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This issue of the Association's newsletter includes:
Annual Meeting Review
Recent HFBOA Initiatives-Learn about the Member Forum!
Meet New Board Member George Roeck
Commission Management Practices- From Soft Dollars to Hard Boiled Bucks?
Calendar of Events
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ANNUAL MEETING REVIEW
This year's meeting was attended by nearly 130 industry professionals and included many Association members and some professionals new to HFBOA. The meeting opened up with a morning workshop that tackled the operational issues of due diligence. During the first half of the workshop, Chris Addy of Castle Hall Alternatives led a panel of hedge fund investors who covered the factors most relevant in their reviews of fund operations. The panel discussion covered significant ground, addressing considerations from valuation to IT infrastructure. The panel then broke up into discussion groups focused on the due diligence issues specific to fund strategy. The discussion format was very well received and we will be sure to include more time for break out discussions at next years meeting.
The main part of the conference commenced with an extended session on financial reporting and covered FIN 48, FAS 157 and valuation standards. The rest of the event included expert lead panels with two sessions featuring Thomas Biolsi, Associate Regional Director for Investment Management Inspections, of the U.S. Securities and Exchange Commission Northeast Regional Office (NERO) who provided clarification on SEC reviews and managing conflicts of interest.
Another highlight was keynote session by Paul Roth and Joel Press. For the past several years, these two industry icons have delivered insightful messages at the annual meeting and once again helped us pause and take a big picture look at the industry. In fact, their reflection that the current 'credit crunch' really is a 'liquidity crunch' seemed to resonate loudly with all attendees. We were also fortunate to have Barry Barbash join us on the second day and provide his forecast of regulatory initiatives for the hedge fund world. Based in Washington D.C. and a former financial services regulator with the SEC, Mr. Barbash provided the attendees with a real insider perspective.
On behalf of the Association, we extend a tremendous thank you to the Board of Directors for all of their time and input which shaped the agenda. We also thank each of the meeting's presenters for sharing their time and expertise with us! Planning for the 2008 meeting will commence in just a few short months, so please watch for more details and send us your comments on topics that you’d like to see covered.
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RECENT HFBOA INITIATIVES: LUNCHEONS, SOCIALS AND THE MEMBER FORUM
In the July newsletter, we announced a member social at the Beer Bar in NYC. The gathering was open to all members and was a great opportunity for members to learn more about the Association as well as meet a few members of the Board of Directors. As we’ve received great feedback from the attending members, plans for the next social are in the works.
The monthly luncheons took a sabbatical in August and September, but have returned stronger than ever with the next luncheon scheduled for October 11th. With Thomas Biolsi of the SEC joining us as the discussion leader, luncheon spots have gone quickly. There are only 2 remaining spots, so register today at http://www.hfboa.org/luncheon.aspx?ccode=ot120 if you want to attend. Participation is on a first-to-register, first-served basis.
And, if you were wondering what else the HFBOA has done for you lately, this is the perfect time to tell you about the Members’ Forum. The Association’s website now includes a Member Forum (see the homepage, it’s just below the Home navigation button at the top) that is open to all members and gives you a platform to post questions, comments or share suggestions with your peers. Since the Forum is reserved for members, you will need to log-in before you can see or post a message. The Forum includes an initial list of discussion categories, but can always be expanded based on your input. Please send an email to hmurrin@frallc.com with any questions or recommendations for enhancements.
We hope you find the Forum to be a great resource and ask that you remember to use standard ‘netiquette’ when posting or replying to posts. The Forum is strictly an educational and networking resource and shouldn’t be used to promote services.
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MEMBER FORUM GUIDE
For anyone new to web forums, here are some basics:
-Log into www.hfboa.org using your email and password.
-Click on Forum (located just under the Home button at the top of the web page).
-On the Forum page, you will see a list of topics, their description and information on the number of discussions that have been posted for each topic.
-To add or view a discussion, click on the topic name in the Board column. You will be taken to a page that allows you to either add a new discussion or respond to a prior one that is already posted.
-For each posting, there is a link titled 'report-abuse' that allows you to alert us of any misuse of the Forum.
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MEET NEW BOARD MEMBER GEORGE ROECK
The Hedge Fund Business Operations Association welcomes George E. Roeck to the Board of Directors. George is the CFO and CCO of Agamas Capital Management, LP. He joined Agamas Capital Management, LP, a manager of relative value focused, multi-asset class hedge funds, as Chief Financial Officer upon its founding in September 2004.
