Linedata Exchange invites HFBOA members to join them this October 19th in New York City for a networking and educational event with some of today's market leaders.  Registration opens at 7am and the networking cocktails end at 7:30 pm

Register online today!

Exciting sessions focus on relevant and current issues in our industry today:

• Compliance
• Trading
• Outsourcing
• Upcoming regulations
• New investment strategies

and more!

Much consternation has been given to expenses borne by hedge funds. In an industry where managers may receive 2% management fees and 20% of the annual profits, it may sound trivial to focus on a few basis points here and there as it relates to professional fees, overhead charges or other financial relationships with service providers. However, when applied properly, expense charges can be indicative of a true value proposition from an investor’s perspective.

Segregation of Duties and Independence...I’ve Got a Feeling

Perhaps the most valuable aspect of having expenses charged to hedge funds is the practical and perceived segregation of duties and independence. Most notable is the external administration fee. Over a decade ago, it was not uncommon for the manager to "self-administer" accounting and administrative aspects of a fund; charging back all or some of the manager’s overhead to the fund to cover such costs. In this scenario, the internal accounting function does not adhere to the best segregation of duties because the authorization, execution, recording, reconciliation and approval of NAV are performed by the same personnel or are under the direction of the same management team. Back in the day when I was an independent auditor on various hedge fund engagements, I even witnessed employee bonuses being allocated as hedge fund expenses. For some of the mega hedge funds, this would equate to only a few basis points of a burgeoning NAV--but it still never felt "right". This feeling was due to the weakened segregation of duties and independence that was apparent in self-administration. Since self-administration is effectively a service provider payment--lacking independence and a solid "arms-length" nature--I was always perplexed why this was not outsourced to a third party provider. Today, this is much less apparent and with the growing expertise of administrators, managers are hard-pressed to claim they can "do it better". As far as doing it for less than an independent administrator--any perceived savings is greatly overshadowed by the lack of independence. For managers who charge employee costs (e.g., bonuses) back to hedge funds, you can simply ask if they also pay their service providers (e.g., auditors, legal, etc.) bonuses, and that tends to drive the point home.

Aside from looking at how expenses can reduce performance, we also need to look at what they add to the overall investment experience. Certain expenses can be true indicators of adding value to investors. For example D&O and E&O insurance can be apportioned to hedge funds and still be a fair and valuable asset to investors. Many managers employ policies where trade errors, if a loss, are borne by the manager, not the fund, and gains are retained by the fund. This sounds great, but an investor does not necessarily want the manager to be susceptible to a large loss, possibly emptying firm coffers and subjecting the control environment to deterioration if employee compensation is reduced due to a lack of available profits and cash. Furthermore, in the event of litigation, most funds have indemnification provisions where investor’s capital is used by the fund, directors and management to defend themselves. As an investor, it does not seem fair that my assets can be used against me in the event of shareholder activism against a fund. A reasonable insurance policy, whereby the fund pays a portion of the premium, can mitigate this concern; both at the management company level for trade errors, as well as the indemnification provisions of the fund.

For allocators and fund of funds, operational due diligence has gained prominence. Whether it is from an astute investor in a fund of funds or an unknowing beneficiary in a sovereign wealth or a state pension plan that allocates to hedge funds, operational due diligence is extremely valuable. These investors and beneficiaries are arguably willing to pay a price for such value in a post-Madoff era.

Having a separate layer of expenses for external due diligence is a valuable asset. Hedge funds that bear this cost can mitigate future instances of management reduction in these efforts from a cost perspective--and once the Madoff tides begin to ebb we should all be wary of lessened operational due diligence. Furthermore, it also creates an additional level of segregation of duties and independence.

