Projecting Light Onto Hedge Fund Transactions

Giving power to investors in the trade lifecycle

Originally published in the June 2012 issue

Since the subprime crash of 2008 the alternative investment industry has been focusing in unprecedented detail on the issue of operational risk. This is being driven forwards from a number of quarters, including by regulators and investors concerned that assets might be placed in jeopardy as a consequence of future systemic failures. There is a general appreciation, however, that within the hedge funds industry there are systemic issues in the way business is being done that will need to be addressed if operational risk is to be reduced.

The investor community in particular is seeking solutions that will allow it to improve the efficiency of the hedge fund trade cycle, providing for enhanced interaction with fund managers and service providers like administrators and custodians.

Talk of ‘transparency’ is more prevalent than ever: we have statements to this effect from regulators and investors (e.g. in the recent survey of managers and investors published by Ernst & Young). But can we properly define what we mean by hedge fund transparency and produce a benchmark industry standard? Commentators have discussed the transparency of the trade, for example in equities pricing, but how can you translate this into hedge fund investments? In the post-Madoff environment, transparency now means proper verification of every stage of the trade, from the initial investment in the fund to where the assets are held.

From the perspective of the investor, for example a typical pension fund or family office, an investment in a hedge fund is treated as a security, and with that comes concerns about liquidity: where is the investment held? Ehat it is worth? How is it treated from a legal perspective?

In short, investors would like to be able to see their alternative investments alongside their other assets, be they exchange-traded securities or long only mutual funds. The problem is that hedge funds – and their private equity equivalents – are more opaque and are still seeking solutions that will allow them to deliver this degree of enhanced reporting to the investor community. It is difficult to get away from the spread sheet when it comes to managing an alternative investment portfolio: finding out what something is worth is hard enough using Excel; what about providing a confident measure of liquidity?

Creating effective liquidity reporting
A detailed liquidity report of an underlying portfolio of hedge funds, one that could be dynamically updated, was the Holy Grail for many funds of funds in the dark days of 2008. Proper liquidity reporting is underpinned by effective data and tools. It requires a degree of investment in technology that can be proactive, agile and responsive.

One of the real tests of any portfolio management system occurs when things go wrong: in the world of money management, operational failures, for instance on the part of a business further down the service provider chain, can force the portfolio manager to re-evaluate retrospectively. Can he be sure that such revaluations are being consistently applied, especially if multiple individuals within the same firm are juggling dozens of spread sheets? Once mistakes creep into the historical portfolio picture, they can be difficult to track down and correct, and they can continue to have an unforeseen impact on reporting further down the line.

Beyond the problems of effective performance tracking, investors in hedge fund portfolios today want to feel they have a better grip on what is happening in underlying hedge funds. This means being able to view a more complete operational picture. Their questions cover key issues relating to fund liquidity, including whether funds have the ability to gate withdrawals, whether gates have been initiated, the expiry of each tranche lock up, and what the options are to reduce lock ups and when. Better information on the liquidity scenario can deliver important additional advantages to the portfolio manager.

It all comes down to a question of confidence: can an investor feel confident that a trade has been properly executed? Has it been confirmed by the relevant custodian and underlying transfer agent? How long does it take to receive the estimated and real NAVs? Do they always come in on time? Are communications with relevant parties secure and dynamic enough to process real-time information flows?

With a more detailed picture comes a higher degree of confidence in the underlying investment and a superior level of reporting to end investors when required. This also helps the portfolio manager to allocate further funds more efficiently.

Dealing blind

The parties to any single trade, be it the fund manager, the custodian, the investor or the administrator, are incorporating a degree of estimation in the course of the transaction process. It is still difficult to operate otherwise. Each participant is using different parameters to view mission critical data and communications. Each still relies on paper-based processes and spread sheets to manage billions of dollars of alternative investments. But can any of them express with 100% confidence that a specific trade is at a specific location in the transaction trade at any given time of the day? And can they put a value to it when they do find it?

At this juncture in time we stand in an industry that is becoming increasingly institutional, with over 60% of the assets being managed by hedge funds now originating from institutional clients. The client complexion of the industry has changed while the legacy technology in use within many firms harks back to an earlier and simpler era.

Technology issues are becoming a bottle neck for institutional investors, particularly with regard to managing and reviewing hedge fund portfolios. This is creating a demand for a more proactive and integrated approach to client reporting using technology that has the ability to break down the different components of the hedge fund trade. By bridging these operational processes, institutional investors can manage and review accurate data with a higher degree of confidence.

The scale of the problem facing the industry has been highlighted by Swift’s SHARP (Swift Hedge Funds Harmonisation Project) initiative. Swift identified a number of key operational issues within the hedge fund transaction process. While custodians and administrators can handle the paper trail when transaction volumes are low, the largest service providers to hedge funds now process well over 1000 transactions every month. Each order may come with up to 50 pages of documentation attached. A typical team within a hedge fund administrator might be handling 600-700 orders with a dedicated staff of a dozen or so. Apart from reconciling data with their own records, they must also ensure investors are complying with KYC and other regulations.

Because subscription processing is time consuming and error prone, the entire cycle from the time when the order is taken until confirmation is received and accounts are reconciled can be as much as a month. Faxes of subscription agreements must be sent to transfer agents, which in turn must be confirmed by phone, with final documents being sent over by courier (see Fig.1).

For a fund with monthly liquidity, these transactions can prove costly, particularly if the market has moved. Missing a deadline for an order could lead to a fund holding unnecessary cash, while a missed redemption deadline would leave a fund exposed to an unwanted position for another month, quarter of a year or more.

If funds restrict liquidity, or extend their lock-in periods, or raise gates, the risks of moving transactions in and out of funds grow. It is still very hard for custodians to provide funds of funds with accurate status reports, particularly when they are bombarded by faxes from administrators and transfer agents at the end of the month. For larger custodians, with dozens of service providers to deal with, the problem is only magnified.

During the years in which Comada’s senior management team has been involved in the hedge funds industry, the explosive growth of hedge fund assets has continued to outstrip the infrastructure needed to support it. Without this, the industry will continue to be impeded by systemic issues.
Hedge fund allocators are now requiring more sophisticated levels of efficiency from investment processes and service providers, but are still not seeing them. Neither investors nor managers want to be ambushed by inadequate liquidity profiles, as some were in 2008. Transparency is critical here, as without an in-depth level of continually updated knowledge of the hedge fund trade, liquidity management will continue to be even riskier than it needs to be.

The real challenge is to consolidate processes with dynamic workflow architecture which integrates investor, custodial and administrative hedge fund practices. Despite the disparate nature of the sector, it is still possible for flexible technology solutions to make a difference by simultaneously addressing the commercial and operational challenges the industry faces.