June 2015 Managed accounts: The solution to the trend of institutionalization in hedge fund investing? Peter Dom and Bas Nagtzaam
Content 1. Introduction 2. Industry Institutionalization Trends 2.1 Development hedge-fund industry 2.2 Impact institutionalization 3. Possible investment structures 4. Managed accounts further explained 4.1 Definition of managed accounts 4.2 Managed-account structure 4.3 Operational set op 4.4 Legal, regulatory and tax set up 4.5 Available managed account product structures 4.6 The positive aspects of managed accounts 4.7 Disadvantages of managed accounts 5. Suppliers of managed accounts 5.1 Background and company profile 5.2 Product/service offering 6. Implementation of managed accounts 7. Conclusion 8. About AF Advisors 3 4 4 5 12 14 14 14 17 18 21 22 25 28 29 30 31 34 35 White paper managed accounts June 2015 2
1. Introduction The hedge fund industry has changed dramatically over the last decade. Hedge fund assets have tripled as investing in hedge funds has become more mainstream and institutional investors have increased their allocations to hedge funds. As a result of the increasing importance of institutional investors to the hedge fund space, more stringent requirements are forced upon hedge fund managers, especially with regard to transparency and control of assets. The trend of institutionalization will continue with the expected growth of institutional assets. This will impact the products and services offered by hedge funds. Next to institutionalization, the sector is currently dealing with a wave of new regulations. In this paper we describe the different possible investment structures for hedge fund investments and how they relate to changing investors requirements and new regulations. We focus on the possible solution of managed accounts to fulfill the institutional investor requirements and describe the advantages, challenges and practical aspects of implementing a managed account. This paper provides insights for institutional investors and financial institutions investing (or considering investing) in hedge funds. The paper seeks to bring a clear and balanced view on the various investment vehicles for hedge funds with a particular focus on managed accounts. Finally, we will answer the question whether managed accounts are the right answer to the trend of institutionalization of hedge fund investing. White paper managed accounts June 2015 3
2. Industry institutionalization trends 2.1 Development hedge fund industry The global hedge fund industry showed a strong growth over the last decade. The assets under management (AuM) have grown to a record $ 2.36 trillion as of June 2014 1. As such, hedge funds respresent about 1% of global financial assets. Figure 1: AuM ($, trillion) in hedge funds (1997-2014) excluding Fund of Fund investments 2,50 2,00 1,50 1,00 0,50 0,00 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: Barclay Hedge Increased allocation towards single manager hedge funds by institutional investors has been the primary driver of this growth in assets. Recent research showed that institutional investors account for 62 percent of the industry s AuM. 2 Hedge funds appeal to a broad range of investors though. Within the category institutional investors, foundations are the largest investors in hedge funds: 19% of institutional hedge funds investments are held by foundations. Fund of hedge funds and private sector pension funds are also significant investors in hedge funds, as Figure 2 and 3 show. Figure 2: Total hedge fund assets per institutional investor type Foundations 19% Family Offices 7% Fund of Hedge Funds 16% Asset Managers 4% Private Sector Pension Funds 15% Insurance Companies 4% Endownment Plans 12% Investment Companies 1% Public Pension Funds 9% Sovereign Wealth Funds 1% Wealth Managers 8% Others 4% Source: Preqin Global Hedge Fund Report 2014 1 Estimations by Eurekahedge and Barclay Hedge. 2 Goldman Sachs Annual Global Hedge Fund Investor Survey 2013. White paper managed accounts June 2015 4
Figure 3: Hedge fund assets per institutional investor type over time 25% 20% 18,9% 19,5% 15% 10% 5% 0% 7,5% 9,9% 2,5% 6,9% 2009 2010 2011 2012 2013 Public Pension Funds Private Sector Pension Funds Endowments Family Offices/Foundations Insurance Companies Sovereign Wealth Funds Source: Preqin Special Report November 2014 Recent surveys of the hedge fund industry indicate that the total AuM of the hedge fund industry are expected to continue to grow 3. The increase of the capital invested by institutional investors will be the key driver behind the expected growth 4. In the current market environment characterized by low interest rates, low credit spreads and high equity valuation institutional investors are searching for yield in alternative asset classes including hedge funds, as both fixed income and equity markets may face headwinds going forward. As the institutional investors will remain the most important investors for hedge funds, the trend of institutionalization of hedge funds investing will continue and will impact the key product characteristics. Figure 4 depicts the key issues the hedge fund industry is currently facing according to institutional investors. Achieving performance on a long term basis is essential for institutional investors. The introduction of new regulation frameworks such as the the Alternative Investment Fund Managers Directive has also lead to significant changes in the hedge fund sector. Another important change in the industry is the increase of the alignment of interest between hedge fund managers and investors through fee mechanisms. Investors are paying more attention to the management and performance fees of hedge fund managers. Finally, investors are increasingly requiring transparency with respect to their hedge fund investments. In the subsequent paragraphs these key issues will be discussed in more detail. 3 Deutsche Bank Alternative Investment Survey 2014. 4 Goldman Sachs Twelfth Annual Global Hedge Fund Investor Survey 2013. White paper managed accounts June 2015 5
