The ICFA Alternatives Panel 2010

Transcription

1 The ICFA Alternatives Panel 2010 ON THE PANEL: xxxxxx ON THE PANEL: Dermot Butler, Sébastien Danloy, Joan Kehoe, Toni Pinkerton and David Whelan Dermot Butler Chairman, Custom House Global Fund Services Sébastien Danloy Global head of sales and relationship management, Societe Generale Securities Services Joan Kehoe Chief executive officer and founder, Quintillion Toni Pinkerton Global head of fund administration, Maples Finance David Whelan Managing director, Admiral Administration 40 August/September 2010 icfamagazine.com

2 With controversial new regulation upcoming and having survived intense challenges throughout the financial crisis, the alternatives business looks set for radical shifts. ICFA asked five service providers their take on where the industry is headed. ICFA: What will be the main impact of the Alternative Investment Fund Managers (AIFM) Directive? BUTLER: Any answer to this question will be speculation, because we haven t yet seen the final text of the directive. It now looks as if the earliest that a compromise can be reached will be around the first week of October. There are an extraordinary mixture of pressures between the European Commission, the European Council and the European Parliament. Furthermore, while it is likely that there will be a compromise some time in the next two or three months, the possibility of a complete breakdown is still on the cards. But whatever eventually happens, the directive will probably increase demand for European Union (EU)-domiciled funds, including Undertakings for Collective Investment in Transferable Securities (Ucits), which will benefit all Irish service providers. Danloy: The AIFM directive will establish the strict regulation of non- Ucits assets managers. It will require authorisation from the home member state regulator. Alternative investment fund managers will be subject to operating conditions and they should, among others, display their operational activities, like arrangements for governance, risk management and liquidity management. Moreover, alternative investment fund managers should report regularly and periodically to regulators and investors on various matters and alternative investment fund managers should have minimal capital requirements. Providers of alternative investment fund management would also be regulated. Firstly, the valuation should be independent and the directive would provide regular valuation requirements for all alternative investment fund managers. Secondly, the statute of the depositary, and particularly the missions and the liability regime, would be clearly tackled by the directive. Moreover, conditions of commercialisation of alternative investment funds domiciled outside the EU would also be governed by the directive. The directive could also have a big impact on the fund administrator business model if the European Council version is voted for. The independence of the fund administrator was not defined in the first draft of the directive. Since that, the European Parliament and the European Council have drafted different versions. However, at this stage, the version proposed by the Belgian Presidency of the Council in August is not clear and the AIFM directive continues to be discussed by the member states, the European Commission and the European Parliament. Kehoe: While a great many criteria in this directive, even infrastructural criteria such as the status of the Cayman Islands, remain unclear, what is certain is that the standard of compliance and reporting will be elevated to a higher level. For administrators, as for managers, this will impact directly on the responsibilities and scope of services particularly around risk and reporting. The development and delivery of AIFM directive standard reporting requirements will be the key for administrators in this regard. PINKERTON: While discussions have resumed after a summer recess and some positive compromises in favour of the hedge fund industry seem to be emerging, the most significant issues that threaten the international passport that hedge funds and investors currently enjoy remain unresolved. While some non-eu managers have launched parallel structures or re-domiciled to European jurisdictions, most are maintaining the status quo pending the final outcome of the directive. The prevailing objectives of the directive, to increase transparency and improve systematic risk assessment, are undisputed and the implications are clear. Requirements for more onerous reporting and independence impose challenges on fund managers who may not have the infrastructure and technology to support the new requirements. These challenges create opportunities for fund administrators who can provide scalable outsourcing solutions, partnering with fund managers to deliver performance and transparency. Whelan: With a number of key provisions to be agreed, the main impact of the proposed directive cannot be fully assessed. However, one significant impact will be the cost of operating a hedge fund marketed within the EU, regardless of the domicile of the manager or of the investment vehicle. The imposition of stringent valuation, capital and transparency-reporting requirements on managers will effectively increase the cost to operate as a fund manager. The cost of increased regulation and the possibility of increased liability attributable to the fund s service providers is likely to result in increased operational costs being passed on to the fund. ICFA: How is the use of multiprimes, which has risen following the 2008 collapse of Lehman Brothers, affecting operational aspects of fund administration? Butler: Hedge fund managers with circa $200 million or more have used multi-primes for several years now. As such, the greater use of multi-primes should not affect the operational aspects of fund administration to any great extent. Having said that, obviously there is more work involved, but if the administrator s systems are adequate, this should not present any major problem. international custody & fund administration 41

