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HFMWEEK
S P E C I A L
R E P O R T
HOW TO START A HEDGE
F U N D I N T H E U S 2013
TECHNOLOGY
Choosing an effective risk management system
REGULATION
Meeting rigorous demands before start up
DUE DILIGENCE
Establishing investor identification procedures
FEATURING ACE IT Solutions // Agio Technology // ALPS //
Concept Capital Markets // Ernst & Young // HedgeServ //
The IMS Group // Investor Analytics // Misys // Orangefield //
Sadis & Goldberg // US Bancorp Fund Services
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AMPLIFY YOUR ADVANTAGE
Fund Administration | Middle Office Services | Regulatory Reporting | Risk & Portfolio Management
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
A
s the US economy begins to pick up pace, the
number of hedge fund launches has also begun to
rise. But although many of the challenges faced by
managers are still very much the same – including
capital raising and establishing a robust business
strategy – firms will be entering a different playing
field from years past.
The whole industry has had to re-evaluate and
adapt to greater regulatory and compliance burdens,
as well as increasing investor demands. What this means for emerging hedge
fund managers is that a comprehensive and concrete pre-launch analysis must
be in place to reduce the risk of early issues.
This does not mean that the homework is different this semester. Attracting
investor capital is as difficult as ever and perhaps even more challenging is
accommodating demands for transparency and reduced fees from institutional
investors, as institutional capital continues rising in the alternatives space.
As this HFMWeek report discusses, considering the strategies, structures
and partnerships available to emerging hedge fund managers prior to launch
is crucial. And as preserving capital remains as important as ever, so too is
choosing the right service providers and understanding the distinction between
essential and complementary solutions.
For example, a start-up’s valuable capital can end up being consumed by the
creation of an in-house technology system, which can take time to implement
and even result in changes to service providers if they struggle to stay current
with the changing regulatory environment. Finding a skilled technology
provider that is able to grow with the business can make all the difference.
Looking forward, managers will need to focus their business strategies,
considering infrastructure, operations, marketing and legal demands for their
hedge funds’ performance in the context of greater investor and regulatory
scrutiny. Read on for a comprehensive review of the US start-up space.
Roberto Barros
REPORT EDITOR
HEDGEFUNDMANAGER
HFMWEEK
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CONTENTS
H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
06
TECHNOLOGY
EFFORTLESS IMPLEMENTATION FOR
MAXIMUM PRODUCTIVITY
21
LEGAL
SUCCESSFUL LAUNCH
25
With so many aspects to get right when launching a hedge fund,
Ron S. Geffner of Sadis & Goldberg takes a look at the most critical
aspects to a successful launch
11
ORIGINAL STR ATEGIES
TECHNOLOGY
PREPARING FOR LAUNCH: HOW TECHNOLOGY
CAN HELP
29
FINANCIAL SERVICES
33
PERSPECTIVES FROM THE LONE STAR STATE
HFMWeek talks to Adrienne Main and Christine Jha of Ernst & Young
to find out the facts about launching a hedge fund in Texas
18
FUND SERVICES
As increasing investor scrutiny and tighter regulation become a
part of the hedge fund industry’s operating environment, Paul
Garvey of ALPS discusses the strategies that need to be top of the
agenda for fund managers
FUND SERVICES
OPER ATIONAL UNDERSTANDING
TECHNOLOGY
ESSENTIAL TECHNOLOGY
Bart McDonough of Agio Technology talks to HFMWeek about
how firms can establish a cost-effective IT solution, without
compromising on quality
Two thirds of the major hedge fund launches in London featured
in HFMWeek’s recent ‘Ones to Watch’ article have selected Misys’
Sophis VALUE platform. We spoke to Pierre-Alois Koch of Misys to
find out why
15
RIGOROUS DEMANDS
Joseph Holman of Orangefield describes the start-up environment
in the US, and how regulation, investor demands, and distribution
are central in a manager’s analysis prior to launch
Warren Finkel of ACE IT Solutions explains the most important points
to consider when selecting a technology platform
08
FUND SERVICES
COMPLIANCE
IMPLEMENTING A ROBUST AML
PROGR AMME
As demand for anti-money laundering programmes among
investment advisers increases and is driven by new regulatory
reforms, Zabrina Barile and Wendy Toribio-Torres of HedgeOp
Compliance LLC, an IMS Group company, discuss the requirements
that any start up hedge fund manager will need to consider
Christine Waldron of U.S. Bancorp Fund Services, LLC talks to
HFMWeek about shifting trends in due diligence and the impact
increased inquiries on transparency and operational infrastructure is
having on new managers
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
EFFORTLESS
IMPLEMENTATION FOR
MAXIMUM PRODUCTIVITY
WARREN FINKEL OF ACE IT SOLUTIONS EXPLAINS THE MOST IMPORTANT POINTS TO CONSIDER WHEN SELECTING A TECHNOLOGY PLATFORM
L
Warren Finkel
is the managing partner of
ACE IT Solutions and brings
decades of business and
technology experience
when consulting with clients
in the alternative asset
space to help them build
a robust IT infrastructure
and connect their business
initiatives to focused
technology strategies and
solutions.
aunching a hedge fund – or any new investment firm – is a major undertaking, requiring a methodical approach and an extensive
amount of planning and preparation. Of primary concern to a start-up hedge fund is its
technology infrastructure. A solid technology
platform must be created in order to securely carry the
valuable and sensitive information that a hedge fund utilises and distributes on a daily basis.
A successful technology platform needs to function efficiently from day one. There is no margin for error. Whether you are a start-up or an established fund, the demand for
seamless, efficient IT solutions is consistent and required
as part of an investor checklist.
The specific technology required will vary between
funds, but there are a few essential requirements that all
firms must consider. Data centre storage, hardware, network design, implementation, email, ongoing support of
mission-critical infrastructure, security, disaster recovery,
and compliance requirements are just the beginning. Additionally, hedge funds demand 24/7 uptime to ensure
operational efficiency and profitability.
Hedge funds can take advantage of a variety of platforms
to build their technology infrastructure; including on-site,
cloud, private and hybrid solutions – each platform offers
its own advantages and disadvantages.
The decision to outsource (cloud) or take internal control (on-site IT) will weigh heavily when deciding which
technology platform best serves your business. However,
any useful platform should place an emphasis on new technology integration, future performance, security, flexibility, manageability and scalability. A firm’s applications and
operational strategy should also play an important role in
selecting a specific technology solution.
ON-SITE IT
Before the rise of the cloud, emerging hedge funds followed a conventional path involving the hire of on-site
IT staff to manage technology in-house, paying for extra
space to build out a server room and significantly investing
in technology infrastructure.
Building out a complete on-site IT infrastructure offers
maximum control over a fund’s data, but requires large
upfront capital resources. The hedge fund directly incurs
the capital, operational, and management costs for the
physical resources with this platform; not to mention the
unforeseen technology costs associated with maintenance
and regular technology refreshes. Additionally, an on-site
IT infrastructure has its potential risks, including downtime, data loss, natural disaster and security breaches.
Because hedge funds cannot tolerate downtime, funds
with on-site technology infrastructures often engage managed service providers like ACE IT Solutions to help keep
their technology running smoothly and to ensure uptime
with few surprises. Start-up hedge fund managers have
their hands full with other tasks, so they rely on technology partners to keep their technology infrastructure up
and running seamlessly.
THE CLOUD (IAAS)
Due to hedge funds’ increased reliance on technology, the
faster nature of today’s business environment and disaster
recovery requirements, start-up funds are finding it necessary to host at least part of their infrastructure off-site via
private or public networks that provide a dynamicallyscalable infrastructure for application, data, and file storage. Additionally, the costs of computation, application
hosting, content storage, and delivery can be significantly
reduced by taking advantage of the cloud.
Firms can choose to deploy applications on public,
private, or hybrid clouds. Cost-conscious start-up funds
typically get excellent value from the public cloud and
established hedge funds concerned about security are
building out private clouds or taking advantage of a hybrid
infrastructure to ensure maximum flexibility, scalability,
security and uptime.
Private clouds are built exclusively for an individual
enterprise and are tailored to meet the demands of each
fund’s unique requirements. The downside of a private
cloud is that security, flexibility and control come at a
higher price tag than public clouds.
Since public clouds are owned and operated by thirdparty service providers, clients benefit from economies of
scale. Infrastructure costs are spread across all users, allowing each individual client to operate on a low-cost, pay-asyou-grow model.
As far as security of the public cloud, this varies from
provider to provider, but overall it tends to be limited in
scope, which often drives hedge funds to a hybrid solution. Hybrid platforms provide middle ground between
the cost-benefits of public clouds and the control and
security of on-site IT and/or a private cloud. This is the
type of platform that most funds will employ. With a hybrid platform, a firm leverages third-party cloud providers
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TECHNOLOGY
with message archiving services that store communications for the designated period of time and recover any
necessary communications in the event of an SEC inquiry.
in either a full or partial manner. This platform increases
flexibility by providing on-demand, externally-provisioned scalability.
