Hedge Fund Operations: 4 Service Providers, Functions, Filings, Team Roles, outsourcing, offshoring

Now, in general, hedge funds are less regulated than mutual funds. Hedge funds are thought to be more complicated to understand than mutual funds and also have the potential to be riskier due to the amount of leverage and short selling that's allowed. Hedge funds also have higher fees and their redemption terms are generally longer. They're however, still required to invest with the SEC if they have assets under management in excess of $150 million. Accredited investors, by the way, are defined as people making more than 200,000 per year or 300,000 for a couple for the last two years and and having a net worth in nexus of $1 million. Also, entities worth over 5 million in assets are considered accredited. Now, most hedge fund entity structures have what's known as a master feeder structure with two parallel entities that their partners can invest in, one onshore and one offshore. The onshore is utilized by U.S. taxpaying individuals or entities, while the offshore vehicle is used by foreign investors and tax exempt partners. This structure allows the foreign and tax exempt entities to keep their preferential tax status. Now I'm going to talk about some of the more hedge fund terms, starting with fees. There are typically two types of fees that are charged to investors. The first fee is on assets. This is referred to as a management fee and is typically in the 2% range and it's charged on a quarterly basis, for an example, 50 basis points per quarter. The second fee is the incentive allocation which is sometimes referred to as the carry. This is typically 20% and refers to the portion of the gains that the fund will retain as its incentive for doing well. For example, if an LP invests 1 million and the fund is up 10% for the year, the overall gain will be 100,000. The fund will keep 20% or 20,000 and the LP will get the other 80,000. The incentive fee calculations are typically done at the end of the year. There's usually a term in the agreement referred to as a high water mark. This means that if the fund is down at the end of the year, the manager won't take any fees next year or even in subsequent years until they make back what they lost and only will take fees on the amount above the high water mark. By the way, this is the reason why many hedge funds close down. If they get too far below the high water mark, the probability of earning incentive fees in the future gets too low to run the business. In other words, there literally is no incentive to keep doors open. Key employees may leave because they feel they won't get paid for a very long while if ever including the manager. Redemption Terms Redemption terms inform you of the options of liquidity that you have. Unlike mutual funds that provide daily liquidity, hedge funds are typically quarterly or annual. Ours are actually five years. There will usually be a different fee structure depending on the liquidity term that you choose. The longer the funds are locked up generally the lower the fees. A somewhat controversial term that relates to liquidity or what are referred to as gates. A gate term will disallow redemption for certain reasons and usually if too many LPs try to redeem at once. The gate provision will only allow pro rata percentage of your account to be redeemed. It's a good idea to look for this in the docs if you're investing and a good idea to add it to your docs if you're managing a fund. Its purpose is to prevent a run of the bank type scenario and that can have a devastating impact on your fund without it. Now the expenses of the fund are typically broken out into two types. Expenses that are borne by the fund, meaning the LP pays for them indirectly, and expenses that are borne by the management company that are paid for by the management fee that's already been levied. Fees that are typically borne by the fund are fees like audit expenses and legal expenses that relate to the fund. Fees that are typically paid for by the management company out of the management fee are things like rent and salaries. Now these are market terms, not required terms, so it's important to deliberate on both of them from both an LP and PM consideration when you're looking at setting up your fund. So here are the dominant documents and filings for any given hedge fund. First, we'll start with the documents. The offering memorandum, which is typically called the om, spells out the terms of the fund and also discloses the pertinent risks of the fund. The subscription documents, also called sub docs, are what the investor fills out to gain entry to the partnership. The key term Here is the LPs must attest that they are accredited The Limited Partnership Agreement the LPA is basically just the agreement between the LPs and the Fund. It spells out all the LP's rights and obligations. The Compliance Manual is required for hedge funds and it contains all compliance policies and procedures. This is a crucial document to hear to as the SEC will examine the fund and this is the blueprint. The due Diligence, or DDQ is basically a Q and A for investors that describes all the policies and procedures for the fund that an investor would care about. The ISDA or the International Swaps and derivatives agreement become a little more popular in news these days. Defines the terms between the HED and the investment bank when dealing with OTC derivative products. Now there are also many filings that a hedge fund may or may not need to make