3 Danloy: The main challenge of multi-primes use is the integration and consolidation of the information received from the various prime brokers. Once you have established links with the prime brokers and are using a flexible system that facilitates automated reconciliation processes and information consolidation, the impacts are very limited. Kehoe: We have certainly seen a noticeable increase in the desire for a multi-prime environment from our clients, even smaller funds that traditionally would have used a single prime broker. At Quintillion we have always dealt with multi-prime broker relationships and it is not really new or an issue for us at all. It is important to have open architecture in place when it comes to the infrastructure and technology you use and to employ an advanced model that is geared to a frontto-back multi-prime broker model, both in terms of a reconciliation environment and reporting to clients. What is very important, and even more so in a multi-prime-broker world, is the frequency of reconciliations that are performed between valuations. Administrators must have in place a daily processing environment that allows for independent cash and position reconciliations to be performed and this type of model has certainly gained more traction in the current environment. Pinkerton: The transition to a multi-prime environment to mitigate counterparty risk following the collapse of Lehman and the bail-out of other institutions also deemed too big to fail is just one component of an evolution in the hedge fund space that is forcing managers to consider significant investment in infrastructure and technology. Demands from regulators and investors for increased transparency and reporting are also straining resources of fund managers and diverting their attention away from their core competencies: sourcing deals, managing portfolios and securing performance. Fund managers are now looking for outsourcing partners who can provide this infrastructure, including platforms for trading operations and extending through to middle- and back-office support. Specifically in relation to a multi-prime environment, fund administrators are well equipped to seamlessly integrate trade and market data flowing to and from multiple and diverse sources to generate consolidated reporting and position level transparency. Whelan: The use of multiple prime brokers by hedge fund managers to reduce counterparty risk has not only risen but is now commonplace. It is important that administrators have the technology in place to report and reconcile holdings on both an aggregated and a segregated basis. Doing this efficiently can be challenging for administrators that do not have an automated solution in place to retrieve data from the prime brokers, and do not have a centralised data warehouse to store this counterparty data. If an administrator has to introduce a manual process to accomplish this, then the speed at which this information gets produced goes down and the internal cost goes up. ICFA: How will consolidation in the alternative fund administration business play out in the short to medium term? Butler: In the last few years we have seen the arrival of a plethora of small fund administrators, particularly in the US, and I would expect that the next stage of the consolidation in the alternative fund administration business will be the acquisition of small to medium-sized ($10 billion to $25 billion of assets under administration (AUA)) administrators by larger administrators. There is also obviously an appetite for larger deals, as demonstrated by the Credit Suisse acquisition of Fortis fund services business. However, it is likely that the top 10 administrators will, as in any business, account for 75% 80% of hedge fund assets. The consolidation will, primarily, be medium-sized firms acquiring the smaller firms, almost like a steroid, to build up their AUA, which will then, presumably, make them more attractive for the behemoths, and so the cycle continues. Danloy: We feel that there will be significant consolidation within the alternative fund administration business in both the short and medium term. Clients will want to work with strong well-capitalised financial institutions like SGSS that offer the full suite of fund services, that is the one-stop-shop solution for all client needs. The industry consolidation is inevitably going to lead to the takeover of smaller providers by larger, more established institutions. With our well-established reputation and industry experience, strengthened by recent global alliances, we feel that SGSS is very well placed to grow further and to benefit from the industry consolidation. Kehoe: I clearly have a different perspective on this to many others but, from where I m sitting, it s an opportunity. I believe smaller administrators with strong technology and expertise can provide an alternative to the behemoths that are now being created. There are still many decent-sized managers out there who place a value on having an expert, client-centric team dedicated to their relationship. There is no doubt in my mind that the degree of consolidation under way at present will lead to a dilution in responsiveness and service levels for many mid-sized managers who just won t represent a big enough revenue number to command attention. Some recent acquisitions have been strategic in gaining access to new jurisdictions such as Ireland in anticipation of potential opportunities in Europe pending the outcome of the AIFM directive Toni Pinkerton 42 August/September 2010 icfamagazine.com

