I recently came across the attached white paper* from Merlin Securities which highlights, in part, the distinction between managing money and running a hedge fund business. This is an concept that I have been emphasizing whenever someone asks me about forming a new hedge fund. There are numerous examples of talented money managers that attempted to go their own way and ended up closing their shops. They failed, not because they didn’t know how to make money for their investors, but because of operational collapses. The challenges in building a sustainable hedge fund business and raising external assets cannot be overstated. This may be a bigger issue for individuals leaving investment banks or mutual funds than prior hedge funds. Given the financial rewards achievable by successful hedge fund managers, the better a foundation you build, the greater the chances for success for your investors and yourself. Starting with the right team (both internal and external) is just as important as partnering with quality investors.

Please feel free to add your thoughts to the discussion.

*Reprinted with permission from Merlin Securities.

George Roeck, Chief Operating and Financial Officer, Charter Bridge Capital Management, L.P.

Executive Board Member, HFBOA

The hedge fund universe is entering a new post credit-crisis era of increased institutional flows resulting in demand for greater Investor transparency and increased regulation & oversight. In this new environment, organizational maturity - a hedge fund's ability to match its operational and infrastructure needs with its size and scope - is becoming a key differentiating factor. The maturity of a fund's organizational structure, the robustness of its operational controls, and the resilience of its technology infrastructure are becoming determining factors in the allocation of capital.

In the second Prime Finance publication of 2010 this key topic has been explored through over 75 in-depth interviews with COO's, CFO's, and heads of strategy, from a broad cross section of hedge funds from start-ups and spin-outs, to emerging funds and institutional size firms, up to the franchise heavyweights of the industry. These interviews provide the foundation of views put forward in this article.

Findings of these interviews have been translated into a Hedge Fund Maturity Model that details the organizational, operational and technology characteristics of hedge funds across four stages of maturity linked broadly to the size of their AUM. This maturity model provides a framework for the industry to discuss organizational "best-practice" and forms the foundation for the Citi Prime Finance Business Advisory team to partner with our clients and help them shape their evolution and growth.

To view the full report please go to:

https://primebroker.citigroup.com/public/PlanningforChange_Dec2010.html

*this was reposted with permission from Citi*

In this post Lehman era, the question I continue to grapple with is: How many prime brokers do you need?

Given that our fund is one of the more plain vanilla Long/Short equity funds, I think more than two is really unnecessary.  We launched our fund in the end of 2008 with three prime brokers and a segregated cash custody account (when I was hired, our initial thought before Lehman was just one prime broker and no cash).

The problem I run into with multiple primes - other than the hassle of additional reporting. reconciliations, etc - is being able to spread my balances to each.  I don't end up with significant assets at any one area to use as leverage for cost savings.

I understand being able to spread counterparty exposure over multiple primes is definitely something investors are thrilled with - I get it - but there has to be a happy medium to it.

I pose the question to the website from an investor and hedge fund prospective.  What is the right number? 1, 2, 5??

Do we still need to have our free cash in a segregated cash account, and if so what percentage of NAV are investors happy with? You have to remember that performance is affected in these situations - not enough balances, can't negotiate down financing rates.  Need to have x% of NAV away from PB - might be borrowing from Peter to pay Paul.  In the world of uncertain market performance, the last thing any hedge fund manager needs is additional basis point hits to an already weak 2010 performance number.

With all of this in mind, having multiple primes does have advantages above and beyond minimizing counterparty exposure, such as free competition to get locates on hard to borrow names.  Letting the brokers fight it out can actually save some significant performance depending on how long you hold your positions.  They also can go in and borrow stock from you and then you can use the other brokers as a benchmark for rates.  This enables a manager to more effectively manage the financing game.

What are your thoughts? What stories do you have recently? I would love to get a lengthy blog going on this topic.

Marc Abel, Chief Financial Officer, Dabroes Management LP

Executive Board Member, HFBOA

It’s not like me to be quite a salesman for anything,　but I thought I would give my views regarding the HFBOA conference and why I believe it will be beneficial to hedge funds CFOs such as myself.