Figure 4: Key issues facing the hedge fund industry Performance Regulation Fees Transparency Volatility Investment Opportunities Correlation Liquidity Economic Environment Other 0% 5% 10% 15% 20% 25% 30% 35% 40% Source: Deutsche Bank Alternative Investment Survey 2014 2.2 Impact of institutionalization The institutionalization of the hedge fund industry has impact on the following aspects: Performance Risk management Control Liquidity Transparency Fees Hedge fund beta Alignment of interest Compliance and regulation Performance A major concern of institutional clients is that hedge funds may deliver beta returns whereas the reason to invest in hedge funds is to achieve absolute uncorrelated returns. Institutional clients are not willing to pay hedge fund managers relatively high fees to deliver just beta returns. Despite the on average fairly disappointing and sometimes market corelated returns, the expected growth of institutional assets in hedge funds indicate that institutional clients still believe in the ability of hedge funds to generate absolute return. Across investor type and geographies, the majority (61%) is expecting a return between 6% and 10%, while 35% expect to have a return of 11% to 15%. In four years, the percentage of investors targeting double digit returns for their hedge fund portfolio has dropped from 52% to 37%. 5 Hedge funds now have to live up to both the ambitious expectations of institutional investors and the expectation of largely uncorrelated returns. Risk management Risk considerations have always been a component of hedge fund investing. In recent years however, institutional investors have paid increased attention to market risk, liquidity risk, counterparty risk and operational risk. While some years ago it was acceptable to experience periods of negative returns, institutional investors no longer seem to have patience to wait for market dynamics to change. As a consequence institutional investors 5 Credit Suisse Global Survey of Hedge Fund Investor Appetite and Activity 2013. White paper managed accounts June 2015 6
require a greater understanding of their investments and associated risks. In order to keep up with market standards and expectations with respect to governance, investment committees, boards and regulators are increasingly seeking more extensive and sophisticated risk reporting. As a result institutional investors require risk data and reporting that is both current and accurate on portfolio and hedge fund levels. Especially since the onset of the financial crisis counterparty has risk received increased attention. Institutional clients desire a frequently updated integrated view of their total counterparty risk. This means that the investments in external hedge funds need to be included in their internal counterparty risk reports. Finally, institutional investors must take operational risk into consideration. Hedge funds often invest in illiquid instruments and complex OTC contracts, requiring skilled and experienced fund operations staff. Research shows that operational risk is of great importance as the majority of the hedge fund blow-ups are caused by operational failures or weaknesses. 6 Institutional investors are aware of the importance of these risks. In fact, operational robustness is now perceived as one of the most important factors influencing the allocation decision. 7 Control Control issues can be split into two related considerations issues regarding control and governance over the underlying assets and issues surrounding conflicts of interest. A number of fraudulent cases like Madoff and blow-ups of hedge fund managers have all raised serious questions about the level of control investors have over their investments. In addition there is an inherent risk of conflict of interest between the manager and the investor. The source of this conflict lies in the objective of the hedge fund manager to attract assets and generate fees. Managers can increase risk in their portfolio (e.g. leverage, extreme bets, deviations of the investment style) in order to boost the performance. Institutional investors want to mitigate the risk of conflict of interest and require more control over their investments. Pension institutions in particular have very high standards regarding governance and asset control in traditional asset allocations and are increasingly applying equivalent standards to their hedge fund investments. 6 Capco white paper Understanding and Mitigating Operational Risk in Hedge Funds Investments March 2003. 7 Goldman Sachs Annual Global Hedge Fund Investor Survey 2013. White paper managed accounts June 2015 7
Liquidity Over the last years there has been a clear shift in preference for greater liquidity. Although there is substantial difference in the outcome of research, the majority of investors are currently invested in funds with at least monthly liquidity. 8 It should be noted that long-term investors like pension funds have different requirements regarding liquidity and can generally accept lower liquidity. Figure 5: Single strategy hedge fund liquidity terms 2008 and 2014 2008 2014 11% 5% 31% Monthly or Less 29% 2% 2% 8% Quarterly Semi-Annual Annual 81% More than Annual 45% Source: Goldman Sachs Global Hedge Fund Investor Survey 2014 While ongoing liquidity terms in hedge funds are improving, the majority of institutional investors still accept some lock-up period. Pension funds, insurance companies and endowments generally accept longer lock-up periods than other institutional investors because they benefit from a capital base that allows them to apply a longer term view. There are substantial differences in investor opinions about lock-up periods per region. US institutional investors are more willing to accept longer lock-up periods and gating provisions while European institutional investors strongly prefer that the liquidity of the fund matches the liquidity of the underlying investments. 9 Transparency Transparency continues to be an important issue for institutional investors. The level of transparency of hedge funds has generally improved throughout the years, but institutional investors requirements are pushing this trend further. Institutional investors often require full position transparency and detailed portfolio reports. Institutional investors require this level of transparency in order to monitor the manager, to monitor sources of performance and to facilitate risk management. One aspect that is often overlooked is the importance of the quality of data. The added value of transparency in terms of sophisticated risk management and performance measurement is only valid if the quality of the data provided is both accurate and reliable. Fees Nowadays, institutional investors have more bargaining power to achieve better results in setting the level of fees. As a result the typical 2 and 20 model has been abandoned to a large extent. The increased flows of institutional assets, disappointing performance of hedge funds over the course of recent years and the increased cost consciousness of institutional investors are the main reasons for institutional investors to continue to push back on fees. The arguments used by investors to (re)negotiate fees include less favorable liquidity terms, lock-ups, early stage investments and finally poor or beta related performance. 10 8 Deutsche Bank Alternative Investment Survey 2014. 9 Goldman Sachs Twelfth Annual Global Hedge Fund Investor Survey 2013. 10 2013 Credit Suisse Global Survey of Hedge Fund Investor Appetite and Activity, and DB 10th annual Alternative Investment Survey. White paper managed accounts June 2015 8