Even when an internal Operational Due Diligence team has veto power over the Investment team, one must consider the practicality of the Operational Due Diligence team actually wielding such power. While I truly believe in this age that most Investment and Operational Due Diligence team’s interests are mutually aligned, if a true disagreement exists, vetoing against the team that includes personnel who determine your compensation and general career track does not bode well. The use of an external team alongside the internal team mitigates this perceived conflict of veto power and also reduces the instances of group think since the external team is not paid a bonus and does not enjoy the upside potential of approving a manager who later has great performance. They also do not have to listen to the investment team saying how great a particular manager is day in and day out. As an investor, I completely welcome this slight additional expense since it enhances operational due diligence, adds an external independent element and ensures the continuity of such a process in the future.

We should all continue to analyze expense ratios, review expenses in absolute dollar terms and compare to industry practices as well as specific cases. However, as investors, we should also understand what we get out of these charges and make sure they enhance the overall control environment and protect our capital.

Dan Federmann, CPA, CFA
Board Member-Hedge Fund Business Operations Association

Managing Director & Chief Financial Officer

Protégé Partners, LLC

As the CFO and co-Head of Operational Due Diligence at Protégé Partners, a multi-billion dollar Fund of Funds complex that focuses on investing with and seeding smaller specialized managers, I often find myself on both sides of the operational due diligence table. I am frequently walking through our infrastructure and control environment with large institutional prospective investors, benefiting from the various perspectives that such institutions offer through their reviews based upon their unique geographical presence, investor base or corporate philosophy. On the other side of the table, I get the chance to turn my hat around and play grand inquisitor, questioning my existing or potential managers regarding their operational process and procedures.

What I have found is that most reviews comprise a balance of both qualitative and quantitative measures. When you strip out the investment performance from the review process, the pure operational due diligence review tends to be more qualitative. For example, knowing a Hedge Fund has reputable service providers, ensuring maximum independence throughout the valuation and verification process; and having enough direct knowledge about those service providers (i.e., not relying on the manager) is more valuable to me than a scoring mechanism that attributes points to numerous categories of operational criteria.

I was recently interviewed by Susan Trammell who is writing an article for CFA Magazine "Can Hedge Fund Operational Risk be Quantified?" (expected publication September 2010) and I found myself sticking to the qualitative aspect of a due diligence review. Practical experience is extremely valuable; and having been on both sides of the table, you can balance practical risks versus hypothetical risks-- piercing through perception issues and surface level procedures that don’t have the depth to accomplish what is ultimately desired.

While there certainly is no single approach to Operational Due Diligence that can be championed above all others, one must consider the uniqueness of each Hedge Fund that is being reviewed and allow for non-systematic evaluation to take place. A simple example of this is that the mere existence of an administrator is not necessarily a box that can be checked off satisfactorily for independence of NAV calculation. The administrator should be reviewing properly authorized instructions from the manager, reconciling independently to the street and independently gathering valuation data from recognized pricing organizations or sources. NAV light (fortunately a dying concept) gives the facade of independence and segregation of duties through an administrator, but in reality the manager themselves is still ultimately providing the inputs into the NAV calculation process. Another example would be reliance on SAS 70 certified administrators or other service providers. One must not just check a box and assign a score if a SAS 70 exists. The appropriate questions should include: "Does the SAS 70 contain all the controls that you believe should be adhered to?", "Is your target Hedge Fund excluded from the SAS 70 testing?" and "Does your target Hedge Fund have bespoke procedures or processes that are covered through a typical SAS 70 review?". While the initial questions are all necessary, simply checking a box and creating a quantitative measurement score does not necessarily give you any further practical comfort. A thorough Operational Due Diligence approach should always embrace old fashioned elbow grease, flexibility to work outside of a checklist, and the ability to customize your review and approach as necessary.

Despite the depth of tactics needed for successful Operational Due Diligence approaches; there are some simple scoring techniques that can be employed that will raise red flags. Implementing these techniques will provide both the investment and operational due diligence teams with additional data points for further focus and scrutiny. One such measurement is known as the Bias Ratio, invented by my partner Adil Abdulali of Protégé Partners (white paper and related articles attached for your reference).

