Know Your Score and Get to the “Sweet Spot”

Executive Summary

Over the past two years, Merlin has published several white papers that are designed to highlight and help managers implement industry best practices – from shoring up their business model to identifying their target investors based on the development stage of their fund.

In continuing with this theme, our latest white paper discusses the importance of business process automation within an asset management firm at all stages of development and how these organizations can measure their current processes versus investor expectations.

It is critical that business process maturity and automation evolve over the life of a fund in a disciplined and forward-looking manner as they are key components to maintaining a scalable business. As a firm grows, processes that are maintained manually or with home-grown spreadsheets will stress and may break, adding business risk and overhead to a firm’s operations. This concept is especially important for fund managers because they cannot afford distractions and errors caused by broken or manual processes that affect the viability of the fund.

THE IMPORTANCE OF BUSINESS Process Automation

Managers, investors and due diligence teams all analyze and measure the business risk and process maturity of a fund. Funds must continually review both their organizational structure as well as the level of automation resident in their systems and procedures. For example, it is easy to see key-man risk if only one person holds all the senior positions in a fund (chief compliance/operating/risk/financial officer, portfolio manager, trader, head of marketing, etc.) versus each role being occupied by a distinct experienced professional. Business process risk is as critical, but can be more difficult to identify. Manual processes, for example, are present in one form or another at all hedge funds. Some of these processes are obvious; trade reporting and position monitoring are done on paper or a home-grown spreadsheet or an operations person is tasked with pulling together reports each night by collecting data from disparate sources such as emails, the Web and prime brokerage reports. Many times, performance, financial, research and investor information are stored in ways that increase the risk of data corruption, loss or simple human error.

The Risks of Ignoring BUSINESS Process MATURITY and Automation

A hedge fund’s assets, number of strategies, the number and type of its investors, and the amount of people required to run a fund, invariably strain the original processes a fund used when it was a startup. At some point, legacy processes, lack of automation and the lack of delineated roles pose significant operational risk and often impede a fund’s ability to scale and succeed.

For example, the use of spreadsheets to track positions, manage investors and calculate performance/risk/attribution, etc., is risky even when a hedge fund initially launches. In fact, because spreadsheets are so powerful – they are visual, quick, iterative, flexible, well-known and inexpensive – many hedge funds erroneously believe they have the same functionality of mature systems and as such become embedded. However, as a fund grows and its investors become increasingly institutional, the reliance on spreadsheets can be cumbersome and appear unprofessional. Existing investors may ask why their reports seem to be prepared manually and, in the worst case scenario, errors caused through spreadsheet use can seriously jeopardize a fund’s credibility.

Furthermore, the sophisticated investors a fund seeks to attract as it grows expect a certain level of process maturity. Investor due diligence will quickly reveal where a fund comes up short. Due diligence teams and investors not only want to see scalable businesses and repeatable performance, but also want to see automated systems, processes and tools that are being used by sophisticated professionals.

As funds grow it is imperative that their business processes have the rules, controls and a level of automation that is commensurate with the growth of the fund and the type of investor being serviced. Funds that ignore the natural progression of process maturity will do so at their peril.

MEASURING BUSINESS PROCESS AUTOMATION

Merlin has created a score sheet for funds to assess and measure their process automation risk. We call it the Process Automation Score Sheet, or PASS.

 The PASS analysis extends to:

• The processes and procedures for keeping track of a fund’s critical information (performance, attribution, risk, investors, multi-primed assets, etc.); and,

• Reliance on either manual spreadsheets or automated tools that are scalable and not dependent on specific individuals.

Some funds may be perfectly content managing a limited amount of capital for a fixed number of investors. For them, the business process automation analysis is perhaps irrelevant. However, the majority of fund managers aspire to attract larger, higher-quality institutional investors. In order to do that, funds must build out certain processes today that will attract the investors it wishes to have tomorrow. A process that is tolerated by investors in the early stages of a fund’s lifecycle will likely not be acceptable to investors in later stage funds and will almost certainly be disallowed by the institutional investors who allocate to mature, successful funds (see Merlin Spectrum of Hedge Fund Investors white paper).

Knowing when to upgrade processes and technology and when to hire additional people is a common challenge for all businesses. The Process Automation Score Sheet (PASS) is a simple tool to help managers identify their current stage of automation across ten high-level process components.