Figure 6: The average management fee and performance fee paid by asset owners investing in hedge funds 18.5 Average Performance Fee (%) 18.0 17.5 17.0 16.5 Pension Fund: 1.5 / 17.7 Endowment/Foundation: 1.58 / 16.31 Asset manager/fund of funds: 1.68 / 18.24 Family Office: 1.69 / 17,76 All Respondents: 1.69 / 18.21 Private Bank/Wealth Manager: 1.74 / 16.6 16.0 1.45 1.50 1.55 1.60 1.65 1.70 1.75 1.80 Average Management Fee (%) Source: Deutsche Bank Alternative Investment Survey 2014 Hedge fund beta Increasing focus on cost, coupled with a notion that hedge funds may be nearing an alpha generating capacity constraint as an industry, has led investors to consider adding hedge fund beta to their portfolio. Currently, several institutional investors are pioneering on this investment frontier. Essentially, hedge fund beta can be replicated either top-down or bottom-up. The top-down approach encompasses running backward-looking regressions of historical hedge fund index returns on various capital market risk factors (e.g., stock indices, bond indices, commodities, stock volatility). If the regression analysis showed a high explanatory power it is said to have replicated hedge fund returns. In practice however, backward-looking regressions appeared to have only a limited amount of predictive power. As a result, top-down approaches have been surpassed in popularity by bottom-up approaches. This approach starts by attempting to understand the underlying securities and trading patterns of various hedge fund strategies. If the core of certain hedge fund strategies have little-to-no discretion in what and how they trade, the bottom-up approach replicates the actual hedge fund strategy using a similar set of systematic trading rules. As such, the bottom-up replication product is akin to an actual hedge fund manager using a rules-based, quantitative approach to trading the underlying securities associated with a particular hedge fund strategy. The bottom-up approach is also referred to as alternative beta or alternative risk premia. Aligment of interest Institutional investments are a driving force behind the increased focus on alignment of interest between hedge fund managers and investors. Institutional investors main focus with respect to creating alignment is on economic terms. They increasingly expect that management fees should not generate profits for the hedge fund manager but rather should be set at a level to cover reasonable operating expenses of a hedge fund manager s business and investment process. To this end, managers are required to be transparent about their costs and managers should provide investors with sufficient information regarding their operating expenses and breakeven asset levels, so that investors can assess the appropriateness of the management fees being charged. Performance fees should include proper use of high water marks and hurdles. The need for a proper longterm incentive for the manager to maximize value over a typical investment period of 6 to 10 years became particularly acute after the recent financial crisis. White paper managed accounts June 2015 9
Figure 7: Illustration of the abundance of new hedge fund regulations Performance fees typically crystallize annually. This has lead to situations in which an investment in a hedge fund has produced a profit for the hedge fund manager but not for the investor. After serious drawdowns in 2008, numerous long-term investors realized that, as a result of the timing of profit splits, the hedge fund manager was the only one with an actual profit arising from the investor s allocation to the fund. As a result, performance fee mechanisms that provide true alignment between hedge fund manager and investors, i.e. with clawbacks over multiple years, are becoming increasingly in vogue. The clawback provision allows investors to reclaim earlier charged performance fees. However, many of the clawback arrangements currently in place in the US, could lead to the consequence of fund managers being taxed on deferred income. In other words, they have to produce a cash flow now, while the performance fee cash flow occurs at a later stage. This has been mitigated by the introduction of a performance fee in the form of a stock appreciation right. Instead of being paid a (deferred) performance fee in cash, the hedge fund manager is granted an option on the value of his hedge fund. This mechanism effectively allows the incentive fee to accrue over the life of the allocation which creates a long-term co-investment between investor en fund manager. Apart from performance fee retained within the fund, institutional investors also expect senior investment professionals from hedge fund management organizations to have a significant amount of their net worth invested in the hedge fund. Compliance and regulation: As regulators have been focusing their attention on hedge funds since the financial crisis, regulation has become the second-largest challenge hedge fund managers are currently facing in the industry.. As of July 2014, any hedge fund, private equity fund or real estate fund wishing to market or manage its fund in the European Union needs authorization under the Alternative Investment Fund Managers directive (AIFMD). As a result, many previously exempt hedge fund bodies have been included in the scope of regulators. White paper managed accounts June 2015 10
