Choosing appropriate service providers is one of the cornerstones to creating a successful hedge fund business.
All too often, start-up managers try to appoint the big, bulge-bracket names but this is folly. Unless the manager in question has existing relationships with the likes of Goldman Sachs, and is launching with USD250 million or more in AUM, they will have precious little chance of becoming clients of the industry's leading asset servicers.
So the first thing to consider at the pre-launch phase is: who would be the best service providers to support you relative to the size of your fund?
"If you're launching a USD20 million fund you may not need the largest law firm but select a law firm that has the experience drafting fund documents and understands fund related issues. Mid-market and smaller law firms are fine for small start-ups. But don't hire a family attorney or a law firm that has experience with only a limited number of hedge funds; they may not be current with recent developments affecting the industry," asserts Anchin, Block & Anchin's Jeffrey Rosenthal (pictured).
With respect to the auditor, managers should select one that can offer a cost-effective service and has a good industry reputation and experience. If the manager intends to become a registered investment adviser with the SEC, the auditor needs to be registered and inspected by the PCAOB (Public Company Accounting Oversight Board).
"The same applies to the prime broker and fund administrator. Partner with those that are the most cost-effective for your business needs and have deep knowledge with respect to the securities that you will be trading in the fund. There should also be a cultural fit," adds Rosenthal.
Given that the Prime Broker and Hedge Fund Administrator are integral partners, they will be the focus of this chapter.
Prime brokerage considerations
There are many criteria to think about when drawing up a short list of potential Prime Brokers but some of the more salient issues to consider would tend to include: alignment of interests; experience of the PB team; soundness of operational infrastructure; robustness of technology offering; platform stability; custodian and capital introduction capabilities, and finally the financial strength of the PB.
Have a proper business plan
Before a new manager embarks on meeting with Prime Brokers, they should ensure that they have a solid business plan in place. They need to evidence that they have a long-term vision, and a roadmap to grow the business over successive years. The business plan should also clearly articulate the investment strategy.
"The more information we have the better prepared we are when it comes to making a decision on whether to make a proposal to the manager, and what the pricing of that proposal should be. Just blindly meeting a manager and then agreeing to take them on as a client is not something that we would ever entertain," explains Jack Seibald, Global Co-Head of Prime Brokerage, Cowen Prime Services.
By having a proper business plan, it will give the sales team at a prime brokerage the ability to gain a deep understanding of exactly what the manager plans to do. They will need to know precisely what asset class(es) will be used in the strategy, the types of securities to be traded, degree of leverage, and the extent to which the strategy will employ short positions.
BTIG has built a prime brokerage division on the foundation of helping emerging managers launch their funds. It has assembled a group of experienced prime brokerage professionals, many of whom have spent the majority of their careers at bulge bracket Prime Brokers where they've garnered experience working on complicated fund strategies and structures.
"We educate ourselves in every facet of the manager's business including understanding the fund's strategy, the manager's longer term business plan as the fund grows and even the names of other service providers the fund is engaging (Legal, Auditor, Administrator, etc.)," explains Justin Press, Co-Head of Prime Brokerage at BTIG.
"We also want the manager to explain how they manage and monitor risk, as well as gauge how they will handle Compliance. Lastly, we ask a pertinent yet simple question, `What is important to the fund in selecting a Prime Broker?' By understanding what the fund is looking for in their Prime Broker, we can make a determination if BTIG's platform is aligned with the needs and requirements of the manager."
Prime brokerage agreement
All of this information then goes into the producing the Prime Brokerage Agreement. "We make a proposal based on the parameters provided to us by the manager," says Seibald.
The pricing structure offered by the prime broker, as detailed in the Prime Brokerage Agreement, has become a more sensitive issue in recent times because of the impact of Basel 3 regulation. This is causing banks to more closely scrutinise how they are utilising their balance sheets. As such, every Prime Broker needs to have a clear understanding of the revenue stream they can expect to get from any new client they onboard. After all, there are only a limited number of ways that a PB can generate revenue.
