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Hedge Funds in Asia A Guide to Operational Due Diligence

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Investing in Asian hedge funds presents a number of challenges. For North Ameri-can and European investors, distance is an obvious impediment, which makes Asian funds harder – and much more expensive – to diligence than managers in New York and London. Each market presents local legal and regulatory issues, managers are gen-erally smaller with fewer assets and fewer employees, and service providers may be region or country specific. It is also notable that Asia has also not been immune from managers suffering from strategy failure (such as Basis Capital) and outright fraud (such as Charles Schmidt)1.

Castle Hall Alternatives and Select Fund Services work together to help global inves-tors complete operational due diligence on managers throughout Asia. Each review is conducted using OpsDiligence, our pro-prietary due diligence framework, which

allows Asian funds to be subject to the same defined and consistent due diligence process already applied across more than 1,000 funds worldwide. Equally, our due diligence benefits from an on the ground team with deep and seasoned knowledge of market conventions across Asia. This helps avoid the “check the box” mentality which can result if due diligence does not take account of the unique characteristics of the Asian marketplace.

Asia is a dynamic part of today’s hedge fund industry.

The growth of China and the Asian economies over the last decade

has brought benefits throughout the region, whether it is the trading

economies of Hong Kong and Singapore or the resources-driven

economy of Australia. Other “emerging market” jurisdictions have

also faired well and niche funds have emerged investing in the

ASEAN region as well as other smaller capitalized markets such as

the Philippines and New Zealand.

1- Information on more than 500 cases of hedge fund opera-tional failure available to subscribers in OpsFraud, Castle Hall Alternatives’ proprietary database of hedge fund fraud and operational loss.

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EurekaHedge recently estimated assets managed by the Asian hedge fund industry to total $134bn2, represented by more than 1,200 individual funds. HFR reports the number of Asia-focused hedge funds to be 1,067, representing more than 10 percent of the global industry3. In terms of location, HFR shows increasing manager numbers in mainland China (PRC) and Singapore, offset by some contraction in Japan and Australia.

THE SIZE OF THE MANAGERS

The hedge fund industry as a whole has seen a “flight to size”, with investors worldwide showing a preference for the perceived safety (whether justified or not) of managers with established track records and higher assets under man-agement. Manager concentration is also a key trend in Asia, with 62% of capital in Q2 2011 invested with the largest firms (assets in excess of $500 million) accord-ing to a recent Bloomberg article4. This statistic is further reinforced by Business Insider, which recently reported that “the top twenty percent manage eighty percent of the total assets”5. However, while a rela-tively small number of managers dominate current AUM, Asian focused strategies often face capacity limits: this creates an opportunity for new managers to gather assets as existing leaders become capacity constrained. Other investors may prefer to

allocate to smaller managers in any case, preferring the closer relationship and enhanced transparency that can often be available from a smaller firm.

Given the large number of managers with more modest assets, investors building a portfolio in Asia are likely to have at least some exposure to smaller manager organi-zations. Unavoidably, these smaller firms have fewer operational resources and a less developed operational infrastructure. While these factors can increase operational risk, an investment in effective due diligence can give investors the confidence they need to allocate to a younger, more nimble manager. A “deeper dive” can identify managers who, while small, do have acceptable operational controls – and could have the potential for very attractive performance.

A final characteristic of the Asian industry is the large number of managers with cur-rent assets of less than $20 million. This suggests that barriers to entry (including key costs such as salaries and office rental) can be lower in Asia-Pacific countries than the US or UK. While these firms may cur-rently run small portfolios, this dynamic pool of early stage managers will be the source of the next group of industry lead-ers over the coming years.

AN OVERVIEW OF HEDGE FUNDS IN ASIA

2- Bloomberg http://www.bloomberg.com/news/2011-08-24/asia-s-hedge-fund-assets-to-grow-may-reach-180-billion-eurekahedge-says.html

3- http://www.hedgefundresearch.com/pdf/pr_20110809.pdf

4- http://www.bloomberg.com/news/2011-08-10/asia-hedge-fund-startups-fall-38-as-investors-seek-pedigree-.html

5- http://www.businessinsider.com/here-are-the-emerging-trends-to-watch-in-asian-hedge-funds-2011-5#ixzz1VoDqihCU

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OPERATIONAL DUE DILIGENCE ON ASIAN HEDGE FUND MANAGERS

Investors looking to Asia face a diverse group of markets, domiciles and regulations. Due diligence can be challenging for all investors, be they an allocator considering a first fund in Asia, or a more experienced investor with an established Pan Asia portfolio. As markets continue to evolve, we have highlighted four issues – management and operations, legal and regulation, tax, and service providers – which impact an effective due diligence program.

