US East Coast Hedge Fund Services 2008 · hedge fund faith US East Coast Hedge Fund Services 2008...

US funds flee sub-prime woes forglobal opportunities

Investors step uppressure onadmin quality

Institutionalinvestors keephedge fund faith

US East CoastHedge Fund

Services 2008

Apr 2008

In this issue…03 Institutional faith keeps managersbuoyantBy Suchita Nayar

05 Building a strong capability for USclientsBy Jacques Bofferding, Fortis Prime Fund Solutions

08 Credit woes highlight new demands onservice providersBy Suchita Nayar

11 Sub-prime woes pose questions formanagersBy Joe Seet, Sigma Partnership

US EAST COAST Hedgeweek Special Report Apr 2008 www.hedgeweek.com | 2

CONTENTS

Special Reports Editor: Simon Gray, [email protected]

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Photographs: NYC & Company; Siobhan Brownlow

Published by: Hedgemedia Limited, 18 Hanover Square, London W1S 1HX

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Most hedge funds may have weathered sofar the gales blowing through the financialmarkets following last summer’s implosion ofthe US sub-prime mortgage sector, but thecrisis is far from over.

The sub-prime meltdown has sinceupended credit markets across the globeand jolted equities as well. Add leverage,and you have all the ingredients forworldwide financial contagion, one that hassounded the death knell for hedge funds bigand small. Notable casualties include fundsrun by high-fliers such as Bear Stearns,Citigroup, Focus Capital, Peloton Partnersand Sailfish Capital Partners.

Is there a wider shakeout coming? Withserious macroeconomic problems looming,investors surely have reason to pause.Hedge funds rang up an average loss ofnearly 3 per cent in January, their worst-evermonthly decline since 2000, according toindex providers, and after a mixed February,managers are reporting a fresh round oflosses for March.

A lingering problem is that the underlyingreal estate linked to troubled paper remainsin the doldrums, which means that deflationof the credit bubble still has some way to go.Asset valuations, meanwhile, remain hard todetermine in a market that has to a large

O V E R V I E W


Institutional faithkeeps managers

buoyantBy Suchita Nayar

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At Prime Fund Solutions, the part of Fortis Merchant

Banking dedicated to servicing the alternative and

traditional investment community, we are committed to

building strong and lasting relationships within the global

investment industry. Focusing on the future needs and

opportunities in any type of investment funds, ranging from

traditional through hedge funds to funds of hedge funds,

we deliver cutting-edge services and invest in state-of-the-

art information technology. Providing a first class package

of fund administration, custody, clearing, securities lending

and borrowing, cash management, bridge and leverage

finance, we are ready to face your challenges with you.

For more information please contact:

London (+44) 207 444 8682 - Dublin (+353) 1607 1860

Luxembourg (+352) 42 42-81 07 - New York (+1) 212 340 55 43

Hong Kong (+852) 2823 0598

www.merchantbanking.fortis.com

Prime Fund Solutions

Getting you there.

Endowments and institutions in the US havebecome the dominant investors in the hedgefund industry, drawn by the potential ofgenerating returns that are uncorrelated withtraditional equity and bond markets. With theincrease in their hedge fund allocations, theyare in a position to demand that managersseek higher levels of fund administrationservice as an additional assurance toinvestors.

Third-party fund administrators areincreasingly becoming managers’ chosensource for independent net asset values,which can be cross-checked against thenumbers tallied internally by the managers.They expect fund administrators to produceNAVs in an error-free and timely manner, andlooking forward, they expect administratorsto provide detailed information on howperformance is calculated.

At the same time, the complexity ofinvestment strategies being pursued bymanagers is increasing. The clients of FortisPrime Fund Solutions are not only tradingcomplicated instruments but are diversifyinginto private equity and real estate investments.The boundaries that previously separatedalternative investments into various assetclasses are rapidly becoming blurred. That isgiving rise to accounting, legal and taxcomplications, which makes for an even morechallenging task for the fund administrator.

Fortis Prime Fund Solutions has adaptedquickly to keep pace with these changes,adding specialists to handle administrationtasks associated with complex derivatives andother esoteric strategies along with associatedaccounting and tax matters. The firm’sspecialised desks are equipped with completeexpertise in these complex areas while manycompetitors still cater mainly to long/shortequity, which are the easiest funds to handle.

