GoCommentary
As a leading independent provider of fund administration services to global clients representing hundreds of distinct hedge and mutual funds, GlobeOp is uniquely placed to identify and comment on trends and developments in the hedge fund industry, financial services sector and overall financial markets.
GoCommentary offers views drawn from the extensive hedge fund and Wall Street experience of GlobeOp's management team.
- 14 Jun 2010 | Vernon Barback, president & COO | Operational Due Diligence – Early and often is key for investors
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A widely-quoted study once estimated that more than 50% of hedge fund losses were due to operational issues. (Capco 2003, re-quoted Edhec 2004)
These are losses you can control. Just as the investor’s business plan drives the choice of fund strategy, and individual integrity and performance drives the choice of fund manager, early and regular due diligence into the quality of a fund’s operational structure can prevent or mitigate future headaches.Research in this area should be as comprehensive as it is for strategy and manager selection. A strong operational structure, managed by an independent third party, can help mitigate operational risk and provide transparency about the manager adhering to the agreed investment principles.
Recent GlobeOp statistics confirm that investors enlightened by the recent financial turbulence increasingly consider a fund’s administrator their partner.
- GlobeOp saw a 30 percent increase in due diligence meetings with investors, as well as a significant increase in the sophistication and the number of questions asked
- Pricing, asset verification and payment wire controls are key concerns
- An increased demand for additional detail and supporting data
- On-site investor visits to GlobeOp facilities doubled in the last 18 months.
In the spirit of solutions & best practice, below are 10 operational areas where investors should conduct personal, demanding and thorough due diligence.
1. Read ALL legal documents. Check there is no conflict between the terms of the private placement memorandum (PPM) and other documents.
2. An authorized written valuation policy should be available for review.
3. Conduct personal, detailed due diligence on all counterparties, including prime brokers, derivatives counterparties and the administrator. Check the creditworthiness of the administrator.
The next points relate specifically to administration due diligence:
4. Is the administrator truly independent, free of conflict created by other trading, lending or custody activity?
5. Is the size of the fund manager mandate appropriate for the administrator? Mandates exceeding 10 -15 percent of current assets under administration (AuA) can increase the risk of client domination, and of significant impact from any uncapped litigation related to the fund.
6. Is technology a source of innovation and target of continuous investment? The market will continue to require robust, scalable new solutions.
7. Are processes subject to a controlled environment? Is real-time transparency accessible to investors and administrator management? Ask for a demonstration.
8. Is there a clear program to develop domain experience and scale in the administrator’s human resource pool?
9. Visit off-shore teams and operations. Ensure they are all integral and adding value to operations.
10. Ask for a personal presentation of the SAS 70 Type ll audit. This should cover the entire year and include all the services, controls and offices the investor and fund manager require.The recent financial crisis, Madoff-related events and hedge fund capital-raising activity shifted a greater balance of power to investors …….and brought the issue of operational risk management to the fore in people’s thinking. That’s a very good place for it to stay.
- 01 Dec 2009 | Jon Anderson, head of Valuations & OTC Derivatives | Independent Valuation - Trust but Verify
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As markets evolve in response to the turmoil of 2008-2009, institutional investors – pension funds, endowments, family wealth offices – other buy-side institutions and their stakeholders are turning a sharper eye toward valuations. There is distinct and certain change on the 2010 horizon.
Investment committees that previously focused on analyzing alpha and risk from investment managers’ figures now demand increased comfort around the accuracy of the positions and valuations underpinning net asset value (NAV) statements. Transparency into the price determination process is becoming a standard requirement. References to “valuation policies”, “manager marks” and “single source pricing” are now routine during valuation committee meetings. “Appropriateness”, “consistency” and “verification” are the new watch words. But how can institutional investors be confident in the veracity of fund portfolio valuations? “Trust, but verify” will be become the institutional mantra in 2010.
Valuation committees increasingly seek independent proof that portfolio pricing is being scrupulously and independently checked with custodians, prime brokers and counterparties. The institution’s auditors echo this demand. And while regulation has not yet been finalized, it is clear regulators will require more data, not less. All seek confirmation that pricing methodologies are accurate, timely and appropriate.
As they seek to better understand where pricing discrepancies occur, and determine corrective actions and process improvements, valuation committees need clear, customized data. To strengthen oversight and increase transparency, many are now turning to independent valuation service providers for exception-based management reports. Independence, product coverage, pricing accuracy and consistency, plus aggregated and customized reports, are key service provider criteria. Expertise, scale and robust process controls are also essential to verify large protfolios of trades. Detailed support must be readily available for analyses of differences at the position level.