In quick review, here are the topics of the conference:

• Regulatory updates: At home and abroad
  • Regulation at the state level: New implications for private fund managers
  • The future of offshore jurisdictions
  • what you need to know about the European Alternative Investment Fund Managers Directive
• Accounting, auditing and tax updates
  • the impact of the new carried interest law
  • Updated disclosure requirements for ASC 820 (Formerly known as SFAS-157)
• Managing your third party relationships more effectively
  • cleaning up your prime broker arrangements
  • New trends for administrators: asset verification and price verification reporting
• financial management for the fund and fund advisor
  • compensation challenges: from high water marks to deferred compensation plans
  • what can I legitimately charge to the fund?  Legal and ethical considerations
• Managing investor relationships: From due diligence to fundraising
• How do investors' approaches to due diligence differ? Investor Panel Discussion!
• terms, liquidity, and fundraising: A look at varying expectations

 Given the market environment these days, I am always facing different questions and I believe this year is one in which going to the conference will be of most value.

I am very concerned about the EU directives because my fund is primarily invested in western Europe.　 Of particular interest is short bans by country: There is going to be much more compliance required in certain countries (which will require monitoring position size on shorts to say the least) and I am curious what the panelists will say are "more likely than not" to stick once the books are written.

As far as the new carried interest law, we are generally a short term capital gain shop, but everyone wants to be able to get as much capital gain vs ordinary, especially since the elimination of all those offshore deferral compensation plans that were so popular a few years back.　 The combination of the new carried interest law and the elimination of the Bush tax cuts (or what looks to be possibly amendments with Obama’s stamp, but again favoring tax treatment away from the hedge fund managers) should make for some interesting discussions, both at the conference and going forward in the months before 2011: How managers will operate as tax-efficiently as possible.　 Are we going to need to accelerate capital gains to take advantage of lower tax rates? 　What will happen with all these dividends that were getting preferential treatment that will no longer apply?　 Are swaps still going to get around all that offshore withholding?　

The pendulum for prime broker agreements are swinging more in favor of the managers again.　 The collapse of the world back in 2008 (when I launched our fund) dictated that funds needed to 　take on multiple prime brokers as well as a cash custody account for free cash.　 That put hedge funds at the mercy of the brokers and banks and terms for hedge funds were very unfavorable.　 　I think now is the time to really push back and renegotiate agreements and possibly eliminate the need for four or more prime brokers and discuss terms that favor funds a bit more.　 I think this particular conference session will provide significant value to hedge fund manager CFOs, though will probably benefit all attendees to some degree.　 Another key question: What will administrator’s agree to in their new agreements for 2011 and beyond?　 Can we as an industry apply enough pressure to renegotiate what is currently in place regarding price verification?　 Can we get them to agree to pricing the portfolio vs. a price verifier?　 I would love to hear what my peers think.

As for income and expenses of the funds moving into next year, what will the trends be to the following?

1.  High water marks-what will we as an industry be expected to make before we collect our 20% (if it stays there)

2.  What is going to be the industry standard for management fees-i.e. is 2% acceptable anymore?

3.  What about expenses that funds feel comfortable charging to the fund, given a downward trend away from the 2%?　 IF we charge less to the funds can we stay at 2% or if we go to say a 1% benchmark will investors "expect" to pay for more and have the manager pay for less?　 OR is there such a paradigm shift that will require into 2011 and beyond (dare I say) 1% fees and also very little fund expenses?

4.  As to liquidity terms, we are looking to see what PPMs will look like going forward-what will investors "expect" to be given in addition to fee terms, specifically liquidity?　 At our fund, we have bounced that around a lot recently to figure out whether you can have a hard lock, just a soft lock, some combination of lock or (if the fund is liquid enough) really not have any lock up at all?　 I am curious where investors stand on this as they need to appreciate that managers are looking for long term partnering relationships.　 Although it’s important to give on some liquidity, especially if the fund is liquid, we don’t want to be managing our fund quarter to quarter or month to month if it ever gets to that point.　

 These final areas of the conference I think will really leave people with some thoughts to consider.

Again, not being a salesman, I nonetheless hope I sold everyone on the need to attend and get ready for a very exciting few days.　 Attendance has grown year over year and I think this is the perfect time to join your peers for what I feel are strong sessions on key issues as we head into next year.　 See you there.

Marc Abel, Chief Financial Officer, Dabroes Management LP

Executive Board Member, HFBOA

Some years ago, we had launched a "’40 Act" fund (more specifically a Registered Investment Company, or "RIC" under the SEC’s 1940 Act). This RIC is a fund of hedge funds targeted only to accredited investors, yet allowing for unlimited investors with initial minimum investment amounts far below the typical $1mm+ required by other funds. The first product launched in the early naughts when expanding investor access to hedge funds through traditional retail channels was deemed to be its primary raison d’être. This market of moderately HNW clients looking only a dip a toe into the hedge fund waters proved a reasonable opportunity. Investors were happy with the reduced minimums as well as the fact that this fund had elected to provide 1099 tax reporting, as opposed to K-1s. This was also an important selling point of the fund. 1099s are distributed to investors in January following year-end as opposed to K-1s which get distributed anywhere from February (highly optimistic) to as late as in the summer months, which can be frustrating to investors and their accountants.

