Part 6
Summary—Fund Administration Notes
Abstract
The following is a summary of the subject matter of this book: (1) Investment industry (2) Types of fund entity (3) Investment (4) Types of product used in investment (5) Operating structure of funds (6) Services and issues in setting up a fund (7) Prospectus/offering memorandum/scheme particulars.
Keywords
fund administration
investment industry
operating structure
capital growth
liquidity
The following is a summary of the subject matter of this book
1. Investment industry—Still recovering from market crash and liquidity problems with investors, both private and institutional, wary of issues like security and reconciliation over the assets of a fund (Madoff), large and sudden drop in Net Asset Value of some funds (suggesting unrealistic valuation of assets), and a general negative view of participants in the financial markets (short selling, high performance fees, bank rip offs, lack of control etc.). Alternative investments are popular, for example, buying gold, art etc.
There has been significant regulation and legislation introduced including the Alternative Investment Fund Managers Directive (AIFMD), The European Markets Infrastructure Regulation (EMIR), UCITS V, Markets in Financial Instruments Directive II (MiFID) Dodd-Frank (United States) with more emphasis on transparency and reporting.
Also legislation aimed at tax avoidance like Foreign Account Tax Compliance Act (FATCA).
2. Types of fund entity—Three main structures found with the oversight responsibility for each:
a. Investment company—board of directors—established under company law in the jurisdiction.
b. Unit trust—trustee—established under trust law of a jurisdiction.
c. Partnership—general partner—established under partnership law of a jurisdiction.
d. There can also be funds with no legal personality often called Common funds operated by a management company.
e. Retail fund—Can be sold to anyone, high level of regulatory protection for investors, usually has to have transferability (can enter/exit fund on demand), diversity in the portfolio and does not have liabilities like cash borrowing.
f. Qualifying Investor, Expert, Market Professional funds, some Fund of Funds, Exempt funds—restricted investor base (market professionals, institutions, high net worth individuals (c. $1 or 2 m), need and have less regulatory protection.
3. Investment—Revolves around key concepts as follows:
a. Risk and return are related.
b. Time to realize the return is important—long, medium, and short.
c. Risk appetite—
- Low-conservative—Diversified across many assets, no use of derivatives (except for currency risk management and hedging risk) and other “risky” assets, no borrowing (gearing/leverage created liabilities), no risky strategies, for example, short selling, foreign exchange risk removed through forward contracts, often benchmarked or tracker type funds (passive).
- Medium—Diversified portfolio of assets, some use of derivatives mainly to hedge risk, limited gearing and exposures, major part of the portfolio in low risk assets like G7 government bonds, blue chip equities, rest in more volatile assets, for example, high yield bonds, speculative equities—example split 80–20% or 70–30%, often actively managed.
- High-low diversification, wide use of derivatives and structured products, use illiquid assets like private equity and property (real estate) gearing/leverage common, unlikely to distribute income, use high risk strategies like short selling, skewed exposures, mainly absolute return funds.
4. Types of product used in investment—
a. Assets and asset allocation used to create the portfolio.
b. Asset classes.
- Equities—shares
- Debt—bonds (long term), Notes (medium term), Bills and money markets (short term).
- Cash—deposits and currencies.
- Property—housing and commercial (offices, shopping malls, warehouses).
- Commodities—agricultural, softs (coffee, cocoa, butter etc.), metals, energy.
- Alternatives—antiques, art, wine, forestry.
- Capital growth—for example, equities, currencies, property, and private equity.
- Income—for example, debt (interest), equities (dividend), and property (rental income).
- Ethical and specific funds—environmental/green funds, and Islamic funds.
- Master/feeder funds and fund of funds—investment in another fund or funds rather than assets.
5. Operating structure of funds—
a. Type of entity—company, trust, partnership, or common fund.
b. Owner/sponsor—investment company operating sub funds, for example, the SICAV in Europe, hedge fund run by fund companies or individuals—track record/reputation major importance.
c. Investment manager(s) and advisers—make investment decisions or provide suggested investments (decision made by investment committee/board/general partner based around the mandate/offering documents plus regulatory constraints, risk appetite/profile of the fund. Operate under an Investment Management/Advisory Agreement (IMA).
d. Fund administrator—often an external, “independent” party covering potentially three main areas:
- Operations—transaction inputs, reconciliation, recordkeeping.