The Bias Ratio is designed to detect the presence of return smoothing or subjective pricing policies for a Hedge Fund. This ratio measures the shape of return histograms around the critical area surrounding zero percent return. Managers with hard to value securities or securities valued predominantly by use of broker quotes could deviate from a systematic valuation procedure when faced with a slightly negative return. For example, discarding a third broker quote because it appears to be an outlier could bring a monthly fund return from (0.5%) up to 0.0% or even a slightly positive return. Some of the biggest hedge fund frauds have started with simple or minor cover ups such as return smoothing.

The Bias Ratio is then measured against a peer group to determine if the critical area of returns is in line with their peers. Any outliers are identified as potential candidates for return smoothing (which may be tantamount to fraud) or perhaps the existence of difficult or hard to value securities (of which a prospective or current investor may not have known the manager invested ). I particularly like this tool as it allows me to dig deeper into a manager’s valuation process and bring to bear my qualitative approach by using a fairly transparent quantitative measurement to prove why I need to look further.

What I like most about this technique is that it can be applied to any particular style of due diligence. It is not intended to replace an existing process and can be used effectively by due diligence teams of varying expertise levels. Even now however, despite changing their due diligence techniques, some of our peers (who may still feel the cold ripples of the Madoff fraud) are not using the Bias Ratio as much as they should. The attached article by Riskdata shows how the Madoff fraud would have been identified (i.e., a red flag would have appeared signaling the need for further due diligence).

While debate will continue amongst the quantitative analysts and the qualitative practitioners regarding the optimal due diligence approach, there are simple tools that already exist, such as the Bias Ratio, that respect the approach of both camps and can be layered into the due diligence process.

Dan Federmann, CPA, CFA
Managing Director & Chief Financial Officer

Protégé Partners, LLC

Links to white paper and articles:

 http://www.hfboa.org/pdf/Abdulali.pdf

http://www.hfboa.org/pdf/Ambrose.pdf

This article is written by Janaya P. Moscony, President of SEC Compliance Consultants and the chairperson of the October 27th Hedge Fund Registration Master Class.  We've reposted it from the FINalternatives website, where it was featured on August 11, 2010

(Psssst.... Reference this blog posting code: FMP197 to save 15% off the registration fee for that one-day program)

The article:

Are Hedge Funds Ready for SEC Registration? In most cases, they are more ready than they believe.

October 16, 2009 - We at the SEC are committed to pulling back the curtain on hedge fund operations and taking a close look at their activity. We are developing a variety of initiatives to do that involving greater specialization and expertise, improved technological tools to track and analyze trading, better coordination among regulators and law enforcement, new legislative initiatives, and other means to address these areas.

Based on the above quote, who can blame a hedge fund manager for being a little skittish about pending SEC registration?

Despite the hype, the SEC is not out to get hedge funds. They are focused on improving their batting average with finding fraud and hedge funds provide good headlines. Even though the number of hedge funds willfully engaging in misconduct is minute, hedge fund managers should expect to be examined by the SEC. Although the implications and cost of on-going registration may appear burdensome, many firms may be better prepared than they think. By formalizing existing procedures as part of a complete compliance program with policies and procedures mapped to a thorough firm-wide risk-assessment, any SEC visit should be routine.

Nonetheless, many managers to hedge funds continue to be concerned. This is to be expected with the recent passage of the Private Fund Investment Advisers Registration Act of 2010. The registration act is part of the larger Dodd-Frank Wall Street Reform and Consumer Protection Act. The 27 pages of the registration act could easily be missed in the 2,307 pages of the larger reform bill. However, the impact of those few pages will be dramatic on hedge funds with assets greater than $150 million.