depending on various factors, but the following are the most common. Form ADV is a required annually filed form for hedge funds that manage over 25 million in AUM. It notes general key information about the fund and its key members and service providers. Form 13F is a publicly available SEC form that is filed quarterly by firms managing in excess of 100 million. It lists all equity positions held in the last day of the quarter you have access to it. It has some serious flaws though. Namely it doesn't need to be filed until 45 after quarter end. It also doesn't have short positions on many derivatives, so it's limited in value and in fact can be very misleading. Form PF is a form that's non public. It's filed with the SEC either quarterly for large funds or annually for smaller funds. It's an extremely broad and complex document and detailed filing is primarily designed to disclose potential systemic risk that the fund poses for the entire financial system. So it's a really important document. So now we're going to discuss the standard functions and roles of a relatively mature hedge fund. Startups have these functions as well, but depending on the size of the fund they may not have hired senior people for all these roles. In fact, outsourcing, as you're going to see, is now the go to for most startups in many of these roles. Not the first one though. Portfolio management is handled by the portfolio manager and that's a day one role. PM is also usually the founder. We're going to talk more specifically about the requirements of this role a little later in the presentation. The management of the entire process is handled by the Chief Operating officer and this is a day one role as well. Therefore, the COO is usually a founder of the fund. It's an important role and it's important that the PM remain focused on the portfolio, not have to worry about running all the aspects of the business. The COO will work closely with the PM and the senior executives, including the cfo, to ensure that the business operates efficiently and effectively. A top COO will focus on all processes of the business, including optimizing the processes for research and portfolio management. The research function is handled by the analyst team who reports into the pm. We're going to discuss that function a little bit more in depth, a little bit later in a few slides later. Legal function is supervised by the firm's chief counsel. The GC works with other senior members of the management team, is responsible for all contractual matters, mitigating legal liabilities, overseeing investigations. Important function of the GC is to work closely with and sometimes even supervise the chief compliance officer. Now the compliance function is overseen by the firm's chief compliance officer. The CCO is responsible for ensuring a culture of compliance at all levels of the firm. It's especially important that senior management expresses how important compliance is. This is referred to as the tone at the top. CCO's Bible is the compliance manual that we previously discussed. Ensuring that the firm is properly trained in all areas of compliance is a crucial function of the cco. Since insider trading is such a potential risk area. High potential risk area the pm, the analyst team and the firm's traders should all be viewed as part of the compliance team since they're on the front lines. If they're not well trained to spot insider trading red flags, the firm is at risk. Once you've stepped over the line, it's too late. Insider trading is in the black and white area, so training is really important. The CCO is responsible for the firm's regulatory filings and along with the gc, for managing any SEC exams or investigations which will happen. The trading function is supervised by the firm's head trader. Portfolio managers. Sometimes managers decide what to trade and then the trader decides how to trade it. Some guidance from the pm. They can execute the orders in one of two ways, either electronically themselves or through counterparties of the firm, like the big investment banks that also serve as prime brokers for the fund. The trader has a very important role because there's significant costs involved with trading. The two types of costs are execution costs and the other are commission costs. Breakage costs are the difference between where the PM decides to put the trade and ultimately where it gets executed. Commission costs are a highly coveted source of revenue for the counterparties and the trader will want both execution and research in return for the firm's commission dollars. The accounting and tax function is the respons responsibility of the firm's chief financial officer. The responsibilities include supervising the firm's annual audit by working with the firm's outside auditors and administrator. Overseeing the books of the firm, overseeing the records of the firm, A management company, the treasury management, ensuring that all tax filings are proper. There's a lot of responsibilities for the CFO now. The operations function of the firm is responsibility for the director of operations. The operations Function is generally considered to encompass all processes necessary to settle trades after they have been executed by the trading team. In that regard, the operations team works closely with the trading team and then the process is handed off to the accounting team to record the trades. A crucial role the Director of Operations plays at a hedge fund is securing the borrow necessary for shorting stocks from the