THFJ: Why do you think concerns about tax technology are coming more into focus at this point in the hedge fund industry’s development? What do you think are the spurs to it now?
MS: I think it is happening for a number of reasons. Firstly, the environment is getting a lot more complicated. This is not just in the US, but globally. The environment is getting more complicated across the board, across the globe. There are different initiatives happening, the tax structure and laws are getting more and more complicated. Investors are requiring and asking for greater transparency in the tax process. General partners and owners are asking for more transparency and greater tax efficiency. The tax directors (TDs), or CFOs, if they don’t have tax directors, are looking for ways to streamline the process, minimise the risk associated with the process and get the best answers that they possibly can for their investors and for the general partners of the funds.
Let’s assume that the fund has a tax director. The interesting thing is that the tax directors in the US have multiple constituencies they have to deal with, and it drives what their decision-making has to be. The first constituency is obviously the general partners, the individuals that own the ultimate flow of the management fee and the incentive. The second constituency is the investors. The investors may or may not care about certain aspects of the process as much as the TDs do. It depends on the entity and it depends on who the investors are. And then finally the tax directors themselves, who have to deal with the administrator, the accounting firm, and be able to deal with these mounds of data that are continuing to accumulate and have gotten harder and harder every year. I’m going into my 31st year in the business and it has just continued to get more complicated, both domestically and globally, as the years have gone by. It is a very difficult process.
THFJ: Could you talk me through what the solutions are that firms like yourself, and others, are offering? What does it actually consist of? Is it front-to-back integration? How far does it go?
MS: What everybody is driving for is end-to-end integration, full transparency and data flow. Integration to the fund administrator, the accounting firm, then integration back to the client. That is really what everybody is driving for and I think the industry is ultimately moving to where you will see the tax director, or the CFO, with the ability to look into the system on their desk and work at the same time with the accounting firm or with the fund administrator, and be able to give daily information that a lot of people want. One of the interesting components of this is not so much the transparency or the end-to-end solution, but the securities analysis and analytics. People are looking for different ways to analyse data. They take into account holding periods, ramifications from the United States and also from a state and local perspective. If you are global the ramifications of dealing with multiple countries and the associated reporting are becoming more and more difficult to deal with as time goes on. The concept of country-by-country reporting is coming out and it will be part of the whole process. If you are a global fund that has multiple offices and investments that are multi-jurisdictional, the reporting, the needs and the analytics really start to grow.
THFJ: How does dealing with multiple jurisdictions work? Obviously there must be a massive increase in complexity. How does that work from the technology side?
MS: The technology has to be able to handle the multi-jurisdictional nature of the reporting that is going to be required. The requirements for the type of package of data that can get supplied in a consolidated way to the different countries will have to flow out of whatever system is purchased by the fund. That will be driven by what the BEPS requirements are. BEPS multi-country reporting has to be integrated into the systems that are built, because it will require the same type of data effectively that is used on an actual basis. You will see systems that will have the ability to produce globalised reports on a multi-jurisdictional basis.
THFJ: Do you think that this task will become simpler as a result of consolidation of tax regimes, or do you see divergence ahead?
MS: Ultimately, divergence. I don’t think it will become easier. The standardised reporting I believe still allows for differences in countries, but the standardised package is what gets created. And by the way, you still have to deal with Asia; you still have to deal with South America. There is much more than just the country-by-country component of BEPS. I think it will continue to get more complicated.
THFJ: Do you think daily tax analytics will become the norm, or do you think it would be focused to specific firms?
MS: I think it is going to become the norm for funds that have differences in holding periods. It can really make a difference. It can make a difference from a state and local perspective; it can make a difference from a country-by-country perspective. At some point it will be normal to have those kinds of analytics already in the technology. Even for those funds that are smaller that might not have the necessity all the time for it, or might not have the ability to pay for it or be able to do it because it will become the norm inside of the technology.
THFJ: So do you envisage that this technology drive will become a source of value to the bottom line for your clients or for hedge funds in general?
MS: Absolutely. First of all it will create efficiency in the business, which is good, but it will also increase after-tax returns for the funds.
THFJ: What kind of uptake have you had? Do you find that these firms are keen to take this on board, or are they waiting for tried and tested things to filter through?