The BUSINESS PROCESS automation sweet spot

Once a fund fills out the score sheet and receives its PASS score, that score is placed on the Automation Sweet Spot chart. Managers can then see whether they are ahead of or behind the curve when it comes to automating the processes that govern their business based on their fund’s stage of development.

If a fund’s score puts it below the Sweet Spot, its processes are overly manual and represent risk to the principals and investors. The scores earned from the PASS will help managers and operators identify where the technology and process gaps exist – in trading, reporting, operations or the middle office. Similarly, if a fund’s score places them above the Sweet Spot, it may become clear that it has invested too much or too early in processes and may need to reassess.

With the PASS results, managers can map expenditures to the achievement of specific fund milestones such as asset growth or number of strategies. As investment management firms grow their assets, having this roadmap makes it much easier for them to invest for growth in the right areas at the right time rather than try to rapidly catch up to it. These tools help managers avoid investing in unnecessary processes that exceed their actual needs or people who will put their firms and their client’s money at risk.

The Challenge: Getting to the Sweet Spot

The remainder of this paper examines the strategic approaches managers can implement to get their business into the Sweet Spot.

There are three basic ways a fund can institutionalize processes:

o   Build new systems in-house;

o   Buy prepackaged solutions, integrate and customize them to meet its needs; or,

o   Outsource to a third-party technology provider.

Most funds will be guided by a general bias toward one of these options, however, a fund can, where appropriate, utilize a mix of solutions to create the optimal process. As detailed in a previous Merlin white paper called The Business of Running a Hedge Fund, the most cost-effective way for smaller and mid-size funds to implement mature processes is typically through outsourcing. Larger funds, on the other hand, with significant assets, strong recurring revenues and an existing technology infrastructure, may be best served by building their own process solutions alongside the proprietary systems they already have in place.

Even for very large funds, however, the case for third-party solutions is compelling. They can represent a variable rather than fixed cost and can scale in capacity as needed without additional servers and data center space. Funds can also use third-party solutions to lower their overall technology spend and leverage the scale that those providers have achieved by selling solutions to a broad marketplace of clients. Finally, outsourced technology providers have a very strong market-driven motivation to stay on the cutting edge – to keep pace with changing asset classes and securities, as well as the demands of regulators, investors and, of course, managers.

CONCLUSION

The business landscape has changed dramatically for both hedge fund managers and the in­vestment community over the past several years. The industry has matured to the point where managers must cater to the needs of institutional investors in order to grow and thrive. In addition, new risk, reporting and regulatory requirements, along with volatile markets, make having reliable automated processes essential components to running an efficient hedge fund. Manual work, key-man risk and a reliance on spreadsheets will be clear red flags to in­vestors and prospects alike.

As a result, possessing the optimal levels of process ma­turity and automation are no longer just a luxury. Rather, hedge funds seeking to retain institutional assets, grow their AUM and attract more sophisticated investors must look ahead and be prepared to invest in and proactively deploy long-term solutions.

To successfully accomplish this, managers must truly understand where the current and future gaps exist in their businesses’ process maturity and automation and what technology solutions they will need to remedy those gaps. Understanding this through the PASS analysis, and then striving to remain in the Automation Sweet Spot, gives managers a navigable plan as to when to commit the capital and resources required to achieve the process maturity and automation that is commensurate with both the current stage of the fund and where they wish to be in the future.

For access to the PDF version, click here.

 CONTACT

Ron Suber

Senior Partner and

Head of Global Sales and Marketing

rsuber@merlinsecurities.com

(212) 822-4812

About Merlin Securities

Merlin is a leading prime brokerage services and technology provider, offering integrated solutions to the alternative investment industry. The firm serves more than 500 single- and multi-primed managers, providing them with a broad suite of solutions including dynamic performance attribution analytics and reporting, seamless multi-custody services, capital development, 24-hour international trading, securities lending experts and institutional brokerage. With more than 100 employees, the firm has offices in New York, San Francisco, Boston, Chicago, San Diego and Toronto. Merlin utilizes the custodial and clearing operations of J.P. Morgan, Goldman Sachs, Northern Trust and National Bank of Canada. Merlin is a member of FINRA and SIPC. For more information, please visit www.merlinsecurities.com.

