American Fund Markets - Hedging on the future

Written by by Dermot Butler, CEO, Custom House Global Fund Services

Tuesday, 03 March 2009 10:54

International company Custom House explains the various challenges of the hedge fund industry
Custom House Global Fund Services Ltd is a new company, formed as the result of a merger between Dublin-based Custom House Administration & Corporate Services Ltd, with the offshore funds services business of Equity Trust. Equity Trust is the largest independent trust company in the world. As a result of that merger, Custom House Global Fund Services Ltd. (“Custom House”) was established in Malta as an active administrator and custodian of Funds of Hedge Funds. It also acts as the parent holding company of several subsidiaries, including Custom House Fund Services (Ireland) Ltd (the original company). In addition, Custom House now has subsidiaries in Chicago, Guernsey, Luxembourg, the Netherlands and Singapore.

Prior to the merger, Custom House had offices in Dublin, Chicago and Singapore, which enabled them to provide a “24/5” round-the-world and round-the-clock service. This, in turn, enabled them to produce over 100 daily dealing NAVs. In effect, because Custom House operates off one central, fully-integrated, system, which is open to all offices, Custom House, effectively, starts its week at midnight Dublin time on Sunday, when the Singapore office opens. It ends its week at midnight Dublin time on Friday when Chicago closes for the weekend.

International investments

Since the merger, Custom House now has the added ability to offer its Luxembourg administration facility, service Guernsey clients and commence using specialist products established in the Netherlands.
Furthermore, Custom House in Malta is licensed and authorised to act as a Custodian of Fund of Funds. Custom House in the Netherlands can provide a specialist Netherlands service known as ‘Bewaarder’. Custom House is now a truly global operation. It does not have offices in the Caribbean or Bermuda because all those clients can be efficiently serviced by other offices. There is therefore no point in maintaining an office in the high cost Caribbean and Bermudan jurisdictions, especially given the long term employment restrictions for ex-pat staff.

In today's market environment, it is a brave or foolish person who predicts how the market is going to behave over the next 12 to 18 months. Nevertheless, when running a business, it is essential that management makes such predictions and establishes a strategy accordingly. We believe that, during 2009, times will be difficult - probably more difficult than in 2008. But, and it is a big “but”, it is an undeniable fact that, hedge funds made losses and did not preserve capital as they were expected to do. Nevertheless, they did produce ‘alpha’, by outperforming traditional long only assets by between 15% and 20%. It is, therefore, we believe, inevitable that professional, sophisticated investors will recognise this fact and will return. Those who had left or reduced their holdings in the hedge fund market for whatever reason will come back, albeit they will be more selective in their allocations.

Independent administration

Furthermore, as a result of the Madoff affair, major investors are already demanding that US funds in particular should appoint independent administrators, and not continue to be self-administered. This is going to change the market substantially because there are still a high proportion of American hedge funds that are self-administered.

There is likely to be some increased regulation, but it is difficult to predict what that will be. One can only hope that it is intelligent and effective and not “knee-jerk”. The FSA has now lifted the short selling ban, and it is to be hoped that the regulators will realise that the short selling ban restricted a viable business, and did not add anything to the equation.

There is considerable talk about regulating hedge funds, which largely emanates from the United States. There, the perception is that the hedge fund manager, being the general partner, is the “hedge fund”. It is my firm opinion that there is little point in regulating the fund, which is a relatively amorphous entity and usually does not employ any staff. It is the hedge fund manager, often a general partner in the United States, which is a legal entity responsible for the management of the fund, together with the Board, if the fund is a Company. It is this manager, which does employ staff and which should be regulated. This is how it works in almost every other jurisdiction apart from the United States. And, dare I say it, it works quite well.

It is, of course, almost inevitable that hedge funds have been, as described last year by Charlie McGreevy, “demonised”. Accordingly, some newspapers, in fact, almost all of the western world’s popular and broadsheet press, are apparently responsible for the whole economic collapse. However, those who think clearly, are fully aware that the fault lies with the banking fraternity, and those who supported the marketing of sub-prime mortgages to people who were incapable of paying. Whilst on this subject, I do think that the US practice that lenders of defaulting mortgages can only have recourse against the property on which the money was originally lent and not against the borrower, has led to reckless gambling by those borrowers who actually understood what they were doing. I have more sympathy for those who had no idea what they were doing – the apocryphal NiNjNas – no income, no job, no assets – and whose second or third language is English. As you will no doubt have gathered, my belief is that regulation should concentrate on: (i) restricting leverage in banks; (ii) imposing a requirement on all banks and all lenders that they have satisfied themselves that borrowers are able to meet their obligations; (iii) introduce more aggressive “Know Your Client”/best advice selling regulations, similar to those imposed by the FSA on UK investment advisors; and (iv) proper regulation of American hedge fund managers.

The other changes to the hedge fund market that I anticipate are pressure on fees, which I think (and this, like this entire article, is a personal opinion) should result in the 2% management fee being reduced on volume. Thus, 2% is reasonable up to, say $200 million, then it should reduce to 1.5% up to US$500 million and, thereafter, 1%. The incentive fee is always a matter of negotiation, but my gut feeling is that most investors would be happy with a benchmark above which the incentive fee is charged. At the other end of the scale, it is arguable that the manager should be paid on ‘alpha’. That, of course, would not please investors once they realise that this means that most hedge funds would have received an incentive fee in 2008 because they generated alpha, albeit they also lost money.

How does anyone trying to run a business establish a strategy in these market conditions? I think one has to try to be prudent - the original definition, not Gordon Brown's recently discredited version. But still you have to be proactive and, in this regard, we intend to continue marketing our product, albeit changing the marketing strategy to concentrate on both US self-administered funds, as well as those funds that require daily dealing NAVs. (In this, I believe that, in providing daily dealing NAVs for 25% of all the funds and sub-funds that we administer, we are unique in the hedge fund administration field). I think that investors will impose pressure on liquidity, whilst at the same time, managers, particularly Funds of Funds managers (if there are any left) will want to impose lock-ups and reduce liquidity for which they will offer reductions in fees. The next couple of years are going to be interesting but, whatever happens, we are going to see substantial changes over the next 18 months, including a requirement by investors that a fund of fund’s liquidity should match the underlying investments.

Custom House prides itself on being independent and in providing an independent service to clients with regard to verifying the existence of the assets in the fund’s portfolio and verifying the value of those assets, on the basis of which we calculate the NAV.

In the context of “independence”, I had an interesting experience at the GAIM Fund of Funds Conference in Geneva last November. I was in conversation with an ex-prospective client, who, in fact, went with an administrator that was part of an international banking group. We had a civilised conversation during which I said I hoped everything was going well. I also told him that I was sad that we hadn’t got his account, because we thought we would have provided him with a very good service. He said that everything was going reasonably well, but the reason that we had not won the contract in the first quarter of 2008 was exactly the reason that we would have won it in the second quarter of 2008 – namely, Counterparty Risk. The Counterparty Risk with Custom House was too high in March last year, because we were not associated with a major bank. “That Counterparty Risk had declined substantially by November 2008 “because we were not involved with a major bank”, an extraordinary reversal that nobody could have anticipated.