Investment Management: Operating a Hedge Fund (2024)

This article provides an overview of how to operate a hedge fund and the important role that hedge funds play in the field of investment management.

Infrastructure Requirements for Hedge Funds and Investment Management

A hedge fund, like any financial services organization, has daunting requirements for operational infrastructure. Recent regulatory developments in the wake of the 2008 Financial Crisis have added a further layer of complexity to operational planning and execution. Typically, when people think of hedge funds, they think of investment management research and portfolio construction.Infrastructure is just as vital for a hedge fund’s success and longevity. Allocators of capital to hedge funds have placed ever-greater emphasis on a robust infrastructure since the crisis.

We can break down the operational requirements of hedge funds into seven general categories:

• Business Management
• Trade Flow
• Cash Management
• Reporting, Audit and Tax
• Legal and Compliance
• Corporate Governance

A Hedge Fund Investment Management Company Is A Business

A hedge fund investment management company is a business that happens to be engaged in investment management. In a sense, it is an industrial business charged with manufacturing a distribution of returns from the raw inputs of market opportunity, using a particular technique or strategy. As such, it requires a similar set of support functions in order to be a going concern, including:

• Human Capital Management and Leadership
• Real Estate
• Payroll and Benefits
• General Office Management
• Information Technology
• Accounting
• Marketing and Investor Relations

The fact that the investment management company is, first and foremost, a business is an important one that managers discount at their own peril. Many hedge funds have failed or have under-performed because the manager has failed to comprehend this simple fact. If the business operations of the management company are not designed and implemented properly, they can be at least a significant distraction from investing and, at worst, they can lead to the collapse of the client hedge fund. These functions are straightforward. People need to be led. They need a place to work and equipment to use. They need to be paid and to have competitive benefits. The management company has accounts. The fund needs to raise assets from the sale of new limited partnerships and the fund needs to conduct a sophisticated investor relations program with existing investors.

Trades Must Be Executed And Processed Without Failure

Based upon the fund’s proprietary investment processes and the diligence of its investment professionals, the portfolio manager will construct a portfolio of securities. These securities need to be traded, which involves placing an order, executing the order, confirming the transaction, making the payments and housing the security positions, in addition to financing the portfolio, as necessary. These functions necessarily involve the movement of investors’ cash and leave no room for error. Executing, confirming and reconciling trades is a very technology-intensive process.

The portfolio manager starts the process by entering a trade into his Order Management System (“OMS”). The order may have limits or other conditions attached to it. In the case of Over-the-Counter product, the transaction may involve direct negotiation, obviating the need for an OMS. But for cash equities and many other instruments, an OMS is the most direct way to execute a trade. The OMS routes the order to the hedge fund’s counterparties, through a network called the FIX network. While the trade is in the OMS and prior to its execution, the portfolio manager may monitor it, amend it or cancel it.

Once the counterparty executes the trade, the counterparty sends a report to the portfolio manager and to the hedge fund’s prime broker. The prime broker acts as a central clearinghouse for the hedge fund, maintaining its cash and securities in a custodian account. The prime broker will adjust its accounts with the hedge fund to reflect the executed order and send a report of the portfolio to the management company, reflecting all adjustments including executed trades, fees paid and net financing costs. These reports may be sent daily or in real time, for funds that require it.

One key element of the trade execution and reconciliation process for master/feeder structures with onshore and offshore feeder funds is the requirement to allocate trades between the two entities in a manner that is consistent with the methodology prescribed by the fund’s offering documentation.

For firms that outsource reconciliation to a third party called an administrator, the prime broker will also send the same report to the administrator. Finally, at the end of day, the management company sends its self-determined snapshot of what the portfolio balances should be to the administrator. The administrator reconciles these reports, communicating back any discrepancies to both the fund and the prime broker for subsequent investigation and correction. It is important to note that it is the hedge fund that employs the prime broker and the administrator; the management company is an advisor to the hedge fund.

Naturally, the more frequently the management company trades, the greater the potential for error. Getting the operational process correct, minimizing reconciliation discrepancies and fixing errors as quickly as possible reduces the possibility of distraction of the portfolio manager from the competitive business of investing. A good operations staff is absolutely essential for a competitive hedge fund.

Ensuring Cash is Handled Properly

After Madoff, Lehman Brothers And MF Global, Investors Want To Ensure That Cash Is Handled Properly

Cash is the center of any fraud and it is the key to any operational failure. Checks and balances are used to ensure that no individual agent has sole control over the cash; daily reconciliation by multiple, arms’ length parties gives the fund’s underlying investors comfort that they are protected from obvious sources of fraud and preventable operational shortcomings.

There are three principal actors involved in the reconciliation of the fund’s cash balances: the management company, the administrator and the prime broker. No one agent can instruct the movement of cash; in a properly designed system, at least two and possibly all three are required to sign off on the transfer of fund cash. Poor cash controls enabled the Madoff ponzi scheme.

