FTfm on the 7th of March had an interesting report by Chris Flood on research done by Cerulli headed “Absolute return funds ‘a myth’”. What grabbed my attention though was the comment that absolute return UCITS III funds launched by hedge funds needed a “reality check”.
They really do.
The push towards UCITS has been fuelled by the AIFMD. Investors view UCITS vehicles as safer because of the regulatory requirements such as the need to provide valuations and liquidity. I wrote about these concerns last year in October – “Making sense of it all – Newcits”.
As an investment objective absolute returns are supposed to be one of the characteristics that supposedly differentiate hedge funds from other mutual fund structures that do not normally charge performance fees. The concept of absolute returns is closely aligned with one of the overriding principles that a hedge fund should have – that of the preservation of capital. But it is not just investment strategy that needs to be geared to the preservation of capital – the structure needs to be suitable too for the risk taking that is proposed. Here too reality checks are necessary.
One area where the need for reality checks is essential in a structure is in relation to the safe custody of assets. It is not enough to have a big name custodian – which until you understand the basis may just be a Fig leaf. It is essential to understand what proportion of assets will be held by prime brokers to the fund as collateral for financing, what proportion of unencumbered assets will be held by the custodian, what proportion of the assets can the prime broker require to be transferred as collateral and whether there are sub custodial arrangements and how they will operate. Investing in emerging markets create their own twists which must be properly understood.
The custodian is there to protect the funds interests in the legal title the fund has to assets and how they are used – the custodian controls the assets and only releases them from its safekeeping in accordance with agreed procedures. It is important to understand what those procedures are.
AIFMD will introduce some new requirements making the custodian role one where the custodian (referred to as a depositary) will need to assume more liability than it it has previously been prepared to accept. There will be a requirement to ensure that cash flows are properly monitored and payments made by or on behalf of investors upon the subscription of shares or units of a fund have been received and that all cash has been booked in accounts in the name of the fund or the manager or the depositary on behalf of the fund. These are activities that a fund administrator would typically perform and fund administrators have set up subsidiaries providing depositary functions for funds that their groups administer.
AIFMD as it currently stands means that in Europe funds will either be governed by the UCITS or the AIFMD regimes. Both regimes will need investors to perform reality checks.
Investors need to understand where their assets will be held. For example if there are master feeder structures – then it is the depositary of the master fund structure that is going to require more examination. Establish who holds the voting shares or controls the structure and what the conflicts of interest might be with those who safe keep the assets – if you find that it is the same entity that does so then how are potential conflicts of interest managed? If there are umbrella structures make sure that you understand whether there is cross umbrella protection through segregated pools of assets for each different fund – it may have been set up purely for the fund managers convenience and may afford little protection to the investor if something was to go wrong.
Regulatory regimes for all the well meant protection they are designed to provide are still no substitute for investors rolling up their sleeves for a bit of reality checking.
©Jaitly LLP