Prior to joining Agamas, George was a Vice President and Director of Fund Administration and Tax Services at The Bank of New York where he was responsible for financial reporting, compliance and tax services for $250 billion in third party assets. He also served as CFO of the $12+ billion BNY Hamilton family of mutual funds and the Ivy Multi-Strategy Hedge Fund, a registered hedge fund-of-funds. Previously, George was the CFO of Greenbridge Group, a mergers and acquisitions boutique which advised strategic participants in the telecommunications, technology and internet industries and sponsored a related venture capital fund that invested alongside management. Prior to Greenbridge, George was the CFO of GSC Partners, a private equity fund manager specializing in leveraged buyouts, distressed investments, mezzanine lending and CDOs. George joined GSC from Arthur Andersen LLP where he served for 11 years and provided tax advisory services to broker/dealers, hedge funds, mutual funds, private equity, venture capital funds, investment managers, banks and real estate developers.
George is a Certified Public Accountant and member of the New York State Bar. George received his BS in Economics from Wagner College, an MBA from St. Johns University and a JD from Touro College School of Law.
Many of you have had the opportunity to meet George at the annual meeting and our monthly luncheons. He brings a great perspective to the Association and we look forward to working with him!
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COMMISSION MANAGEMENT PRACTICES - FROM SOFT DOLLARS TO HARD BOILED BUCKS?
By Jason Kim, Principal Consultant
Detica Consulting www.detica.com
Relationships Change
The relationship between the buy-side and the sell-side has undergone many changes in the past five years. The perceived power struggle between the buy-side and the sell-side has seemingly swung to the buy-side, who holds the keys to broker-dealer revenue. In addition, asset managers and hedge funds have taken advantage of the dynamic environment by scrutinizing traditional pricing models and questioning market structures. Advances in technology and the maturity of the buy-side trading experience have enabled the buy-side to perform functions which were traditionally handled by the sell side. Buy-side traders are behaving more like the sell-side, due to increased market transparency and a stronger understanding of trade strategies.
One aspect of this relationship which has received much attention is the management and designation of the commission fees, typically for trade execution and research services. Commission management is a sell-side service that allows the buy-side to have the visibility into where their fees with the sell-side firm are going, and can offer access for the buy-side to manage how their execution and research fees are allocated. Sell-side broker consolidation as a result of regulation is imminent. This presents an opportunity for sell-side brokers to improve their relationship with buy-side clients. In response to the changing market dynamic, sell-side institutions must establish a wider suite of value-add brokerage services that cater to the buy-side’s current and future needs.
Soft Dollar is a Dirty Word
Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor to buy-side firms who use commission dollars to obtain research and brokerage services from registered broker-dealers. The recent surge of regulatory scrutiny and need for transparency have been spurned by initiatives like Sarbanes-Oxley, Regulation NMS, MiFID, and in general, anything that Eliot Spitzer went after while in the NY Attorney General’s office. Because Eliot Spitzer tackled “soft dollar” practices of mutual funds in 2003, a greater focus on commission management has resulted.
There are several aspects of commission-based pricing that have clarified the activities that the buy-side is responsible for:
- Ensuring that execution and research activities are classified appropriately
- Determining whether execution and research services received assist them in improving performance
- Assessing whether the value of execution and research services are on par with the commissions paid
The following diagram depicts the changing buy-side and sell-side relationship for research and execution:
Figure 1. Historic & Future State Sell/Buy-Side Relationships
Historically, buy-side firms worked with a variety of sell-side brokers – for trade execution in specific markets, access to research, or sometimes for the overall relationship. This structure allowed for some ambiguity in the buy/sell-side relationship and the emergence of soft dollars provided a vehicle to use the allocated buy-side fees for almost anything (i.e., trading terminals, access to conferences, etc.).
Seize the Sell-Side Moment
Although Section 28(e) provides additional clarity over the responsibilities of the buy-side and their relationship with sell-side institutions, there are challenges in the interpretation of the regulation. In the past, a lack of granularity and perhaps intentionally murky interpretation of the products and services that could be “soft dollared” provided an avenue for questionable behavior. Rather than identifying the appropriate execution and research services to optimize performance, soft dollar arrangements provided wiggle-room to use these pre-allocated fees to a variety of things. In order to combat this, Section 28(e) clarifies the classification of services that can be included in buy-side commission payments.