4 Pinkerton: Historically, the volumedriven, highly automated environment of traditional onshore mutual fund servicing was separate and distinct from the servicing of alternative hedge funds, the latter characterised by complex derivative instruments, intricate onshore/ offshore fund structures and nonroutine performance fee calculations. Convergence of service providers in these distinct markets fuelled the first wave of consolidation, which sought to leverage congruent processing capabilities and capture new market share. More recently, driven by investor demand and regulatory reform, further consolidation continues. The evolution of hedge fund administration from traditional monthly net asset value (NAV) calculation to a full outsourced solution for fund managers has driven up the cost of implementing and maintaining technology, driving some smaller players to merge with larger counterparts. Some recent acquisitions have been strategic in gaining access to new jurisdictions such as Ireland in anticipation of potential opportunities in Europe pending the outcome of the AIFM directive. Still further consolidation is driven by administrators looking to fill gaps in service offerings as they transition from traditional services to full outsourcing solutions. According to the 2010 ICFA Alternative Fund Administration Survey, the top five hedge fund administrators account for 65% of hedge fund AUA. While the trend towards consolidation is likely to continue as fund administrators continue to make strategic plays into new markets and services, the divergence between these very large players and the specialised, independent offerings of the smaller administrators will continue to address the diverse and evolving requirements of the industry. Whelan: The demands on administrators have never been greater. Managers are demanding better reporting solutions at lower costs and investors are demanding more transparency into both the funds positions and the administrators internal controls. Since there are more players than ever before in the administration industry, Some of the methods we have put in place in terms of trade processing, especially around the overthe-counter piece, have been a huge leap forward in eliminating manual processes Joan Kehoe one can assume that these additional costs of operation will result in mergers among the small and medium-sized administrators. Administrators with strong balance sheets but weaker technology will acquire administrators that have already made the investment in systems. Likewise, technologysavvy administrators in a strong financial position will acquire weaker administrators for their book of clients. ICFA: How important is the trend towards automation of key manual processes for fund administrators? Butler: The trend towards automation of key manual processes is critical. In the interests of, inter alia, efficiency and accuracy and reduction, the automation of all is essential, not just key manual processes. This includes not only the creation of a broader range of reports and the efficient delivery of those reports, but also the development of full middle-office services, as well as tools to verify prices and the existence of assets. Danloy: Increase in automation has always been a key target at SGSS. Automation will improve integration of data from the fund administrator and depositary, and the information will be dispatched to all our subsidiaries. This means safer and quicker flows to our clients. Nevertheless, manual processes are sometimes the best way to deal with some requests. Kehoe: From inception, Quintillion has advocated the use of technology to automate the core fund administration processes. This has obviously been made easier by the fact that we had a blank sheet of paper when we started and no legacy issues that needed to be dealt with. Instead, we could implement some innovative approaches to areas that have traditionally been quite onerous and manually intensive. Some of the methods we have put in place in terms of trade processing, especially around the over-the-counter (OTC) piece, have been a huge leap forward in eliminating manual processes. On top of this we have built out a suite of our proprietary tools called Q-Rec, which has made the daily reconciliation of cash, positions and profit and loss (P&L) numbers much easier. The simple truth that I have learnt in the last 20 years of working in this business is that manual processes lead to mistakes. It makes more sense for administrators to employ staff to investigate exceptions and focus on the clients issues rather than spending their days inputting data into spreadsheets. They must invest heavily in technology and in the people using that technology to create a scalable environment. It might be a model that works for others, but we fundamentally do not believe in outsourcing this to India or Poland, which have traditionally been more manually intensive environments. Pinkerton: The automation of key processes for fund administrators in the current environment is critical. As a direct result of the liquidity crisis, there has been a marked shift in the balance of power from the fund manager to the investor, which is being reinforced through regulatory reform across all of the key hedge fund jurisdictions. New demands are being placed on fund managers to deliver greater transparency, improved liquidity, independence and risk management, in addition to generating returns that exceed relevant benchmarks. At the same time, while we are seeing investors re-enter the market, they are cautious and fund launches are 44 August/September 2010 icfamagazine.com