Last November, I commented in this space on a white paper which attempted to make the case that smaller, more nimble hedge funds were less risky and generated greater alpha than larger, more established hedge funds-one of several such papers issued in the last ten years. A recent survey out of Deutsche Bank predicted record hedge fund inflows for 2011 and noted that smaller managers were seeing growing interest from investors. Notwithstanding the expanding list of commentators jumping on the bandwagon, the statistics for 2010 are in, and ,guess what?-once again, the majority of capital put to work in 2010 went to the largest most established firms. Why does this remind me of the old adage-“Do as I say and not as I do”? 

The attached article by Steven Simmons, Head of Prime Services, Maxim Group, entitled “Happy Days are Here Again…. Not So Fast…” * caught my eye, and he is absolutely dead on.  Allocators are looking for reasons not to invest instead of focusing on the value proposition offered by emerging managers.

Simmons goes on to offer some suggestions on how emerging managers can make themselves more attractive to allocators who have traditionally opted for more established hedge fund names.

With a number of larger hedge funds announcing that they are closing down and/or returning capital to investors, smaller managers can only hope that allocators are forced to focus their gaze upon them and you never know, they just might end up liking how it affects their portfolio’s returns.

*Reprinted with permission of Maxim Group

George Roeck
Chief Operating and Financial Officer
Charter Bridge Capital Management, L.P., Executive Board Member, HFBOA

Happy Days are Here Again... Not So Fast

Many of my industry colleagues have expressed extreme optimism regarding opportunities for capital allocations in 2011, particularly for the emerging and middle tier managers.  As a salesman, I am an eternal optimist, however I would like to strike a cautionary note before coming across like the mayor in “Jaws” declaring, “It’s a beautiful day, and everyone should be heading back into the water”. The dialed up rhetoric from some of the largest pension plans and traditional allocators reflects a renewed interest and commitment to the smaller end of the hedge fund spectrum, yet there still remains a decided lack of intestinal fortitude to commit financially. Investor acceptance and greater understanding of the inherent positive return bias during the first few years of fund launch and relative outperformance compared to more established peers has been a proven maxim within the space. And indeed, the number of investor mandates we have received for emerging and middle tier funds has significantly eclipsed those from the last few years.  Now before the bottles of champagne are all uncorked, there still remain significant headwinds for the smaller manager in 2011.

Returns for 2010 averaged 10.8 %, not a particularly high benchmark which many emerging and middle managers beat handily.  Now while the enhanced alpha typically garners institutional investor, many of the “household” name funds (Bridgewater +38%, Paulson +35%, Third Point + 34%, and Pershing Square +22%) more than crushed the benchmarks. Therein lies the dilemma for an institutional investor with fiduciary responsibility to their respective plan – “Do I allocate to Bridgewater, Paulson etc., or do I put my money with unknown emerging manager XYZ that also put up great numbers?”  The old maxim of “not getting fired for buying IBM”, holds true when it comes to hedge fund investing.  Despite rhetoric to the contrary, it is still very difficult – even for the best performing emerging managers to attract significant attention - let alone capital- from the largest allocators.  The days of simply producing alpha and the money magically finding the firm has long passed and managers have to work harder than ever to attract attention.

With such fierce competition for capital, investors remain firmly in the driver’s seat, and the screening process, due diligence, and investment terms have never been more stringent. Many of the investor mandates we have seen are very specific in nature, however there have been a significant amount of investors simply asking to be shown the best managers capturing alpha – thus opening the door to a very broad playing field. The biggest buzzword among institutional investors this year seems to be “clarity”, specifically regarding the “clarity” of the strategy itself.  The manager’s “elevator pitch” and corresponding marketing material has never been more important, and failure to deliver a concise vision of what it is they do to create alpha is the fastest way of alienating a potential investor who is looking for any reason to take a manager off of their radar. Specific attention is also being given to the underlying teams at the funds.  The “two guys in a garage approach” is long dead, and smaller funds are faced with the Catch -22 of having enough capital to hire a full time marketer / investor relations person, who can ideally, raise enough capital to help expand and grow the business. Outsized returns may capture investor attention, but the delineation of job roles i.e., the portfolio manager not being the head of marketing and client relations etc. is very important as well, especially for those managers who have just hit the all important 3 year track record. Now more than ever, proper infrastructure and the ability to coherently and concisely define your edge in creating alpha is paramount to just getting your foot in the door.