The objective of AIFMD is to introduce a common regulatory framework for previously unregulated funds in the EU to increase investor protection and to enable better monitoring of systemic risk issues by obliging hedge fund managers to provide extensive information to regulators. Funds that are regulated under UCITS are excluded from the scope of this regulatory framework. AIFMD requires hedge fund managers to obtain authorization, live up to ongoing operation requirements and comply with transparency and reporting requirements.. The directive is pushing hedge fund managers to improve their risk management and to use externals for valuating their portfolios. An aspect of AIFMD which challenges established practices in the hedge fund sector is the potential restriction of remuneration through bonus deferrals and clawback provisions. In addition, the AIFMD also enables competent authorities to intervene and et limits on leverage when deemed necessary with respect for the stability and integrity of the financial system. The majority of hedge funds are based in the US but when they are marketed to investors in the EU, they are in scope of AIFMD. At the moment, nearly 50% of the largest managers with asset under management of $ 5 billion or more had thought about exiting markets because of increased regulations. 11 In addition, smaller hedge fund are likely to spend more on regulatory compliance, both as a percentage of assets under management and relative to operating costs, than larger managers. Institutional investors are certainly more aware of the risks they are taking by investing in traditional or alternative funds and will seek to avoid negative publicity or difficult questions from stakeholders such as boards and underlying (pension) clients. Investors require their managers to be on top of the new regulation standards as well as to quickly anticipate any further upcoming changes. Factors that an investor will consider when evaluating the preparedness of a given manager to handle and anticipate these changes include an evaluation of the legal compliance and operational resources of the manager. 11 2014 Preqin Investor Outlook: Hedge Funds. White paper managed accounts June 2015 11
3. Possible investment structures Investors may gain exposure to hedge fund strategies through several different types of vehicles. Figure 8: Illustration of different types of hedge fund vehicles Manager Platform Provider Fund governance: Manager Investment policy governance: Manager (Client as shareholder) Service provider governance: Manager Asset control: Manager Transparency: Limited Fund governance: Manager/Client Investment policy governance: Client/Manager Service provider governance: Manager Asset control: Manager Hedge Fund/FoHF Transparency: Dependent on manager and no uniformity Fund of One Dedicated Managed Account Client Commingled Managed Account Fund governance: Client/independent Fund governance: Platform Investment policy governance: Platform/Manager (Client as shareholder) Service provider governance: Platform Asset control: Platform Transparency: Partial transparent (with delays and not always with full holding transparency) Investment policy governance: Client/Platform/Manager Service provider governance: Platform/Client Asset control: Client/Platform Transparency: Full transparency The most common ways to invest in hedge funds include: 1. Direct fund investement: The investor invests directly in hedge funds. These hedge funds are set up and managed by the hedge fund manager. The hedge fund manager is the entity that has control over the fund and the assets. The hedge fund manager determines the governance structure of the hedge fund, the level of transparency provided towards investors and selects the fund s service providers. The liquidity terms of the hedge fund are defined by and generally in favor of the hedge fund/manager (typical hedge fund liquidity terms are monthly or even quarterly with long notice periods). Hedge fund fees consist of a management and performance fee, and fees for service providers (e.g. administrator, custodian, transfer agent, legal advisor, and accountant) and other costs such as marketing and organizational expenses. The majority of the hedge funds is set up in lightly regulated domiciles like the Cayman Islands, Jersey or B.V.I. Recently, a number of hedge fund managers have issued mutual funds regulated under the US 1940 Investment Company Act. 2. Fund of hedge funds: A fund of hedge funds is a fund that invests in several different hedge funds to provide better diversification. The manager of the funds of hedge funds is responsible for manager selection, portfolio construction and portfolio management. Ultimate control over the assets is exercised by the underlying hedge fund managers. While offering investors the advantages of greater diversification and manager selection expertise, the disadvantages include limited transparency, liquidity constraints and additional costs. As the assets are held by the underlying manager, transparency is limited at the fund of hedge fund level. The liquidity of the fund of hedge fund is linked to, and might be constrained by, the liquidity of the underlying hedge funds. Fund of hedge funds have a double layer of costs as both the fund of hedge fund and the underlying hedge funds will each charge management and/or performance fees, service providers fees and other costs. Similar to hedge funds, fund of hedge funds are often set up in lightly regulated domiciles like the Cayman Islands, Jersey or B.V.I. White paper managed accounts June 2015 12
3. Fund-of-one: This is a dedicated fund that is set up by the hedge fund manager at the request of a large investor to manage the investor s assets pari-passu with the reference hedge fund. The manager retains ownership and the control over assets and maintains the relationships with the market counterparties and service providers. A fund-of-one is set up as a separate vehicle effectively segregating the assets from the other assets of the manager. Large investors will be able to customize the fund on certain aspects like investment guidelines, transparency and governance (by appointing one or more directors of the fund). For these investors it should also be possible to negotiate lower management fees as the fund-of-one is not competing with the reference hedge fund of the manager. The fees of the service providers should remain comparable to those of the reference fund. The fund can be set up in the investor s domicile of choice. 4. Managed account: A managed account is an investment structure that is set up and governed by either the managed account provider, the client, or the independent board of directors (hereafter called sponsor ) to manage the assets pari-passu with the reference hedge fund. Typically the managed account will be set up as a separate vehicle enabling the ring-fencing of the assets. The managed account can be fully customized to the sponsor s specific needs and restrictions. The hedge fund manager will only be involved in portfolio management without having any control over the assets or the operating model. All operational aspects are handled by service providers that are chosen by the sponsor of the managed account. Similar to the fund- of-one, the sponsor will be able to negotiate reduced management fees for a sizable dedicated managed account. The costs of service providers will be charged to the fund (account) but can be kept relatively low as the fees can be negotiated on the basis of the sponsor s total AuM. The fund (account) can be set up in the sponsor s domicile of choice. White paper managed accounts June 2015 13