MANAGEMENT AND OPERATIONS001

REGIONAL TAX ISSUES003

LEGAL AND REGULATION002

SERVICE PROVIDER DUE DILIGENCE 004

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Given the large number of small, early stage managers across Asia, the man-agement of a fund – especially in terms of personnel and resources - are often sig-nificant due diligence issues.

Key Man: An obvious concern is key man risk related to the founder or CIO of a small organization. As with any fund, investors should look for reasonable key man pro-tections, including a key man clause in the offering document to waive lock ups and other redemption restrictions, perhaps sup-ported by side letter provisions. Investors

may also wish to discuss key man triggers in ISDA agreements for funds which are material de-rivative users, and more

broadly consider business management issues such as key man insurances. For larger managers, more formal succession planning could be discussed: we recognize, however, that the hedge fund industry as a whole remains remarkably undeveloped in this area. Very few firms worldwide have ef-fectively formalized the process to transfer active businesses from the original found-ers to the next generation of leaders.

Access to Talent: A broader question is whether the manager has access to an adequate pool of professionals to sustain growth, whether in the front or back office. Compared to the now mature hedge fund industry in the UK and US, Asia’s smaller hedge fund sector can make it more chal-lenging for managers to identify and re-cruit experienced staff. More recently, the number of high quality professionals has risen as regional staff gain experience and as professionals have been attracted to re-locate to Asia from other financial centers. Even so, while the talent pool has increased, so has the number of managers competing for top tier employees.

Relevant Experience: It is also important to consider the background and qualifications of back office staff at each level of the or-ganization. Again, given the younger hedge fund industry in Asia, it is more common to find Chief Operating Officers and other

key professionals who do not have an op-erations, accounting or legal background, and instead come from brokerage, sales or other front office positions. This can cre-ate more variation in COO / CFO skill sets than would be typical in the US or UK, with back office leaders holding differing levels of technical operations knowledge. Face to face due diligence, where investors can meet the key professionals and assess their capability and contribution, is key. A careful review of the resumes of all operational staff is also important to ensure all staff have the requisite experience for their roles.

Segregation of Duties: Given the number of smaller firms in Asia, segregation of du-ties can be a frequent due diligence issue. While many managers have established a baseline of controls, we have found some Asian managers to be less conscious of the importance of segregation between front and back offices. For investors, a careful review of controls around the life of a trade can identify any weaknesses, from trade au-thorization through execution, to confirma-tion, settlement and reconciliation. If due diligence does identify issues, constructive feedback to the manager is important and, we have found, well received by virtually all Asian managers.

Spin Outs: Finally, a number of Asian hedge funds have been formed as a spin out of a trading team from an existing financial insti-tution – or another hedge fund. In these cas-es, the dynamic of the new structure needs to be evaluated carefully: these new firms can no longer rely on the infrastructure sup-port of a parent, and must create their own business structure sufficient to meet the operational demands of the strategy.

MANAGEMENT AND OPERATIONS001

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In Europe, London is the dominant hedge fund centre and the NY/Connecticut cor-ridor is the nexus for hedge funds in the US. Across the Asia-Pacific region, hedge funds are dispersed between Singapore and Hong Kong with smaller, but important, centers in Tokyo and Australia. Each loca-tion has advantages and disadvantages, but the favourable tax and regulatory environment in both Singapore and Hong Kong have proved attractive for managers. Australia has built its own industry, with a number of new fund launches by well

regarded professionals.

Singapore: In Singa-pore, the Monetary Au-thority of Singapore (the “MAS”) has traditionally

adopted a “light touch” regulatory regime for exempted, international hedge fund managers. However, it is notable that the MAS conducted, with help from two major audit firms, on-site visits to every hedge fund manager in Singapore in the wake of the Madoff scandal. This demonstrated that the regulator has the reach and re-sources to inspect every hedge fund man-ager, whether regulated or exempt.

Singapore overhauled its regulatory re-gime in 2010 with a view to introducing capital adequacy and closer regulation of larger hedge funds. Prior to recent regula-tory changes, the “exempt fund manager” status was seen to a straightforward hurdle when establishing a manager organization. Given new capital adequacy rules, due dili-gence practitioners should consider, for ex-ample, the implications of maintaining free cash in the management company. Look-ing forward, some commentators have

suggested that changes to the MAS rules could raise the threshold level of assets needed to run a financially viable hedge fund, with a potential impact on smaller Singaporean funds. Summary details of a manager’s regulatory status are also avail-able from the MAS via their website, which is a useful due diligence resource.

Hong Kong: Hong Kong’s burgeoning hedge fund community also benefits from lower tax, although Asset Management Li-censes have always been slightly more dif-ficult to obtain due to the requirement for the recipient to sit exams. Hong Kong has, however, recently moved to simplify certain aspects of its regulatory regime, including granting an exam exemption for seasoned investment professionals. License approval times in Hong Kong have also been reduced to 10 weeks according to the Securities and Futures Commission (the “SFC”).