Hedge fund managers will need to quickly become familiar with Rule 206(4)-7 of the Investment Advisers Act of 1940 known as the Compliance Rule. Enacted in 2004, following scandals almost a decade ago, Rule 206(4)-7 requires registered advisers to adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act by the adviser or any of its supervised persons. The rule requires advisers to consider their fiduciary and regulatory obligations under the Advisers Act and to formalize policies and procedures to address them.

Rule 206(4)-7 does not specifically list the elements that advisers must include in their policies and procedures. The SEC acknowledges that advisers are too varied in their operations for the rules to impose a single set of universally applicable required elements. Each adviser is required to adopt policies and procedures that take into consideration the nature of their specific operations. Advisers must therefore have customized policies and procedures designed to prevent violations from occurring, detect violations that have occurred, and correct promptly any violations that have occurred.

It is our experience that many unregistered hedge fund advisers already have procedures and controls in place in certain areas of their business that are pretty close to satisfying the SEC's expectations. In some cases, prime brokers and third party administrators and trading platforms provide certain checks and verification procedures which can be incorporated into a compliance program.

Below are some of the compliance areas hedge fund advisers may have procedures close to satisfying SEC requirements.

Portfolio Management Processes.

This includes allocation of investment opportunities among clients, managing portfolios consistently with stated mandates, and abiding by applicable regulatory restrictions. Given that certain private fund advisers may manage more than one fund, matters regarding allocation and adherence to the different mandates and objectives of each fund, are already in place.

Trading Practices.

In many cases, hedge funds have established practices. It may be an issue of formalizing them into written policies and procedures.

SEC Compliance Consultants’ Guide to SEC Registration for Private Fund Investment Advisers provides a complete guide to the SEC registration process and the on-going compliance requirements.

As many of you know, Wall Street Warfighters < http://www.wallstreetwarfighters.org/ > is an organization focused on benefiting Service Disabled Veterans. Its mission is to identify, develop and place disabled veterans in long-term professions in the financial services industry following their military service.

The Inaugural NYC "Warrier Poker - Celebrity Charity Poker Tournament" is to be held on the Intrepid Sea, Air, and Space Museum on Thursday September 30, 2010

The "Warrier Poker - Celebrity Charity Poker Tournament" features Tony Sirico (The Sopranos) and will feature other celebrities and pro poker players as they become available.

for more information, contact: David J. Walker, Managing Partner, COO, Flintlock Capital Asset Maangement, LLC: david.walker@flintlockcap.com or 212-537-4421

Once expectations have been set and a good TMA is in place the next step is to begin working with a (hopefully your) prime broker to get the account up and running. In this Part II of the blog we will talk about the nuts and bolts of opening an account including executing on the TMA to working with prime brokers and allocating bulk trades via your executing brokers.

If your fund is not a new launch you may have forgotten all the things you had to put in place to fulfill the operational requirements of the fund. Hopefully you kept good notes because you now have to do it all over again for the new managed account including replicating ISDA’s, broker agreements, FX arrangements, client specific ID’s if needed in foreign jurisdictions, etc, etc. If the managed account is on the small size you may also run into the prime broker’s reluctance to open ISDA’s and other arrangements on the same terms as your core fund.

One of the key compliance issues is your policy on trading practices and potentially using bulk trades with allocations to each fund/account. When dealing with bulk trades and allocations there needs to be a policy in place to insure that neither the managed account nor the fund is receiving preferential treatment on trades. What will be your policy regarding bring the account back into balance with your core fund if you have agreed to run the managed account pari passu? Mid-month liquidity can wreck havoc on your trader depending on your and your client’s expectations. Additionally, if the prime broker of the managed account is not the same as your core fund you now have the challenge of (hopefully seamlessly) allocating trades. Depending on your investment and trading style you may be able to get away with using a simple trading system however if you use multiple executing brokers and deal with securities globally you may need to look at additional in-house capabilities such as OASYS.

