Month: May 2009

The “Expenses” Debate – worth examining?

The current media interest on UK parliamentary expenses is a good moment to take stock of what constitutes a reasonable expense for an investment manager to charge a fund as opposed to a cost that it should bear itself.  

I have always found it very interesting to see what an investment manager will charge as an expense to a fund it manages.  Practice varies enormously.  Some managers will charge bonuses payable to their traders as a fund expense, others research related travel or the costs of information technology and risk management systems.

Received wisdom in the alternatives industry justifies a two tiered fee structure on the basis that the management fee charged – typically on a monthly basis – covers the running costs of the investment manager including staff, systems and premises.  The performance fee is the reward that the investment manager receives for generating the risk adjusted returns for which he is appointed.

The fund itself bears its own direct costs such as the costs of trading, audit, service provider fees (including those of the investment manager), direct legal costs and director’s fees.

Soft commissions or bundled commissions are another way for an investment manager and the fund it manages to receive additional benefits that the fund indirectly pays for through the commissions it is charged for trading.  These are considered acceptable expenses where the investment manager receives benefits which may for example be research related such as the provision of Bloomberg terminals for the investment manager.  The benefits become more nebulous when they relate to travel and accommodation or entertainment.  Different regulatory systems may also specify what is permissible or not for investment managers regulated by them.

Where an investment manager starts to charge expenses to the fund that would typically be investment manager costs such as trader bonuses and information technology – it raises a basic philosophic question as to what the management fee is supposed to represent?  Is it no longer representative of the investment manager’s running costs or is it to be viewed as a monthly premium for the privilege of having the investment manager manage the fund?  Is it reasonable for the investment manager to charge a pure fixed profit element in the form of these fees if running costs are also to be charged to the fund as additional expenses?

Who for example should bear the costs of the investment manager and its staff having to travel to research investment opportunities used for trading the fund’s portfolio?  Are these exclusively for the benefit of the fund or are there other clients of the investment manager who receive a free benefit as a consequence?  Is it not this very expertise for which the investment manager is appointed and if so are you as an investor paying twice for it?

Investors will often accept the status quo based on the investment manager ‘s success but it is essential that investors understand what they will eventually be picking up the costs for – and whether this was something acceptable or that they were prepared to accept.  Success generally keeps these issues at the bottom of the pile.

A careful fund investor should understand the expense profile of the fund.  A good investment manager should be able to justify the management fee it charges based on properly budgeted staffing, research costs, premises and systems so that the management fee is what it is described to be – a fee for managing the fund’s portfolio.  Where the costs of an investment manager and the management fee it receives begin to diverge – then this should be the catalyst for a review and a discussion between the investment manager and the investors in the fund.   

©Jaitly LLP

The “independent” administrator…….

The “independent” administrator……….

As reports come in about the appointment of independent administrators it is perhaps worth adding a note of caution to the panacea that such an appointment suggests.  As ever, the devil is in the detail and the appointment of an independent administrator on its own may be insufficient.  

Why is that?

The appointment of an independent administrator is an indicator that there may have been a change in mind set by fund managers whether driven by investor demand or by market best practice.  That is a good thing – but how good it is, depends on the contractual terms that have been agreed between the administrator and the fund to which it has been appointed.  It also depends on the administrator’s experience  and infrastructure as to whether the agreed services can be provided to an adequate standard.

It is possible to find independent administrators to funds who in fact provide nothing more than what the industry calls a NAV lite service or who simply provide transfer agency services.  There is absolutely nothing wrong in the provision of these services – it is simply important to understand that the service provided is limited to that service alone.  

Tread cautiously too where independent valuation services are provided as they may not always be as independent as you might presume.

It is not uncommon to find wording in the offering memoranda of funds where an independent administrator is responsible for verifying the valuations used by the fund to state that where it is not possible to obtain independent verification then the values used will be those provided by the board of directors or the investment manager to the fund.  From the administrator’s point of view this is perfectly reasonable and is important in managing their own risks in providing such services to the fund.  But where does this leave the investor who believes that the net asset value that they have received from the administrator comprises prices fully verified by the administrator?  Because this wording is so common I generally try to insist that an obligation is created whether by side letter or by amending the fund’s documentation that the administrator or the manager is obliged to inform my investor where the net asset value comprises non independently verified prices (or prices provided by the directors and managers) which form say more than 5% of the net asset value.   This is essential so that the investor is able to form a better view of the values that comprise the net asset value being reported to them.

