Hedge Fund Administrator Improves Client's Results

by Carla Johnson, Investors Offshore, London

07 March 2002

International Fund Administration ("IFA"), a provider of fund administration services to US and international hedge funds, reports that its clients' returns have exceeded a number of industry benchmarks over the past two years. After examining the performance of their current client base, IFA found that on average their clients generated returns of 6.1% in 2001, compared to 4.4%, -13.0%, -21.1% and -17.8% for CSFB/Tremont Index, S&P500, Nasdaq and MSCI World, respectively.

Deborah Butler, IFA's Director of Marketing and Client Services explains: "Our criteria for taking on a client is in many ways similar to the process of selecting a manager for investment purposes. Since the performance of our clients directly influences our company we are quite diligent in taking on only those clients that we believe have the highest probability of success. Similarly, we actively manage our client list when we see poor performance over an extended period of time. We think our approach is very sound given the nature of our business, our fiduciary responsibilities and is predicated on quality managers wanting to work with IFA".

International Fund Administration (IFA) is a financial service firm dedicated to providing operational resources to investment managers. IFA provides its clients with all the services necessary to successfully launch and operate a private U.S. or offshore investment entity.

The firm was founded in 1993 by professionals from the money management industry. IFA strives to distinguish itself from other organizations by supporting highly specialized investment programs, offering exceptional, personalized service and providing an environment where a client's fund can realize its full potential.

IFA offers comprehensive accounting, investor, and corporate secretarial services to meet the needs of each of client's entities. If a client desires, IFA's staff can be very active in helping to structure investment products and oversee the entire creation process.

Usefully, IFA's site describes its approach to the structuring of a hedge fund for maximum success:

'The time and effort dedicated to carrying out ongoing compliance for a limited partnership or offshore entity is a major undertaking. Through this service division, we offer money managers and their legal counsel comprehensive compliance services.

'IFA has identified that there is an industry need for the outsourcing of certain operational functions associated with portfolio management. The objective of this service area is to provide back-office support to the portfolio manager.

'Properly structuring a product for the market is critically important and will be a major determining factor in its overall success. In structuring an onshore or offshore hedge fund, there are six key areas that must be evaluated. They are:

Tax issues
Regulatory issues
Business issues
Investment issues
Marketing issues
Operations issues

'Addressing these areas prior to starting up a fund (or funds) can eliminate a multitude of problems later on and can pave the way for the money management firm to meet its expectations. It is important to understand that all of these areas are closely related and can easily affect on another.

'The tax issues to be evaluated can relate to three distinct areas: (a) the nature of the investors; (b) the money managers themselves; and (c) the investment program. With regard to investors, U.S. taxables generally prefer to be in a domestically organized vehicle that is a flow-through entity for tax purposes, such as a limited partnership. In a flow-through entity, the entity itself pays no taxes, but rather the profits "flow through" to the investors who are responsible for paying any taxes due.

'U.S. tax-exempt investors, including ERISA money, will generally prefer to invest directly into an offshore entity that is not a flow through, such as a corporation. The reason they prefer this is that were they to invest in a flow-through vehicle, they may be subject to taxes on any gains relating to leverage, which for U.S. tax purposes would include short sales.

'Offshore investors will prefer to invest into an offshore corporation. There has been a safe harbor for these investors under the U.S. tax code since the late 1960s. This year, legislation was passed amending this safe harbor to allow more activity to occur onshore and possibly allowing non-U.S. investors to directly participate in U.S. domestic products. Given the fact that, were it a partnership, direct reporting would be going to the IRS and other issuers, it is unclear at this time as to the level of interest by offshore investors.

'With regard to the tax implications for the money manager, the manager will want to ensure that the offshore fund has provisions to allow deferral of management and incentive fees. This will allow the manager to defer his or her order fees for a predetermined period and allow them to grow along with the fund on a tax-deferred basis. It is important to understand that the election to defer has nothing to do with the fact that the entity is offshore, but rather that it is not a flow-through vehicle. Were it a flow-through vehicle, the fees would not be reflected as expenses for tax purposes and the investors would be paying tax on profits associated with these fees (particularly incentive fees). Deferral of compensation is a standard tool in compensation plans in the United States and is particularly valuable to implement in the context of an offshore fund.