Regardless of the infrastructure platform a hedge fund
selects, there are a few factors that do not change.
CAREFULLY VET THE CLOUD PROVIDER
Through our closely-vetted technology partners,
ACE IT Solutions offers best-of-breed technologies that provide the highest level of quality, reliability and security. Our cloud infrastructure solutions can support a broad array of workloads and
integrate with a firm’s network, existing data and
application management systems.
SECURITY
Security is fundamental when considering the
technology set-up and network infrastructure of a
new hedge fund. Firms must do their due diligence
– or rely on experts like us to do the legwork –
before settling on a cloud platform, as not every
cloud is secured in the same way.
SCALABILITY
Technical solutions should be scalable. Envision
how your firm will look over the longer term to
avoid investing in short-sighted solutions. Your
cloud platform should have the necessary technological systems in place to support a larger business
should your firm grow significantly.
DISASTER RECOVERY
Regardless of the platform your hedge fund selects, a plan for disaster recovery and business
continuity must be in place. Increased pressure
from investors and regulators has shifted the need
for redundant IT infrastructure to include a comprehensive plan to keep investors’ money safe and
protect valuable data in the event of a disaster.
A business continuity plan and a corresponding disaster recovery system have become essential in today’s marketplace, with investors looking
for funds to demonstrate how they will be able to
maintain operations regardless of external events.
ACE IT SOLUTIONS CLEARLY
UNDERSTANDS OUR NEEDS
AND HELPED US DEPLOY
AN EFFICIENT, RELIABLE
AND SECURE TECHNOLOGY
INFRASTRUCTURE THAT
MET OUR BUDGET,
PRODUCTIVITY, AND
COMPLIANCE GOALS
COMPLIANCE
On the compliance front, there are a number of demands
placed on hedge funds and investment firms. Currently,
the SEC advises funds to retain all internal and external
email and instant message communications that are business-related. We offer cloud solutions that provide firms
”
MANAGEMENT
Don’t overestimate your capacity to manage technology. Most start-up hedge funds do not have the
time or the expertise to deal with overwhelming
issues such as maintaining an IT staff, installing
servers, network monitoring and fending off security threats. Funds that outsource the management of their IT operations to experts like ACE IT
Solutions benefit from knowing the core of their
infrastructure is in good hands, allowing them to
concentrate on growing the business.
ACE IT Solutions understands the importance of
technology to today’s financial firms. Our business process ensures that every detail is covered by supporting a
hedge fund’s unique requirements with effortless, hasslefree network implementation. We are fully committed to
deploying a technology platform that meets the specific
needs and goals of our hedge fund clients, no matter how
stringent the requirements. n
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
SUCCESSFUL LAUNCH
WITH SO MANY ASPECTS TO GET RIGHT WHEN LAUNCHING A HEDGE FUND, RON S. GEFFNER OF SADIS & GOLDBERG TAKES A LOOK AT THE
MOST CRITICAL ASPECTS TO A SUCCESSFUL LAUNCH
T
Ron S. Geffner,
partner, is a member of
Sadis & Goldberg LLP and
oversees the financial
services group. He regularly
structures, organises and
counsels private investment
vehicles, investment advisor
organisations, broker-dealers
and commodity pool
operations, and provides
legal services to hundreds
of various funds.
he hedge fund industry has matured over the
past 10 years. Investors and regulators continue to evolve, becoming more sophisticated and asking more probing questions than
the prior year. Now more than ever, successfully launching a hedge fund is dependent
upon selecting the proper structure and complying with
the ever changing federal and state regulations governing
hedge funds. Structuring a hedge fund involves both the
creation of one or more entities through which investments will be made (both domestic and offshore hedge
funds), as well as the management entities through which
the advisory services will be provided to the hedge funds
– the general partner and/or the
investment manager. The structure and domicile of the hedge
fund is primarily dependent upon
two variables: (i) the nature and
demographics of the prospective
investors, and (ii) the investment
strategy employed by the investment manager. The structure and
domicile of the investment manager is primarily determined by the
citizenship and tax considerations
of its owners, as well as the regulatory regime of the domicile.
ECONOMIC ANALYSIS
In determining whether or not to form both a domestic
and an offshore hedge fund, it is advisable to determine
the amount of anticipated assets which will be invested in
the hedge funds within a few months after the launch of
the funds. In short, the anticipated aggregate investment
made at, or shortly after, the launch of the business may
not justify the formation of both a domestic fund and an
offshore fund and to create both may impair the investment manager’s ability to survive due to the organisational
expenses and the costs of maintaining both domestic and
offshore hedge funds. With early stage managers, cash
burn is often overlooked and can be critical to the survival
of the newly formed asset management firm. The manager must have
an opportunity to establish a proven track record.
THE US FUND IS OFTEN
REFERRED TO AS A
‘DOMESTIC FUND’ AND
MOST DOMESTIC FUNDS
ARE ORGANISED IN
DELAWARE
STRUCTURING THE HEDGE FUND
Investors can be divided into three
classes: (i) US taxable investors,
(ii) US tax exempt investors, and
(iii) non-US persons. In the majority of circumstances, if the investors are US taxable
investors, the fund will be formed as a US limited partnership or limited liability company. The US fund is often referred to as a ‘domestic fund’ and most domestic funds are
organised in Delaware. If the investors are US tax-exempt
investors or non-US persons, the fund generally will be
formed in a jurisdiction outside of the US as a corporation
(or other analogous entity). The non-US entity is often referred to as an ‘offshore fund’. Most offshore hedge funds
organised on behalf of US-based investment managers are
organised in Bermuda, the British Virgin Islands and the
Cayman Islands. US tax-exempt investors typically prefer
to invest in an offshore fund set up as a corporation because if the offshore fund purchases securities on margin
(often referred to as leverage), an offshore fund which is
set up as a corporation blocks the unrelated business taxable income (UBTI) that would otherwise be taxable to
the US tax-exempt investor.
SIDE-BY-SIDE, MASTER FEEDER &
MINI-MASTER STRUCTURES
Managers seeking to launch both
domestic and offshore funds have
several options available in structuring. The three most common
structures are side-by-side, master
feeder and mini-master. In a sideby-side structure, the domestic
fund and the offshore fund make
direct investments pursuant to
the investment strategy and trade
tickets are allocated between the
domestic fund and the offshore
fund. In a master feeder structure,
a third entity is created (the ‘master fund’) and the domestic fund and the offshore fund, rather than making direct
investments, invest all of their assets into the master fund.
In turn, the master fund makes the investments on behalf
of the domestic fund and the offshore fund (often referred
to as the domestic feeder and offshore feeder). The minimaster structure generally is comprised of two entities;
an offshore feeder and a master entity. While the offshore
feeder is taxed as a corporation to benefit US tax exempt
investors and block UBTI, the master entity may be structured for tax purposes as a partnership. Rather than the
US-based manager receiving its incentive as a fee from the
offshore fund and being subject to ordinary income tax,
the US-based manager may receive the incentive as an allocation from the master entity, in an attempt to benefit
from capital gains tax treatment.
There are many legal and commercial drivers in determining the ideal structure. For example, if the strategy calls
”
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LEGAL
for significant investment in illiquid or thinly traded positions, which are difficult to allocate among two brokerage
accounts, a master feeder structure may be preferred as
the investments will be allocated on a pro rata basis at the
master fund yet only require the investment manager to
purchase and sell the positions through one brokerage account. Also, in many transactions involving early stage or
seed investment, if the seeder is located offshore a master
feeder structure may be preferred so that all fees and allocations may be taken at the master fund and thus avoid
the US tax regime. Conversely, employing a tax efficient
strategy for US taxable investors may be of little benefit or
detrimental to US tax-exempt investors and non-US persons. Thus, a side-by-side structure allows the investment
manager the ability to employ tax efficiency with the domestic fund, while maximising the entry and exit points of
securities positions without regard to long term tax gains
for the offshore fund.
STRUCTURING AND DOMICILE OF THE INVESTMENT MANAGER
The structure and domicile of the investment manager
is primarily determined by the citizenship and tax considerations of its principals. Empirical evidence suggests
that the super majority of hedge funds are managed by
US-domiciled entities structured as either limited liability
companies or limited partnerships which are taxed as flow
through vehicles (rather than as corporations). In circumstances involving non-US persons, if the non-US persons
own the majority of equity in or receive the majority of
the economics from the investment manager and their
interests are controlling, the investment manager may
be organised in an offshore jurisdiction to accommodate
the tax needs of the non-US persons. Historically, federal
and state regulation often impacted the location at which
the investment manager maintained its office in the US.