4. Managed accounts further explained 4.1 Definition of managed accounts Although managed accounts have been in use for more than a decade, there is still confusion about the concept of a managed account for hedge funds. This confusion may stem from the terminology because the managed account structure is similar to the segregated mandates given to the traditional long-only managers by institutional investors. For managed accounts, as with segregated mandates, the manager acts as investment advisor to a portfolio of assets that is tailored to the client needs and operates within the client s framework of service providers. To provide greater clarity about the concept of managed accounts for hedge funds, the following definition will be used: A managed account for hedge funds is an investment structure: That is governed by either the managed account provider, the investor, or the independent board of directors (the sponsor ). Where the assets are typically managed pari-passu with the reference hedge fund. That is tailored to the specific needs and restrictions of the sponsor. Where the hedge fund manager s role is limited to executing the trading strategy Where certain operational tasks such as valuation and accounting are carried out by independent third party providers that are chosen by the sponsor. Where the sponsor is responsible for the operational oversight of the managed account (e.g. risk management, monitoring investment limits, cash management, reporting, legal, compliance, tax). 4.2 Managed account structure Managed accounts can be structured in many ways and can be customized to the needs of the sponsor. The diagram below shows a typical managed account structure, the parties involved and their main tasks. White paper managed accounts June 2015 14
Figure 9: Typical managed account structure, including involved entities and activities HF portfolio management Legal, Tax Compliance Investor Risk Mgt Operations Reporting Operational Risk Trading Advisor Hedge Fund Manager Trading Advisory Agreement Board of directors / manager, general partner Managed Account (company, Trust, LP) contractual fund) Service Agreements Service Providers & Market Counterparties Trading strategy replication Governance Asset Control Auditor Secretary Management company (if applicable) Administrator Legal Advisors Investment Management Agreement Managed account provider Investment Manager (AIFM in the EU) Custodian/Depositary in the EU Registrar & Transfer Agent Prime Brokers OTC Counterparties Monitoring Trading Advisor Risk Management Operational Controls Reporting Performance Monitoring Legal, Tax, Compliance Explanation: Managed account: For each managed account a separate legal structure is incorporated. This incorporation requires regulatory approval or notification. As each managed account is a separate legal entity, the assets are ring-fenced and there is no risk of contamination across managed accounts. The party that governs the managed account varies by structure a company structure will have a board of directors, a trust structure will have a manager and an LP will have a general partner. The governing body is responsible for, amongst other things, the appointment of the trading advisor, service providers and market counterparties. Trading advisor: The hedge fund manager is appointed as the trading advisor to manage the assets of the managed account within a set of agreed upon investment guidelines as set out in an Trading Advisory Agreement (TAA). The TAA is the key legal document that governs the relationship between the managed account and the trading advisor. In Table 1 the key elements of a TAA are summarized. The trading advisor typically needs to be approved by the regulator: in the US as a Registered Investment Advisor and in the EU under Mifid or AIFMD regulations. Investment manager: The party that is appointed as investment manager of the managed account will perform the daily operations of the managed account (subject to the specific requirements of the investor/ sponsor). In most situations the managed account provider will be acting as investment manager of the managed accounts, as only large investors will be able to act as investment manager themselves. A managed account provider acting as investment manager typically needs to be approved by the regulator: in the US as a Registered Investment Advisor and in the EU under AIFMD regulations. White paper managed accounts June 2015 15
Table 1: Overview of key elements of the Trading Advisory Agreement Investment related aspects Business aspects Legal aspects Operational aspects Investment guidelines: Approved markets, sectors and instruments Concentration limits Liquidity of underlying investments Leverage limits Exposures Capacity Management & performance fee Liquidity of the MAC Most Favoured Nations (MFN) clause Termination Liability & indemnity Reps & warranties Confidentiality Description of roles and responsibilities Insurance Ongoing due diligence Trading process and IT Typically the investment manager is providing the following services (not limited to): - Trading advisor monitoring: Monitoring the daily process. - Risk Management: Stress testing, calculation of risk data, report investments guidelines breaches and coordinate corrective actions as necessary. - Operational tasks: Cash management, checks on valuations and trade errors, monitoring of the subscription and redemption process and monitoring service providers and market counterparties. - Performance Measurement: Performance reporting and analysis of the managed account, the reference fund and any tracking error. - Reporting: Making available periodical managed accounts and risk reports - Legal, Tax and Compliance: Negotiate and draft legal agreements, perform legal proceedings, tax filing, and legal