Finally, there has been, and continues to be a dramatic shift in the landscape for key service providers that deal with the emerging and middle tier managers. The introducing prime space, long the stalwart supporters of the developing managers, has seen a significant shake up via mergers and outright exiting the space.  The introducing prime space traditionally has provided support for enhancing and delivering the manager’s message to the institutional investor space (ideally) via capital introduction services.  While many of the introducing primes have exited the space, larger, traditional primes rarely focus on the smaller funds, contrary to much of the rhetoric on the street.  Only the most choice (read: revenue generating) funds will continue to be courted by tier one primes and receive access to capital introduction services. Newer managers are forced to be extremely judicious when picking their service providers insuring they are getting a true value added service with a partner that has a vested interest in seeing them (and thus helping them!) grow. 

One of the family offices we are currently working with stated, “We are very keen to put money to work this year with smaller funds; but we are looking for EVERY reason possible to AVOID putting money into them”. Any reason that they can “check the box” not to invest is used, and the first reason they cited was poorly done marketing materials and an incoherent vision. For the emerging and middle tier managers, success in raising capital in this tumultuous environment, beyond an excellent track record of outperformance, is largely dependent upon a clear vision and the ability to delineate it. Marketing pitches and materials should be reviewed and tested with outside eyes and ears, preferably with someone who has a vested interest in seeing them succeed. Funds need devils advocates, not cheerleaders.

There are numerous reasons to be bullish in this space. Funds with the ability to speak up clearly and say “here’s why were different, and here’s why we work” should reap the benefits of the renewed interest in this space. Without that clearly defined message, it might seem like a great time to go swimming, unfortunately it might be too late to realize you are only chum in the water…

I recently came across the attached white paper* from Merlin Securities which highlights, in part, the distinction between managing money and running a hedge fund business. This is an concept that I have been emphasizing whenever someone asks me about forming a new hedge fund. There are numerous examples of talented money managers that attempted to go their own way and ended up closing their shops. They failed, not because they didn’t know how to make money for their investors, but because of operational collapses. The challenges in building a sustainable hedge fund business and raising external assets cannot be overstated. This may be a bigger issue for individuals leaving investment banks or mutual funds than prior hedge funds. Given the financial rewards achievable by successful hedge fund managers, the better a foundation you build, the greater the chances for success for your investors and yourself. Starting with the right team (both internal and external) is just as important as partnering with quality investors.

Please feel free to add your thoughts to the discussion.

*Reprinted with permission from Merlin Securities.

George Roeck, Chief Operating and Financial Officer, Charter Bridge Capital Management, L.P.

Executive Board Member, HFBOA

The hedge fund universe is entering a new post credit-crisis era of increased institutional flows resulting in demand for greater Investor transparency and increased regulation & oversight. In this new environment, organizational maturity - a hedge fund's ability to match its operational and infrastructure needs with its size and scope - is becoming a key differentiating factor. The maturity of a fund's organizational structure, the robustness of its operational controls, and the resilience of its technology infrastructure are becoming determining factors in the allocation of capital.

In the second Prime Finance publication of 2010 this key topic has been explored through over 75 in-depth interviews with COO's, CFO's, and heads of strategy, from a broad cross section of hedge funds from start-ups and spin-outs, to emerging funds and institutional size firms, up to the franchise heavyweights of the industry. These interviews provide the foundation of views put forward in this article.

Findings of these interviews have been translated into a Hedge Fund Maturity Model that details the organizational, operational and technology characteristics of hedge funds across four stages of maturity linked broadly to the size of their AUM. This maturity model provides a framework for the industry to discuss organizational "best-practice" and forms the foundation for the Citi Prime Finance Business Advisory team to partner with our clients and help them shape their evolution and growth.

To view the full report please go to:

https://primebroker.citigroup.com/public/PlanningforChange_Dec2010.html

*this was reposted with permission from Citi*

"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to heaven, we were all going direct the other way - in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only."

-Charles Dickens, A Tale of Two Cities, English novelist (1812-1870)

When we look back to 2010 hedge fund start ups, will we be quoting Charles Dickens? Despite the enormous challenge of raising investor capital in this post-Madoff environment, many other aspects of starting a hedge fund have rarely been more favorable.  The pool of available talent (both front and back office) is wide and deep and can be accessed at a lower cost than just a few years ago.  The Volcker rule is pushing entire teams out of investment banks and many are looking for a new home.  Service providers (administrators, prime brokers, attorneys and accountants) are hungry for business and agreeing to take on newer and smaller firms just to get their foot in the door.  Real estate is more plentiful and less costly and lessors are willing to cut better deals.  There is a lot of available space already built out which saves precious dollars for new hedge fund managers.  Technology is also more readily available and cost-effective when accessed through a hosted (ASP) environment. 