Certain states have compulsory registration requirements
which require an investment manager with an office in
those states to register as an investment adviser prior to
the launch of the hedge fund. Prior to The Dodd Frank
Wall Street Reform and Consumer Protection Act (Dodd
Frank), certain managers chose to maintain offices in
neighbouring states which did not have compulsory registration requirements so as to avoid having to register as an
investment adviser. Post Dodd Frank, managers have accepted registration as an investment adviser as inevitable.
RESPONDING TO INVESTOR DUE DILIGENCE
Due diligence is a critical part of the hedge fund investment process. A successful launch also depends upon
providing prospective investors with comfort regarding
non-investment considerations, such as the manager’s
operations, compliance and risk management. Having a
standard due diligence questionnaire (DDQ) is recommended and it is critical that managers be consistent in
all of their disclosures to investors. Consistency across
documents is vital to the maintenance of a manager’s
credibility in the due diligence process. The same level
of care and consideration should be invested in marketing material, DDQs and requests for proposals. Each
of these documents should respond to each item in the
same manner, as even a single different word can change
the message or meaning and result in a different understanding to the investor.
CONCLUSION
While cash burn is critical to a new manager, the quality
of the firm’s infrastructure cannot be sacrificed. Having
spent approximately two decades practicing law in this
industry, both as an enforcement attorney with the SEC
and in private practice, I have had the benefit of witnessing
many successes and failures. It is important to use service
providers who have corporate, tax and regulatory experience in connection with structuring hedge funds. Failure
to properly structure your firm will have material opportunity costs. A firm with structural issues is less likely to attract investment and more likely to be plagued with investor litigation, regulatory prosecution, limitation on capital
resources and reputational damage. The costs associated
with fixing a problem far exceed the costs of doing the job
correctly at the outset. n
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[email protected]
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01/03/2013 16:19
TECHNOLOGY
PREPARING FOR LAUNCH: HOW
TECHNOLOGY CAN HELP
TWO THIRDS OF THE MAJOR HEDGE FUND LAUNCHES IN LONDON FEATURED IN HFMWEEK’S RECENT ‘ONES TO WATCH’ ARTICLE HAVE SELECTED
MISYS’ SOPHIS VALUE PLATFORM. WE SPOKE TO PIERRE-ALOIS KOCH OF MISYS TO FIND OUT WHY
Pierre-Alois Koch
is head of buy-side
business development
for Misys and is based in
New York. He works closely
with product management
to determine the strategic
development of Misys’ buyside offering, Sophis VALUE.
Pierre holds an MSc in
Advanced Engineering from
Ecole Centrale Paris.
I
ncreasing investor demand and regulatory burdens
are just some of the business aspects that hedge
fund managers have been required to grow accustomed to. To manage these aspects going forward,
start-up hedge funds in particular will need to be
attentive when it comes to fully understanding
the technology solutions available to them in order to deal
with change effectively. At a time when regulation and risk
management are top priority in the industry, Pierre-Alois
Koch of Misys discusses how building a robust platform
upon launching can be costly in the short-term but can
lead to sustained benefits in terms of operational efficiency,
scalability, cost savings and increased sophistication across
the front-office and risk management in the long run.
increasing need for ‘tropicalisation’ of plain vanilla asset
classes. By this I mean the software changes and enhancements that need to be made to the way certain instruments
are managed in the system to adapt to local market conventions. These changes can be significant when trying to
tap into markets like Brazil, Mexico, or Korea, for example.
Separately, as hedge funds are often opportunistic, when
they raise capital their strategy encompasses a narrow
scope of asset classes. However, after a sustained period
of success, they tend to bring in new portfolio managers
and start trading across new asset classes. The modular approach of Sophis VALUE allows hedge funds to add new
asset classes and functionality with ease and minimum disruption to the business, making the system highly scalable.
HFMWeek (HFM): What asset classes do your clients
typically trade across and how does this influence the
technology solution they require?
HFM: Why is it important to have a risk management
platform in place that combines sell-side technology
capabilities with buy-side flexibility and fast implementation?
Pierre-Alois Koch (PAK): Our clients and prospective
clients focus on strategy, which will define their requirements in terms of asset class coverage. The typical strategies that are driving interest in products like Sophis VALUE are merger arbitrage strategies, global macro funds,
fixed income funds, and equity long/short funds.
Firms are not only looking for systems that have crossasset coverage, but also cross-geography coverage, with an
PAK: Many start-up hedge funds have a significant number of employees coming straight from the sell-side. The
fact that Sophis VALUE originates from the sell-side gives
it the necessary foundation with regards to functional cove
rage across asset classes. Sophis was founded in 1985, with
a sell-side platform called Sophis RISQUE, which is why
we are in the unique position to answer the needs of fund
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
TEN TECH QUESTIONS A FUND SHOULD
CONSIDER PRIOR TO LAUNCH:
1. What asset classes will our firm trade across now and in the future?
2. How will our firm ensure that traders have timely and accurate information for PnL and risk management?
3. What risk management tools and risk analytics will we need to reassure
investors during their due diligence?
4. Will our firm benefit more from an integrated or best of breed approach
to technology?
5. If we choose to outsource some of the operations, how will we keep
control of what is being done?
6. What are our data requirements and what will be the associated costs?
7. Which third parties will we need to connect to?
8. What will be our solution for reporting and compliance?
9. Do we favour a hosted or onsite delivery for our technology platform?
10. How will our firm ensure that future growth is not constrained by
system and operational limitations?
”
managers who have a background in investment banking.
Some fund managers may have used Sophis RISQUE prior
to moving to the buy-side.
Historically, risk management requirements are far
higher on the sell-side than they have been on the buyside. However, this is now changing due to the influx of
buy-side regulation. This was the main driver for Sophis to
build a buy-side solution in 2001.
A lot of what we built for Sophis RISQUE was replicated in Sophis VALUE, and hedge fund managers appreciate
that. Today, most of our development is driven by the requirements of our buy-side customers.
It is also important to mention the significance of speed of implementation and IT footprint. Sell-side systems are heavy in terms of
IT architecture. It is only if you have a separate
product, linked to the buy-side, that you can
really address these requirements and deliver a
solution acceptable to hedge funds.
We increasingly see a grey area between
functionality that was typically only required
on the sell-side that is now being demanded by
the buy-side, such as a solution for collateral
management. Similarly, some of the functions
needed by traditional asset managers are being
requested by hedge funds in areas like performance attribution and compliance.
Therefore, it is important to have a system
that is able to cover all of these functions and
moreover, with a componentised approach for straightforward on-boarding.
PAK: In the US, the first thing that springs to mind is Form
PF. Hedge funds, irrespective of their size, have to decide
how to address the need for Form PF reporting, as well as
risk management. With regulation in general, in the near
future we will see the requirement of trading through swap
execution facilities (SEFs), and the need to confirm trades
electronically. All of these needs have to be addressed.
To address increasing regulatory demands, Sophis
VALUE allows our clients to automate a lot of the processes because of the front-to-back nature of the system. It
facilitates this level of optimisation so that the operational
burden can be removed from hedge funds.
With this system in place, firms do not need
to be that labour-intensive with regards to
managing middle- and back-office operations.
Also, aspects like regulatory reporting can be
automated, alleviating a lot of the burden that
increased regulation adds and a lot of the cost
associated with it.
IN THE NEAR FUTURE WE WILL
SEE THE REQUIREMENT OF
TRADING THROUGH SWAP
EXECUTION FACILITIES AND
THE NEED TO CONFIRM TRADES
ELECTRONICALLY. ALL OF
THESE NEEDS HAVE TO BE
ADDRESSED
HFM: What technology requirements should be considered in terms of risk analysis, regulatory reporting
and compliance?
”
HFM: In what ways can an integrated system like Sophis VALUE assist firms in
keeping costs to a minimum while addressing all of its portfolio management needs
and data requirements?
PAK: Sophis VALUE brings increased operational efficiency to hedge funds. You can have
a single database in place which is robust and
much more sophisticated than managing spread sheets, for
example. We have seen an intrinsic trend over the past few
years of investors and regulators driving hedge funds’ service provider needs. In the UK, funds in the past decade
prioritised looking for a risk management system, whereas
in the US, where regulation is less stringent on that front,
1 2 H F M W E E K . CO M
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TECHNOLOGY
”
selecting the best order management systems were seen
as the priority by start-up hedge funds.
Nowadays on both sides of the Atlantic, risk management is clearly high on hedge fund managers’ agendas;
hence funds are primarily looking for an effective and transparent risk management
system, which is where Sophis VALUE excels
over our competitors. From the investors’
viewpoint, we have seen a shift in the interest in, not only risk management systems, but
also shadow accounting. This signifies that
even if some operational aspects are being
outsourced to a fund administrator or prime
broker, investors are requiring hedge funds to
have more and more control over what these
sub-parties are doing.
Five or 10 years ago in the US, not all hedge
funds had an administrator. Nowadays investors are asking to bring back some of the calculations around accounting, position keeping, and cash management into their funds.