Fortis Prime Fund Solutions established a

presence in the US two years ago. The firmhas serviced offshore funds for US managersfor a long time, but took the decision tocreate the business in order to begeographically closer to its clients. The 15-strong sales and client relationshipmanagement team services a wide range ofclients, most of them located in the hedgefund hothouses of New York and Connecticut.

Considering the dominance of USmanagers in the global hedge fund market,Fortis has decided to expand its businessofferings in the country further, establishingan operational hub in the US that will offerlocal fund accounting, share registry andbanking services to national clients. This isimportant because Fortis wants its touch andfeel to be like a US company, so that localclients are more comfortable in their dealingswith the company.

Unlike other banking houses that haveacquired fund administration operations, suchas Citigroup’s acquisition of Bisys in 2007 andDeutsche Bank’s purchase of HedgeWorks inFebruary this year, Fortis’s strategy is toexpand its offerings organically. The PrimeFund Solutions business is not short of skillsor technology, capable of relying on its strongglobal systems and knowledge to propel theUS expansion. The firm is adapting itssystems to US standards and plans to takethis initiative live over the next few months.

The latest offering will round out what’salready a robust service, including fundadministration, tax support, custody, andbridge and leverage financing. Fortis hasbuilt outstanding expertise in servicing blue-chip funds of hedge funds, which comprisemore than half of its total US business, whilein single-manager funds its strength lies inthe ability to handle clients that are active inmore complex and high-volume tradingstrategies, such as multistrategy products. ■

F O R T I S


Building a strongcapability for US clients

By Jacques Bofferding

Jacques Bofferding is regionalmanaging director, WesternHemisphere at Fortis PrimeFund Solutions

extent seized up, resulting in longerredemption terms. Finally, equity markets arealso weakening, despite the US FederalReserve’s attempts to revive the economy byrepeatedly slashing interest rates.

“There’ll be more hedge fund blow-upsthis year than ever,” says Michael Hennessy,managing director of investments at MorganCreek Capital Management, which wasestablished in 2004 by Paul Yusko, formerinvestment chief and a colleague ofHennessy at the endowment of theUniversity of North Carolina at Chapel Hill.

“Price discovery, when it occurs, will likelythreaten if not devastate hedge funds andeven financial institutions. There’ll be month-to-month hits and then, in the case of hedgefunds, redemptions which, combined withtighter lending, will cause the classic deathspiral.”

That makes the job of managing moneythat much harder. Recent losses are creatingreal liquidity problems at some funds offunds, according to Virginia Parker, founderand chief investment officer of USD600mStamford, Connecticut-based fund of hedgefunds manager Parker Global Strategies.

Hedge funds are imposing longer lock-upsand gates, Parker says, and there is nothinga fund of funds manager can do other thanhope to have redeemed before the underlyingmanager triggers this move. This meansmanager due diligence has to be rigorous inorder to “pick managers that know how tokeep their powder dry”, she says.

The bar for due diligence and riskmanagement is being raised, industryparticipants say. An effort is being made toimprove disclosure and transparency viainitiatives such as the President’s WorkingGroup on Financial Markets, which hasnearly completed drafting a report designedto address key investor concerns.

Separately, two industry bodies, theAlternative Investment ManagementAssociation and the Chartered AlternativeInvestment Analysts’ Association, are co-operating on a guide for hedge fund investors,written by Alexander Ineichen, seniorinvestment officer at UBS Asset Management,with help from California Public Employees’Retirement System portfolio manager KurtSilberstein. The guide is due to be publishedduring the second quarter of this year.

Among the issues that are expected to beaddressed by the various reports andpublications are the overuse of long lock-ups, side-pockets and illiquid investments,over which experts have already raised redflags.

Current market conditions call for evengreater manager scrutiny, according to GaryWitt, a managing director of ratings agencyMoody’s in New York. Ensuring the managerhas sound funding is more important todaythan it was a year ago, says Witt, who leadsthe agency’s unit that gives ratings to hedgefunds.

In turbulent times, funds should not havea single source of funding, and operationalrisks need to be vetted. “Hedge funds areusually started by traders coming out oflarge institutions and haven’t run businessesbefore,” he says. “They are focused ongenerating returns, not taking care ofmundane business issues.”

One likely result will be a slowdown innew entrants coming in to the market.Institutions now want to see longerperformance records and larger volumes ofassets under management, criteria that havebecome particularly difficult to meet incurrent market conditions.