compliance. Custodian/Depositary: The custodian, typically combined with a depositary function under EU AIFMD, ensures that the issue, repurchase, redemption, sale, and cancellation of shares are carried out in accordance with the prospectus and any other applicable legal documents (articles of association, trust deed). In addition, the custodian/depositary is also responsible for the safekeeping of the assets. Under AIFMD the depositary function includes supervising the managed account s investment activities and cash flows. The custodian may also be required to conduct the annual shareholder reporting and to confirm the managed account s accordance with its prospectus and the applicable regulations. The custodian is allowed to delegate the whole or any part of its custodial functions to a third party, provided that the liability of the custodian regarding the safe keeping of the assets will not be affected. The custodian must exercise care and diligence in choosing and appointing a third party as a safe-keeping agent and must maintain an appropriate level of supervision over the safe-keeping agent. The depositary function, as required by AIFMD, cannot be delegated. White paper managed accounts June 2015 16
Registrar and Transfer Agent (RTA): The Registrar and Transfer Agent has responsibilities that include the processing of subscription and redemption orders, maintaining the shareholder register, carrying out anti-money laundering checks and sending notices, reports (including the interim and annual reports), financial statements and other documentation to the shareholders. Prime brokers, clearers, and OTC counterparties (market counterparties): Each managed account will normally have the same market counterparties as the reference fund. In order to mitigate counterparty risk each managed account should have at least two prime brokers and a number of OTC counterparties. Each managed account will execute its own agreement with such prime broker, clearer or OTC counterparty. Administrator: An independent administrator will (in most cases) be appointed for the administration and accounting valuation. The administrator is often also responsible for collateral management. Registered Auditors: A chartered auditor is appointed to produce and approve the annual report of each managed account. Legal advisors: Legal counsel will be appointed to provide legal services to the managed account. Secretary: A company secretary can be appointed to provide a registered office for the managed account, to prepare (board) meetings, to maintain minutes of those meetings and to ensure that required filings with the regulator are made. 4.3 Operational set up The operational set up of a managed account is designed in such a way that the trading advisor is able to trade for the managed account and the investment manager is able to perform its oversight function. Although the operational set-up may vary per managed account provider, the typical set up is illustrated in Figure 10. Figure 10: Operational structure, including cash and securities flows Client Cash A/C Cash allocation to Client custody account Transfer Agent Cash A/C Aggregation of managed account orders Transfer Agent custody account Allocation to prime brokers & OTC counterparties Fund Cash A/C Fund Treasury Securities A/C Cash sweep for investments Fund custody account Prime Broker A Cash A/C Prime Broker A Securities A/C Prime Broker B Cash A/C Prime Broker B Securities A/C OTC Counterparty Cash A/C Prime Broker custody account Securities & OTC trading Executing Brokers & Other Market Counterparties Money Market Counterparties White paper managed accounts June 2015 17
4.4 Legal, regulatory and tax set-up The managed account can be tailored to the institutional investor s requirements regarding legislative framework, domicile and regulation, legal arrangements, taxation, and local support of service providers. Domicile Traditionally managed accounts were set up in more lightly regulated offshore domiciles like Cayman, Bermuda and Jersey. In the recent years institutional investors often demand properly regulated hedge funds domiciled in an onshore location with strong regulatory governance. The demand for better regulatory oversight stems from regulatory developments but is also based on self-regulation of investors. Anticipating on this client demand, several managed account platform providers have moved their platform to onshore domiciles. The most popular domiciles to set up European onshore managed accounts are Luxembourg and Ireland. Where Luxembourg is the logical choice for plain vanilla mutual funds or UCITS funds, Ireland has the preference for non-ucits hedge funds. Although the regulation and legal vehicles are quite similar, hedge fund managers tend to have a slight preference for Ireland. Most US managed accounts are still domiciled offshore in the Cayman Islands, but onshore structures in Delaware or equivalent onshore juridictions are gaining more traction. Regulatory framework The EU regulatory framework available for managed accounts can be divided in UCITS and AIFMD. In the US the Dodd-Frank Act introduced hedge fund supervision by the SEC, whereas the majority of hedge fund used to operate under an exemption. Broadly speaking, UCITS is fund-focused regulation, providing only some requirements for fund managers, while AIFMD is mainly targeting the fund manager s organization. The introduction of the AIFMD largely ended the existence of unregulated funds in Europe. UCITS hedge funds have witnessed significant growth since 2007 as managers have continued to attract investment interest from insurance companies, pension funds and other institutional investors. Important drivers for this growth are investor s restrictions on investing in non-ucits funds and the robust regulation of UCITS (e.g., diversification requirements, liquidity, transparency). In reaction to this trend several managed account platform providers have set up UCITS managed account platforms. Large institutional investors, especially from outside Europe, have, however, little to no interest in UCITS managed accounts. Generally, the added value of UCITS compared to a managed account in an onshore domicile is questionable. As the liquidity, transparency and advanced risk management are already intrinsic to managed accounts, and proper regulation and governance are intrinsic to onshore domiciles, UCITS seems more a marketing gimmick than that it actually adds value. The regulation can even be detrimental as UCITS limits the usage of total return swaps and provides stringent requirements to quality of collateral. White paper managed accounts June 2015 18