Looking forward, allocators (pension funds, life insurers, endowments, etc.) have made promises to their constituents which they will not be able to cover in a low interest rate/return enviroment and will need to seek out the higher returns that alternative investments are known for.  I have seen some commentary forecasting a 2-3X increase in AUM for the alternatives industry over the next 20 years.  Firms starting up now will have a chance to build a track record in advance of the coming needs.  Speaking of needs, while it is clear that the largest hedge funds are attracting the lion's share of the assets currently being allocated, I am hearing an increased din of unhappiness with the largest firms.  Feedback along the lines of the larger firms are too correlated with the markets (and each other) and that returns have decreased as AUM increased.  This has lead many investors to seek out newer and smaller firms with good pedigrees. 

We will not know for some time whether 2010 was such a great year to start up, but as the saying goes, "You have to be in it to win it". 

George Roeck, Chief Operating Officer & Chief Financial Officer, Charter Bridge Capital Management LP

Executive Board Member, HFBOA

In this post Lehman era, the question I continue to grapple with is: How many prime brokers do you need?

Given that our fund is one of the more plain vanilla Long/Short equity funds, I think more than two is really unnecessary.  We launched our fund in the end of 2008 with three prime brokers and a segregated cash custody account (when I was hired, our initial thought before Lehman was just one prime broker and no cash).

The problem I run into with multiple primes - other than the hassle of additional reporting. reconciliations, etc - is being able to spread my balances to each.  I don't end up with significant assets at any one area to use as leverage for cost savings.

I understand being able to spread counterparty exposure over multiple primes is definitely something investors are thrilled with - I get it - but there has to be a happy medium to it.

I pose the question to the website from an investor and hedge fund prospective.  What is the right number? 1, 2, 5??

Do we still need to have our free cash in a segregated cash account, and if so what percentage of NAV are investors happy with? You have to remember that performance is affected in these situations - not enough balances, can't negotiate down financing rates.  Need to have x% of NAV away from PB - might be borrowing from Peter to pay Paul.  In the world of uncertain market performance, the last thing any hedge fund manager needs is additional basis point hits to an already weak 2010 performance number.

With all of this in mind, having multiple primes does have advantages above and beyond minimizing counterparty exposure, such as free competition to get locates on hard to borrow names.  Letting the brokers fight it out can actually save some significant performance depending on how long you hold your positions.  They also can go in and borrow stock from you and then you can use the other brokers as a benchmark for rates.  This enables a manager to more effectively manage the financing game.

What are your thoughts? What stories do you have recently? I would love to get a lengthy blog going on this topic.

Marc Abel, Chief Financial Officer, Dabroes Management LP

Executive Board Member, HFBOA

It’s not like me to be quite a salesman for anything,　but I thought I would give my views regarding the HFBOA conference and why I believe it will be beneficial to hedge funds CFOs such as myself.

In quick review, here are the topics of the conference:

• Regulatory updates: At home and abroad
  • Regulation at the state level: New implications for private fund managers
  • The future of offshore jurisdictions
  • what you need to know about the European Alternative Investment Fund Managers Directive
• Accounting, auditing and tax updates
  • the impact of the new carried interest law
  • Updated disclosure requirements for ASC 820 (Formerly known as SFAS-157)
• Managing your third party relationships more effectively
  • cleaning up your prime broker arrangements
  • New trends for administrators: asset verification and price verification reporting
• financial management for the fund and fund advisor
  • compensation challenges: from high water marks to deferred compensation plans
  • what can I legitimately charge to the fund?  Legal and ethical considerations
• Managing investor relationships: From due diligence to fundraising
• How do investors' approaches to due diligence differ? Investor Panel Discussion!
• terms, liquidity, and fundraising: A look at varying expectations

 Given the market environment these days, I am always facing different questions and I believe this year is one in which going to the conference will be of most value.

I am very concerned about the EU directives because my fund is primarily invested in western Europe.　 Of particular interest is short bans by country: There is going to be much more compliance required in certain countries (which will require monitoring position size on shorts to say the least) and I am curious what the panelists will say are "more likely than not" to stick once the books are written.

