REACHING THE OPTIMAL STRUCTURE REQUIRES ANALYTICAL AND OPERATIONAL FOCUS
The optimal structure is the one that is going to contribute to making potential investors happy and thus actually invest in it.
This paper focuses on the technical traps a young manager should avoid when setting up an alternative asset management structure. It shows as well that there is always a solution to any given situation providing the appropriate analytical and technical skills are called in and used.
Away from the “comfortable” environment of big investment banks where all logistics, services (from legal to IT and Operations) are provided for, nothing is for granted.
It is thus essential to find the most cost-efficient structure set up (lower the costs of set up in picking the location, the legal format, the service providers….). At the same time, this structure will be managed on an on-going basis and that means that choices made for the set up also have to prove efficient over time. The cheapest is not necessarily the best provider. The biggest name does not necessarily bring the highest quality of service. Service providers are not good at everything for everyone: picking the ones most adapted to the sponsors/managers objectives is essential.
Every single step has to be carefully taken, every decision must be the result of a thorough analysis in conjunction with the inter-actions between the various parameters at play so as to avoid costs overrun or inefficient organizational processes at all levels. For example, if you pick a PB that has a poor IT connection with the global custodian you have chosen, even if they are on an individual basis very good in their respective areas, the lack of coordination will result for the fund manager in a waste of time and cost overruns to fix the issue.
We will take the case of Luxembourg to have a close look at all the pieces that need to be assembled to come up with an optimal structure. The process is the same and most conclusions reached can be transposed easily to other jurisdictions.
As said, before acting, serious efforts have to be put into thinking the project over. The approach should be global so as not to miss the impact of the inter-actions between the various components of the set up. Within that framework, each component should be treated with the appropriate focus. The back and forth process between global and specific will eventually bring the most efficient end result.
We will go through the successive points of the process and describe at each step, the options that are available with their respective advantages and drawbacks.
We will derive from the analysis the types of competences needed to set up the structure and then those needed on an on-going basis.
THE KICKSTART : THE STRATEGY
The strategy to be implemented by the portfolio manager is THE reason for starting the whole process. The strategy has to be best served (cost/quality) by the environment to be defined. It is thus essential to review thoroughly how the strategy is defined and what the consequences/constraints of its implementation are at the operational, regulatory and technical levels: products/instruments traded (FI/Equity/ Forex/ Commodities/real estate assets…. and cash/derivatives, OTC/ET, vanilla/complex….), geographical markets to be reached, trading volumes, liquidity, time horizon of the investments…
As a matter of fact, the first approach to a high level definition of the set up will come from the review and coordination of these constraints which materialize at the legal, tax, regulatory, IT and operational levels.
So, what does “defining the strategy” mean? Here are the elements to look at:
Describe precisely the products that will be used: this leads to defining the types of legal agreements to be signed for using these products, the array of best service providers in each category of products, the IT systems requirements to handle(execute-clear-settle-safekeep) the products, defining the numbers (risk numbers in particular) around the relationship with the selected product provider(s), the potential pricing issues in case of complex OTC derivatives or illiquid markets for example. In this case, it is necessary to have a pricing policy establishing the parameters and calculation formula along which the assets are going to be valued with the pricing agent in coordination with the auditors to avoid any bad surprise in the determination of the NAV and thus the performance. (it is now a regulatory obligation under the AIFMD to have a proper valuation policy and is the AIFM’s responsibility to have it implemented).
Describe the volumes for each category of products: this leads to another constraint on service providers, operations and systems as the higher the volumes, the more reliable and seamless operational processes should be in order to minimize operational risks. Fixing an error in a high frequency environment may well prove quite difficult and time-consuming.
Describe the limits that the portfolio manager is going to voluntarily apply. This can translate into absolute levels of geographic exposure, market parameter exposure, leverage but also into VAR limits; in any case the compulsory limits as defined by regulations such as AIFMD or UCITS (often dependent on the type of investment vehicle that has been picked) have to be complied with.
Describe the target clients: retail, small institutional entities, major institutions, private banks, insurance companies, pension funds, public sector entities, funds of funds…….. : this leads to constraints regarding the legal set up, type of investment vehicle, frequency of valuation,
Based on this set of constraints, you have to find the most efficient set up.
The set-up is comprised of a legal structure (Manco and fund) where the AUM will be managed and controlled/reported, and a number of service providers (lawyer, prime broker, global custodian and fund administration, accountant, auditor) to be selected based on the matching between their specific skills and the requirements of the strategy.