Daily reconciling of the account for cash and positions also remains your responsibility. You’ll probably have a new administrator to work with so be prepared to deal with their unfamiliarity with your account and practices. You’ll typically be expected to either prepare the invoice yourself for management and incentive fees or at least be able to verify that the numbers your client provides are accurate. If you are not setup with an internal portfolio and partnership accounting package then now may be a good time to consider one. Software in the sub-$20k range is now available to handle these requirements. Remember the administrator on the managed account is not your vendor and you therefore have much less control and flexibility over them than the one you use for your fund.

In summary, while having a managed account is an added layer of complexity to your firm but if you are prepared it can be great asset and if you do a good job can it set you apart from your peer firms.

Duncan Huyler, CFO, 360 Global Capital

Post-Madoff and post-Lehman one of the more significant predictions in the hedge fund space was the potential for a huge increase in the number of separately managed accounts (SMAs). Increased transparency and the demands for liquidity after the meltdown the industry experienced in the recent past brought SMA advocates out of the wood work. The reality is that the "trend" may have been overblown or at least overhyped, however, for those funds willing to embrace the trend there is a differentiator that is potentially valuable and even lucrative.

Working with an allocator that has previous experience with SMAs can be a relatively simple process if you have your back-office operations in order. Ideally the Trading Management Agreement (TMA)—the contract that defines the role of the trading manager and the advisor-- calls for the portfolio to be traded pari passu to your core(target) fund. Any variation between the investment policies in the OM of the target fund and that of the SMA should be clearly spelled out in the TMA. Legal counsel should be enlisted to insure protection of the investment advisor in regards to indemnification- not just who is indemnified, but for what and by whom. The role of soft dollar accounts, expenses that can be charged to the SMA, the charge-back for admin, legal & audit fees as well as when & how the management fee and incentive fee are payable should also be detailed in the TMA. Confidentiality clauses need to be agreed upon as do expectations on reporting requirements.

Performance between the SMA and the core fund should be essentially identical however, differences can occur especially with significant cash flows. A policy should be in place so that when cash flows occur trades are placed to bring the account back into balance with the target fund. The trading manager should be prepared to reconcile any variances in performance to the satisfaction of the account owner.

If expectations have been set and a good TMA has been reviewed and is in place the next step is to begin working with a (hopefully your) prime broker to get the account up and running.

In Part II of this blog we will talk about the nuts and bolts of opening an account including executing on the TMA to working with prime brokers and allocating bulk trades via your executing brokers.

Duncan Huyler, CFO, 360 Global Capital, LLC

In my last blog post I talked about boiler plate agreements used by vendors that service the hedge fund industry. Today, let’s look at agreements used when the hedge fund or the hedge fund manager is the "vendor." The most common agreement in this category is probably the subscription agreement by which an investor purchases an interest in the hedge fund. The subscription agreement memorializes the terms of the investor’s purchase by incorporating information contained in the hedge fund’s private placement memorandum (or equivalent document) and soliciting certain information and representations from the investor regarding their eligibility, authority and understanding of the investment. Subscription agreements are standardized to insure that only "eligible" investors are allowed to purchase interests and so that all investors "invest" under the same terms. Generally, if modifications are made to the terms of investment, it is done through a "side letter" rather than an actual modification to the wording found in the subscription agreement. As is the case with any vendor, it is in the hedge fund’s best interest to treat all of its investors equally and, therefore, to enter into as few side letters as possible.

Another agreement commonly used by hedge funds is the investment management agreement between the hedge fund and its manager. This agreement generally also incorporates the terms of the hedge fund’s private placement memorandum as the standard by which the manager will manage the hedge fund’s affairs and invest its assets. It is through the ratification of the investment management agreement that the directors of a hedge fund (if organized as a corporation) delegate the investment management authority to the hedge fund manager. By signing the investment management agreement, the hedge fund manager accepts certain fiduciary responsibility for the hedge fund and, in turn, its investors.