- Accounting and valuation—pricing, NAV calculation, accounting records of the fund.
- Transfer agency—dealing with subscriptions, redemptions, fund register, investor due diligence, AML checks, investor communication etc.
- Other areas—fund set up, secretarial services.
e. Custodian—holds the assets of the fund in either physical or electronic format depending on the asset and offers other support services.
6. Services and issues in setting up a fund.
a. Jurisdiction/location—onshore/offshore.
b. Regulator—who is the regulatory authority (some investors wary of funds that are not regulated/authorized but lower cost can be attractive).
c. Regulation—what is applicable to different types of funds.
d. Tax related to the the fund business as well as investors. Tax on income and capital gain, with holding tax (WHT) and tax treaties plus tax exempt status where applicable.
e. Legal—agreements, constitutive documents, offering documents.
f. Fund set up—applications, licenses, registrations, listing etc.
g. Offering documents—prospectus (investment company—retail and alternative), offering memorandum (hedge fund/PE/Property), scheme particulars (trust).
h. Investment management—inhouse, outsourced, combination.
i. Secretarial.
j. Banking.
k. Sales and marketing—outlets—fund management company, prime broker, financial advisers, banks, brokers, online selling, coupons in journals etc.
l. Administration services—records, valuations, dealing with investors (inhouse/outsourced).
m. Prime broker/broker relationships including possible custody service.
7. Prospectus/offering memorandum/scheme particulars—contain all the relevant information and disclosures about the fund including:
a. Investment objectives, risk profile, functionaries (including investment manager, management company, trustee, directors, general partner, administrator, custodian, auditors), subscription and redemption details, investor constraints, taxation, etc.
b. Legal details, regulator.
c. Fees and charges applicable to the fund including any performance fee payable to the investment managers if targets are met.
d. Rights of the share or unit holders or the limited partners in a partnership.
The regulator oversees the whole process authorizing funds under the terms of the relevant legislation in the jurisdiction (Diagram 6.1).
Diagram 6.1 Investment funds relationships.
Funds can be authorized for general sale, for example, European UCITS funds or for sale to qualifying investors only (nonretail funds).
There can also be unauthorized funds with restricted investor base and Exempt funds, given exemption from the local regulation as they are regulated elsewhere to a satisfactory standard (these funds usually cannot be sold to domestic investors even qualifying investors).
The general structure of a fund is shown in Diagram 6.2.
Diagram 6.2 General structure.
The management company deals with the day to day process of the fund operation.
Investment management is done by managers and or advisers in conjunction with investment management agreement, investment committee etc. and through brokers, the prime broker for securities, commodities and derivatives, agents for property, advisers/agents/directors of private equity firms for opportunities for PE funds etc.
The administrator manages the day to day processing of the activity of the fund and the custodian holds the assets and deals with settlement of the asset transaction.
1. Fund administration—A service based product that has developed from the independent provision of pricing and valuations of assets and portfolios into a broad based product covering:
a. Fund operations—Asset trade capture and inputs to records, validation and verification of positions (exposure limits/mandate), assets (settlement status and location, eg, custodian), and reconciliations.
b. Fund accounting and valuations—Statutory accounts, general ledger, pricing of assets, posting of actual and accrued income (from assets, eg, dividends, interest from debt instruments and cash deposits), and expenses (from transactions, eg, broker commissions, services, eg, custody fees, audit fees, licenses and registrations, bank charges etc.).
c. Transfer agency—Managing subscriptions and redemptions, client due diligence, AML checks, the fund register, and communication with clients.
d. Secretarial services, risk and compliance management, fund set ups.
2. Change to the service requirement—Driven by the need for funds to show higher degree of control and management over the day to day operation of the fund including risk management and compliance—Key issue is quality and professionalism.