All well and good so far, yet despite the simplification of the Form 1099 from an investor’s viewpoint, it poses additional challenges for the fund. Subchapter M of the IRS Code spells out certain needs for a Registered Investment Company, the largest challenges for a fund of hedge funds (or even stand-alone hedge funds) being:

• Quarterly asset diversification testing, and
• Annual distribution of fund profits (else face an excise tax).

The quarterly asset diversification test, while conceptually mechanically simple, requires all underlying managers to divulge their positions on a quarterly basis. The test is made to ensure compliance with the IRS Code’s Subchapter M rule which compels that the RIC fund hold no more than 5% of its assets in a given investment.¹ There are some other concentration tests as well, but this 5% rule is a challenge as it creates the need for the RIC to aggregate all of its investments on a look-through basis.

Outbound portfolio dissemination is not always favorably viewed by hedge fund managers, particularly the smaller ones who may have a policy of non-disclosure, or who otherwise wouldn’t be compelled to disclose (e.g. 13-D filings). This leads generally to a business decision by the underlying manager as to whether to change their stance. In our funds, we have eased the pain somewhat through processes whereby portfolios are transmitted on a confidential basis to a third party service provider to receive portfolios. However, not all hedge funds become converts, which somewhat narrows the investment opportunity set, and could provide some tracking error versus a similar non-registered fund.

The second hurdle comes from the need to determine effectively before the end of December as to what dividend to declare. Simply stated, the IRS Code says that a RIC needs to distribute 98% of its annual income during the calendar year. This requires receipt of reasonably good taxable income estimates early in December from all of the RIC’s underlying fund mangers and aggregation of these amounts. Then a safety margin gets built in, (fingers get crossed), and a dividend gets declared in the final days of the year. In our fund, our investors elect to reinvest the year-end dividend, so fortunately there’s no additional cash movements required. The downside to missing this estimate is a 4% excise tax impounded against any upside variance.

What makes this process work effectively is active communication with the underlying hedge funds to get the best possible data possible. In the following year, a measurement is made on a retrospective basis, as to where the estimates used in compiling the RIC’s dividend compare relative to the actual full year taxable results. Given the volatility of the latter portion of most Decembers (flash crashes aside), it’s impossible to have all mangers be spot-on. Yet given normal distribution patterns, hopefully the late variances to the downside offset those to the upside, and thus an excise tax is avoided.

Challenges aside, we happily still see robust interest from investors for a registered product with 1099 reporting.

^{1 More technically, the 5% restriction is made as to "issuer", which means that all securities of a given company (i.e. equities, bonds, options ) are aggregated together to make the test.}

-Matthew Jenal, Senior Advisor, CADOGAN MANAGEMENT, LLC 

Adam Alesandro, Chief Technology Officer from fund administrator AFA (Advanced Fund Services) shared his thoughts on technology as a differentiator in the fund admin space. AFA was founded in 2007 by Peter Young formerly of Citi Hedge Fund Services and BISYS and uses SunGard’s VPM product suite in their firm.

Adam stressed the flexibility of the platform when choosing a portfolio and partnership accounting package and noted the three levels of software packages as well as the pros and cons of each: excel based, proprietary and enterprise level systems. Two of the main differentiators are whether the software uses "structured data" as well as whether the system is scalable. He noted that while excel is flexible and generally easy to use it is typically not sufficient in today’s demanding hedge fund back office environment.

Adam also highlighted the importance of "straight through processing"- limiting the amount of manual intervention and the potential errors and additional manpower that goes along with those entries that need to be done outside of a fully automated workflow.

The group discussed the potential of the administrator and their technology’s ability to enhance and facilitate the internal processes and policies of the hedge fund CFO. AFA frequently provides customized reporting to the funds as often as daily to help the fund back office in their responsibilities to their clients. For those funds that chose to not shadow their administrator’s work on a daily and monthly basis AFA can provide reports and extracts to compare to the prime broker’s data in helping the back office get a comfort level that their controls are sufficient.

For smaller funds or funds with limited internal systems the fund administrator should be able to provide services to facilitate working with third party risk management and reporting firms.