Industry data on new launches is startingto indicate a slowdown from the record paceof recent years. According to a survey byAbsolute Return, 30 funds were launched inthe second half of 2007, compared with 51 in

O V E R V I E W


p3 ➧

the six months to June. In total, USD31.5bnwas raised last year, compared withUSD40bn in 2004 and USD35bn the followingyear, albeit slightly ahead of the USD30bntotal in 2006.

According to BarclayHedge and TrimTabs,investors added USD2.5bn in net new capitalto hedge funds in January, which wasUSD200m more than in December but farshort of the USD21.8bn figure for November.

“As the market matures, you’re going tosee fewer wannabes joining the market,”says Michael Caccese, head of the financialservices practice at law firm Kirkpatrick &Lockhart Preston Gates. “Those who arehaving difficulties surviving will exit. Thesuccessful ones will expand and will find iteasier and cheaper to acquire new strategiesthrough acquisitions rather than trainingtalent.”

Cases in point are the acquisition ofLondon-based Castlegrove Capital by IsraelEnglander’s Millennium Capital, andBlackstone Group’s purchase of GSO Capitalin New York. There have been plenty ofsimilar deals and more are on the way,

according to Karim Leguel, investment chiefat New York-based financial advisory firmRasini & Co.

“I expect more M&A in the industry asbigger hedge fund managers acquire smallerones, given the increased costs of running ahedge fund and the economies of scale andthe reach and talent of bigger managers,”Leguel says. “I also believe that institutionalinvestors will be buying more stakes inhedge fund managers, allowing them moresustainability and potential access to capitalin tough times.”

The good news is that hedge funds stillenjoy institutional support. Darien,Connecticut-based consultancy Casey, Quirk& Associates forecasts that institutionalcapital invested in hedge funds will rise toUSD1trn by 2010, almost triple the USD360bnthe firm recorded in 2006.

Inflows might not pour in as a straightupward line on a graph, but they willcontinue to grow, according to Casey Quirkchairman John Casey. All told, institutionsallocated a record USD66bn to hedge fundsin 2007, of which an estimated USD52bn isstill waiting to be deployed.

Hedge fund investment is now a normalpart of the institutional allocation process,according to Patrick Keane, a managingdirector in New York with third-partyplacement agent Liability Solutions.

“Despite spectacular headlines of somehedge fund disasters, institutional investorsare increasing their use of hedge funds aspart of their portfolio diversification strategy,”Keane says. “They are no longer consideredan exotic part of a typical, diversifiedinstitutional portfolio.”

Where’s the new money going? Managerssay the possibility of bargain-hunting hasdrawn investors to credit strategies, whilemanaged futures, global macro and selectivecommodities have drawn strong investorinterest since late last year. By contrast,equity long/short, certain emerging markets,event-driven and merger arbitrage in generalhave lost some lustre.

The temporarily debilitating forcesnotwithstanding, Hennessy says, hedgefunds as a whole will again prove their worththis year in terms of portfolio diversification,defensiveness and superior risk-adjustedreturns. ■

O V E R V I E W


Firms that provide services to hedge fundsare changing the way they do business, andthe reason is institutional investors. As theseinvestors allocate increasingly large sums tohedge funds, they view the quality of serviceprovision as an important aspect of riskmanagement.

These investors come with a high level ofrequirements, according to Fortis PrimeServices’ Western Hemisphere head JacquesBofferding. They want net asset valuesdetermined more frequently, without delaysand errors, and to have a clear view of allthat follows once a trade is placed at themanager’s end. Says Bofferding: “They areraising the bar – they want to make suretheir money is in a safe place and willreturn.”

While the instinct for preserving capital isnothing new, it is particularly crucial rightnow. Investment banks have already sufferedUSD190bn in losses linked to the sub-primemeltdown and are far from done yet, with

some forecasters suggesting that total write-downs could escalate to as much asUSD600bn. Global markets, meanwhile, haveseen significant falls, claiming many hedgefunds as casualties.

Practitioners say the problems areintensifying. Amid the unfolding credit crisis,leverage is adding to industry woes. Whilethe going was good, prime brokers andother lenders were quick to offer credit tofunds to enable them to juice up returns,especially in strategies where profit marginsare wafer-thin.

With asset values falling, leverage hasamplified losses, pushing investors to theexit in droves. Banks are making new linesof credit scarcer and pricier and are callingback outstanding loans or raising marginrequirements. This credit squeeze is forcingmanagers to sell assets in order to raisecash, but buyers are scarce even for whatare still deemed good quality assets, sendingprices still lower.