The below diagram provides guidance for research and execution services that are considered in and out-of-scope. It is evident that the market regulators want to ensure that the usage of buy-side expenses is aligned with their execution and research needs. The individual investor requires the transparency to understand where their investment dollars are going and what the intrinsic value is to overall performance.
There is no exact science on how sell-side institutions quantify the value of their execution and research services to buy-side firms. The execution technology and services that sell-side institutions provide must tangibly benefit buy-side trading decisions. Section 28(e) is a targeted effort to increase the transparency of commission fees paid, ultimately to provide this transparency back to the individual fund investor. The methodology of quantifying this value has yet to be standardized across the industry, but also provides an opportunity for sell-side firms to be proactive about how their performance is measured.
In order to clarify the roles played by the various parties and to streamline buy-side commission spending, the concept of Commission Sharing Agreements (CSAs) has emerged. Conceptually established by the FSA in the UK, CSAs are contractual agreements that simplify and distinguish the agency relationships for buy-side institutions. With CSAs in place, sell-side executing brokers have access to a variety of research providers (both internal and third-party) to enrich the buy-side’s performance. In this way, buy-side institutions will be able to separate their execution and research decisions more effectively. A by-product of this structure will be the consolidation of sell-side brokers utilized by buy-side firms. While sell-side institutions would hesitate to the notion that the sky is falling, they are working on enriching their current execution/research capabilities and establishing research relationships to put CSAs in motion. As buy-side firms will only have a handful of these CSA relationships, it is imperative for the sell-side to initiate and engage their clients to obtain this foothold.
Broker Consolidation
While there has been much attention paid to the shift in power from the sell-side to the buy-side, there is scrutiny over the allocation of commission fees. Fund investors want optimal performance from the use of their investment dollars and will not stand for unscrupulous practices by their fund managers. There have been several examples of large-scale investment managers taking advantage of soft dollar practices and accepting gifts, tickets to the Super Bowl, lavish 5-star dinners, etc. Buy-side investment managers will need to determine which executing brokers they want to do business with and understand their research requirements in order to assess the CSA relationships that they require. In addition, decision tools such as Transaction Cost Analysis (TCA) and broker performance ratings will help buy-side institutions understand their execution requirements.
A Look to the Future
Faced with a changing industry and evolving regulatory environment, every buy-side institution needs to engage and scrutinize their existing sell-side relationships:
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Trade Execution
Sell-side brokers must provide overall transparency into their execution performance for their buy-side clientele. Specific execution targets (either at the transaction or portfolio levels) need to be communicated and measured against when evaluating sell-side execution performance. In addition, much like any other critical (external) relationship, the overall performance and quality of the relationship should be evaluated on a periodic basis.
Research
Each buy-side firm needs to understand the expertise they demonstrate, both internally and externally. External research and analysis should be leveraged in areas in which internal expertise is not available, or when an independent opinion can be incorporated. The buy-side must rationalize and proactively plan for external research that they require from their sell-side brokers. Buy-side brokers will also be able to target independent research providers through their existing sell-side execution relationships.
Value-Add Services & Technology
Value-add services and tools such as transaction cost analysis (TCA), historic performance reporting and industry-wide broker ratings/rankings motivate the competition in the trade execution space. While sell-side firms will continue to show their value in the trade execution and access to research, value-add services and technology will be their differentiator for their buy-side relationships.
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Without a concerted and proactive approach to commission management by leading sell-side institutions, buy-side firms and their fund investors will choose other providers that meet their needs. Section 28(e) establishes that the traditional relationship between the buy-side and sell-side is changing. However, it is the interpretation of these rules and the re-validation of existing sell-side broker relationships that will be critical for buy-side institutions to remain competitive.
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Calendar of Events
Webinars
Preparing for and Surviving an SEC Exam October 11th, 2007
Managing Counterparty Risk for Hedge Funds October 18th, 2007
FIN 48 and Hedge Funds October 30th, 2007
Understanding the SEC and NASD’s General Advertising Requirements October 31st, 2007
PIPEs Regulatory Update: New SEC Developments November 15th, 2007
Mark to Model or Mark to Market- What Hedge Funds Should Know about FAS 157 November 27th, 2007
Conferences
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