Irish and Luxembourg AIF structures The most popular fund structures for institutional investors are a Qualifying Investor Fund (QIF) in case of Ireland and a Specialized Investment Fund (SIF) when the domicile is Luxembourg. Both fund structures typically qualify as AIF (alternative investment fund) and are suitable for a variety of hedge fund strategies as the investment restrictions are limited (no borrowing or leverage limits) and the fund structure is reserved to professional investors. Figure 11: Comparison of regulatory requirements of different vehicles in Ireland and Luxembourg Ireland QIF Minimum EUR100,000 investment No investment limits Short selling permitted 24 hour authorisation Complex incentive fees Broad range of permissible strategies Luxembourg SIF Individual investor: minimum EUR125,000 investment Risk spreading limit of 30% only. Minimal restrictions Short selling permitted No lead time to authorisation. Must file within 1 month following creation. Broad range of permissible strategies As the US does currently not have a regulatory regime equivalent to the AIFMD, US-based managed account structures typically have no regulatory investment strategy constraints as compared to a QIF or SIF. Legal vehicle Typically there are two main legal vehicles used to set up managed accounts a corporate vehicle and a trust or contractual fund. Corporate vehicles The Investment Company is the most common legal vehicle used for managed accounts. In Luxembourg the SICAV is the preferred choice, whereas US-based managed accounts typically opt for an LLC. Recently, the Irish Collective Asset Management Vehicle (ICAV) came into full operation. Each company, comprising one managed account, is managed and controlled by its board of directors (SICAV, ICAV) or by a managing member (LLC). The board of directors or managing member is allowed to delegate certain duties to third parties (e.g. investment management duties, administration functions), but remains responsible for ensuring that the company is managed in the best interests of the shareholders. This legal structure can easily accommodate specific client needs on control and ownership, as independent or affiliated directors can be appointed to the board of directors. Unit Trust/contractual fund A Unit Trust is frequently used for managed accounts that are sold to US, Japanese, and UK investors. A Unit Trust is constituted by a trust deed made between the trustee and the manager. The trust deed defines the rules of the fund and the rights of the unit holders. A Unit Trust is not a separate legal entity and therefore the trustee acts as legal owner of the fund s assets on behalf of the investors. White paper managed accounts June 2015 19
A contractual fund, like a unit trust, is a collective investment undertaking which is constituted as an unincorporated body established by a management company. The unitholders, by contractual arrangement, participate and share in the property of the collective investment undertaking. This structure is frequently used for European investors. For all of the above vehicles it is possible to structure a fund as an umbrella fund. Umbrella funds are often used for managed account structures as it is the most cost efficient structure while segregation of liability between the sub funds is (in most jurisdictions) arranged by law. Many managed account providers or institutional investors still prefer to have stand-alone funds because a theoretical risk remains that there will be contamination between the sub funds as the segregation has not been tested in US courts. In addition, the funds may also provide for the establishment of different classes of shares or units within a fund or, inthe case of an umbrella fund, within each sub-fund of the fund. Tax All of the above investment vehicles are exempt from tax on their income and gains and no withholding tax is levied on income distributed to its investors (except when the EU savings directive is applicable). In Luxembourg there is an annual subscription tax of 0.01% of the net asset value for institutional funds (exemptions are applicable for pension funds and investments in other funds that are already been subject to subscription tax). Investment companies are generally not tax transparent and are qualified as per se corporate entities for US tax purposes, making it impossible to be treated as partnership for these purposes ( check the box ). Unit trusts and contractual funds can be structured as tax transparent and, as such, can be looked through for U.S. tax purposes. Selection legal structure The investor and managed account provider have to decide what the best structure is for all intents and purposes and should therefore take the following aspects into account: Desired domicile, regulatory oversight and framework Tax considerations Ability to provide for control or influence of the sponsor or investor Familiarity of the end investor with the legal structure Type of investments and applicable investment restrictions Figure 12: AF Advisors Investment Structure Selection Framework Control over the terms of the fund Flexibility to change if markets change Proper Fund Governance Control over the invested cash Transparent reporting on returns, risk & costs Taking advantage of tax reclaims Fiscally Optimized Alignment of fund with client s fiscal situation Selection of Investment Strategy No costly operational mistakes Low operational fees to optimize returns Low Operational Costs & Complexity No costly operational mistakes Low operational fees to optimize returns Requirements of Targeted Clients Freedom to pursue investment strategies Fund Terms Attractive For Clients Adherence to agreed investment restrictions Good liquidity terms Liquidity match investments & fund Appropriate fees Fund Terms Enable Execution of Strategy Appropriate transparent fees White paper managed accounts June 2015 20
