- November 1, 2016
- Posted by: Vincent Sarullo
- Category: Direct Lending, Fund Administration, Fund of Funds, Hedge Funds, New Funds, Private Equity / Venture Capital, Real Estate, Tax Liens
Starting a fund is not only time consuming, it can be more costly than one would expect. Aside from the multitude of fees you have already paid out to form the fund, have you taken into consideration the ongoing hedge fund costs your fund is required to cover? These costs include administration, audits, tax preparation, compliance, and outsourced trading desks. Let’s take a closer look at the purpose of each service provider to help you decide on the right ones.
With true fund administration, the administrator is responsible for handling the back office operations of the hedge fund. This includes taking responsibility for all aspects of the NAV production and direct reporting to the investors. For hedge funds, this would encompass a review of investor subscription documents with cash inflows, plus redemption requests and payment to investors in accordance with the fund’s offering documents.
The administrator captures all trade activity and reconciles this activity to the broker with independent valuation of the portfolio at the NAV reporting date. Additional responsibilities include payment of fund fees and expenses, anti-money-laundering monitoring, and audit coordination.
For private equity and venture capital structured funds, the fund administrator is also responsible for sending out capital call notices to the investors (based on the investors’ respective ownership percentages needed to fund investments) and for transferring the money needed to complete portfolio company acquisitions.
Fund of Fund structures require the administrator to monitor the liquidity of the underlying investee funds and make investments or withdrawals from the underlying funds according to investor needs. The administrator is also in close contact with the underlying fund managers and/or administrator to ensure timely receipt of the valuations of the accounts so the NAV can be completed.
Eighty to ninety percent of the work that your service providers are doing for you is the same as what all the other service providers in that field will do. The differentiator is what they do for the other ten to 20 percent. Most importantly, are they with you through good times and bad? As much as prospective investors focus on getting to know you as a manager, you should take the time to get to know your service providers, especially the administrator, since they are the ones you will interact with all year long. A good indicator of how your investors will be treated when they contact the administrator is how the firm treats you. Do they treat you like a number or are they interested in you and your success? Ask what their staff retention rate is. High staff turnover drains resources from you, because getting new people up to speed on the specifics of your fund can lead to much frustration for everyone involved.
The role of the auditor is to come in and test transactions of the fund and review the disclosures in the footnotes of the financials to determine if they are fairly stated in accordance with Generally Accepted Accounting Principles (“GAAP”) in the US. Remember, these are your financials. The auditor may make recommendations on how things should be presented to be in compliance, but if you have everything that’s required, don’t allow the auditors to take over the financials and remake them in their image. My own years as an auditor and working with auditors have made me realize that no audit manager or partner can take a set of financials that has been reviewed by many people before them and not put pen to page to make a change.
Make sure your auditor knows investment funds, understands your strategy, and has experience in those areas. Just because it is in a private fund structure doesn’t mean they know what they are doing with your investments. Private equity, real estate development, and real estate tax liens require an understanding of the deals and valuation issues. Unless a firm has worked with these types of investments before, they will quickly find themselves in an uphill battle trying to learn about them – with the learning being done on your dime!
US tax issues and reporting can be a daunting challenge even for the most seasoned investment manager. Having a tax team made up of tax attorneys and accountants right from the start can stave off a lot of headaches down the road.
Besides the traditional tax returns required to be filed by US funds such as Form 1065 with investor K-1s, the US government and other jurisdictions have added to the reporting burden with Foreign Account Tax Compliance Act (FATCA) filings, tax withholding requirements for foreign investors, and a myriad of information reporting requirements.
You need to have all your service providers coordinate to collect and share information with each other in order to keep up with these reporting requirements. The last thing you want to do is have to explain to your investors that even though you had a great year with returns, they have a huge tax burden or personal reporting requirement that could have been avoided with the right planning. For further information, a great tax guide is Tax Compliance and Reporting for Hedge Funds and Their Investors by Joseph Pacello.
It is bad to not have policies and procedures, but it is unforgivable to have them and not follow them! Your “compliance program” manuals should not be just another checked box item on your due diligence questionnaire. The templates that you can get are a good starting point for examining what you are doing from an operational and reporting aspect, and adding functions that tie up loose ends. The first stop that regulators will make when they come in for their regular desk or onsite examination will be at your compliance manuals. With these in hand, they will have a road-map they can follow through your firm. Your manuals (or the lack thereof) will determine if their examination will be a smooth sail or a bumpy ride. They place a lot of weight on how much thought you have put into the compliance program. To them, it sets the tone for how committed you are to the business from a compliance point of view. They want to see how the tone is set from the top of the organization.
Like your business plan, your compliance program manuals should be ever-evolving process that grow and change with your business and the regulatory landscape that you are facing. You probably receive the barrage of emails from law firms, audit firms and other industry professionals on an almost daily basis, frantically shouting about a new regulation or discussion memo that the SEC or other government agency has put in place. You don’t need to get sucked into the “sky is falling” mayhem that seems to be blowing around with these alerts, because it can make you crazy. Instead, let them serve as a reminder that the industry is in constant flux and you just need to keep these things in the back of your mind. A good practice is to designate one person in your firm to monitor these regulations, either in a formal role as the chief compliance officer (CCO) if you have the bandwidth to do so, or just informally, so you can schedule meetings with your attorneys or outsourced compliance group to address these changes.
When considering a compliance professional or group, keep these areas of coverage in mind: do they take the approach of learning about who you are and what you do, or do they take a cookie-cutter approach and try to hand you a “package”? How much time do they plan to spend in-house to be involved with your operations? They should be a part of your valuation committee and portfolio risk team and be available to review all work created for marketing. These functions require being in your office and spending time with you and your staff. These roles are as critical as what you would expect your compliance professional to do on the technical side of the job. The compliance team would be responsible for Form ADV preparation and filing, Form PF filings, Form 13F filings, due diligence questionnaire reviews, mock SEC examinations, staff training, and would provide constant consulting on new regulations and how they impact your business. If they don’t cover these areas, find another group.
Every member of your firm needs to be compliance-aware and perform their specific duties with compliance in mind. As with all laws, ignorance of the law is not a defense and in your case, it’s a bigger issue because you are required to educate your staff so they are not ignorant.
Outsourced Trading Desks and the Emerging Fund Manager
Outsourced trading desks can lift the burden from a manager who is trading either one or multiple markets. Dedicating the time to ensure the best execution as a lone manager or with an in-house trading desk can be challenging. Investment selection and strategy should be your focus. We also know that you are not always tied to your trading screens or are traveling. Having a resource to cover you when needed can give you a better night’s sleep.
Many brokerage firms will designate a person or team knowledgeable about your fund to trade your orders as you would. They can leverage their technology and markets network to get the best execution and trade cost available. If you are trading in various markets around the globe, they will have people in those markets who can save you from being up at all hours of the night to make those trades. Even if you don’t use them on a regular basis, it is worth looking into and having the capability there when you do need it.
Whether or not you agree, your fund cannot be run as a “one-man operation”. Think of the old saying, “it takes a village to raise a child”. Your fund is your child, and the above mentioned services are the village your child needs to ensure its growth and well-being. Take the time to do your research and be aware of the exact needs of your fund!
Written by Vincent M. Sarullo, co-founder of Tower Fund Services