Additionally, the ability of the fund administrator and their systems to provide daily NAV’s has become an increasingly important function of hedge funds with limited internal resources.

The luncheon concluded with a networking session where many hedge fund executives got to share ideas between themselves as well as key service providers.

-Duncan Huyler, CFO, 360 GLOBAL CAPITAL and Executive Board Member, the HFBOA

Post-Madoff and post-Lehman one of the more significant predictions in the hedge fund space was the potential for a huge increase in the number of separately managed accounts (SMAs). Increased transparency and the demands for liquidity after the meltdown the industry experienced in the recent past brought SMA advocates out of the wood work. The reality is that the "trend" may have been overblown or at least overhyped, however, for those funds willing to embrace the trend there is a differentiator that is potentially valuable and even lucrative.

Working with an allocator that has previous experience with SMAs can be a relatively simple process if you have your back-office operations in order. Ideally the Trading Management Agreement (TMA)—the contract that defines the role of the trading manager and the advisor-- calls for the portfolio to be traded pari passu to your core(target) fund. Any variation between the investment policies in the OM of the target fund and that of the SMA should be clearly spelled out in the TMA. Legal counsel should be enlisted to insure protection of the investment advisor in regards to indemnification- not just who is indemnified, but for what and by whom. The role of soft dollar accounts, expenses that can be charged to the SMA, the charge-back for admin, legal & audit fees as well as when & how the management fee and incentive fee are payable should also be detailed in the TMA. Confidentiality clauses need to be agreed upon as do expectations on reporting requirements.

Performance between the SMA and the core fund should be essentially identical however, differences can occur especially with significant cash flows. A policy should be in place so that when cash flows occur trades are placed to bring the account back into balance with the target fund. The trading manager should be prepared to reconcile any variances in performance to the satisfaction of the account owner.

If expectations have been set and a good TMA has been reviewed and is in place the next step is to begin working with a (hopefully your) prime broker to get the account up and running.

In Part II of this blog we will talk about the nuts and bolts of opening an account including executing on the TMA to working with prime brokers and allocating bulk trades via your executing brokers.

Duncan Huyler, CFO, 360 Global Capital, LLC

One of the topics that is being proposed for this October’s 5^th Annual Meeting of the Hedge Fund Business Operations Association is "Cleaning Up Your Prime Broker Arrangements." It seems that in late 2008 as hedge funds scrambled to ensure their prime broker business was no longer concentrated at one firm, many fund managers agreed to boiler plate agreements without fully understanding all of the implications of the terms of those agreement. Since I work for a fund of funds with no direct trading operations, I would never profess to be an expert on the intricacies of prime broker agreements. I can say with certainty, however, that the fact that issues can arise from the use of boiler plate agreements is not unique to prime broker arrangements.

One of the results of the "institutionalization" over the last several years of the hedge fund industry is a proliferation of "best practices" not only for hedge funds themselves but also for the wide variety of vendors that service the industry. These best practices have brought about tremendous improvements and standardization in the industry. As part of the standardization, every vendor has worked with their legal counsel to develop service agreements that accurately outline the terms of their services such as scope, cost and limitations and that also solicit representations from their clients that limit the vendor’s liability under certain circumstances or even gives the vendor the right to refuse or terminate services if the representation proves to be inaccurate, or becomes inaccurate over time. It is in the best interest of the vendor to deviate from their standardized or boiler plate agreement a little as possible.

It is important to do your homework and know the range of services and options available across competing vendors. It is a manager’s responsibility to negotiate the best arrangements possible for the benefit and protection of their investors. This includes both selecting the vendor best able to meet their needs when all factors are considered and negotiating the best terms possible. It is also important to have a complete understanding of the terms of the agreements entered into and the representations they contain. Without periodic reviews of agreements that are in place, veteran managers can miss seemingly irrelevant terms that become relevant over time or can forget representations they have made or circumstances can change and cause the representations to no longer be true. New managers may have limited operational bandwidth or experience with certain vendor arrangements and many look for turnkey solutions.

We have learned in recent years that a change in the industry can move obscure, hard to interpret provisions of an agreement between a fund and a vendor to a focal point of a fund’s survival. Such an event, or the lack of compliance with even the most minor terms or representations in an agreement, can give the vendor unintended power in the relationship, particularly when they hold assets of the fund or have mission critical functions in their hands.

Have you lived through an unexpected twist in a vendor relationship as a result of a boiler plate agreement? Will you share it with us so we can benefit from your experience?