Credit woes highlightnew demands onservice providers

By Suchita Nayar

S E R V I C E P R O V I D E R S


“The liquidity crisis is one of the biggestwe’ve seen in a long time,” says KarimLeguel, investment chief of asset advisory firmRasini & Co in New York. “Banks and brokersare in distress due to regulatory arbitrageinvolving structured products, and this affectseveryone,” he says, referring to their use ofoff-balance sheet vehicles to avoid having toset aside capital to meet adequacyrequirements. There is zero tolerance for errorin current markets, he argues.

On the accounting front, valuation ofassets is also proving difficult. Hedge fundinvestments have increasingly branched outinto exotic securities, which are complicatedto value at the best of times. Compoundingthese problems, the future still looks murkyfor US real estate, which is at the core ofmany of the structured products that areunder water.

“On the fixed income and asset-basedlending side, lack of transparency is aconcern,” says Campbell Harvey, professorof finance at Duke University’s Fuqua Schoolof Business. “Investors are wondering howmuch more bad news is yet to come.”

In this fraught economic landscape,investors are bracing for the worst andhoping that at least their funds’ serviceproviders are on the ball.

Merrill Lynch’s prime brokerage business,which ranks third behind Goldman Sachsand Morgan Stanley in industry rankings, iswell prepared to handle current challenges,according to Jeff Penney, co-head of Merrill’sglobal markets financing and servicesbusiness.

“The current market adversity is playing toour advantage,” he says, claiming that Merrillhas picked up a number of new clients inrecent months as hedge funds move awayfrom the traditional model of having just oneprime broker to a multi-prime system.

“Global prime brokers like ourselves arebeing added to hedge funds’ prime brokerlists, because they are seeking to diversifytheir investments both geographically and byasset class. Hedge funds see the benefits ofhaving a diversified portfolio of globalassets.”

Merrill Lynch has hired selectively thisyear, a period during which some of itsbiggest rivals, like Morgan Stanley, have lostsenior prime broker bankers.

Penney says Merrill has expanded itsinfrastructure and offerings to meet thegrowing needs of the market. For example, itlaunched the Merrill Middle Office Solutionwith hedge fund administrator GlobeOp latelast year for hedge fund managers with morethan USD1bn in assets, touting benefits thatinclude efficient data aggregation and tradereconciliation along with compatibility withother prime brokerages.

Merrill also sees interesting growthopportunities in electronic access to marketsalong with prime brokerage custody andfinance, and is focusing on Asia and EasternEurope as key regions for expansion,Penney adds.

Some of Merrill’s rivals, including Citigroupand Credit Suisse, have also invested heavilyto build technology that can host multipleprimes. This trend is expected to continuedespite a recent US General AccountabilityOffice report finding that the increasing use



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To date some 287 federal cases related tothe sub-prime crisis have been filed byunhappy investors in the US. While there isno doubt that some hedge funds will beensnared and implicated in some of theselawsuits, it’s a fallacy to hold hedge fundswholly responsible for this crisis.

Responsibility for securitising and ratingmortgage-backed transactions lies with theinvestment banks and rating agencies, andmost hedge funds are only investors in thesesecuritised transactions. Some of the lawsuitsseek to implicate hedge funds, but theproblems lie clearly on the origination side ofthe mortgages and with the poor due diligenceby the rating agencies and investment banks.

Valuation is another important issue facingall hedge funds, and mortgage-backed andother illiquid assets, such as small-capequities, can be very hard to value. Model-based valuations are no substitute formarket-led ‘willing buyer, willing seller’ pricedtransactions. Hedge funds are finding itincreasingly difficult to value problematicassets, and when faced with significantredemptions, the only viable option is toliquidate the fund and close the business.

There is also the matter of governance andthe role played by fund directors. Many ‘career’directors have had it too easy for too long, andit is questionable whether they truly understandthe new and complex accounting rules cominginto play. In today’s litigation climate,disgruntled investors are likely to sue funddirectors as well as the managers themselves.

Career directors who are simultaneouslyoverseeing tens of funds while spendingmuch of the week on the golf course areespecially at risk. Managers need to rethinkseriously the key role of fund directors andadopt best practice to appoint trulyprofessional and knowledgeable directorswith no conflicts of interest.

The credit crisis is a very serious problemfor hedge funds and funds of funds. Withinvestment banks sitting on hundreds ofbillions of dollars of write-downs in their owntrading and non-trading books, the naturalthorough reassessment of credit lines tofunds is having a contagion effect on theindustry.