In any case, what is worth remembering is that there is always a solution, a structure, an organization that will fit your constraints and enable you to dedicate your time as a fund manager to actually manage the AUM that investors have entrusted you with. Your responsibility is to realize that you need operational competences to meet your objectives, both in the short term and in the longer term. Whether they are internalized or outsourced, these competences have to be picked early on.
1- WHAT LEGAL FORM? IN WHAT ENVIRONMENT?
The choice of the legal form is first driven by regulatory and technical reasons.
There are 4 major possibilities: UCITS, Part II, SIF, RAIF(QIF in Ireland), SCsc/SCsp (used in Private Equity strategies). The more recently-approved RAIF shows that new solutions are explored by major market participants and can be taken through the whole legal approval process . Worth mentioning that the self-managed format is not favored by the regulators for obvious safety reasons (lack of buffer capital).
Some types of strategies (because of the products used such as commodities OTC derivatives, or the trading patterns such as significant short positions), cannot fit the UCITS shell. Some banks have designed ways to dodge the regulation, with portfolio swaps or other structured products but the spirit of the law should be respected and such arrangements should not be used or at least stay within the boundaries of common sense.
UCITS will also come with some constraints for example regarding the liquidity, that is the frequency of the NAV calculation. It has been originally designed to be a common frame and a safe haven for retail money in Europe and it has actually turned out to be the perfect product to that purpose. This is why it is important not to pollute the concept.
As to the environment to be used, there are four main options. We will review each of them with their respective features that will help the manager choose based on the constraints of the strategy, the competences he has gathered to manage the project and his/her personal circumstances. The four options should be assessed in order to make a well informed choice. They are presented in increasing order of control of the manager over the structure. This also means in increasing order of internal work (operations, risk management, internal control, compliance….) to be handled directly or sub-contracted with the responsibility to oversee the sub-contractors’works.
a sub-fund in an umbrella fund with a third party asset management company:
full-fledged fund with a third party asset management company:
own fund with own asset management company.
The managed account is easy to set up both in terms of time and costs. In actual terms, the manager has a mandate to manage the account opened in the name of the investor on a platform that takes care of all the operational work. The platform makes all the controls and checks on the trades and the manager is accountable to the platform for the strict adherence to the investment strategy as it has been defined with its associated risk limits. The remuneration will be negotiated but will usually be limited to a performance fee (and depending on the status of the manager may include a fixed part equivalent to a salary) as all operational costs are born by the platform. There can be varying agreements with a management fee being paid to make up for the costs left to the account manager (such as cost of research, Bloomberg access…). Furthermore, the platform allocates costs to the account that the manager is not in control of whatsoever. And this is a drain on the performance.
The sub-fund in an umbrella fund with a third-party asset management company. This is one step ahead in terms of control as the manager would have some room to negotiate the documentation pertaining to the sub-fund, both for the sub-prospectus and the sub-IMA. That would noticeably concern the on-going cost to the fund including the costs of the service providers such as the Custodian/Depositary/Administrator (including accounting, transfer agent, registrar, domiciliation…). But most agreements may have been signed before the sub-fund is created and thus the room for maneuvering may be quite limited. This means that the impact on the performance is not easy to control. Side letters may accommodate part of the deviations from the general agreements in place but one should be cautious with side letters regarding their transparency vis a vis the auditors and the regulator for fear of their not being recognized as valid at the time of closing of the accounts. Besides, regulators are less and less favorable to side letters which may be seen as creating a biased playing field for the investors. Remuneration to the manager would usually include a management fee and a performance fee. Depending on their own characteristics, operations and associated services will be dealt with by the platform or left for the manager to take care of. Management fees will be sized accordingly.
A fund with a third-party asset management company. This is the next level in terms of independence. The guidelines set by the third party manco apply regarding items such as risk management but the fund has some leeway in choosing the service providers even though there is an advantage to those who have their pre-set draft documentation already negotiated with the manco. In that set up, the manco gets a fixed remuneration for the structure set up that includes the legal cost for the IMA and the prospectus and the obtaining of the regulatory approval; then, there is an annual fixed fee which covers the responsibility of the manco to the regulatory authority (CSSF) as well as the reporting that has to be issued regularly and along the lines dictated by regulations (AIFMD in particular has set several new demands on reporting). The fund keeps the relationship with its investors and gets paid the fees as have been defined in the prospectus.
It has become clear that third party asset managers have increased the hurdles and that being accepted by one of these platforms has become more difficult. The manco carries a broader responsibility and consequently sets demands on the potential client to limit their risks. It is all the more clear when the portolio management function cannot de delegated and thus its responsibility lies with the manco. This is the case when the portfolio manager is not/does not need to be a regulated entity in its country and thus can only be investment advisor to the Lux fund. Furthermore, higher costs make small clients unprofitable.