4.5 Available managed account product structures In the earlier paragraphs the managed account concept, the legal structure and the operational set up have been described. There are a number of ways to invest in managed accounts. Generally the following managed accounts product structures are available: Commingled managed account Fund of managed accounts Dedicated managed account Structured managed account Commingled managed account This is a managed account that is set up by a managed account platform provider who is offering a range of individual managed accounts covering multiple hedge fund strategies to institutional investors and high net worth individuals. The managed account provider acts as investment manager of the managed account and is responsible to control and operationally manage the managed account for the benefit of the investor. As all the investors invest in the same managed accounts the investments of the investors are effectively commingled. Fund of managed accounts In this structure the investor invests in a fund that is set up by the fund of hedge fund manager. The fund of hedge fund manager is managing a portfolio of managed accounts that are either controlled by the fund of hedge fund manager or by a managed account platform provider. The investor can profit from the portfolio management and the manager selection capabilities of the fund of hedge fund manager in combination with the advantages of managed accounts. Dedicated managed account Dedicated managed accounts are set up for a single investor either by the investor or a managed account provider. There are essentially three types of dedicated managed account structures: 1. A dedicated managed account structure where a managed account provider is acting as investment manager and has the full fiduciary responsibility for the managed accounts. Some activities can be excluded from outsourcing to the managed account provider and be carried out by the investor. Customization is possible but to a limited extent as the managed account provider is ultimately responsible and therefore liable for the managed accounts. With this structure the investor is using the expertise and economies of scale of the managed account provider while limiting its liability. 2. A dedicated managed account structure where the investor is acting as investment manager and has the full fiduciary responsibility for the managed accounts. The investor can either set up and manage the managed account completely by itself, or can use a managed account provider to set up and perform certain tasks for the management of the managed accounts. In case the managed account provider performs certain duties like onboarding of new managers or operational support, the investor remains responsible and is involved in all processes. This structure gives the investor ultimate control and opportunities to customize the features of the managed account to their requirements. In reality there will be very few investors that are able to set up and manage managed accounts completely themselves. 3. A dedicated managed account structure that is a hybrid structure of option one and two. In this structure the investor is having a formal role in the governance of the managed account structure (e.g., as sub advisor or by delivering one or more directors of the board). The investor enters into a service agreement with the managed account provider to set up and perform certain tasks relating to the operational management of the managed accounts. The managed account provider will be acting as investment manager. Because the investor has a formal role in the governance structure, significant control over the managed accounts can be realized while the platform provider has effectively the main fiduciary responsibility for the operational management of the managed accounts. It must be noted that more involvement of the investor in the governance and operational management will also bring more potential liabilities. White paper managed accounts June 2015 21
The picture below details the difference between the three types of dedicated managed account structures: Figure 13: Illustration of differences between three types of dedicated managed account structures Manager Option 3. Option 1. Dedicated MAC Platform provider in the lead Platform Provider Fund governance: Platform/Independent Investment policy governance: Platform/Client/Manager Service provider governance: Platform/Client Hybrid Dedicated MAC Client and platform provider in the lead Asset control: Platform/Client Option 2. Fund governance: Client/Platform Investment policy governance: Client/Platform/Manager Dedicated MAC Client in the lead Service provider governance: Platform/Client Asset control: Client/Platform Fund governance: Client/independent Client Investment policy governance: Client/Platform/Manager Service provider governance: Platform/Client Asset control: Client/Platform Structured managed account With a structured managed account the investor is investing in a product (e.g. principal protected note, option, certificate, total return swap) where the underlying investments are one or more indices that reflect the performance of the relevant managed account. The client effectively has exposure to managed accounts and is therefore benefitting from the advantages of (daily) liquidity, transparency and active risk management of managed accounts, but holds no shares or units of the managed account itself. Structured managed account products are only possible for liquid hedge fund strategies like CTAs, Global Macro, FX and Commodity. An important aspect to take into account is the possible credit risk this structure entails. Depending on the specific product type and the underlying investments, the investor can profit from offered features such as capital protection or unfunded investments. With the last product structure the investor can realize exposure to managed accounts without necessarily exchanging any initial capital. 4.6 The positive aspects of managed accounts Key beneficial features of managed accounts that have contributed to the popularity of this segment are: A. Improved governance and asset control A managed account is governed by a managed account provider, client or (independent) board of directors instead of a hedge fund manager. The hedge fund manager s role is limited to manage the assets pari-passu with the reference hedge fund without having any control over the assets and operating model. The segregation of the key roles and responsibilities of managed accounts results in the following advantages for the investor: Elimination of conflicts of interests: The segregation of the trading responsibility from the fund management and custodial responsibility, potential conflicts of interest are eliminated. Managers are no longer involved in for example the decision making regarding approving NAVs, suspensions of NAVs, and valuations of underlying positions. White paper managed accounts June 2015 22