Given Hong Kong’s licensing regime, the due diligence review should consider the type of license required by the manager and the whether their licence accords with the investor’s understanding of that require-ment. Hong Kong also has taken an active role in respect of targeting insider trading in the local market, with some high profile cases widely reported in the press. An in-dividual’s disciplinary records are available through the SFC website and occasionally make interesting reading.

Importantly, neither Hong Kong and Singa-pore are subject to the same prescriptive rules on soft dollars as the UK, making it ad-visable to study the usage of soft dollars by funds. Conventions are changing, however, and some managers have adopted stand-

LEGAL AND REGULATION002

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ards set by the FSA in the UK following pres-sure from investors to ensure soft dollars are only used for appropriate purposes.

Australia: In Australia, lifestyle benefits can be an important factor in choosing to lo-cate in Sydney or Melbourne. However, the regulatory licensing process is lengthy and document intensive. Managers without the necessary citizenship status may also have to set aside additional capital to meet im-migration requirements to establish a busi-ness in Australia.

Finally, regional regulators are working with the EU in respect of the Alternative Invest-ment Fund Management Directive. The implementation of this directive should be monitored by investors as it will have an ef-fect on the region’s hedge fund managers, particularly if equivalence requirements come into force.

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The large number of potential markets within a Pan Asian mandate inevitably exposes funds to different tax regimes. As a first step, investors should look for the manager to engage effective service pro-viders to access appropriate tax guidance and accurate tax accounting. The PB / custodian, auditor, administrator and legal advisor all play important roles in tax plan-ning and compliance.

FIN 48: For US investors subject to US GAAP financial reporting, two Asia markets, China and Australia, raise particular issues

in relation to FIN 48, “accounting for uncer-tainty in income taxes.” In China, current rules related to the treatment

of Capital Gains Tax (“CGT”) are fluid, with some variation in the policies adopted by different institutions acting as the Qualified Foreign Institutional Investor (QFII). The prevailing view is that the collection of the PRC taxation of capital gains on A Shares is presently unclear and fund directors, in conjunction with the relevant QFIIs, have to exercise their judgment on the Fund’s po-tential liability for any CGT obligations. Due diligence should establish each fund’s tax position – which may differ by counterpar-ty – and monitor ongoing developments in Chinese tax rules.

REGIONAL TAX ISSUES003

In Australia, uncertainty regarding taxa-tion has led to growth in the swap market for trading Australian shares by offshore funds. In particular, an investor based in a non-treaty country (e.g. a hedge fund based in the Cayman Islands) investing in shares listed on the ASX has faced some risk that income could be subject to Australian taxa-tion, if considered to be Australian sourced. Recent updates to Australian tax law are in-creasing clarity on this issue, but we would still recommend a detailed tax discussion as part of each due diligence review of an Australian manager.

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SERVICE PROVIDER DUE DILIGENCE004

Administrators: Virtually all hedge funds in Asia have appointed a third party fund administrator from inception, meaning that issues of self administration and lack of external oversight are rare. The majority of Asia funds are serviced by administrators from offices in the region, with the result that fund admin market share is some-what different to the global industry. Asian administration is still dominated by three, long standing vendors: HSBC (having pur-chased the traditional regional leader, the Bank of Bermuda, back in 2003), Citco and

Credit Suisse (formerly Fortis Prime Fund Solu-tions). Moreover, the administration service model for the major-ity of funds remains

traditional, focused on month end NAV accounting and reporting. Aside from a few large funds, there is less focus on hiring an administrator to be an outsourced back / middle office: smaller AUM and emphasis on equity strategies reduces the need for administrators to assume the heavy lifting of complex derivative portfolios.

Fund administration continues to evolve, however. Some administrators, notably Cit-co in Singapore and HSBC in India, are ex-panding in Asia to add lower cost resources (and take advantage of round the clock time zone benefits) to service their North Ameri-can and European clients. M&A activity con-tinues, with a recent example being Apex Administration’s purchase of an Australian fund administrator business. A final trend is the emergence of businesses which can of-fer a “plug and play” back office infrastruc-ture for small, early stage managers.

For investors, due diligence on administra-tors can raise region specific issues. Global administration firms may issue a single SAS 70 report across their entire organiza-tion, but distant offices across Asia may be scoped out or, even if included, will likely not be subject to on the ground SAS 70 work every year. Investors should be conscious that regional offices of the fund administra-tors may have specific issues that may not

apply to other offices elsewhere in the world and, as such, should be reviewed individu-ally. Legal and contractual terms may also differ: we recently encountered a regional administrator which sought to limit liability, even in the event of gross negligence, willful default and fraud, to only the fees paid by the fund in question.