"One is through trading activity and the other is through the financing revenue that might accrue through the use of leverage and the use of shorting. If a sales person brings in a prospect we encourage them to fully understand the investment strategy and whether, from Cowen Prime's perspective, it's worth allocating resources to an account," says Seibald.
"It's important for us to be intellectually honest with ourselves and our prospects. We have to be mindful of the resources we will be allocating to any new manager and properly service an account and if the strategy is one that is not conducive to a revenue stream required to cover the cost of servicing that account, obviously it's not going to be worthwhile pursuing."
When asked what some of the typical mistakes made by new managers when selecting a prime broker, Press comments: "A mistake we have seen is assuming the brand name of a provider alone will attract investor capital. It is important to work with service providers that have experience in Prime Brokerage, but hedge fund managers should make sure their interests are also aligned with the Prime Broker with which they partner. A fund can be overlooked if they are managing a USD50m fund on a Prime Brokerage platform where the average client size is USD500m‑plus.
"The manager needs to assess if the Prime Broker is truly interested in a long-term partnership and not just short term profitability."
Capital introduction
The one thing on every manager's mind when selecting a Prime Broker is capital introduction. Some Prime Brokers have made a bigger commitment to this service in terms of the size of their capital introduction teams but the number of people allocated to do this work doesn't necessarily equate to a successful capital introduction service; sometimes it is more of a marketing tool to try and win new mandates.
"Our approach is that an investment with a manager has to stand on its own merit. It ought to be based on the manager's strategy and verifiable performance track record. It's important to understand that in our capital introduction effort we represent the asset allocator, not the Prime Brokerage client," says Seibald.
This is an important point. Managers tend to assume that capital introduction is a value-added service that is there to serve them and deliver investors on a silver platter. The reality is quite different.
"Don't rely on Prime Brokerage capital introduction teams to be the primary source of asset raising. Rather, rely on them for consultative services; pick their brains on the trends they are seeing, what are they hearing from allocators, to set your business up as best as possible," emphasises EisnerAmper's Frank Napolitani.
To clarify, a capital introduction team will need to understand the investment strategy and verify the relationship between the performance track record and the investment strategy. This will allow them to articulate it to an audience that has an interest in that type of strategy.
"Our capital introduction team truly digs in to a manager's strategy and results and effectively becomes an extension of the manager so that when they go out to the marketplace they are fully prepared to answer any questions and concerns that investors might have," says Seibald.
Fund administrator considerations
There are in excess of 100 different Hedge Fund Administrators so uppermost in any manager's mind has to be ensuring that the one they finally opt for will be the one that can best support their strategy without issue.
As such, technology capabilities are a key factor in the selection process. Where this is most valuable, and where managers will typically find variations among administrators, is technology that facilitates the delivery of data to the manager and to the investor. The manager needs the ability to draw down data ad hoc in real time for portfolio management purposes. Does the administrator have a portal for supporting this? Equally, for investor reporting, does the administrator provide an online portal for investors to access fund documents, K1 documents etc.?
Every administrator will, of course, say that they have great technology. But that means nothing. The key is validating it. So talk to clients of those administrators on the short before arriving at a final decision. Find out how they receive their data and what the quality of reporting is like.
Expertise
Ascertaining a Hedge Fund Administrator's expertise should not be underestimated. After all, they are the one who ties all the service providers together (legal, prime brokerage, auditor, custodian). When the manager's auditor conducts its annual audit it will work with the Hedge Fund Administrator to get the information they need in order for them to prepare the audit and sign off the financial statements.
Legal counsel will be involved in drafting the legal documentation that outlines the investment guidelines the manager needs to follow. And it's within those documents that the administrator sets out the fund's criteria; what the fund expenses will be, how they will be allocated, what the investment parameters are. Subscription documentation prepared by legal counsel is another key document that the Hedge Fund Administrator needs for transfer agency as investors allocate into the fund and redeem out of it.
Managers should therefore do their homework to determine the types of hedge fund strategies that the HFA works with, how long they have worked with those funds, the size of the funds, the suite of middle-office reporting services that are available, and also look at the assets under administration: have they grown in recent years, have they plateaued or have they contracted?