It is also not uncommon to find that the contractual terms for the provision of price verification are drafted in such a way that the administrator is protected if they rely on prices provided by the manager or directors of the fund and so there is little obligation contractually to seek out independent verification where current publicly traded price information is not available.  When one starts to look at the contractual documentation of a fund – because everyone is so concerned about managing the risks that may attach to them – it is sometimes difficult to see who if anyone is contractually responsible for the valuation of a fund.  

Investors need to insist that contractual obligations are created so that there is proper independent verification of prices used for a net asset value – if necessary as ‘agreed upon procedures’ if the uncertainties in valuation are so inherently risky.   There is nothing wrong in a fund investing in securities that have inherent uncertainties around their valuation – what is important in such instances is that there is a clear and replicatable set of steps and processes that would enable an independent third party to apply them and reach the same price/value – and that these steps and processes are reviewed and checked as being applied by an independent party.

So what should an investor look for in an independent administrator?   Here are some basic questions and issues to consider:

  • Is the administrator’s business  sufficiently diversified so as not to be dependent on the fund manager’s business?
  • Does the administrator have the capacity and infrastructure to deal with the investment strategies of the fund (don’t necessarily be seduced by a big name – get to know the team that will service the fund – there can be infinite variety between teams)  Can they meet the necessary deadlines?  Administrators can grow too quickly and lack safe capacity.  Does the administrator understand the fund’s strategy and have teams with the requisite experience to deal with it.  e.g. appropriate valuation teams?
  • Does the administrator have robust quality control procedures and a good supervisory and training environment?
  • Do the contractual arrangements create a real responsibility to provide a “Full Service Net Asset Value and Transfer Agency Service” to the fund and its investors?
  • Is there a mechanism in place to inform investors if the net asset value includes non independently verified prices over an agreed threshold and whose responsibility is it to report it?
  • What history does the administrator have with previously reported problems on funds?  Is there any litigation that you should be aware of and consider?
  • Have you done any due diligence on the administrator and the team that will service the fund you are investing in?
  • Who owns the administrator?  Is the administrator able to invest in the funds it services – and does it?  Are there any other conflicts of interest that need to be considered?

If you can get suitable comfort on these issues then indeed you will have an independent administrator worthy of that name on the fund you are about to invest in.

©Jaitly LLP

Training in Operational Risk

If you want an investment professional to understand the niceties of operational risk there can be no better training opportunity than to send them to attend a meeting of creditors and investors convened by the liquidator of an offshore fund that has gone wrong.

I attended such a meeting last Thursday.   There were a number of things that struck me about it.

Firstly only a handful of investors attended the meeting – some joined the meeting by phone but very few had made arrangements to attend or be represented at the meeting.  Was it concerns over publicity, costs – throwing good money after bad, an assessment of the hopelessness of the situation?  It is difficult to say.

Meetings of this nature are designed to impart information to those affected by the events in the Fund – and there are significant costs attached to doing so.  These costs are inevitable and inevitably they eat into the pot available for recovery.  Is there a case to insist on some mechanism such as insurance to cover such eventualities on investments in future?

The nature of the classifications into investor and creditor claims and the priorities given to each type of claim throw into sharp relief what remedies are available to those who stand to lose money from the collapse of such a fund. Who recovers what ahead of whom, where there are funds to distribute to such claimants, can then become significant issues – the difference between getting some recovery or none at all.  It also highlights what a fine balance there can sometimes be between a fund being classified as solvent or insolvent based on how a claim may be classified.

Despite the wonderful clarity of vision 20/20 hindsight brings with it – and whether or not there were tell tale signs before the allegations of potential  negligence and wrong doing arose – what is instructive about such a meeting is for investment professionals to consider ahead of an investment the sort of things that they may need to deal with in the event an investment of theirs goes wrong…….

  • What avenues are available to them to recover their investment if things went wrong
  • Do they really understand how their assets will be held and how they can be dealt with
  • The nature of claims that could arise and the priority in which they would be paid
  • The expenses involved in recovering what is left of an investment and who should bear them or whether it is worth paying for insurance to cover such eventualities
  • What justifications would there be for the investment if the disclosed risks actually came to pass
  • Can service providers to a fund be properly held to account for their actions or inactions in relation to the fund and to what extent is it reasonable to rely on them in making such an investment.

Where there is fraud – no amount of prior work may necessarily unearth the issues and however good ones risk management – controls can always be overridden.  But what is important from a training perspective is to bring home the reality that these things do happen and the only way to emphasise to investment professionals the complications in unravelling such matters is in my view by making them attend these types of meetings – so that they understand first hand what happens when a fund ‘blows up’ and that it is not simply a theoretical risk.

©Jaitly LLP