If a hedge fund manager also provides services to managed accounts, a third agreement that could be viewed as a combination of the subscription agreement and the management agreement will be common. This agreement is the investment advisory agreement between the owner of the account to be managed and the hedge fund manager. Since investment advisory services to managed accounts are not offered by way of a private placement memorandum, the investment advisory agreement generally will contain in its body, or as an appendix, detailed information on the investment strategy intended for the managed account as well as the related risks. The investment advisory agreement delegates authority for the investment management of the account by the account owner to the hedge fund manager. The hedge fund manager obtains the necessary information, representations and approvals from the account owner through the investment advisory agreement.

The private placement memorandum and equivalent information for a managed account, the subscription agreement, the management agreement and the investment advisory agreement are all closely related. It is important that they are not inconsistent with each other and that both the information and representations they contain are correct. They also need to be consistent with the current practices and strategies of the hedge fund manager. What process do you use to insure this consistency? How often do you request updated information and representations from your investors and managed account owners?

Michelle Kline, Member of the HFBOA Executive Board

One of the topics that is being proposed for this October’s 5^th Annual Meeting of the Hedge Fund Business Operations Association is "Cleaning Up Your Prime Broker Arrangements." It seems that in late 2008 as hedge funds scrambled to ensure their prime broker business was no longer concentrated at one firm, many fund managers agreed to boiler plate agreements without fully understanding all of the implications of the terms of those agreement. Since I work for a fund of funds with no direct trading operations, I would never profess to be an expert on the intricacies of prime broker agreements. I can say with certainty, however, that the fact that issues can arise from the use of boiler plate agreements is not unique to prime broker arrangements.

One of the results of the "institutionalization" over the last several years of the hedge fund industry is a proliferation of "best practices" not only for hedge funds themselves but also for the wide variety of vendors that service the industry. These best practices have brought about tremendous improvements and standardization in the industry. As part of the standardization, every vendor has worked with their legal counsel to develop service agreements that accurately outline the terms of their services such as scope, cost and limitations and that also solicit representations from their clients that limit the vendor’s liability under certain circumstances or even gives the vendor the right to refuse or terminate services if the representation proves to be inaccurate, or becomes inaccurate over time. It is in the best interest of the vendor to deviate from their standardized or boiler plate agreement a little as possible.

It is important to do your homework and know the range of services and options available across competing vendors. It is a manager’s responsibility to negotiate the best arrangements possible for the benefit and protection of their investors. This includes both selecting the vendor best able to meet their needs when all factors are considered and negotiating the best terms possible. It is also important to have a complete understanding of the terms of the agreements entered into and the representations they contain. Without periodic reviews of agreements that are in place, veteran managers can miss seemingly irrelevant terms that become relevant over time or can forget representations they have made or circumstances can change and cause the representations to no longer be true. New managers may have limited operational bandwidth or experience with certain vendor arrangements and many look for turnkey solutions.

We have learned in recent years that a change in the industry can move obscure, hard to interpret provisions of an agreement between a fund and a vendor to a focal point of a fund’s survival. Such an event, or the lack of compliance with even the most minor terms or representations in an agreement, can give the vendor unintended power in the relationship, particularly when they hold assets of the fund or have mission critical functions in their hands.

Have you lived through an unexpected twist in a vendor relationship as a result of a boiler plate agreement? Will you share it with us so we can benefit from your experience?

Michelle Kline, Member of the HFBOA Executive Board

We’ve heard talk amongst industry commentators that hedge funds are regaining negotiating power with investors, the result of improved performance more generally and an increase in investor interest as sophisticated investors begin to re-engage with the marketplace. The HFBOA was curious: How much has leverage in negotiations been affected by the fiscal crisis? And are investors really expecting better terms and lower fees, or just greater transparency and openness during more rigorous and ongoing due diligence? So we sat down with a panel whose members represent a wide range of investors and asked them what they think about fees, liquidity, leverage, and the outlook for negotiating power in the hedge fund space.

Check out the latest HFBOA newsletter  to read the interviews!

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