Michelle Kline, Member of the HFBOA Executive Board

I recently attended a symposium hosted by the Chicago office of a law firm with a substantial investment management practice. Topics discussed were broad but focused primarily on operations, with several interesting points. In general, the duration of time to complete operational due diligence on a manager has increased substantially.

Back office responsibilities have expanded to include portfolio stress testing and risk management. Value at Risk under different scenarios such as oil price shocks, the sub-prime defaults, inflationary periods and the Greek credit crisis are typical. Further, the time period to completely liquidate the portfolio under the aforementioned scenarios should be addressed.

Managers that run a co-mingled fund along with managed accounts are facing additional scrutiny. Should the owner of the managed account force a complete liquidation, the manager needs to demonstrate how asset prices in the co-mingled fund are potentially affected.

A comprehensive disaster recovery and business continuity plan must be in place with evidence of robust testing, even for advisors that are not registered with the Securities and Exchange Commission. Also, compliance manuals and a code of ethics are frequently being requested from non-registered advisors.

A usual query by a potential investor is how the portfolio or business would be affected should the CIO or a key analyst be "hit by a bus." This question is now being posed in the instance of the CFO’s or COO’s unexpected demise. Be prepared to define the responsibilities of all back office\operational personnel, and the adverse affect on the organization should any operations personnel become suddenly inactive.

Sincerely,

Kurt Koeplin, Chief Financial Officer, Rail-Splitter Capital Management, LLC

Member of the HFBOA Board of Directors

The April luncheon was held April 22^nd in New York.  Thank you to Linedata Services for hosting this event.

The topics discussed were: Institutional Hedge Fund Due Diligence, Properly Managing Operational Risk –Technology’s Increased Role in Fund Management and What to Expect from Regulators in 2010.

 Institutional Due Diligence-The New Checklist.

 The panel started out by agreeing that investors are spending significantly more time on due diligence and that the investment process has lengthened averaging about six months in duration. Small hedge funds are being held to standards that previously only applied to larger hedge funds and investors are demanding proof that managers actually are doing what they promised to do.

 The panel suggested that managers put a risk assessment process in place to review (no less than annually) their firms in an effort to spot conflicts and issues with respect to their operations. Managers need to be able to recognize issues, address them and document how they resolve the particular matter. If necessary, it was suggested that Committees be formed and/or outside persons be brought in to assist with the review.

 Additional best practices suggestions were strengthening internal management, having real time risk management, automation of processes front to back and multiple prime brokers and custodians to reduce the risk to assets.

 Investors performing due diligence are looking for any inconsistency between what is in the fund’s marketing and organizational documents and what they hear or see is actually occurring. As part of the due diligence process, it is not uncommon for investors to ask to meet with traders, back office and compliance personnel as well as tracing transactions from front to back.

 New Operational Requirements

 Investors want to know who has access to information at a firm? They want to know what are the security protocols for data transmissions? What are the disaster recovery procedures? How quickly can you recover? What are the controls on cash and cash movements? How are trades aggregated and allocated when there are multiple funds or a managed account running alongside a commingled fund? What is the manager’s valuation policy? They want to test it.

 While an outside administrator is a necessity-How does the manager check the work of the administrator? Does the manager reconcile to the administrator? How often does the manager meet with their service providers? How often does the manager review the service provider’s level of service?

 The greater the degree of automation the better. Stand-alone excel schedules are frowned upon. Investors want to see systems in place and controls against human error.

 Remember, there are always other places to invest-investors want to be with managers that are continually upgrading their systems and controls and providing transparency on their operations.

 What Can We Expect From Regulators?

Most commentators are expecting that Advisors will have to register at some level of AUM whether that is 30 million, 100 million or 150 million. While it is expected that there would be some period to ramp up, the panel recommended not waiting until the last minute to register, as there may be delays in the registration process.

For advisors that have been in business for some time, that will most likely require a scrubbing and updating of their organizational documents. While most advisors whether registered or not, have best practices in place, the biggest change is probably undergoing the required audit by the SEC.

 SEC audits have become more intense and time consuming. Current areas of interest to the SEC are controls on cash, operational controls, insider trading, best execution, how analysts get their investment ideas, fund expenses, soft dollar arrangements and disclosure thereon.

 SEC examination teams may have enforcement division staff mixed in in an effort to obtain greater insight on the hedge fund business. This carries a greater risk to managers that may not be aware of the mixed make up of some teams.

 Advisors need to have procedures in place to maintain all of the information required by the SEC and be able to produce it in a short period of time if requested by an examiner.

 - George Roeck, Executive Board Member, HFBOA