5 smaller than they were two years ago, putting added pressure on fund expenses including management and service provider fees. In order to meet these demands, managers are leveraging relationships with fund administrators with scalable technology platforms with highly sophisticated integration tools that allow for the effective automated processing of data flowing to and from a diverse array of managers, prime brokers and market data vendors, to deliver transparency through comprehensive portfolio and risk reporting. Whelan: Automation of processes is vital for two reasons. First, demands on administrators to collect more data from more sources (for example, positions from multiple counterparties, pricing data, reference data) are ever increasing. As a result, administrators need to have an automated solution in place to efficiently collect and reconcile this data in order to deliver it in a timely manner. Second, the labour cost of collecting and reconciling this data is very expensive if the process is not automated. Even if an administrator can get the job done using manual processes, they probably cannot economically compete with administrators that have implemented automated solutions. ICFA: As more hedge funds are launched under the Ucits format, what challenges does this present for fund administrators mandated to service these investments? Butler: The administration of a Ucits fund is not, essentially, much more complex than the administration of a hedge fund. Indeed, in most cases it is less complex because of the investment restrictions that have, to date, limited Ucits to effectively long-only funds. The ability of certain hedge funds to operate utilising swaps (or similar structures) to cover their short trading activities does add complications in valuing the swaps. Another component of a Ucits fund is its liquidity, which means that administrators have got to be able to create NAVs at least twice a month and, for most Ucits, on a daily basis. The main challenges, however, are to comply with the Automation will improve integration of data from the fund administrator and depositary, and the information will be dispatched to all our subsidiaries Sébastien Danloy regulatory reporting procedures, which are more intensive than for a qualified investor fund, special investment fund or public investment fund. It is obviously important that administrators ensure that the fund they are administering complies with the Ucits regulations and that they are comfortable with the pricing methodology used to value the swaps or other derivative instruments used to create the short side. Danloy: There are indeed a lot of hedge fund managers that launch Ucitscompliant products. These products tend to mirror existing offshore funds but follow the investment restrictions that surround Ucits structures. At the same time, there are fund-hosting platforms that are established by prime brokers and large asset management companies, and that allow hedge fund managers to benefit from the administrative and regulatory support of large and well-established household names. For fund administrators, there are several challenges that arise. The first one is a more established use of OTC products that are difficult to value independently unless you have built an in-house independent OTC pricing team. The second one is a larger number of operational relationships with small to medium-sized asset management companies that need to be established. There can be simultaneous requests that need to be handled by the operational integrations and IT teams and this can sometimes be a heavy process. Finally, the compliance process is more complex as your fund administrators need to understand various different and sometimes complex investment strategies. Kehoe: One of the most immediate changes to come about is the frequency of producing an NAV with intra-month liquidity a minimum requirement. There is no doubt that the marketplace is moving towards weekly or indeed daily liquidity. From our perspective, we have always tried to operate a daily processing environment for most of our clients when it comes to producing P&L numbers or reconciliations, so the need for additional liquidity is not a huge leap for us. Again, the type of infrastructure and technology you have in place is critical for this to operate successfully. There can also be considerable work when it comes to providing more in-depth reporting to clients both in terms of investment holdings, exposures, risk, and so on. Pinkerton: Many administrators that focus on the administration of offshore hedge funds do not have a presence in the EU where regulation requires fund administration to be performed in-state. This is a significant barrier to overcome, and may result in further consolidation in the industry as mergers and acquisitions are considered and effected to gain exposure to European markets and products. This also creates opportunities for fund administrators with a presence in Europe. These administrators will have the infrastructure and technology in place to deal with the more frequent onerous reporting requirements relating to Ucits. Whelan: The greater operational demands of servicing a Ucits product in meeting the challenges of shorter trading frequencies, enhanced reporting requirements and adherence to the prescriptive rules governing Ucits furthers the need to automate key operational processes. As the lines between traditional and alternative trading strategies employed under the Ucits umbrella become blurred, administrators must ensure they international custody & fund administration 45