We provide a high level of shadow accounting
and ensure it is not too resource intensive for
hedge funds. This is also something that Sophis VALUE
can help with as we have delivered sophisticated portfolio management and risk management to our customers
for a very long time and understand the needs of buy-side
firms. Having an integrated risk management system ena-
bles a firm to turn the functionality and the infrastructure
they need on or off, depending on a firm’s growth. This is a
very powerful option for hedge funds especially when they
need to adapt to rapidly changing market conditions.
WE HAVE SEEN A SHIFT IN THE
INTEREST IN RISK MANAGEMENT
SYSTEMS AND SHADOW
ACCOUNTING. INVESTORS ARE
REQUIRING HEDGE FUNDS TO
HAVE MORE AND MORE CONTROL
OVER WHAT THESE SUB PARTIES
ARE DOING
”
HFM: How should a firm’s technology outsourcing needs be analysed in the context of
its operational strategy? And what are the
advantages of using a hosted platform compared to on-site infrastructure?
PAK: The advantage of using a hosted platform is that clients can completely outsource
their IT administration. Start-up hedge funds
are not keen on large initial investments and
prefer smaller recurring investments. We
offer hedge funds peace of mind in terms of
managing the hardware, operating system, and
the network.
Basically, we are very close to a point where
no IT knowledge is required from our clients.
Obviously, the fact that clients do not need
to have an IT administrator to start the hedge
fund helps towards being cost efficient. One key part of
our value proposition is that by outsourcing and depending on the experience and expertise of Misys consultants
and our product management team, firms can concentrate
on their core business of trading. n
H F M W E E K . C O M 13
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When you’re starting
a journey, it’s important
to follow the leader.
At Ernst and Young,
we’ll
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you
opportunities
For more
than
years,
we have to
forservice
the world’s
leading
been a work
leading
provider
for
businesses
in an environment
hedge fund
start-ups.
that we know you’ll find
Many of
our clientsand
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challenging
stimulating.
way toWelcome
the top and
areworld
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we supported their evolving
ey.com/careers
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See
transaction services.
To find out more, visit
ey.com/assetmanagement
© 2012 Ernst & Young LLP. All Rights Reserved. ED 1015
See More | Commitment
Untitled-2 1
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
FINANCIAL SERVICES
PERSPECTIVES FROM THE
LONE STAR STATE
HFMWEEK TALKS TO ADRIENNE MAIN AND CHRISTINE JHA OF ERNST & YOUNG LLP TO FIND OUT THE FACTS
ABOUT LAUNCHING A HEDGE FUND IN TEXAS
T
Adrienne Main,
is an assurance partner in
Ernst & Young LLP’s financial
services office. Based in
Dallas, she serves a variety of
asset management clients,
including emerging managers
together with large, highly
established private equity and
hedge funds.
he US has several hedge fund ‘hubs’ and
while the largest is New York, the State of
Texas has a lot of advantages. A well established hedge fund centre with an infrastructure that already plays host to several large
firms, The Lone Star state continues to see
new fund launches. To find out more about what the state
has to offer and the steps a prospective fund manager needs
to keep in mind when launching a fund, HFMWeek talked
to Adrienne Main and Christine Jha of Ernst & Young LLP.
HFMWeek (HFM): What are the key steps involved in
setting up a hedge fund?
Adrienne Main (AM): I think the first question that
needs to be addressed is whether or not the manager really
wants to set up a hedge fund. Managing a hedge fund includes a lot more than just managing money which is what
many traders are used to doing; it’s about running a business as well. Developing a detailed business plan is critical
to making that decision. I would start with thinking about
cash flows, as a lot of funds are starting with less capital
than they had in the past so this needs to be fully and intelligently optimised in the right ways. Once you have made
the decision to set up a hedge fund, the next consideration
is jurisdiction.
HFM: What considerations factor into where the manager should set up shop?
Christine Jha,
based in Dallas, is a tax
partner with Ernst & Young
LLP’s Financial Services Office.
Her experience includes
involvement at both the
fund and fund manager
level regarding structuring,
tax planning, as well as
coordinating the tax reporting.
Christine Jha (CJ): First, the jurisdiction must provide a
supportive business environment which will not only allow the manager to launch a fund, but also create a longterm venture. My initial thought leans towards tax. Texas is
one of the few states without a personal income tax, which
is an obvious benefit.
Texas has a long-standing history with the asset management industry, which a newly arrived manager will
find helpful. There is an existing infrastructure to serve
the needs of a hedge fund from accounting firms to prime
brokers, attorneys and administrators. Finally, I would add
that Texas has a number of outstanding universities, which
can provide a talent pool for the new manager.
AM: Texas is also in a strategic central location allowing
for quick access to both coasts. The large population of
high net worth investors in Texas could be another advantage in providing fundraising opportunities. Once jurisdiction is established, selection of service providers is generally the next step.
CJ: The manager is going to need to select a law firm, an
accounting firm and most likely an administrator. This will
be the first time a start-up manager is meeting and interviewing prospective service providers. It is critical that
both time and effort is spent in making these selections. A
manager will want to work with reputable service providers who are well-known within the hedge fund industry.
This industry is very specialised and when due diligence
begins, this is where a manager will begin to see the impact
of his or her selections.
Of the three service providers, the lawyers and accountants can be most helpful in working through the structure
of the fund and management company. The optimal structure for your fund depends upon many considerations,
including the investor base, type of financial instruments,
trading jurisdictions, investment manager/general partner
compensation arrangement and expected capital. Having
the ability to work through the considerations with an experienced advisor will prove fruitful.
I should also mention that the manager will need to select a prime broker. In many instances, a start-up manager
will be coming out of a larger shop and will already have a
relationship with a particular prime broker.
HFM: What other matters should fund managers be
aware of in selecting service providers?
AM: Service providers can also assist a manager with
understanding other matters that he or she may not be
familiar with, such as regulatory and compliance obligations and accounting requirements. A manager should also
consider the cost benefit of hiring key positions internally
versus outsourcing. For an emerging manager, outsourcing
can be a very cost effective way to address many of the necessary non-core business processes.
As I mentioned earlier, launching a hedge fund means
running a business. Hence the manager will need to arrange the various matters needed to run a business – from
obtaining lease space to IT infrastructure. Additionally,
the manager will need to create fundraising materials and
due diligence questionnaires.
HFM: What are the biggest challenges that start-up
managers need to overcome?
AM: Probably the biggest challenge faced in the first few
years is simply to survive and grow. You need to understand
how you’re going raise capital in the near-term. Developing a realistic growth plan is essential and understanding
your competitive advantage in the market, which will enH F M W E E K . C O M 15
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
CJ: Finding, hiring and retaining good talent where the
manager can leverage those individuals’ skills to round out
his/her own would be another critical success factor.
able you to communicate effectively with prospective investors. Turning $20m of start-up capital into $250m in
the current market is very difficult. When you consider a
management fee of 1.5% to 2% on assets of $20m, this is
only $300, 000 to $400, 000. By the time a manager leases
office space and equipment, pays for technology, phones,
research, personnel, and so forth, how much remains?
Having a thorough understanding of revenues and
costs is a critical factor to survival.
CJ: To attract capital, a manager may need to negotiate special terms, which could put further pressure on the manager’s new business. For example, a
sizeable investor may want a share of the management company. This is a conundrum for a startup manager.
HFM: What are some key factors to establishing and running a successful hedge fund?
HFM: And finally, what pitfalls should a new manager
avoid?
PROBABLY THE BIGGEST
CHALLENGE FACED IN THE
FIRST FEW YEARS IS SIMPLY
TO SURVIVE AND GROW
AM: It goes without saying that performance
matters, but aside from that, being prepared for the due
diligence process with prospective investors could be the
difference between a successful and a failed launch. For
most investors, the due diligence is very similar whether
they are investing $5m or $50m so when looking at a start
up fund, they are going to expect all of their criteria to be
met. Also, most investors don’t want to be a fund’s largest
shareholder, so if they have investment minimums, fund
size matters.
”
CJ: The manager needs to understand the governing documents of the fund, as well as those of the
management company, as these set the parameters
for his/her business. Additionally, if the start-up
manager is taking on a partner, he or she should
ensure the business arrangement is clearly documented. It’s important not to leave anything open
to interpretation.