Reporting requirements vary – daily, weekly, monthly – and customization typically includes filtering price discrepancies according to staleness, lack of price availability and prices outside tolerance boundaries
Best practice is emerging quickly. Valuation verification agents ideally aggregate third-party vendor prices with pricing information obtained directly from sources such as counterparties, prime brokers and hedge fund portfolio managers. As a control, they should also calculate prices independently using commonly accepted models and independently sourced data.
Independent valuation policy monitoring and price verification are proactive steps that can reassure investors and other stakeholders, and demonstrate institutional commitment to the highest standards of governance.
- 20 Apr 2009 | Hans Hufschmid, CEO | Managed Accounts - Effective Design & Support Key to Success
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Managed accounts are used by institutional and private investors as an alternative to direct hedge fund investment. This option allows investors greater control over assets and increased portfolio transparency. Accelerated investor interest is now being driven by gates or similar redemption limitations imposed by hedge funds in 2008, the logic of independent valuation, and by the lack of independent asset verification at the core of Madoff-related events.
Hedge fund managers have not historically embraced managed account structures as they create additional complexity for fund managers. With most fund management companies now in capital-raising mode, more managers are willing to discuss managed account options.
Investors require specialist administration support with managed accounts, due to the control design elements, transparency and independence objectives and additional operational complexity. Daily, independent reconciliations, P&L and risk statements based on position-level data and independent valuations, and risk analytics are needed across all investor accounts.
Based on GlobeOp’s in-depth experience serving both funds and investors as managed account clients, the following are key factors each party should consider:
Investor considerations
- Retain control of and access to cash and assets in the investor account (vs co-mingled in a pool with other investors in traditional hedge fund investing)
- Managed account managers (i.e. advisors) require power of attorney to deal on behalf of investor's managed account; limits of authority need to be clearly defined
- As the legal counterparty in a managed account, investors are
responsible for negotiating the legal and administrative
infrastructure
- IMA – investment management agreement with managed account advisor
- Bank and prime broker agreements
- Transaction agreements including ISDA and ISMA agreements
- Fixed costs, set-up and administration expenses typically make managed accounts expensive/not cost-efficient for smaller investors
- The administrator should demonstrate experience with managed accounts and be SAS 70 Type ll certified
- Performance monitoring -- the analyzing and consolidated
reporting of the rich data set -- can be time-consuming but the
investor must monitor
- Independent, position-level based reports & reconciliations
- Portfolio valuations
- Counterparty exposure risk reports
- Portfolio risk reports
- Performance attribution
- Style drift.
Account advisor considerations
- Investor strategy, investment guidelines or asset allocations rule can require additional reporting & monitoring, eg certain counterparties or transactions may not be permitted without specific investor approval
- The variety of investor-specific guidelines across different investors wishing to pursue similar investment mandates can add complexity and inefficiency to the portfolio management process
- Account advisors have managed account infrastructure and
investor reporting responsibilities
- Daily, separate position reconciliation, cash break monitoring, P&L and portfolio valuation statements, risk analytics required for each and all investor accounts
- Control or guideline adherence reports may be required
- Weekly, daily or monthly operational reporting
- The administrator should be experienced with managed accounts and be SAS 70 Type ll certified
Investments made through managed accounts can provide investors with greater capital control and portfolio transparency. Significant administrative expertise and system underpinning – with the scalability to adapt to account and investor client growth - is also required to support both investors and account advisors.
- 12 Feb 2009 | Hans Hufschmid, CEO | PBs giving up on OTC “give ups”? - Operational challenges & solutions
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Operational pressure could increase further for hedge funds if prime brokers are giving up on “give ups”. Hedge funds of varying sizes report being given notice by prime brokers that OTC derivative give up arrangements will end – quickly. Funds ranging in size from $25M to $2.5B are being told new derivative trades “done away” will no longer be accepted near the end of the first quarter and that give up relationships will end completely in April.
Give up arrangements – in which the executing broker writes trade tickets on behalf of both counterparties to the trade – provided hedge funds with three advantages: easier post-trade operations, cross margining and credit intermediation.
Challenged by investors to provide increasing levels of transparency, independent validation and reporting frequency, funds would also have to find the operational bandwidth and capability to efficiently manage the complexities of OTC trade processing involving multiple instruments, high volumes and multiple counterparties. And the February 28 deadline after which major dealers will not accept novation consents by email looms.