6 have a robust scalable operating model underpinned by a strong technological platform to address the inherent challenges of servicing such products. ICFA: How are fund administrators coping with hard-to-value instruments and are any standard practices being developed? Butler: There is no doubt that, post- Madoff, there has been a more aggressive approach to instigating a pricing policy for funds, which is essentially an agreement between the administrator and the manager as to how assets should be priced in different market conditions. That policy is then documented and reviewed, and approved by the board. From the administrator s point of view, assuming they understand the structure of any complex instruments, which is critical, then the most important factor is that a written procedure exists as to how these instruments will be valued. This should have existed for most funds before the financial crisis, but didn t in many cases. That is one change. The ability to list some of the more exotic derivative instruments on exchange or have them cleared as widely mooted, will help in the process, although it is still the case that two equally qualified people can value one of these instruments totally differently. Therefore, it is still an art, rather than a science. The science is to ensure that the administration, the manager and the board have reviewed the procedures, are satisfied that they are reasonable and the administrator must ensure that they are complied with. So I suggest that the new standard practices are that every fund will have disclosed procedures, but those procedures are still likely to vary from fund to fund. Danloy: Any administrator can value vanilla products, but when it comes to the more challenging OTC and structured product world, many fund administrators are still finding it extremely challenging to price hard-to-value instruments. This is mainly due to the variety and complexity of products that exist. Considerable time and expertise is required to study the term sheet, so that the products can be set up within the various applications being used by administrators to accurately value these instruments. We at SGSS have an existing infrastructure and expertise, and have been providing accurate valuations for such products for the last six years. During this time we have accumulated more than 50 clients for which we are providing daily, weekly and monthly valuations for hard-to-value instruments. We provide an end-to-end solution that comprehensively covers all asset classes and instrument types in the world of OTC derivatives and structured products. We can offer a one-stop service for the support of OTC derivatives and structured products, but we are also demonstrably flexible and offer a plug and play solution that enables managers to meet current and future alternative needs with reduced operational risk while meeting regulatory requirements. Kehoe: It is obviously crucial to remain independent when it comes to the valuations process and therefore using a specialist vendor ensures the administrator remains independent and does not generate a conflict of interest in terms of pricing the fund s portfolio. Where a specialist vendor that we work with, such as Markit, is unable to ascertain a valuation, it will often fall to a pricing committee to provide a mark. It is very important to work upfront with the manager to establish a comprehensive policy to provide for a transparent Valuation will always be a fundamental challenge within the industry, particularly of esoteric, thinly traded or hard-to-value securities David Whelan valuation process of all the investment positions in the fund s portfolio. Consistency of approach in the process is very important. Alongside this, it is very helpful to provide transparent reporting to both managers and investors that is able to break down price sources for each position in the portfolio, be it vendor-priced, a counterparty mark or a pricing committee price-splitting out the number of prices for each price source and the percentage of the fund priced in this manner based on gross and net exposure. Pinkerton: It is challenging to impose standard valuation practices on hedge funds given the diversity in investment strategies and the wide range of instrument types comprising the underlying portfolios across the industry. Industry associations such as the Alternative Investment Management Association and the Managed Funds Association provide guidelines for best practice, but it is the ultimate responsibility of the directors, general partner or other governing body of a hedge fund to establish and oversee policies and procedures for valuation as they apply to the instruments held by the fund. While, in practice, the NAV calculation and the valuation process are delegated to the administrator, particularly with respect to hard-to-value instruments, there is interaction among the administrator or valuation agent who brings independence, the manager who brings market expertise and the directors or general partner who contribute to the establishment and oversight of delegated functions through good corporate governance. Whelan: Valuation will always be a fundamental challenge within the industry, particularly of esoteric, thinly traded or hard-to-value securities. The investment manager and directors of the fund cannot be far removed from this process and need to ensure a clearly defined valuation framework is implemented. It is necessary for the administrator to establish internal valuation processes to ensure compliance with the fund s valuation policy and best practices. 46 August/September 2010 icfamagazine.com