Hedge Fund Fission

Originally published in the December 2011 issue

The initiation of fund investments—like all investments—requires both investment appetite and capital access. Like protons and neutrons in an atom, these two components are central to making investments possible. However, what if the bond between capital availability and investment affinity could be broken and each one made to stand alone?

By accessing different investor pools and splitting these pieces apart, a wave of untapped economic energy can be released. A fund manager can use that energy to reach a larger universe of qualified investors and increase its chances of a successful fundraise. The combination of two recent product innovations known as the CVRDN—Collateralized Variable Rate Demand Note— and the Fund Enhancement CPC come together to create a solution that will not only help fund managers attract new investors, but will enhance capital retention efforts with existing ones.

Alternatives to direct investing
Taking a cue from recent history, the modern investor is primarily concerned with poor fund performance, lack of liquidity, failure to achieve stated fund objectives, weak operational controls, reputational/headline risks, and fraud. Investors have addressed these issues by moving toward alternative methods of gaining hedge fund exposure outside the direct investing model, such as investing through funds of funds, managed account platforms, separately managed account vehicles, UCITS and other wrappers. Each of these have inherent drawbacks, including loss of investor control, liquidity mismatches, failed or inadequate due diligence, tracking errors, increased operational costs and unexpected compliance burdens. However, these options don’t address the most significant problem investors face today; achieving portfolio exposure to well-run and transparent alternative investment strategies while fully investing their cash in current-income-producing assets that can prove critical to meeting short-term liabilities.

Unleashing the benefits
Splitting the AUM by disaggregating capital sourcing and investment risk is powerful and can be applied by a qualified fund through the licensing of a CVRDN. This structured product innovation can be used to attract the high-volume, low-cost capital that fuels an investment into a sponsored fund. The combined CVRDN-Fund Enhancement CPC solution addresses each of the investor concerns mentioned earlier by incorporating a series of governance and quality control features that play a vital role in today’s market.

Before beginning the transaction, each fund will participate in a operational due diligence examination that will establish a transparent operational benchmark for each manager, thereby creating a comprehensive quality control feature for the system. The due diligence process includes a thorough document review to establish a knowledge base, an onsite visit to bridge any gaps or clarify any discrepancies in the documentation, a testing of manager policy and procedures, and a verification of assets and service providers. The resulting report is not only relied on in the decision to grant a licence, but it is an exceptional tool for a manager to accredit its business with investors in an increasingly challenging fundraising environment. The CVRDN licence acts as a turn-key method of overlaying specific operational controls and governance mechanisms on each fund, streamlining investor relations and decreasing administrative costs to the fund while also enhancing investment transparency, improving investor access to portfolio level performance data, and ultimately increasing investor confidence.

With the licence controls and systems in place, a manager can operate within an investment environment that enables a new investor to gain exposure to a fund’s strategy with almost no capital leaving the investor’s portfolio to initiate the investment. Alternatively, a manager can also create an opportunity for existing investors in a fund to trade fully funded exposure for unfunded exposure to the same strategy and recoup dollar-for-dollar the principal amount of cash previously invested without disrupting fund operations or the underlying investment strategy. In either case, this means that an investor will enjoy both an extremely low cash basis in the trade that will substantially enhance its rate of return on cash, and, as a result, virtually eliminate opportunity cost of investment—even for a longer-term strategy. Moreover, because of the ability to invite an investor to benefit from this unfunded exposure, a manager is in a position to restructure the fund’s return model to significantly increase management’s participation in the performance of its investment strategy.

Investment catalyst
Once a fund has issued its CVRDN, those note proceeds are placed under management upon the delivery of specially designed letters of credit that provides investment support for the fund’s strategy. To make this process simple, scalable and advantageous for fund investors, a feeder mechanism is used to initiate the sourcing of this investment component by the fund’s entry into a credit agreement with the Chicago-based commercial finance company that has engineered this structure—UFT Commercial Finance. The agreement establishes a credit enhancement facility in consideration of a pledge of hedge fund interests and a share in the returns of the fund. Investors then acquire a stake in that credit facility through the acquisition of a Fund Enhancement CPC that carries with it a yield stream reflective of the fund’s strategy.

The Fund Enhancement CPC is part of an entirely new credit asset class known as a Master Credit Participation Certificate, or CPC, and is one of a dozen CPC types being introduced by UFT Commercial Finance. As an investor-friendly alternative to securitizations and the non-scalable transaction-specific nature of credit syndications, CPCs are expected to breed greater trading liquidity than similar instruments due to their highly standardized nature that includes features, such as:

• CUSIP and/or ISIN identifiers;
• conformity with conventional custodial standards for easy administration on a DTC-like basis;
• daily indicative pricing provided by SIX Telekurs,
• enhanced portfolio level transparency through a daily alert system combined with ongoing monitoring of fund portfolio holdings by Duff & Phelps; and
• greater manager accountability.

Beyond these shared CPC characteristics, the Fund EnhancementCPC stands out with the added benefit of affording an investor the ability to purchase it using a letter of credit as currency, rather than cash.

The implementation or re-characterization of a hedge fund investment using this solution instead of a more conventional investment approach splits the AUM into independently sourced cash and credit that:

• enables the investor to gain exposure to the fund’s strategy with only the lending of its credit and little to no cash taken from portfolio;
• enhances net return on cash because of the investor’s reduced cash basis in the trade;
• improves transparency to the investor through accredited third party firms such as Duff & Phelps and SIX Telekurs; and
• repositions the fund manager to enjoy markedly higher performance-based returns in its well-executed strategy.

Moving in a new direction
At a time where investors are torn between the security of sitting in cash and the need to invest in longer-term, higher yielding opportunities to drive returns, the tried-and-true methods of investing are being re-thought. Hedge fund managers need new tools to access more potential investors while maintaining the integrity of their strategies. UFT Commercial Finance’s CVRDN-linked Fund Enhancement CPC creates a ready-made vehicle to respond to investors’ needs for higher investor return on cash, improved transparency and better operational controls.