People
This relates to the size of the team and the amount of employee turnover. Before a manager appoints a Hedge Fund Administrator they should talk to people within the firm, find out how long they have worked there, what the attrition rate is, and what the overall work environment is like.
"One question to consider is, `How many resources does the administrator have for supporting a fund's tax requirements?' Tax and regulatory services are an important consideration for the manager because the administrator is really in the best position to keep on top of regulatory changes such as AIFMD, FATCA, Common Reporting Standards, Form PF, etc," suggests Bob Kern, Executive Vice President at U.S. Bancorp Fund Services.
Financial strength
The stability of a small administrator is not going to be as strong as an administrator with scale: i.e. one with USD100bn or more in AuA. A firm at that level has made a commitment to technology, to its people, and will have the ability to support the manager through thick and then. As such, any new manager should evaluate the strength of the administrator's balance sheet and its financial stability; especially if they are a non-bank owned organisation.
"Financial stability of the Administrator is critical. One of the things you want to avoid after selecting a Hedge Fund Administrator and launching your fund is to discover that the HFA has collapsed for one reason or another. It impacts the manager's ability to raise capital, is transparent and concerning to the investors and places operational strain on the Investment Manager to replace the Administrator," says Dennis Westley, Managing Director (North America), Apex Fund Services.
The HFA's ownership structure should also be considered. There are plenty of excellent bank-owned fund administrators but there might be some restrictions on the counterparties they work with. "Independent, private administrators have the ability to do unrestricted work with counterparties, which is important to know," adds Westley.
Consultative approach
A good HFA is one that engages with the manager in a consultative manner. Do they have the right technology and the right talent in place that understands the strategy, asset class, and speaks the same language as the asset manager? After all, a manager might initially launch with a global macro strategy and then diversify his product offering over time to include variants of the strategy, different fund structures, managed accounts and so on. Knowing that the HFA will support them on this journey, not stymie them, has to be confirmed at the outset.
Often, new managers get carried away with their AUM targets and will try to gravitate towards tier one HFAs. But Kern believes they should take a more considered approach to selecting the ideal administrator:
"If they are going to launch with less than USD100m they are unlikely to court the interests of tier one administrators. What we have seen is certain asset managers that do go down that road are not receiving the expected level of service. Tier one administrators sometimes do not have the appetite for start-ups and these managers tend to find that out fairly quickly when they enter into initial discussions."
Shadow accounting
Whether start-ups should do their own shadow accounting is open to debate. Those managers that run a shadow book tend to be the largest players where they will hire two administrators, one to perform the primary duties and the second to perform shadow record keeping.
At the middle end of the spectrum, says Westley, managers would hire a team internally to provide oversight on the administrator and at the lower end of the spectrum (start-ups) managers would rely exclusively on their appointed administrator to produce the books and records, with little or no oversight.
"The recommendation, from my perspective, is to be somewhere in the middle but there is a cost implication to this and it also depends on the size and strategy of the fund. A USD50m equity long/short fund with five investors and limited trading would not necessarily require an internal team to perform shadow accounting.
"But for a more sophisticated portfolio that trades more frequently and maintains a higher number of investors, it may be in the manager's best interests to have a second pair of eyes in place; not necessarily to do full shadow accounting but to employ some oversight of the books and records on a regular basis to ensure they are accurate and the Administrator is performing as expected."
Key performance indicators
Rarely do managers ask for references before appointing an administrator. In Kern's experience, this is something that managers should pursue. But asking to speak to a couple of existing clients, running similar sized strategies, on the quality of service, the accuracy of calculating the NAV and reliability of fund reports etc., can be beneficial and offer the manager invaluable insights.
"Managers should be asking the fund administrator about their service metrics and service quality management and their reporting programme. Certain items like when do they get K1 documents out? When are they delivering their monthly reporting package? What are the value-adds that are provided in that package: timeliness, NAV accuracy, etc.
"We often share service metrics with our clients to demonstrate the level of service we are providing to help them optimise their fund's performance," says Kern in conclusion