firm's counterparties and also for managing the costs associated with the borrow function. The technology function is headed up by the Chief Technology Officer, or sometimes known as the Chief Information Officer. As the firm grows, there will also be a Chief Information Security Officer, ciso, who is primarily responsible for protecting the firm's data against cybersecurity attacks and theft. That's really important role these days. Especially a Director of software is another role that will be brought in as a firm mature. The responsibilities of the technology firm are to ensure the daily processes and to procure the necessary hardware and software that will allow the various other functions of the firm to seamlessly acquire and disseminate crucial information necessary to run the business. They're basically the firm's nervous system now. The marketing function is also referred to as business development. In the early stages of a fund's life, this also functions as investor relations. But that function eventually splits off into its own role. The Director of Business Development is responsible for raising capital for the fund and he discussed that in more detail as that's a key role for launching any fund. The IR role has become increasingly important as the industry has matured and the investor profile is more institutional in nature now. The risk management function is typically not held by a single person, in other words, a risk manager, until a fund is more mature. Until then, role is split amongst other senior executives and tied together by the coo. Some of the key risks that a hedge fund has are portfolio risk, cybersecurity risk, legal liability risk, counterparty risk, reputation risk schema. There's a lot of risks that need to be overseen by a hedge fund. The key to any risk management process is to identify first the magnitude of impact of the risk and then the probability of its occurrence. In this way you can identify the firm's top risks and this will inform you as to where to spend and allocate the appropriate level of resources to mitigate those risks. The human resources function is managed by the Director of Human Resources. This is usually not a day one role, but it probably should be since human resources are the lifeblood of the firm. This role is responsible for all aspects of human resources. The firm, in coordination with other senior executives Gap analysis, acquisition, retention, compensation, employment practices, training reviews, goal setting and termination. These are all responsibilities of the human resources function. Those are the roles and functions of a hedge fund. Now in launching a hedge fund, there are four key service providers that you'll need to retain. There are many to choose from in each category, so you can be selective and you should be. It's important to know what criteria you're looking for when you're selecting them. Prime Broker is a key partner in the launch of your hedge fund. They have deep resources for free and they also do a lot to earn your future business as you're going to be providing them with lucrative revenue streams for years to come. Many millions of dollars. One of the revenue streams will be financing costs. They will lend money to the fund to invest more than the capital that the fund has on hand. Is also known as leverage or margin. PB will use the fund securities as holdings for collateral for loans. They'll debit your account with the interest on these loans. They'll also lend securities for the purpose of short selling them. They can charge you a borrow fee for that. They're going to also execute trades for you and charge you commissions on the execution. In return for these fees, the funds provide a series of free services or relatively free services such as capital introduction, settlement of securities, investment research and various other advisory services. Another service provider that you're required to retain is the funds administrator. The administrator is an independent third party that keeps the funds books and calculates the net asset value and communicates this to the LPs on a monthly basis. They also can be served to be the sole owner of the books accounting records. But most funds, especially the more mature funds, have at least some sort of parallel books and records. It's important to note that the administrator is not legally liable for the accuracy of the fund records. And that's why it's important to have a system to recalculate those records or a minimum to look over them. Fund will also need to retain an accounting firm to conduct the annual audit and also prepare the fund's tax information. For limited partners, that's a K1. Finally, another required service provider is the fund's law firm. The law firm will prepare the fund's formation documents such as the offering memorandum that we talked about, limited partnership agreement, the subscription documents and the compliance manual. There are always going to be legal issues that the firm's attorneys will need to advise on as fund growth. It's important that funds attorneys are well vetted prior to retaining that they're also quite expensive. Outsourcing of key functions is becoming a more viable and oftentimes desirable option for hedge funds, and especially startups that can't afford a deep bench to start. If the fund hires an experienced CEO that has already managed these functions, outsourcing becomes an even more attractive option. Even as the fund grows, it can bring some of these functions in house or partially in house.