Prime Brokerage: The PB business has also expanded in Asia with most prime brokers increasing their presence on the ground in key Asia-Pacific jurisdictions. In respect of China, the hedge fund manager’s relationship with their PB will be important in gaining access to A Shares through the PB’s QFII entitlement. Sub-custody is also important with regards to the various Asian markets and investors should pay attention to the quality of those relationships with domestic sub-custodians, especially in less developed and frontier markets.

Auditors: The Big 4 audit firms are, of course, represented in all financial centers across Asia. The majority of funds prepare their audited financial statements in ac-cordance with IFRS (International Financial Reporting Standards) which can create some reconciliation issues for US inves-tors: one key difference is the use in IFRS of valuation procedures based on bid / ask pricing which can create differences be-tween the “trading NAV” (usually based on last sale) and valuations reported in the ac-counts. It is also somewhat more common to see Asian funds reporting to a fiscal year end other than December 31, which can also create audit issues for investors sub-ject to US GAAP.

As a separate issue, investors should be conscious that a number of recent frauds have raised concern as to the quality of fi-nancial statement reporting – and the as-sociated audit process - in China. Cases such as Sino Forest and Longtop, while not hedge funds, highlight the risks involved with private assets and other investments not unambiguously held by a custodian in safe keeping.

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SUMMARY

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USEFUL RESOURCES

Monetary Authority of Singapore:

> http://www.mas.gov.sg/

>http://www.mas.gov.sg/legislation_ guidelines/securities_futures/sub_legislation/A_Practitioner_s_Guide_to_the_CIS_Regime_under_the_SFA.html

Hong Kong Securities and Futures Commission:

> http://www.sfc.hk/

>http://www.sfc.hk/sfc/doc/EN/speeches/public/surveys/11/Hedge%20fund%20managers_201103.pdf

Alternative Investment Management Association

> AIMA Hong Kong: http://hongkong.aima.org/

> AIMA Australia: http://www.aima-australia.org/KnowledgeCentre.html

Looking forward, the Asia hedge fund indus-try will continue to grow.

Regional investors will continue to increase their wealth and consequent hedge fund allocations, while global investors are excited by the opportunity to access Asia’s growth economies in a hedge fund rather than long only format.

For allocators, building a portfolio of Asian funds presents two challenges. Firstly, in the post Madoff environment, all hedge funds in a portfolio must be subject to detailed due diligence, consistently applied irrespec-tive of strategy or location. Going forward, allocations to Asian managers must be subject to the same process and meth-odology as US or European funds, even if travel and distance has, in the past, meant that not all investors have conducted onsite due diligence. Secondly, Asian funds oper-

ate against a backdrop of country specific regulation, tax and service issues, some of which we have described in this paper.

In our view, effective due diligence requires deep knowledge and the information advantage that comes from regional specialism. Castle Hall and Select Fund Services are proud to offer their clients a dedicated due diligence focus across Asian markets. Working together, we help inves-tors identify those managers across Asia who set the standards of operational best practice.

SUMMARY

NORTH AMERICA

Montreal

1850 Panama, Suite 415 Brossard, QC J4W 3C6, Canada

Tel: +1 450 465 8880

Toronto

First Canadian Place 100 King Street West, Suite 5600 Toronto, ON M5X 1C9, Canada

Tel: +1 416 644 8338

Halifax

84 Chain Lake Drive, Suite 501 Halifax, NS B3S 1A2, Canada

Tel: +1 902 429 8880

EUROPE

London

53 Davies Street, London United Kingdom, W1K 5JH

Tel: +44 20 7096 5020

ASIA

Sydney

Select Fund Services Level 10, 2 Bulletin Place Sydney, New South Wales Australia, 2000

Tel: +61 (2) 8252 2200

CONTACT

> castlehallalternatives.com> selectfunds.com.au

ABOUT CASTLE HALL ALTERNATIVES AND SELECT FUND SERVICES

Castle Hall Alternatives and Select Fund Services provide their clients a seamless, unconflicted solution to operational risk due diligence across hedge funds, private equity and traditional asset management structures.

Castle Hall, with offices in North America (Montreal, Toronto and Halifax) and Europe (London) has completed comprehen-sive due diligence on more than 1,000 different fund structures worldwide. With more than 20 professionals dedicated exclu-sively to operational due diligence, Castle Hall deploys one of the industry’s largest and most experienced due diligence teams.

Select Fund Services, based in Sydney, Australia, is a leading due diligence provider focused on the Asian marketplace. Castle Hall and Select Fund Services collaborate to provide their clients with detailed due diligence insights on managers based throughout the Pan Asian region.