A fund with own asset management company. This is the total independence. The manager has all the levers in his/her own hands and has the authority to decide on all the topics from the content of the prospectus, the writing of the IMA, the choice of service providers….within of course, the limits set by the regulations that apply to the legal structure.
This independence comes at a cost that has to be weighed against the profitability of the whole structure.
As it appears from the above, the choice may not be straightforward and some back and forth discussions will be needed (with seeding investor, with professional partners…) before making the best possible choice. All the more as the comparability of offerings is never an easy case. That said, your personal preference, as well as the technical terms of each possible legal structure will guide you to the proper choice. You may need to get technical help outside your base team, depending on how you have first chosen your partners. The person in charge of the definition and of the set up of the structure must have the appropriate experience, in all areas and ideally having already conducted the same project type. Ideally, that person will have been both on the sell and buy sides with responsibilities that have led him/her to the same type of challenge (setting up a new global activity, leading positions in key functions such as Risk and Operations).
2- FURTHER CONSIDERATIONS FOR INVESTORS
Two important items keep being raised that deserve proper attention: forex hedging policy and share class definition.
Forex hedging can be used, if needed, on the asset and/or on the liability sides of the balance sheet. Separate hedging policies have to be designed: on the asset side the objective is to neutralize the risk created by the different currencies in which the assets the fund invests in are denominated and which are not its base currency. On the liability side, the objective is to neutralize the risk created by the different currencies in which some share classes are denominated and that are not the base currency of the fund. Except if the investors are willing to manage the risk themselves, which means that they are highly sophisticated in terms of treasury management.
Forex hedging comes at a cost, which can be high in particular for exotic currencies. The market cost is then topped up with the margin of the bank that executes the trade, most often the administrator/custodian of the fund. To keep this cost under control, it is important to design a forex policy beforehand and to make sure that the board has the necessary competences to effectively control what the bank charges for the service on an on-going basis.
The other point to be thought through is the allocation of the forex hedging costs. On the asset side, it is a general expense for the fund that applies to the global portfolio. On the liability side, the question is to define who is going to pay for the share class forex hedging: either the specific share class concerned or all the share classes. There is no clear-cut answer to this question but there is guidance from ESMA and the CSSF that can be used as a basis for the business decision to be made.
The definition of share classes at inception takes into consideration the targeted initial investors of the fund. The main elements to be considered are:
The currencies in which the investors are willing to invest,
The different types of liquidity/lock up periods,
The different minimum sizes of investment and corresponding diverging fee levels,
Other criteria as needed to attract sizable tickets.
In any case, it is worth noticing that it is simple and not very costly to create a share class during the lifetime of the fund. On the opposite, creating more classes than needed at inception creates useless costs. Share classes generate operational costs for all service providers and if they are not justified, the investors could point at their uselessness and ask for their being charged to the manager. It is thus important to have a clear understanding of the marketing targets and their needs at different times during the life of the fund.
3- WHAT SERVICE PROVIDERS?
The depositary bank fulfills in most cases a wide array of duties:
Global custodian : the responsibilities of the global custodian have been made more specific in the AIFMD, which has led most noticeably to the relationship with the prime broker being redefined. As a matter of fact, it has been clearly established that the global custodian has the actual responsibility of guaranteeing the existence of the assets of its clients. This clarification was needed in the aftermath of the Madoff case where custodians in Luxembourg have been unable to deliver the assets they were supposed to safe keep. It is thus clear that if assets are transferred to the prime broker to facilitate the trading activity of the fund, the global custodian has an operational and counterparty risk on the prime broker. There is theoretically no credit risk as such as clients assets are segregated from the proprietary assets of the prime broker. But operational issues whether unintended or intended, (in the latter case it is a fraud), can well lead to the occurrence of a credit risk. It is consequently important to know who are the prime brokers who have a working relationship with the global custodian, before choosing the global custodian. Worth noticing as well as under the AIFMD, there must be one only depositary bank and this applies to AIF’s non EU-domiciled that are placed under the responsibility of an AIFM.
Accountant : the main responsibility is to calculate the NAV with the frequency as defined in the prospectus. The accountant must have the tools in place to guarantee the proper valuation of the assets with adequate policies and procedures for listed as well as OTC complex products. Further on, there must be procedures in place to also guarantee the proper calculation of all fees. (Crystallization/equalization, high water mark, ….) The accountant also manages all the different share classes and the different currencies and thus the hedging of the forex risk linked to the currencies of the share classes, the subscriptions and redemptions in connection with the fund manager;
All these policies, procedures and associated processes have to be validated by the auditors.