3. Product characteristics—Essential that the administrator understands the structure and characteristics of different products the fund may have in the portfolio, for example, the process of accrued interest on bonds, margin, and collateral associated with derivatives, for example, and the possibility of corporate action events. Also the valuation issues surrounding “easy to value” assets like listed equities and “difficult to value” like property and illiquid assets.
4. Workflow—The ability for the administrator to manage the workflow associated with the process of subscription and redemption, through cash forecast update, asset trades, postings, reconciliation, and finally the pricing and valuation process.
5. Identifying problems—Data quality crucial as is the timings and cut offs associated with key processes, for example, asset trade capture from investment manager, receipt of subscription/redemption requests etc. Managing situations in a practical way.
6. NAV calculations—Pricing policy, tolerances and parameters, exception management, initial reasonableness checks, for example, portfolio change versus a benchmark, and correct accruals.
7. Private Equity—Drawdown capital, growth, and then distribution periods, fund has a projected life (5–10 years). Distribution pays off in order:
a. The initial capital of the investors.
b. The preference return to the investors.
c. The carried interest of the general partner.
d. Remaining return distributed across investors/general partner.
Fund is charged fees throughout the life of the fund so initially investors have a negative situation.
8. Futures contracts have:
a. Variation margin based on the contract size/tick size and value—the end of day price and any closing trades.
b. Creates a daily settled process of unrealized profits/losses, realized profit/losses, and commission payments.
c. Initial margin is collateral held by the broker until obligations are closed.
d. Cash covering initial margin still part of the NAV but not available for investment by the manager.
e. Futures have a contract specification, for example, tick size and value, maturity size (FTSE index future on Euronext is £10 × index).
9. Property fund—Often based around the following:
a. Physical property.
b. Shares in property companies, land etc.
c. Rental income from properties.
Property is often managed by a property management company with assets like title deeds held at a legal firm and assets like shares at a custodian.
10. Sources of data are important—Subscriptions/redemptions from 3rd parties, asset trades for investment manager/prime broker, valuations from PE accountants and property management company, price feeds and data from Bloomberg, accruals from ledgers/invoices etc.
11. Cash flow—forecasts and cash management oversight.
Exercise Answer
Day one:
Variation margin—purchases 10 contracts × £10 × 5900 = £590,000
End of day (EOD) price 5907 = £590,700 creating a profit of £700 less commission of £15 = net £685 receivable (this amount is called variation margin or VM).
Cash balance now £60,685—initial margin = 10 × £2500 = £25,000 so cash balance for NAV purposes is £60,685 but for the cash forecast, that is, available cash is £35,685.
Day two:
BFwd 10 contracts @5907
Sell 5 contracts @ 5912 VM = 5 contracts × 10 ticks × £5 = £250
CFwd 5 contracts
EOD price 5915 VM = 5 × 16 × £5 = £400
Total VM = £650 profit less £7.50 commission = £642.50 to receive
New cash balance = £60685 + £642.50 = £61327.50—initial margin = 5 × £2500 = £12,500
Day three:
Bfwd 5 contracts @ 5915
Buy 5 contracts @ 5920 and Sell 10 contracts @ 5906
VM = 5 × 18 × £5 = £450 and 5 × 28 × £5 = £700
Both are losses so total VM = (£1150) plus commission £15 × 1.5 = £22.50
Final cash balance = £61327.50 minus £1172.50 = £60,155
Note: Each day the initial margin is covered by cash so the amount available for investment is the balance minus the initial margin.
1. Fund accounting (Part 2)—Important for an administration team to understand the characteristics of products used in the assets allocation process. Some of the key points are:
a. Realized and unrealized profits and losses.
b. Accruals for income and expenses.
c. Ability to value products issued at a discount—The accreting amount per day.
d. Using correlations to measure the value movement, that is, a relevant index versus the portfolio change.
e. Illiquid (hard to value) products—Use the pricing policy, balance sheet, use similar products, last price traded if not “old,” write up write downs based on economic research etc.
f. Private equity—Often Board representation which can be source of value.
g. Day count convention important—days for accrued interest, that is, 360 (US), 365 (UK).
h. Equalization—High watermark, hurdle rate, calculated excluding any capital inflow/outflow, resets, method of equalization (refer to handout document).