AM: It comes back to the business plan. This
isn’t just so you know where you’re going and
how you’re going to get there – it’s also about
ensuring that when the business grows, that
you have a plan to reassess. For instance, there
may come a time when you need to re-evaluate your
management team. You may determine your business
is under-staffed given the growth or changes that have
occurred, you may require executives with more knowledge or experience, or you may want to bring in-house
services that were previously outsourced. This is an everchanging industry; it’s important to take the time to evaluate your progress and make any necessary adjustments to
maintain momentum. n
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
OPERATIONAL
UNDERSTANDING
CHRISTINE WALDRON OF U.S. BANCORP FUND SERVICES, LLC TALKS TO HFMWEEK ABOUT SHIFTING TRENDS IN DUE DILIGENCE AND THE
IMPACT INCREASED INQUIRIES ON TRANSPARENCY AND OPERATIONAL INFRASTRUCTURE IS HAVING ON NEW MANAGERS
A
Christine Waldron
serves as senior vice
president for U.S. Bancorp
Fund Services and manages
the Alternative Investment
Solutions division which
specialises in the unique
servicing needs of
alternative and private
investment products such
as hedge funds, offshore
funds, and distressed
assets. She has 20 years of
experience in the industry
and has spent the past 15
years with U.S. Bancorp
Fund Services
s a top priority for any contemporary
hedge fund manager, due diligence issues
have attracted heightened scrutiny in recent years as investor demands continue
to rise. Understanding investor priorities
and how to address their concerns remains
crucial for any new manager. Christine Waldron, of U.S.
Bancorp Fund Services, explains the industry’s key due
diligence issues and the steps start-up funds should take
to reassure investors.
HFMWEEK (HFM): How important are due diligence
inquiries in today’s environment and what is driving
the industry’s fixation with due diligence standards?
Christine Waldron (CW): Due diligence inquiries continue to increase and now play a significant role as investors take an active interest in understanding the operations of the
fund they are investing in.
Certainly the scandals of years
past are big drivers for this, but
given market conditions, the internal control environment of a fund
is something that investors should
be looking at to determine if they
are comfortable with the servicing
processes before making a substantial investment.
We have seen a record number of due diligence inquiries that
cover a much broader segment of
operations, for example., meeting
the daily operations team. Certainly some investors use a more
thorough process for obtaining the
data, understanding it, and making
decisions, while others use a ‘check
the box’ type of approach.
However, there is no standard due diligence process
across the industry. The industry still needs to focus on
creating a standard, but we have seen a commitment to
this approach by the investment community which has
benefited the industry and increased investment decisions.
counterparty risk, and what are the key points managers should keep in mind on this front?
CW: From a market analysis point of view, the counterparty risk is something we are probably most familiar with,
because we can track it. We can report back on what the
exposure is to a given counterparty. This is important to
managers, not only in terms of the quality of the counterparty, but also in terms of the size and volume of it.
U.S. Bancorp Fund Services does not dictate what managers should focus on. However, we provide managers with
information for them to develop their own risk procedures.
HFM: With Form PF reporting requirements in
the US proving to be far from straightforward, and
AIFMD regulations impacting the industry globally,
how should funds approach increasing regulatory demands and compliance burdens?
CW: A fund’s approach to regulatory demands and client burdens
must be multifaceted and comprehensive. First, they should put
together a multi-disciplined team,
consisting of independent accountants and legal counsel, service providers (on both the prime broker
and custody side), an administrator, as well as internal resources.
Creating that multi-disciplined
team allows them to align and continue working toward a common
goal. Certainly, as these regulations become more clear, they are
subject to several interpretations.
You want your trusted advisors to
be communicating their direction
to everyone in the group.
Second, managers should be
cautioned on some of these regulations’ finalisations. We
caution people to really understand where the regulations
are going to end up before they early-adopt. For example,
a lot of effort has been put into assessing the impact of
Fatca and the AIFMD. Yet, these documents are not final.
You do not want to request more information than necessary from your investor base or implement multiple infrastructure and procedural changes, then find that those
CERTAINLY SOME
INVESTORS USE A MORE
THOROUGH PROCESS FOR
OBTAINING THE DATA,
UNDERSTANDING IT, AND
MAKING DECISIONS, WHILE
OTHERS USE A ‘CHECK THE
BOX’ TYPE OF APPROACH
”
HFM: In what ways can a comprehensive market risk
analysis be conducted, particularly when it comes to
18 H F M W E E K . CO M
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FUND SERVICES
which is absolutely critical in determining the liquidity of
both their product and the investments in their fund. That
is probably the most often over-looked item when a fund
goes to market: assessing what a manager’s target investor
base is and making sure that the liquidity terms meet that
investor base’s expectations.
There are certainly more accredited investors
coming through who are looking for greater liquidity than institutional investors.
need to be modified and changed again because of a finalisation of regulations.
Another aspect that managers should be considering
is how system vendors are responding. All of the vendors
that are in the industry are looking at these regulations as
well. Making sure that your team knows what those system vendors are doing to respond and to support
these regulations is crucial.
HFM: To what extent is leverage returning to
the industry and how can service providers
assist new managers in maintaining a suitable
level of leverage in today’s highly-scrutinised
climate?
CW: A much more controlled approach to leverage is returning to the industry, and with it,
increased reporting. Not only reporting to the investment manager on a real-time basis, but also to
the investor community on what the leverage is is
increasing. Most investors want to receive some
sort of scorecard that includes facts on counterparty risk, the amount of leverage in the portfolio,
the market pricing, and how that pricing is determined. They will want to see data at the same time
they get their investor statements. The investor
scorecard plays a big part in helping to manage
expectations around leverage.
MOST INVESTORS WANT
TO RECEIVE SOME SORT OF
SCORECARD THAT INCLUDES
FACTS ON COUNTERPARTY RISK, THE AMOUNT
OF LEVERAGE IN THE
PORTFOLIO, THE MARKET
PRICING, AND HOW THAT
PRICING IS DETERMINED
HFM: What should managers consider when evaluating liquidity in a hedge fund context?
CW: They need to consider their target investor base
”
HFM: How has the hedge fund industry’s investor base been changing and what implications is this having on a start-up firm’s business model?
CW: There are two areas where we have seen some
rather significant changes. One is the distribution
of hedge fund vehicles through retail channels.
This practice creates a unique need. Those investors look for more streamlined reporting, and want
access to different data more specific to a retailoriented type product than what the hedge fund
industry has historically provided.
The other side of the equation is that the institutional investor is still a very big part of this industry.
There is the desire on the investor’s part to have the
fund structure in a separately managed account.
That gives investors greater leverage in terms of
what they want to see from a strategy perspective in their
product. The challenge for emerging managers is that this
creates a more costly environment and structure to maintain since the purpose behind these vehicles is to comingle
assets to gain efficiency. n
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27/02/2013 10:21
FUND SERVICES
H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
RIGOROUS DEMANDS
JOSEPH HOLMAN OF ORANGEFIELD DESCRIBES THE START-UP ENVIRONMENT IN THE US, AND HOW REGULATION, INVESTOR DEMANDS, AND
DISTRIBUTION ARE CENTRAL IN A MANAGER’S ANALYSIS PRIOR TO LAUNCH
Y
Joseph Holman
is the CEO of Orangefield
Columbus. Prior to joining
Orangefield Columbus, Mr.
Holman founded Columbus
Avenue Consulting in 2004.
He has more than 25
years of experience in the
financial services arena,
with a particular emphasis
on fund administration and
business development.
ou got your bonus, have some rich friends
and feel now is the time to start a hedge
fund. What does it take to do it successfully?
The answer is money and professional help.
Post 2008, there are two types of hedge fund
launches: those that succeed in attracting
outside capital and those that resemble an investment club.
When launching a US fund, there are three elements to
consider; regulation, investor demands and distribution.
The professionals you hire will navigate you through the
entire process. Below is a brief summary of some of the
challenges you may face when launching a fund in the US.
REGULATION
US regulatory demands are confusing, decentralised and
self-imposed. In the US, it is the responsibility of the manager to ensure compliance with regulation, which is why
hiring an experienced hedge fund attorney is critical. Noncompliance can result in fines, loss
of business and/or jail. Mistakes
are easy, but the consequences are
harsh.
It is important to know that federal and state requirements depend
on facts and circumstances, including asset class, fund size, manager
location and location of investors.
For instance, a fund launched in
Texas or California may have different rules than a fund launched
in New York. Below is a brief list of
common regulatory requirements
that should be considered when
launching a fund.
CFTC – Managers trading commodity interests or other
CFTC regulated instruments may be required to register
with the CFTC as a commodity pool operator and/or a
commodity trading advisor. In this capacity, the manager
would be subject to periodic inspections and reporting requirements, among other CFTC requirements.
State Blue Sky Laws – Blue Sky Filings are generally required in each state that an investor resides, with some exceptions. The filing is informational in nature, is generally
associated with a filing fee and varies from state to state.
IRS – Both managers and the funds they manage will need
to obtain a tax ID number. Generally, the fund will also
be required to prepare annual tax reports and be cognitive
of whether investors are US persons or foreign persons.
Failure to withhold US tax on a foreign person becomes a
personal liability of the manager.
ERISA – To the extent the manager seeks to accept benefit plan
investors that are covered by
ERISA and/or Section 4975 of the
Internal Revenue Code, managers
should be aware that once the fund
comprises 25% or more of benefit
plan investor capital (measured
on a class-by-class basis), the fund
will become a ‘plan asset’ and the
manager will become an ERISA
fiduciary and thus subject to the
Department of Labor’s rules and
regulations applicable to plan assets. ERISA and/or Rule 4975 assets include investors that are pension plans and IRAs, respectively, among others.
