statement on Committee Passage of Derivatives Regulation

October 15, 2009, Washington, DC—The Securities Industry and Financial Markets Association today released a statement from Ken Bentsen, Executive Vice President, Public Policy and Advocacy in response to the House Financial Services Committee’s passage of the Over-the-Counter Derivatives Markets Act of 2009.

“Bringing greater regulatory transparency and oversight to derivatives markets and products is a key component of reforming our financial system. That oversight must also recognize the important role these risk management tools play for countless companies across the country and for our broader economy. Mandating particular transaction modes, as this bill does, could raise transaction costs while not necessarily reducing risk in a commensurate amount—results that we believe are contrary to our shared reform goals. As the legislative process continues we look forward to working with the Congress toward a bill that strikes a balance between the need for transparency and risk management efficiency.”

The Securities Industry and Financial Markets Association brings together the shared interests of more than 550 securities firms, banks and asset managers. SIFMA’s mission is to promote policies and practices that work to expand and perfect markets, foster the development of new products and services and create efficiencies for member firms, while preserving and enhancing the public’s trust and confidence in the markets and the industry. SIFMA works to represent its members’ interests locally and globally. It has offices in New York, Washington D.C., and London and its associated firm, the Asia Securities Industry and Financial Markets Association, is based in Hong Kong.

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PPIP and Hedge Fund Closings

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Treasury Announces Closings and Releases Draft LPA

Last week the Treasury announced the initial closing of some funds under the PPIP.

The Treasury also released the draft form of the PPIP Limited Partnership Agreement. The draft LPA is similar to a limited partnership agreement which you would be part of traditional hedge fund offering documents but are unique in a number of ways.

The following press release can be found here.

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October 5, 2009
TG-311

Treasury Department Announces Additional Initial Closings of Legacy Securities Public -Private Investment Funds

WASHINGTON — The U.S. Department of the Treasury today announced three additional initial closings of Public-Private Investment Funds (PPIFs) established under the Legacy Securities Public-Private Investment Program (PPIP). AllianceBernstein, LP and its sub-advisors Greenfield Partners, LLC and Rialto Capital Management, LLC; BlackRock, Inc.; and Wellington Management Company, LLP have completed initial closings, each with at least $500 million of committed equity capital from private investors bringing the total number of initial closings completed to five and total committed equity and debt capital to $12.27 billion.

Small, minority-, and women-owned businesses that are partnering with the fund managers that have completed initial closings include:
Advent Capital Management, LLC
Altura Capital Group, LLC
Utendahl Capital Management

“The PPIP continues to grow,” said Herb Allison, Assistant Secretary for Financial Stability, “Private capital is being drawn into the market for legacy securities and taxpayers are being given a chance to share in the profits.”

Treasury expects that the remaining initial closings for the other PPIFs will occur throughout October. Following an initial closing, each PPIF will have the opportunity for two more closings over the following six months to receive matching Treasury equity and debt financing, with a total Treasury equity and debt investment in all PPIFs equal to $30 billion ($40 billion including private investor capital). Treasury will be providing updates as additional PPIF closings occur.

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