On the face of it, the hedge fund is no different than any other investor, keeping its balances in accounts that are segregated from those of the prime broker or other clients of the prime broker. However, almost all hedge funds obtain financing for their portfolios by pledging these portfolios (or, at least parts of them) as collateral. Commonly, the agreement between the fund and the prime broker permits the prime broker to re-hypothecate these assets themselves, pledging the collateral the prime broker received from the hedge fund to another market counterparty in exchange for the prime broker’s own financing needs. Why would hedge funds agree to re-hypothecation? Collateralized lending may be the only way for the hedge fund to obtain financing. The prime broker may charge a lower fee for lending on a collateralized basis than on an unsecured basis. Or, the prime broker may provide a greater amount of financing for collateralized borrowing than they would for unsecured borrowing. The leverage from these arrangements can boost a hedge fund’s performance significantly. The hedge fund’s key source of alpha may be its ability to manage leverage.

One key implication of this is that the fund bears the credit risk of the prime broker. Hedge funds who employed Lehman Brothers as their prime broker realized quickly that their assets had been re- hypothecated, in many cases to entities offshore, leaving the hedge fund not with a claim to 100% of the value of its assets, but with a heavily discounted, general unsecured claim against the estate of the US broker-dealer.

In addition, the administrator will work with the prime broker and the management company to process new investors’ purchases of limited partnership interests; the redemption (as permitted) of existing investors’ limited partnership interests; the payment of various permitted fund expenses (including the management fee and the performance fee for the general partner); and the processing of any tax payments as necessary.

Investors Require Regular Reports

The administrator will report net asset values (“NAV”), typically monthly, with the attendant returns, to the limited partners of the fund and to the management company, acting as general partner. Alternatively, the administrator may report the NAV and returns calculations to a third party analytics and data provider who then checks and reformats the numbers to make them directly comparable to those of other funds. The analytics and data provider may also maintain a database of hedge fund returns. The fund may pay the analytics and data provider for inclusion in this database in order to provide its existing investors with easy access to its history, as well as to help prospective new investors see the fund’s performance history.

In addition to this financial reporting, there is tax reporting for individual limited partners and for the general partner in respect of their investments in the fund. To the extent that the hedge fund is organized with a master/feeder structure, there will be naturally separate arrangements for onshore and offshore investors. Funds may elect to have a separate administrator for each of the onshore and offshore entities in some instances.

The fund will also require an annual audit. Ideally, this is from a well-known, highly regarded audit firm operating at arms’ length. One of the key facts in the Madoff case was that a related party audited the Madoff funds.

The Legal And Compliance Thicket Is Only Growing More Complex

It is imperative that a hedge fund has its own legal advisor to produce offering documentation and transactional legal counsel. This applies with equal force to the management company for everything from its actions as general partner to ongoing business requirements of the management company qua business. Increasing regulations, growing regulatory uncertainty, a more institutional investor base and a more difficult investing environment all weigh in favor of sourcing first-rate legal advice.

While the conventional wisdom might suggest that hedge funds are unregulated investment vehicles, this is certainly not true. The offerings of hedge funds are exempt from registration as securities with the SEC under certain safe-harbor provisions of the Investment Company Act. Hedge funds may not have to disclose as much information as mutual funds are required to disclose. However, the laws governing investing in and secondary trading of securities clearly bind the actions of the hedge fund. Hedge funds are still subject to the laws governing fraud.[1] In addition, the Dodd-Frank Act makes hedge fund advisors subject to the same requirements that apply to other regulated investment advisors, subject to carve-outs for smaller entities.[2] This involves a number of requirements, including:

• Compliance with the Advisers Act and procedures for maintaining such compliance
• The maintenance of true books and records
• The maintenance of an annually updated Form ADV
• The adoption of a formal code of ethics, including personal trading
• Restrictions on advertising
• Other hedge-fund specific reporting such as Form PF reporting

The Fund’s Structure Determines Corporate Governance

The hedge fund, qua partnership, is governed by a board of directors and by its offering documentation. In practice, the offering documentation often provides the management company, acting as general partner, with tremendous control over the construction of the portfolio, risk management, operations and disclosure. The offsets to these are the ability of the investors in the open-ended fund to vote with their feet and redeem their interests for cash; the compensation scheme for the manager that puts a premium on performance; the requirement that the manager invests a substantial amount of his personal wealth in the fund; and the credit discipline imposed on the fund by various counterparties, not least of which is the fund’s prime broker.[3]

The higher the performance fees the manager receives, the greater is the imposed discipline and alignment of interests in the principal-agent problem.

Of course, the key governance issue relates to performance disclosure, more specifically, the calculation of performance. While the offering documentation should describe the way in which performance is calculated, governance issues may arise where there are questions requiring discretionary judgment relating to valuation or timing. Managers should use their best efforts to be transparent about the manner in which they are calculating performance, as well as any discretionary assumptions they may make related to key metrics.

Infrastructure Is Critical To Hedge Fund Investment Management Success

A manager cannot raise a fund without a solid infrastructure in place. A manager cannot invest competitively if he is distracted by operational problems. Solid operational execution is a necessary, though not sufficient, condition for the success of the hedge fund.

-Article By Chand Sooran, Point Frederick Capital Management, LLC

Twitter: @csooran

Disclaimer