The US Federal Reserve’s recent rate cutswere designed to boost the economy, butJapan’s experience in the 1990s suggeststhat control of the money supply throughlower interest rates might not be the onlystimulus needed. Many banks and funds aretapping sovereign funds for a bailout.

Meanwhile, many managers with fundsthat have so far focused purely on the USare already in London or considering settingup offices there to access UK, European andAsian market opportunities.

Sigma Partnership is well placed inLondon to offer comprehensive specialistadvice to inbound managers seeking to buildtheir UK and European businesses. Thefirm’s partners have solid investment bankingbackgrounds and eschew the checklist-based methodology of other boutiqueconsulting firms. Drawing on its professionalknowledge and understanding of the needsof hedge funds, Sigma Partnership assists itsclients in the areas of regulatory compliance,accounting, taxation and governance.

Sigma pioneered a series of monthlybriefing notes in 2006 on issues of topicalinterest to managers, investors, participantsand other service providers. The currentdistribution figure is over 1,000 and manynotes are subsequently redistributed byrecipients such as law firms. Topics haveranged from the need to change limitedpartnership agreements under newaccounting guidelines and MiFID regulationto taxation and governance issues. ■

S I G M A PA R T N E R S H I P


Sub-prime woes posequestions for managers

By Joe Seet

Joe Seet is the senior partnerof Sigma Partnership

of multiple prime brokers was fraught withrisk, since no one institution had the fullpicture of a fund’s risk exposure.

Industry participants, however, take issuewith the report’s conclusion. Multi-prime is anecessity and not a matter of choice,according to Stuart Feffer, who withChristopher Kundro heads Cargill subsidiaryLaCrosse Global Fund Services, whichadministers USD14bn in assets.

“Most people I speak with in the marketare very concerned that balance-sheetissues and credit exposure concerns at thebanks could lead them to change theavailability of collateral and lending terms onshort notice,” Feffer says. “Therefore manyfund managers are making sure they haveseveral different prime broking and financingrelationships.”

While the GAO’s report purely highlightedconcerns and did not make anyrecommendations, it might feed into aseparate report being prepared by thePresident’s Working Group on FinancialMarkets.

Even so, the report crystallises the ideathat counterparty risk should be a primaryarea of focus, according to Judith Gross,principal at compliance consultancy JGAdvisory Services in New York. “Marketplayers as well as regulators will certainlyuse this report as a roadmap for planningtheir future programmes,” she says.

“The report was also significant because itmentioned the importance of properdisclosure in risk reduction – that is, potentialinvestors should be aware of risks associated

with a hedge fund investment, but often theydo not understand those risks.” Grossexpects hedge funds and their counterpartyrisk to come under greater scrutiny.

Administrators are also increasingly in thespotlight. Both managers and investorsdemand predictability of good service andscalability of operations from their providers,according to Akshaya Bhargava, who headsBermuda-based fund administrator Fulcrum.Due diligence processes are becoming muchmore rigorous, says Bhargava, who took thehelm at Fulcrum after his former employer 3iinvested USD57 million in Fulcrum last June.

An administrator not only has todemonstrate competence in its work, butmust show strength in its own operationalmanagement, he says. Fulcrum, whichserves its clients around the clock fromoffices in India, Ireland and Canada, isfocusing on building out its middle officeofferings and has automated procedures sothat the same work can be done seamlesslyfrom anywhere in the world.

Sigma Partnership’s managing partner JoeSeet expects institutions to demand highergovernance standards from managers, withthe role as gatekeepers carried out byindependent fund directors. As a result,administrators are not putting their executivesup to be board members due to the obviouspotential for conflicts of interest.

“The competition for funds is so intensethat both prime brokers and fundadministrators are looking for more value-added services to differentiate themselvesfrom the competition and to provide a one-stop shop for the customer,” says ScottAlderson, president of New York-basedPaladyne Systems, which sells front-to-backtechnology offerings to hedge funds andadministrators. Some of the additionalservices include daily reconciliations,technology offerings, risk management andaggregated reporting, he says.

These factors are contributing to the riseof specialist service vendors such asCorrectNet, which offers services thataggregate data from different sources andprovides data management and reportingapplications to hedge fund managers.There’s a growing need for sophisticatedclient reporting and transparency, accordingto chief executive Robert Miller. ■



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