'On the regulatory side, there is a big difference whether the product will be sold to U.S. investors. When U.S. investors are involved, the manager will rely upon an exemption under Regulation D, which allows for the sale of private placements to sophisticated investors, but the manager must bear in mind that he or she cannot publicly solicit or advertise the product in any way.

'If the fund will be trading futures and if it has U.S. investors, it will need to register with the Commodity Futures Trading Commission (CFTC) and the manager will need to register as a CPO or a CTA. In general, hedge funds rely upon exemptions under CFTC Rule 4.7, which limits the fund to qualified eligible participants. Use of this exemption will significantly reduce the disclosure and reporting requirements to a manageable level.

'Stock exchange listings should be evaluated for offshore products - the Irish Stock Exchange being the most widely used. The principal reason for listing is to facilitate French institutional investor participation. If this is not part of a target market, it is likely of little value to list. There are other exchanges, including Luxembourg, Bermuda and Cayman, but it is unclear whether the latter two will qualify for the French institutions and the former has fallen out of favor, due largely to the success in Ireland.

'Among the many business issues that arise, it is particularly important to focus on those that relate to risk management and ensure that the client will pay the correct fees. On the fee side, it is crucial to understand that there is an inherent flaw in the calculation of incentive fees for corporate entities. To illustrate simply, we know that a partnership has capital accounts and therefore, the fee can be readily determined by the profits associated with each account. In contrast, a corporation has shares that will have the same price per share, including an accrual for the incentive fee. Since investors buy their share at different times, and consequently different prices, one may have a profit while the other has a loss. Therefore, we should have one investor with an incentive fee and the other without, which implies two different share prices.

'Under the most widely used performance fee methodology, this will not be the case. The manager will usually not earn all the fees he or she should, and there may be some skewing of equity between investors. There are other methodologies that correct these anomalies, which managers should explore.

'The investment program also must be evaluated within the context of the structure as it may result in modifications that generally relate to liquidity, tax and regulatory issues. Some of the most common issues encountered include trading of hot issues, country-specific investments (which might benefit from specific tax treaties), and registering the entity as a broker dealer Broker dealer registration is used when the manager has a strategy that would benefit from leverage on equities in excess of the 50 percent margin limitation imposed by Regulation T.

'There are many issues that need to be evaluated to ensure that the final product is an attractive one. The most common are liquidity (including lock-ups), valuation frequency, fee structures, jurisdictional selection, regulatory registrations (i.e., Irish Stock Exchange), and investment guidelines or restrictions. The products must be tailored to meet the needs of the target investors. For example, if you wish to get money from a fund of funds group, they will likely want monthly liquidity. In addition, offshore investors generally prefer share-based entities as opposed to limited partnerships.

'The manager should also ensure that the documentation provides flexibility so as to compensate third-party marketing groups and allow special fee arrangements for lead institutional or substantial investors. It is also during the structuring stage that the manager will want to evaluate where prices will be published, in which directories to list, and to which databases to provide performance. It must be emphasized that provision of this information must be carefully monitored so as to remain in compliance with applicable regulatory requirements and in some instances it will be completely restricted

'It is important to ensure that the final product will be manageable from an operational stand point. The key concept here is to "keep it simple," Failure to do so will usually result in: internal and external confusion; increased operational, audit and legal expenses; delays in reporting valuations to investors, and; delays in preparation of year-end tax reporting.

'In addition, and depending upon the complexity of the overall structure, there may be accounting issues to be examined, which ensure that there is no skewing of equity between investors. Any potential pricing issues also should be evaluated at this time.

'Managers will also want to evaluate the pros and cons of using a master-feeder structure as opposed to stand-alone entities for onshore and offshore investors. Essentially, a master-feeder has two feeders - one for onshore investors and one for offshore investors - whose sole investment is an interest in a third company, the master, which contains a single investment portfolio. The advantages of this structure are: a singe portfolio (no trades to allocate and only on reconciliation); uniform track records; creation of critical mass, and; the ability to create additional private-label products quickly and efficiently with a fully diversified and invested portfolio.'

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