Registrar: the responsibility is to maintain an up to date register of all the investors with the adequate level of information on each investor, as requested by laws and regulations ( AML; KYC…). It has to be done thoroughly on an on-going basis, so as not to create any unforeseen delay in case, in particular, of a new subscription or a redemption;
Transfer agent : the responsibility is to process the subscription/redemption process as defined in the prospectus;
Domiciliation: this covers all the duties linked to the fund being domiciled as a corporate entity at the registered address of the depositary bank.;
Corporate services: this covers especially the provision of services such as the organization of general assemblies, writing of resolutions, writing of minutes...
Prime Broker/Clearing Broker
The Prime Broker/Clearing Broker is the day to day business counterpart of the fund. It is of paramount importance that the PB have the skills adapted to the needs of the strategy.
All the elements to be considered when picking a PB/CB have been defined at the inception of the project when defining the requirements linked to the strategy itself. To start with, does the fund actually need a PB? This is a fundamental question to be addressed in the AIFMD perspective that has changed, among other things, the relationship between the PB and the depositary/custodian. The reply to this question has a key influence on the set up, its operational risks as well as its costs.
As already mentioned, one new element has come up as a direct consequence of the AIFMD and this is the now-clearly defined responsibility of the global custodian. This means that the “compatibility check” between the PB and the global custodian has to be carried out very early so as to avoid any bad surprise at a later stage. The best way to go is to first select the PB’s that will serve best the fund in its business objectives.
That said, the custodian selection process should be run in parallel. Time is needed to assess the key characteristics of each of those which have been pre-selected (based on a high level review of their stated business strategy) and have a view on their existing relationships with PB’s.
There are a number of specialized law firms and they all have the competences required. The important point is to have a direct interlocutor who is both competent and client-oriented. (not too much “clock-oriented”). Then, some law firms will make a big difference in the quality of their service and most noticeably the speed at which they process a file based on the size of the client (as bigger size would mean more potential business). It is good to know in order to manage the relationship accordingly.
The auditors are going to work closely with the accountant of the fund. This is why it is appropriate to pick auditors that already have a working relationship with the fund accountant. There again, it is important to pick an auditor adapted to the size of the fund and its major characteristics. The big 4 are not always the best choice.
We have now reviewed all the operational aspects that you have to go through before you can get started with your trading.
There are now two points that need to be addressed in order for the set up to be a real support and help in your fund management activities during the start up phase and in the longer run.
First, you should include the time perspective in all the decisions you are going to make for the set up of your structure. As a matter of fact, the structure should be flexible enough to cope with evolutions over time: it is about scalability. You have to ask yourself questions such as: does the IT infrastructure have the ability to handle volumes 3 times as high, does the pricing of the custody take into consideration the growth of assets, is the operations organization able to manage and reconcile 3 times as many trades, is the execution process robust enough to grow, is the structure flexible enough to handle future regulatory changes and so on and so forth…
The answer is both on the technical level and the human infrastructure level. You need to have the adequate competences to guide you through this whole process. You have to be associated to the process of building your structure as you have to appropriate it to yourself, you have to actually own it not only because you control the equity of the management company but because you learn from the person helping you through the various steps of the set up and come to understand how the whole structure works. If you want to be in control of your business, you have to understand the intricacies of its modus operandi.
Second, you have to calibrate properly the competence level you will need in the start up/building up phase and in the longer term. It is most probable that you have to get a high level of skills in the very beginning as you start from a white sheet and you have to create a whole structure that will have the capacity to handle your business in all its dimensions. And operational capacities are not your area of excellence. You have to choose between hiring a high caliber experienced professional or outsourcing to consultants. Even if you are going to outsource some tasks, you remain responsible for the coordination and you thus need someone of the proper caliber to assist you in the management of the project.
Then, on an on-going basis, your day to day operations will not require the same level of experience. But, in case of any unexpected event, you need to have the adequate skills in place to discuss with the service providers, negotiate with the regulators, understand the changes in the regulations that you will have to comply with.
Consequently, you should make sure that you have access to the appropriate competences at all times whether as part of the firm or as a consultant that could be a permanent advisor on a part time basis.
The waters of the launching of an investment management structure are not easy to navigate. But if you use experience and skills, you will navigate nicely and will have a steady support for your asset management activities that will take you smoothly through the scrutiny of due diligence processes.
Operations are key to the success of your business.