During the Lehman Brothers crisis in September 2008, hedge funds began diversifying counterparty risk by abandoning the practice of single prime broker give ups and converting to multiple direct counterparty relationships. Their three-fold objective was
- to avoid the risk of assets being trapped by investment bank insolvency, locking the fund out of the market as its counterparty is frozen
- to have greater strategic control of collateral management
- to ensure that no one single bank had too much control over the fund’s credit extensions, balance sheet, leverage terms or exposures.
Now, intense revenue pressure on banks and on credit risk overall is forcing banks with prime broking activities to take a very tough approach to profitability. Give ups were, for many, never a core business, used to support the profitable business of lending securities to hedge funds. As risk tolerances and the lending business have become less attractive, the reasons for providing low or non- profitable support services like give ups are falling away.
If the initial signals become a trend as financial markets and the hedge fund sector restructure, outsourcing will increase in appeal as hedge funds simultaneously face
- increased investor demand for independent administration and robust infrastructure
- declining fund performance and management fees to fund or ramp up the required technology and people resources
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continued attractive opportunities for strategies involving OTC derivatives.
- 6 Feb 2009 | Ron Tannenbaum, Co-Founder | Post-Madoff - Independent reconciliation the real investor priority
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Recent trade media articles reflecting on "the Madoff impact" have suggested that new investor demands are based predominantly on independent valuation. While sound valuation policies and robust controls are essential, it is independent reconciliation that is at the forefront for investors today. They want reassurance that assets exist, positions are true and that cash reported is real.
This level of due diligence can only be determined by a full, independent reconciliation to third parties – custodians, prime brokers, trading counterparties - of fund assets claimed by the fund manager. This third party reconciliation is performed by the administrator. Even if assets are relatively simple to value, without independent reconciliation there would be no way to tell whether the balance sheet was real or not.
Institutional and private investors now require greater control and transparency over their portfolios. They will expect daily, independent reconciliations – across all assets and counterparties. In addition to full segregation of duties in confirming portfolio value, timely and transparent communication of those independent reconciliations and valuations will be key to rebuilding investor trust and retaining capital.
- 15 Oct 2008 | Hans Hufschmid, CEO | New market fundamentals
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While the full impact of 2008 events on the hedge fund market is still being determined, we have identified a series of near- and mid-term new market fundamentals:
Diversify & Manage
- Credit Exposure
- Risk
New Essentials
- End of give-ups to single PBs on derivatives; now multi-PBs, moving quickly
- 24/7 real-time access to counterparty credit & risk exposure
- Collateral management - data access, accuracy
- Managed money market access - choices, instant access
- Service provider
- Independent, unconflicted service providers
- Credit worthiness
- Healthy balance sheet
New tools & partners (investor & fund demand)
Partners with sound business fundamentals- Independence, healthy balance sheet, no debt
- Cost-effective services vs in-house builds, associated banking sector risk
- Collateral management support
- Independent valuation
Recent events have made it clear no one is immune from credit deterioration. Hedge funds are no longer able to take the credit of counterparties for granted, and that has led to a change in behavior. We should see a continuing trend of using multiple, rather than single, prime brokers reflecting prudent business practices for hedge funds. Our platform facilitates this shift in behavior as it gives clients access to a multitude of prime brokers and facilitates seamless movements from one to another. This proved key for many clients during recent turbulent times such as the build up and aftermath of the Lehman Brothers bankruptcy. In addition, hedge funds will seek to diversify risk and exposure by working with independent administrators – separate from their prime broker, bank or other hedge funds.
Similarly, the practice of OTC give-ups to a single counterparty should become much less prevalent as hedge funds diversify that risk over multiple banks. To operate successfully under this new model, a hedge fund will require a solid OTC infrastructure that includes pricing, payments, reconciliations and collateral management.
Many hedge funds are below their high water marks and are struggling to maintain their in-house operations and technology. Outsourcing their middle- and back-office can lower their cost base and enable them to scale their expenses as their net asset values decrease or increase.
We believe the continuing turmoil in global markets will hamper the financial sector in the short-term, but we also expect the new market fundamentals to yield mid- and long-term opportunities for top-tier hedge funds and administrators alike. Investors and fund managers will place a sharper focus on risk analysis, collateral management, multiple prime broker and counterparty arrangements, as well as operational cost controls. Historically, periods of market dislocation have produced value-creation opportunities for investors and hedge funds. Now, with diminished competition from investment banks seeking alpha or leverage for their proprietary trading activities, nimble hedge funds will move swiftly to access those opportunities.