As far as the new carried interest law, we are generally a short term capital gain shop, but everyone wants to be able to get as much capital gain vs ordinary, especially since the elimination of all those offshore deferral compensation plans that were so popular a few years back.　 The combination of the new carried interest law and the elimination of the Bush tax cuts (or what looks to be possibly amendments with Obama’s stamp, but again favoring tax treatment away from the hedge fund managers) should make for some interesting discussions, both at the conference and going forward in the months before 2011: How managers will operate as tax-efficiently as possible.　 Are we going to need to accelerate capital gains to take advantage of lower tax rates? 　What will happen with all these dividends that were getting preferential treatment that will no longer apply?　 Are swaps still going to get around all that offshore withholding?　

The pendulum for prime broker agreements are swinging more in favor of the managers again.　 The collapse of the world back in 2008 (when I launched our fund) dictated that funds needed to 　take on multiple prime brokers as well as a cash custody account for free cash.　 That put hedge funds at the mercy of the brokers and banks and terms for hedge funds were very unfavorable.　 　I think now is the time to really push back and renegotiate agreements and possibly eliminate the need for four or more prime brokers and discuss terms that favor funds a bit more.　 I think this particular conference session will provide significant value to hedge fund manager CFOs, though will probably benefit all attendees to some degree.　 Another key question: What will administrator’s agree to in their new agreements for 2011 and beyond?　 Can we as an industry apply enough pressure to renegotiate what is currently in place regarding price verification?　 Can we get them to agree to pricing the portfolio vs. a price verifier?　 I would love to hear what my peers think.

As for income and expenses of the funds moving into next year, what will the trends be to the following?

1.  High water marks-what will we as an industry be expected to make before we collect our 20% (if it stays there)

2.  What is going to be the industry standard for management fees-i.e. is 2% acceptable anymore?

3.  What about expenses that funds feel comfortable charging to the fund, given a downward trend away from the 2%?　 IF we charge less to the funds can we stay at 2% or if we go to say a 1% benchmark will investors "expect" to pay for more and have the manager pay for less?　 OR is there such a paradigm shift that will require into 2011 and beyond (dare I say) 1% fees and also very little fund expenses?

4.  As to liquidity terms, we are looking to see what PPMs will look like going forward-what will investors "expect" to be given in addition to fee terms, specifically liquidity?　 At our fund, we have bounced that around a lot recently to figure out whether you can have a hard lock, just a soft lock, some combination of lock or (if the fund is liquid enough) really not have any lock up at all?　 I am curious where investors stand on this as they need to appreciate that managers are looking for long term partnering relationships.　 Although it’s important to give on some liquidity, especially if the fund is liquid, we don’t want to be managing our fund quarter to quarter or month to month if it ever gets to that point.　

 These final areas of the conference I think will really leave people with some thoughts to consider.

Again, not being a salesman, I nonetheless hope I sold everyone on the need to attend and get ready for a very exciting few days.　 Attendance has grown year over year and I think this is the perfect time to join your peers for what I feel are strong sessions on key issues as we head into next year.　 See you there.

Marc Abel, Chief Financial Officer, Dabroes Management LP

Executive Board Member, HFBOA

Some years ago, we had launched a "’40 Act" fund (more specifically a Registered Investment Company, or "RIC" under the SEC’s 1940 Act). This RIC is a fund of hedge funds targeted only to accredited investors, yet allowing for unlimited investors with initial minimum investment amounts far below the typical $1mm+ required by other funds. The first product launched in the early naughts when expanding investor access to hedge funds through traditional retail channels was deemed to be its primary raison d’être. This market of moderately HNW clients looking only a dip a toe into the hedge fund waters proved a reasonable opportunity. Investors were happy with the reduced minimums as well as the fact that this fund had elected to provide 1099 tax reporting, as opposed to K-1s. This was also an important selling point of the fund. 1099s are distributed to investors in January following year-end as opposed to K-1s which get distributed anywhere from February (highly optimistic) to as late as in the summer months, which can be frustrating to investors and their accountants.

All well and good so far, yet despite the simplification of the Form 1099 from an investor’s viewpoint, it poses additional challenges for the fund. Subchapter M of the IRS Code spells out certain needs for a Registered Investment Company, the largest challenges for a fund of hedge funds (or even stand-alone hedge funds) being:

• Quarterly asset diversification testing, and
• Annual distribution of fund profits (else face an excise tax).