IN THE US, IT IS THE
RESPONSIBILITY OF THE
MANAGER TO ENSURE
COMPLIANCE WITH
REGULATION
”
SEC – Managers who manage private funds are required
to register when their regulatory assets under management
reach $150m. This threshold drops to $100m of regulatory
assets under management if the investment manager has
separately managed account clients. Managers with fewer
than $100m in regulatory assets under management may
be required to comply with state regulatory requirements.
SEC registration generally consists of filing a form ADV
(Parts 1 and 2) and once registered, a manager must comply with the substantive provisions of the Investment Advisers Act of 1940, including setting up and maintaining
a compliance programme and being subject to periodic
SEC inspections and reporting. A significant cost associated with registering is creating and maintaining a compliance programme, in addition to the legal costs associated
with preparing the form ADV.
3c1 vs. 3c7 – A private fund will be eligible to rely on one
of two exceptions from registration as an investment company with the SEC. Under the first exception, the fund
would be eligible to accept funds from up to 100 beneficial
owners who are, at minimum, accredited investors. Under
the second exception, the fund would be allowed to have
more than 100 beneficial owners as long as each such beneficial owner is a “qualified purchaser” (generally an individual with $5m in investments or an entity with $25m in
investments) and an accredited investor.
Private placement offering exemption – Funds typically sell interests using a private placement exemption
found in Rule 506 of Regulation D under the Securities
H F M W E E K . C O M 21
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FUND SERVICES
H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
Act of 1933, as amended. In relying on this exemption,
most fund managers require all investors to be accredited
investors. Further, the exemption prohibits general advertising or solicitations. In particular, there should not
be any broad-based marketing of fund interests and there
should be no public website, among other considerations.
These rules are complex and will change in the near future
with the adoption of the Jobs Act, which will allow certain
advertising and general solicitation, but does not change
investor eligibility requirements.
the prime broker or administrator. Over the years I have
found that the cost of ineffective operations is the most
expensive decision a manager can make. The right decisions upfront can make the difference between robust operations and operational failure.
INVESTMENT PROCESS
Before 2008, the ‘secret sauce’ worked when explaining
fund returns. Today, investors require a thorough understanding of, not only what generated fund returns, but
also how they originated and whether they will continue.
A manager needs to articulate and document the entire
investment process. This process is composed of the following elements.
• Idea generation – How does the manager select
from its investment universe?
• Research – What is the manager’s research process?
How do you see what others do not?
• Investment selection – How does the manager decide which ideas are selected and which ones are not?
• Portfolio construction – How do you construct
your portfolio to achieve the advertised results? Sizing, hedges and covariance between investments all
need to be explained.
• Risk management – How does the manager protect
the portfolio from the unforeseen and what monitoring and action plan do you have in place?
Managers need to work with prime brokerage capital introduction teams as well as outside consultants to
hone in on both the process and the story. Most
newly minted managers know how to invest, but
it takes professional help to institutionalise and
articulate the investment process.
INVESTOR DEMANDS
Pre 2008, investors required very little information from
managers. An investor looked for returns (real or fake)
that correlated positively with their overall portfolio. Today, investors demand adequate capitalisation, robust operations and a verifiable, repeatable investment process.
CAPITALISATION
A new manager’s operations require adequate capitalisation. Investors like to see two years of operating capital
to finance the management company. Managers need to
show they can cover operating expenses (as well as personal) for several years assuming zero revenue growth. A
typical fee structure will provide a 3-4% revenue stream
which translates into $300,000-$400,000 for each $10m
of outside AuM. Given the cost of running a business,
managers need at least $50m of AuM before having a sustainable business.
OPERATIONS
Robust operations mean different things to different people. In all cases it requires a process
that insures the actuary and integrity of the fund’s
financial information. A prime broker or administrator is in the best position to advise on what the
operations should look like. However, in all cases
the operational control environment must ensure
managers have accurate and timely information
to manage the fund and have safeguards in place
to prevent misstatements or misappropriations.
Most new managers accomplish this by hiring the
right CFO and outsourcing the daily operations to
THE OPERATIONAL
CONTROL ENVIRONMENT
MUST ENSURE MANAGERS
HAVE ACCURATE AND
TIMELY INFORMATION
”
DISTRIBUTION
The last piece of the puzzle is distribution. You
have created the perfect strategy and now you
are ready to raise assets. There are many avenues
to take, including: using a prime broker’s capital
introduction team, hiring a third party marketer,
finding seed capital or going to high-net-worth
individuals and family office money. There is no
right choice and no choice is mutually exclusive;
however, if you cannot pass the due diligence test,
no matter what the returns are your fund will never get the
allocation.
CONCLUSION
Launching a hedge fund in the US is not as easy as it once
was. Today, you have greater regulatory and investor demands all driving up the costs of a successful launch. In
2007, a fund could launch with as little as $100,000. Today, a manager needs 10 times that amount just to be a
legitimate contender. Before you embark on launching
a fund, ask yourself whether you can meet the rigorous
institutional and regulatory demands of today or are you
simply happy running a modern day investment club. n
DISCLAIMER: THE ABOVE CONSTITUTES THE OPINION OF THE WRITER, IS GENERAL IN NATURE AND
SHOULD NOT BE RELIED UPON WITHOUT THE INPUT
OF COUNSEL.
22 H F M W E E K . CO M
021-022_HFMWEEK_HOW2US_Orangefield.indd 22
01/03/2013 08:56
Untitled-2 1
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27/02/2013 10:18
FUND SERVICES
H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
ORIGINAL STRATEGIES
AS INCREASING INVESTOR SCRUTINY AND TIGHTER REGULATION BECOME A PART OF THE HEDGE FUND INDUSTRY’S OPERATING ENVIRONMENT,
PAUL GARVEY OF ALPS DISCUSSES THE STRATEGIES THAT NEED TO BE TOP OF THE AGENDA FOR FUND MANAGERS
A
Paul Garvey
is senior vice-president
and director of hedge fund
administration at ALPS. Paul
joined ALPS in 2007 and
oversees the operational
departments in all locations.
Prior to joining ALPS, Paul
served as director of hedge
fund operations at BISYS
Hedge Fund Services in
Boston, a position he held
for seven years. Previously,
he worked for Dublin-based
Investors Trust Ireland, as
well as IBT Fund Services
(Canada), Scudder Stevens
& Clark, and Investors
Bank & Trust Company.
Paul holds a Bachelor of
Science degree in Business
Administration from
Northeastern University.
s the US economy continues its recovery, the demand for emerging managers maintains its growth levels- being especially driven by an influx in
institutional capital. But as start-up
funds are presented with a number of
opportunities, understanding the main challenges before considering structures, strategies and partnerships
is key. HFMWeek sits down with Paul Garvey of ALPS
to discuss the start-up space in the US and the most important business considerations for emerging managers.
HFMWeek (HFM): What key points should managers
consider when starting a hedge fund from the US?
Paul Garvey (PG): Managers need to consider who their
primary investor base will be, what type of structure would
be most appropriate for those investors, and which service
providers would be best suited to provide the proper offering to those investors and the chosen fund structure.
The vast majority of new US funds launch with assets
under $100m. At those asset levels, fund expense loads
have the potential of drastically eating away at performance. It is critical to align the
infrastructure of the investment
advisor and the services rendered
to the fund with the current investor base. If the fund is starting
out with mostly friends and family money, it may not be necessary
to purchase a robust risk software
suite. The fund may also be able
to save costs by delaying NAV delivery by the administrator. Conversely, if the initial capital includes
institutional investors, it may make
sense to increase the services offered, such as engaging the administrator to provide
daily P&L. In the end, the manager needs to assess the
appropriate vendors and services with the actual needs of
the fund.
Investors are looking closer at service providers’ internal controls and procedures. For example, an easy ‘checkthe-box’ test of an administrator’s internal controls is an
annual SSAE-16 issued by a reputable accounting firm.
This ensures the administrator has a proven set of procedures and systems when calculating fund NAVs. This goes
hand-in-hand with tested and proven disaster recovery
plans. Having a sound set of internal controls is meaningless if the service provider is unable to render services during a disaster.
Investors also want to see firms that are well-known
within the industry. A good and easy test managers can
follow is to ask the various service providers they are engaging or considering if they have worked with other firms
they are speaking with. If the manager’s auditor has never
heard of or worked with the administrator, that could be a
sign that the administrator is small or unknown. Another
quick check is to see if the firm has received any industrylevel service provider awards.
Scalability is extremely important. Whether the initial
investors are mostly friends and family or composed of
institutional capital, a new manager should engage service
providers that have the ability to provide a full spectrum
of services that would fit the fund
at any asset level/investor base.