2. Transfer agency—Managing subscriptions and redemptions, client due diligence, AML checks, the fund register, communication with clients to the service requirement.
a. AML checks vital—Individuals, financial institutions (other funds), and corporate companies must have due diligence carried out.
b. Policy for investors introduced by third party, for example, financial advisers, banks etc. Some form of confirmation needed or due diligence must be done by the T/A.
c. Power of attorney over deceased investors.
d. Segregation of distributions into segregated bank account prior to the payment.
e. Update of share register with accumulation shares resulting from distribution.
f. Update cash flow forecast with result of subscription/redemptions amounts.
g. Know the constraints on redemptions—gates, embargoes, shut outs etc.—early exit fees may apply—dealing periods and cut offs.
h. Know constraints on subscription—size, cut off times.
i. Distribution of investor communications—financial statements, periodic statements, notices (pre or post event—“material information” prior to event).
3. Fund compliance—Increasing in importance and the tasks are often outsourced to the administrator (but not the responsibility which remains with the fund directors, trustee, or general partner)—two elements apply—regulatory compliance and internal controls compliance.
a. Fund compliance and Fund Administrators Compliance
b. Regulatory compliance
- Authorization/License terms
- Rules and Regulations pertaining to Collective Investment Schemes, for example, FCA UK “COLL”
- Directives like UCITS, ESD, MiFID, AIFM
– Best execution
– Marketing
– Investment constraints—strategies, borrowing, gearing, investor type
- Responsibilities of functionaries
- Fiduciary responsibility
- Offering documents and disclosures
- Reporting
c. Internal controls
- Mandates and agreements
- Procedures
- Checklists, for examples, for a corporate action
- Management information
- Audit trails
- Logs—administrators should always log any incident, request to waiver any control or procedure etc.
- Compliance checklist
4. Risk management—Also increasing in importance for both fund promoters and investors. Three key risk areas:
a. Market risk—largely the investment managers area based around investment decisions, assets allocation and selection, liquidity, risk etc. Issuer risk—default on a bond for instance.
b. Credit/Counterparty risk—mainly around default possibilities, very important for private equity and other draw down funds as investor default has major risks. Also risk of failure of counterparty holding positions, collateral, assets belonging to the fund, for example, prime broker failure (Lehmans), breach of Custody Agreement or Administration Agreement—failure of investment manager to adhere to Investment Management Agreement (case study–Peter Young Morgan Grenfell Asset Management).
c. Operational risk—mainly day to day operation of fund but also includes personnel/HR risk, technology risk (performance, scope, maintenance, and security), settlement risk, access risk (premises, travel etc.).
d. Other risks include—legal—unenforceable contracts/agreements and regulatory—breaches of rules, mandates, offering documents (prohibited product, unsuitable investor etc.), failure to carry out duties (Fiduciary risk).
5. Killer and key risks—Killer risk is an actual event that would destroy the fund, management company, administrator—key risk would be so serious it would damage the fund or custodian, administrator and may leave it so weak (loss of capital/assets, investors) that they/it eventually closes.
6. Fund and administrator should have Procedure Manuals and Policies for dealing with key processes and controls, including identifying key risk indicators (KRIs) and key performance indicators (KPIs).
7. Must be consistent in the way in which the fund operates key tasks and functions, that is, pricing and valuation, accounts etc.
8. Secretarial services can include risk and compliance management (documenting minutes of meetings, filing returns etc.
9. Fund set ups—key risk for promoter so may use an administrator in the jurisdiction to set up the fund including providing directors etc.
10. Administrator risks—mainly about viability of the business (fees revenue—percentage fee plus some usage basis fees versus costs—premises, salaries, systems etc.) and compliance with Administration Agreement and Service Level Agreement between fund and administrator.
11. Operational risk is often assessed by carrying out a process of “self-assessment” to measure the level of risk.
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