The quarterly asset diversification test, while conceptually mechanically simple, requires all underlying managers to divulge their positions on a quarterly basis. The test is made to ensure compliance with the IRS Code’s Subchapter M rule which compels that the RIC fund hold no more than 5% of its assets in a given investment.¹ There are some other concentration tests as well, but this 5% rule is a challenge as it creates the need for the RIC to aggregate all of its investments on a look-through basis.

Outbound portfolio dissemination is not always favorably viewed by hedge fund managers, particularly the smaller ones who may have a policy of non-disclosure, or who otherwise wouldn’t be compelled to disclose (e.g. 13-D filings). This leads generally to a business decision by the underlying manager as to whether to change their stance. In our funds, we have eased the pain somewhat through processes whereby portfolios are transmitted on a confidential basis to a third party service provider to receive portfolios. However, not all hedge funds become converts, which somewhat narrows the investment opportunity set, and could provide some tracking error versus a similar non-registered fund.

The second hurdle comes from the need to determine effectively before the end of December as to what dividend to declare. Simply stated, the IRS Code says that a RIC needs to distribute 98% of its annual income during the calendar year. This requires receipt of reasonably good taxable income estimates early in December from all of the RIC’s underlying fund mangers and aggregation of these amounts. Then a safety margin gets built in, (fingers get crossed), and a dividend gets declared in the final days of the year. In our fund, our investors elect to reinvest the year-end dividend, so fortunately there’s no additional cash movements required. The downside to missing this estimate is a 4% excise tax impounded against any upside variance.

What makes this process work effectively is active communication with the underlying hedge funds to get the best possible data possible. In the following year, a measurement is made on a retrospective basis, as to where the estimates used in compiling the RIC’s dividend compare relative to the actual full year taxable results. Given the volatility of the latter portion of most Decembers (flash crashes aside), it’s impossible to have all mangers be spot-on. Yet given normal distribution patterns, hopefully the late variances to the downside offset those to the upside, and thus an excise tax is avoided.

Challenges aside, we happily still see robust interest from investors for a registered product with 1099 reporting.

^{1 More technically, the 5% restriction is made as to "issuer", which means that all securities of a given company (i.e. equities, bonds, options ) are aggregated together to make the test.}

-Matthew Jenal, Senior Advisor, CADOGAN MANAGEMENT, LLC 

In the ever-expanding area of operational due diligence, a major focus is given to the operational integrity and risk controls of a hedge fund’s service providers. Of specific concern are those firms with direct access and control of a fund’s assets: administrators and custodians. Some level of risk-management comfort is given by a certification of the service provider’s processes by an SAS 70 audit by an independent audit firm. Coming in June 2011, the current SAS 70 examination guidelines will be superseded by Statement on Standards for Attestation Engagements 16, or simply SSAE 16.

Currently, successful completion of a SAS 70 audit represents that a service organization has been through an in-depth audit of their control objectives and control activities, which often include controls over information technology and related processes. In my fund-of-funds firm, we seek this certification from not only our fund’s service providers but also of those for the underlying funds that we invest in. One technical hitch that can arise in getting access to the SAS 70 reports for the external hedge funds’ service providers arises from the fact that the reports are not meant to be distributed beyond the service provider’s direct clients and their auditors. Not a huge hurdle if you can rely upon a representation of the SAS 70 audit, but there’s an increasing the need to see and verify, which may be solved by a disclosure option under the new SSAE 16.

SSAE 16 highly similar to its SAS 70 predecessor again seeks to have the service organization demonstrate the establishment of control objectives and effectively designed control activities. (As part of the migration from GAAP to IFRS, it has complies with the new international service organization reporting standard – ISAE 3402, for the accounting technicians). SSAE 16 will have three reporting levels, identified as SOCs (Service Organization Controls), two of which can enable external distribution of results. Between the migration to international standards and ability for greater dissemination of reports, one can forecast an increase in demand for these audits.

As the demand for attestation as to service provider controls increases, a greater burden increases on the smaller service providers to have audits of their processes and controls. Many operational due diligence personnel are somewhat wary of firms of small scale, as perceived enterprise risk for these firms are higher. For these small firms, an SSAE 16 examination may be a business imperative.

Matthew Jenal, Senior Advisor, CADOGAN MANAGEMENT, LLC

Executive Board Member, HFBOA