If the fund is starting with mostly
friends and family money, the
manager should ensure that as the
fund grows, the service providers
will be able to scale with the growth
of the fund.
MANAGERS NEED TO
ENSURE THEIR FIRMS HAVE
ROBUST INFRASTRUCTURE,
NAME RECOGNITION AND
SCALABILITY
”
HFM: What should start up managers keep in mind
when selecting the appropriate service providers, especially in the current environment of higher investor
scrutiny and tighter regulation?
PG: Managers need to ensure their firms have robust
infrastructure, name recognition within the industry, and
scalability.
HFM: What fee structures should
managers consider and what role
can the choice of appropriate
structure play in the survival of a
start-up hedge fund?
PG: The capital raising environment has become much
more competitive over the past few years. The standard ‘Two and 20’ may not be acceptable any longer. We
have seen many new funds becoming creative with their
fees. There are more funds employing hurdles based on
benchmarks and others that provide stair-step management fees based on invested assets. These are all creative
methods that are utilised to make the investment that
much more appealing.
One mistake we have seen over the years is when managers set fees that are not commensurate with fund style.
For example, an incentive fee that crystalises quarterly may
H F M W E E K . C O M 25
025-029_HFMWEEK_HOW2US_ALPS.indd 25
01/03/2013 13:31
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RachAds.indd 26
10/08/2012 13:53
H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
not make sense when the fund has a one year lock-up on
new capital. The timing of fees should coincide with the
investment style and any gates or lockups that may exist.
If a fund is employing an absolute return strategy, then a
hurdle based on the S&P 500 doesn’t make much sense,
but a flat 5% hurdle would seem more appropriate.
HFM: To what extent does the choice of US State play
a role for a start-up firm and what recent initiatives at a
State level are likely to influence this decision?
PG: For various tax reasons, Delaware is still the leading
state for fund formation. The investment advisor will be
subject to the regulations of their local jurisdiction regardless of the fund jurisdiction, but if they register with the
SEC, the state becomes much less important.
The key is to have the appropriate attorneys and compliance professionals engaged to help managers navigate the
various jurisdictions.
US managers that have an offshore component to their
structure still favor Cayman as the primary jurisdiction, although we do see some BVI funds from time to time.
HFM: How can the US remain competitive in terms of
hedge fund domiciliation choices, and what regions
have been the most popular for start-up funds?
PG: The US will, in the long-term, remain a popular
choice for domiciliation among managers that want access
to US investors. The cost of setting up a US fund is relatively inexpensive and fairly quick, and the ongoing cost is
extremely low. The low-cost environment, combined with
the access of US investors, is a key driver for the growth of
the industry in the US.
HFM: How has the hedge fund industry’s investor base
been changing and what implications is this having on
a start-up firm’s business model?
PG: Over the past few years more institutional money
has been flooding into the industry. This has led to greater
transparency requirements and shorter (or sometimes the
elimination of) lock-ups. The due diligence of these investors has now extended well past the manager and heavily
into the service providers. This has required investment
advisors to build up their own infrastructure.
FUND SERVICES
We have seen more dedicated CCOs with start-up
firms and more investments into technology. There has
also been a push to leverage the administrator with more
of these requests. We have found ourselves more actively
participating in the new investor due diligence process and
have been building new reports to appease the growing
transparency requests.
Besides institutional investors, we have found that highnet-worth investors have become much more savvy over
the past few years. They are looking for more fee breaks
when agreeing to longer lock-ups and they are looking for
better risk-adjusted returns. This has greatly influenced
start-up funds by making the act of raising capital much
more competitive.
HFM: What can you see the next 12 months holding
for US-based start-ups in terms of challenges and opportunities?
PG: There is going to be a lot of opportunity in the next
year for managers with new or different strategies. If a
’typical’ long/short equity fund launches, it will have a lot
of competition from other existing managers. With that
said, if the manager is doing something a little bit different,
it can go a long way to attract capital.
The operational challenges are going to be derived from
all the new regulations and investor expectations. Things
like Form PF, which comes from the Dodd-Frank Act, are
causing a lot of issues regarding cost and time. In addition,
with the increase in investor demand for more transparent reporting, managers are going to have to invest in risk
analytic software and/or service providers much sooner
than in the past. Managers used to have a free pass for
that level of reporting below $100m, but that has quickly
changed. There is also more of a demand for some level of
daily reporting. We are not necessarily seeing an increase
in demand for full daily NAVs, but we are seeing an increase in portfolio transparency on a daily level and daily
performance estimates.
These increased reporting requirements are driving
up cost, which is creating a greater barrier of entry.
Funds need to start at a higher asset level than was needed three years ago. Although those challenges may seem
daunting, we’ve found that the majority of managers that
have been launching new funds in this environment have
been able to mitigate those issues with careful planning. n
26 H F M W E E K . CO M
025-029_HFMWEEK_HOW2US_ALPS.indd 26
01/03/2013 13:31
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F O R M O R E I N F O R M AT I O N P L E A S E CO N TA C T
v
Emily New ton at +44 (0)207 832 6598 OR email
e.new [email protected]
O R V I S I T H F M W E E K . CO M FO R D E TA I L S
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TECHNOLOGY
H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
ESSENTIAL TECHNOLOGY
BART MCDONOUGH OF AGIO TECHNOLOGY TALKS TO HFMWEEK ABOUT HOW FIRMS CAN ESTABLISH A COST-EFFECTIVE IT SOLUTION,
WITHOUT COMPROMISING ON QUALITY
I
Bart R.
McDonough
is the founder and CEO of
Agio Technology. A noted
thought leader in the hedge
fund technology space, Bart
developed his career around
building and maintaining
superior technology
solutions for some of Wall
Street’s best-known firms
during a time when the
industry’s technological
complexity and data
dependency experienced
exponential growth.
increased competition, more demanding regulatory requirements, and establishing cost-effective
structures with limited capital are all factors that
should be taken into account by emerging hedge
fund managers before launch. And as funds are
tightening their belts in the current environment,
knowing the distinction between an essential service and
one that provides an added bonus, could make all the difference between a business strategy that succeeds or fails.
HFMWeek sits down with Bart McDonough, founder of
Agio Technology to find out what solutions should be considered essential for start-up managers.
HFMWeek (HFM): What technology considerations should be top of the agenda for managers when starting a hedge fund in the US?
Bart McDonough (BM): Starting a hedge fund is surprisingly similar to launching any new business. You want to
preserve capital, move quickly, and invest in technology
that will enhance your current operations to help you grow
your business. Therefore, you need to begin with a list of
essential technology services. This is when it’s important
to separate the ‘must haves’ from the ‘nice to haves’. Far
too often we see managers starting new funds with a ‘must
have’ list that reflects the technology infrastructure of a
10-year-old, multi-billion assets under management fund.
Yes, having all those ‘nice to haves’ would be wonderful,
but what is it you really need?
Once you have your ‘must have’ list of technology solutions, you are now faced with the age-old ‘build/buy/
rent’ conundrum. Again, it is important to remember that
building the robust in-house technology found in more
established funds could very well consume 100% or more
of your start-up’s annual fees – certainly not a plan anyone
would recommend.
Finally, will the decisions about your technology solutions and infrastructure allow you to grow your fund over
time? In a word: are they scalable? If your stripped down
solution saves you money, but cannot grow as you grow,
then you are left with the enormous expense and disruption involved in changing providers. Now is the time to
understand if your solution is scalable.
HFM: What specific technology services would you say
are crucial for start-up hedge funds to have in place?
BM: Hedge funds are not all the same, but every start-up
fund should have the same basic essentials – hosted email,
email security, web defense, file sharing and collaboration,
IT’S A ‘MUST HAVE’ FOR NEW
MANAGERS TO ENGAGE
PROVIDERS WITH DEEP, HEDGE
FUND SPECIFIC EXPERIENCE
”
compliance archiving, and backup and disaster recovery
for all of the previously mentioned services. At Agio, we
offer all of these essentials within SkySuite, an integrated
package of enterprise-class services.
As great as SkySuite is, however, two of the most critical technologies for start-up funds are really e-mail and
telephone services. Providing 24/7 access to skilled technicians who understand technology – and specifically
hedge fund technology – is critical for any emerging fund.
Few, if any, start-ups are staffed with in-house engineers,
and when problems occur, knowing experienced help is a
phone call or email away helps you sleep easier at night.
HFM: Establishing a business structure in a cost-effective manner can be a huge challenge for start-up hedge
funds. How can firms establish an economical IT solution without compromising on quality?
BM: Do not build what you can buy, buy what you can
rent, or rent what you can borrow – sound advice for technology at any start-up hedge fund. Building or buying an
IT infrastructure has three main problems: it spends your
valuable capital, it takes too long, and requires expertise
not central to your firm’s mission. Renting the skilled IT
professionals – employees and contractors – to run it can
be even more problematic.
Partnering with a provider who has the infrastructure,
people and hedge fund technology experience is cost-effective and can have you up and running in less than 10%
of the time it would take with any other solution.