MS: No, it is a very entrepreneurial industry, as you know. There is a lot of hunger to get the new technology on board, even if we are talking about first-generation or second-generation technology, because it enhances the ability of the tax director to provide better information to the TPs and the investors, and it also minimises risk. Even if they are running parallel with old systems, there is definitely a hunger out there to pull it all on.
We launched our system last December, and we are now in our second generation and we are getting an incredible amount of requests from the market to get onto the system. It is just something that is picking up a lot of speed. I think because of the entrepreneurial nature of the business, there is a strong desire by funds to get onto the new technologies.
THFJ: Do you see any trends in strategies or structure of funds that are particularly keen to get on board with it?
MS: Not really. I think it is helpful to differentiate between today and two or three years from now. As of today the funds that have the ability to generate long-term gains and have real differences in their analytics, as opposed to those that are very short-term focused, are the ones that really want toget on the system because it really can enhance their after-tax returns from an analytics perspective. But for some macro funds and long/short equity traders, it is not that big of a deal today but ultimately they are going to want to be on it too because of other aspects of the technology, such as the analytics and the ability to do global reporting.
THFJ: Do you see a higher take-up in one region compared to another or is it pretty steady across the board?
MS: It is mostly US right now because the majority of the industry sits in the US so that is really where a lot of it is being driven. It is being driven more by the larger funds. I would expect the technology implementation to roll the same way that the industry developed historically over the last 30 years. So you started in the US, moved to London and then from London to Asia. I think that is really the direction it will go. The next frontier after the US is clearly London, and we definitely have had conversations and desires expressed by funds in London to get onto the new technologies as they roll out.
THFJ: So from your operational point of view, does that add to the development that you have to do? Do you have to bring on board all these new jurisdictions or is that an advantage of the globalised industry that it fits all?
MS: That is a great question. The answer to both of them is yes, it does create challenges but at the end of the day those challenges were anticipated, and our expectation is to have technology that serves the clients globally and holistically. Whether it is a UK-based fund or a Hong Kong-based fund, it is not going to matter. The idea is to have the technology that holistically serves all the clients and gives them the ability to move between jurisdictions.
That is ultimately what we want to shoot for. For example, you may have a UK-based fund that had UK and other reporting requirements. The idea would be to have technology which would allow for that, regardless of whether they have US requirements or not.
THFJ: With all this information, I know certainly from our point of view we have seen a lot of cyber-security talk specific to the hedge fund industry, and on a far broader level. I presume with all this centralisation of data you have to have, for the most sensitive data, pretty stringent cyber security protocols in place?
MS: Yes. That is absolutely one of the more critical features of the whole structure. If you think about it, you are dealing with a prime broker; you are dealing with an administrator; you are dealing with the hedge fund and then the accounting firm. Data is moving back and forth. Data is flowing back to the fund or off to the investors, you just have a lot of data that is floating out there. So cyber-security is a big deal, and the question is spot on.
THFJ: I take it this isn’t just a technology issue in that I suppose you have to adjust firm cultures and processes. Would you say that is the case?
MS: Sometimes what happens is that there is a rush to think that technology is the answer to things, and that technology is the magic bullet out there, or that you can press a button and technology will give you the answers that you want. That is absolutely the wrong approach to take. We advise our clients that technology is the tool that allows for implementation of what it is that they want to do. But at the end of the day it is the process and people behind the technology and the people that the fund works with and how the fund’s process works that drives the results and drives what it is that they want to do. Funds will make mistakes if they think that they can simply purchase a piece of technology, press a button and the problem will be solved.
The first thing that a tax director needs to do is understand what constituency is he or she going to try to solve for – the middle or back office, the TPs, the GPs or all three. Thesecond thing they need to understand is how their processes work and are they good? Do they need to be enhanced? How do they integrate with the administrator? How do they integrate with the accounting firm? Is there anything about that process that needs to be upgraded as they implement the technology? How does that work? So it is an iterative analysis, but technology is not the sole focal point. The focal point is that technology is merely a component of the process.
THFJ: Do you think there will ever be a point where they are mainly software providers?
MS: No. Accounting firms are not software developers. In our example, we are developing our software but we are also working with third parties to help us with the software, we know our limitations; we are not software developers. I don’t think that will ever happen.
Michael Serota is a Partner with Ernst & Young LLP and the EY Global Hedge Fund Leader and Wealth & Asset Management Tax Leader.