HFM: How has cloud computing changed the way
businesses operate, and what are the advantages of using this solution?
BM: While the cloud may not have changed everything, it
certainly has changed a great deal – most notably allowing
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TECHNOLOGY
H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
technology environment can scale up as quickly and seamlessly as the client, without any interruption or need to
change providers.
Servicing many of the largest and most operationally
complex hedge funds, Agio has the people, processes, and
tools to scale regardless of size or complexity.
emerging hedge fund managers to work from almost anywhere. In many applications the cloud has also significantly reduced costs, especially as it relates to the ‘pay as you
consume’ models that provide greater flexibility. Overall,
the cloud is a win from an economic standpoint.
On the other hand, it has led to some significant data security and privacy issues. While the
Amazon outages have received most of the press
coverage lately, almost all public and private cloud
providers have to cope with these issues. Today,
Agio’s position on the cloud is almost always a hybrid solution, which we’ve seen work best for most
funds in varying situations.
HFM: In what ways is operational transparency
important, and how can it make a difference in
terms of predicting service costs and planning
for business growth?
TODAY, AGIO’S POSITION
ON THE CLOUD IS ALMOST
ALWAYS A HYBRID
SOLUTION
BM: Operational transparency certainly allows for predicting service costs that help with long-term planning,
but it is also critical to ensure the health and reliability
of client systems. With our unique Enterprise Service
Platform (ESP), Agio clients see exactly what we see in
real-time. Our ESP Dashboard provides them with access to what Agio engineers are monitoring and working
on at any given moment, in their environment. Of equal
importance as we mentioned before, is scalability. Agio’s
”
HFM: How can data management solutions
help new hedge fund managers satisfy the
mounting transparency requests from regulators and investors?
BM: The one thing certain about the regulatory environment is that it is changing every day.
Hedge fund managers must carefully select providers who are staying current with all compliance
protocols, and who have the system flexibility to
adjust as new compliance is mandated.
Investors share compliance concerns as well,
and have begun to look for funds with effective control
procedures and carefully structured back-up and disaster
recovery plans. Fund managers should carefully review
their providers’ documentation in these areas, and many
now look for independent verification. For this reason,
Agio recently became the first hedge fund-focused IT service provider to successfully complete the SOC 1 Type 2
SSAE 16 examination for our internal control procedures
and compliance. n
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CC_HFM_V5.pdf
1
3/1/13
11:27 AM
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
COMPLIANCE
IMPLEMENTING A ROBUST
AML PROGRAMME
AS DEMAND FOR ANTI-MONEY LAUNDERING PROGRAMMES AMONG INVESTMENT ADVISERS INCREASES AND IS DRIVEN BY NEW REGULATORY
REFORMS, ZABRINA BARILE AND WENDY TORIBIO-TORRES OF HEDGEOP COMPLIANCE LLC, AN IMS GROUP COMPANY, DISCUSS THE
REQUIREMENTS THAT ANY START UP HEDGE FUND MANAGER WILL NEED TO CONSIDER
A
Zabrina Barile
joined HedgeOp
Compliance, LLC in 2004 and
manages the due diligence
division. She focuses on the
development, growth and
marketing of due diligence
research and reporting
services.
Wendy ToribioTorres
is an assistant vice president
in the due diligence division
of HedgeOp Compliance,
LLC. She has seven years of
experience in background
due diligence investigations
and research.
nti-money laundering (AML) procedures,
already in existence, were further enhanced
by the US Patriot Act enacted by Congress in
2001 to amend the Bank Secrecy Act (BSA),
initially adopted in 1970. The US Patriot
Act requires financial institutions to establish AML programmes to decrease terrorism funding and
money laundering activities.
As the global financial market continues to expand,
regulatory monitoring and reform also continues to grow.
As a result of the regulatory changes following the DoddFrank Act, the Department of the Treasury’s Financial
Crimes Enforcement Network (FinCEN), is now working
on a proposed rule that would call for investment advisers
to implement AML programmes – much like other financial institutions are already required to do. FinCEN’s proposal, which should be made public in early 2013, will also
require investment advisers, including hedge funds, to file
Suspicious Activity Reports (SARs); these filings outline
details of any suspected illegal activity and suspicious or
unusually large transactions. The goal is for investment advisers to assist government agencies in preventing and detecting money laundering activities; these activities could
potentially include insider trading and financial schemes.
DEVELOPING AN AML PROGRAMME
In line with sound business practices and preempting any
mandatory AML requirements likely to take effect later
this year, investment advisers should focus their efforts
on adopting and implementing AML programmes designed to prevent and detect money laundering and any
activity that supports money laundering, finances terrorist
activities or violates the Office of Foreign Assets Control
(OFAC) regulations.
The fundamentals of an investment adviser’s AML programme should be comprised of the following:
• Written policies, procedures and controls which address and identify potential risks. These policies should
take into consideration the types of investors, jurisdiction and the nature of the business relationship.
• Description of patterns and types of activities to be further reviewed and flagged as suspicious and mandating
the filing of a SAR.
• A designated compliance officer/senior manager with
the authority to execute and manage the AML programme and to monitor Know Your Investor (KYI)
policies which are designed to safeguard against iden-
tity theft fraud, money laundering and terrorist financing. Based on a review of any potential risks identified
and any SARs, such designated person may make a determination to accept or decline a prospective investor.
• An employee training programme reviewing AML
policies and procedures of the fund and relevant AML
laws and regulations.
• Periodic independent audit by an external third party/
service provider to review and test the AML programme. Results should be reported and include any
noted deficiencies and areas requiring further followup.
• Record-keeping and documentation with respect to
the AML programme. Some main documents to be
retained include: a copy of the AML written policies
and procedures; documents and checklists reviewed
and prepared during the KYI identification process; all
reported transactions and SARs and records of AML
training sessions and those in attendance.
INVESTOR DUE DILIGENCE
In an effort to detect and prevent terrorist financing and
money laundering, investment advisers should establish
and maintain investor identification procedures and conduct reasonable due diligence prior to accepting an investment in order to verify who their investors are and to ensure that they do not pose a risk to the fund.
The investment adviser may wish to develop an investor
identity due diligence checklist to assist in monitoring any
investor identification controls in place. Such checks, at
minimum, should consist of:
• Collecting basic identifying information like the investor’s name and address; if applicable, obtain their social
security number or tax identification number; confirming if the investor is located in a FATF jurisdiction
• Running a search through the OFAC Sanctions List,
conducting Politically Exposed Persons (PEP) Screening and restricting business with any groups, countries
and individuals that are identified
• Reviewing the fund’s subscription documents to ensure all evidence of identity provided is legitimate and
all related information furnished is accurate. Subscription agreements include investor representations indicating compliance with various federal, state and international laws and guidelines, as well as other disclosure
forms pertinent to AML and OFAC compliance. The
representations should also include a statement noting
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 3
that the source of funds being invested is lawful; if the
investor is a prohibited investor, senior foreign political
figure, or politically exposed person and a statement of
whether the investor is a fund of funds or an entity that
is acting as a representative.
Enhanced due diligence, in addition to standard investor identification procedures, should be conducted when
the investment adviser believes an investor presents highrisk factors for money laundering or terrorist financing.
Some high-risk factors include investors not located in a
FATF jurisdiction; private investment companies based in
a non-FATF jurisdiction; any investor residing in or organised under the laws of, a country or territory designated
by FATF as a non-cooperative jurisdiction; any investor
whose subscription funds originally come from, or run
through, an account kept at an ‘offshore bank’ or a bank organised under the laws of a non-cooperative jurisdiction;
any investor who causes the investment adviser to believe
that the source of its subscription funds may not be legitimate and/or which a SAR has been filed.
CONCLUSION
Noting the FinCEN’s proposal for AML requirements,
hedge funds and investment advisers will benefit greatly
from a robust AML programme. Additional regulatory
reform for the hedge fund industry does not equate to
COMPLIANCE
additional burden. Much of the AML best practices outlined above could be easily achieved with the assistance of
a qualified third-party service provider delegated to:
• Prepare a draft of AML policies and procedures, if they
do not pre-exist
• Assess AML policies and procedures, if already in place
• Review AML processes employed by other third party
providers for consistency
• Test the fund’s AML Programme
• Review investor KYI documents per the investment
adviser’s written procedures or service provider
requirements
• Perform enhanced due diligence and public records
background research for any criminal activity, news
media, regulatory and disciplinary information that
might be available on any investor presenting a high
risk of money laundering or fraud or at the request of
the investment adviser
• Screen select investors against 300-plus sanction and
AML watch-lists
• Develop a report identifying any potential risks and
AML procedures carried out
• Conduct AML programme staff training
• Assist in suspicious activity reporting and filing
• Maintain records of all reported transactions, SARs
and AML training. n
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Untitled-2 1
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01/03/2013 16:17