Administration, Custody & Prime Brokerage

Alain Gurard CAIA 8th March 2012

Agenda
Introduction Hedge Fund Administration Custody Safekeeping Depositary Prime Brokerage Conclusion

Agenda |

Page 2

Introduction

Source: Bank of New York

Introduction |

Page 3

Hedge Fund Administration

What is Hedge Fund Administration?

Core Services
Shareholder Services NAV Calculation Financial Reporting corporate Secretary

Non Core Services Daily NAV and P&L Middle Office Risk & Transparency Reporting (Riskmetrics, Measurisk, OPERA, etc...) FX Banking Liquidity Management Collateral Mgmt
What is Hedge Fund Administration? | Page 5

Hedge Fund Administration (HFA)

Hedge Fund
Daily profit and loss, and exposure reports
NAV reporting

Trades reported daily

Shareholder reporting

Valuation of all

Management fee

Operations

validation
Collateral and margin

management

Administration

Trade capture and

Cash forecasting and

instruments
Corporate action

calculation
Investor and financial

processing
NAV calculation
Trade capture

reporting
Subscriptions and

management

redemptions

Trade reporting and position reconciliation

Securities and collateral movements

$$$ Cash Movements

$$$ Subscriptions and redemptions

Prime brokers & ISDA counterparties Custodians

Bank accounts

Investors

HFA Market
Market Trends Specialisation (Managed Accounts, Credit / Loan Strategies, Regulated structures...) Consolidation (ex: BNY, GlobeOp) Segmentation (global custodian vs. independent vs. PBs) Extension of service offering (custody, cash, collateral management) Alternative UCITS creating a convergence play US is the priority market (SelfAdministration) AIFMD will be a game changer

Name
CITCO State Street
BNY Mellon Goldman Sachs Citi HFS GlobeOp Northern Trust Morgan Stanley

AUA
$507 bn $416 bn
$282 bn $212 Bn $186 bn $174 bn $149 bn $128 bn

SS&C HSBC

$125 bn $124 nb

Source: HedgeFund.net HFA Q2 2011 Survey

HFA Market |

Page 7

Initiation - HFA Selection

AIMA DDQ HF Manager RFI/RFP Independent Consultant Prime Brokerage consulting reports League Tables (HFM / Global Custodian) On-site visit System Demo Meeting the delivery and client service teams Client References
Initiation HFA Selection | Page 8

Initiation - HFA Agreement

The administration agreement will generally cover the following areas:

Services offered by the administrator:

1. registrar and shareholder services functions, such as processing subscription / redemption / transfer &maintaining the share register 2. NAV calculation 3. assistance with the preparation of financial statements and reports & liaising with the fund's auditors, 4. Other services such as Corporate Secretarial Services

Conditions to performance of administrative services Fees and expenses Liability/indemnity Termination Governing law and jurisdiction Dispute resolution AML

Initiation HFA Agreement |

Page 9

Initiation - Service Level Agreement (SLA)

SLAs/Service Level Descriptions are not typically legally binding. It is living document that we evolve with the life of the fund. Description of the operational, escalation and communication framework under which the fund, the administrator and other service providers will operate. What can you find in the SLA: contact details detailed operational responsibilities workflows responsibilities for each parties deliverables and timeline for delivery KPIs

Objective of the SLA is to ensure that the fund administration process is documented, achievable and will result in a satisfactory administration service being delivered.

Initiation - SLA |

Page 10

Initiation - HFA Comments on PPM

HFA will review the PPM and provide on specific comments on section that relates to its activities such as :

Description and functions

Interaction with investors - sections dealing with subscription, transfer and redemption procedures and sub/red docs AML and other regulatory issues Fees especially on the performance fees methodology Circumstances where the NAV is to be suspended or redemptions deferred

Valuation of assets PPM should reflect how the fund is to be valued, including valuation policies, force majeure, suspension provisions and the capital structure of the vehicle.
Initiation HFA Comments on PPM | Page 11

Investor Services 1/2

What are the main activities of Shareholder Services (Transfer Agency or Investor Services)?

maintaining the share register and investor registration detail processing all dealing transactions including subscriptions, redemptions, switch & transfers ensuring proper completion of subscription/application forms, with reference to requisite qualification & eligibility maintaining client subscription accounts and ensuring that transfers are made to the fund's account within cut-off time holding current authorised signatory lists of investors tracking underlying beneficial owner information of nominee investors issuing redemption payments, including the hold back of partial amounts subject to the finalisation of performance fees, redemption penalties or the fund's annual audit; issuing dealing confirmation statements and reports to investors and dealing with investor queries; providing reporting based on estimated or indicative NAV calculations; reporting all such dealings to the fund manager in a prompt and efficient manner;
Investor Services 1/2 | Page 12

Investor Services 2/2

completing all appropriate AML and client identification checks or processing of designated body letters; maintaining fund documentation in accordance with local regulations, e.g., data protection laws, tracking investor lock in periods, where appropriate; where applicable, ensuring compliance with the EU Savings Tax Directive; German tax reporting; UK distributor/reporting fund; tax reporting; Austrian tax; PFIC; ERISA and K1 reporting information to the funds' tax advisors; reporting as required to stock exchanges; monitoring of maximum authorised share amounts across fund structures; processing performance fee equalisation; monitoring terms of side letters; assisting potential investors in carrying out due diligence; providing relevant information to fund auditors.

Investors Services 2/2 |

Page 13

NAV Calculation Trade Capture

Trade Capture

Transaction reflecting trading activity Critical that the trading activity of the fund is properly reflected in the valuation systems of the administrator.
Trade File/Blotter: Daily electronic trade files detailing all the trades done. Common methods include SWIFT, FTP or CSV/Excel files HFA will upload/process the transaction activity into the books and records. OTC and exotic may require manual intervention Update of the static data in the security master Independence is key, trade file is coming from the HF manager and then reconcile to the Street (PB, Custodian, Trading counterparties) Critical Drivers: Automation, Trade Volume, Asset Type, Quality of Static Data & Independence
NAV Calculation Trade Capture | Page 14

NAV Calculation Security Valuation

Two main aspects to the valuation process: price collection and price governance
Price collection covers the mechanical process of collecting prices from agreed sources at agreed times.

Price governance covers the process by which the pricing policy, controls, responsibilities, disputes and issues are escalated and resolved.

Essential guiding principles:

independence of the pricing process (independent sources) Competence, Prudence and Fairness documented process to insure consistency and transparency (pricing and valuation policy) focus on OTC, unquoted instruments or hard to value assets
NAV Calculation Security Valuation | Page 15

NAV Calculation - Pricing Policy

Hierarchy of pricing sources (primary & secondary / reference) for each instruments Escalation procedures Tolerance Levels between sources Price Override policy Approved and reviewed regularly by the board Using the AIMA Guide to Sound Practices for Hedge Fund Valuation & IFIA sample is a good starting point The Board of Directors and the HFA, together with the investment manager, will then agree on how that pricing policy is to be executed. There may be specific responsibilities placed on the HFA in the execution of this policy but investors should not automatically assume a standard model.
NAV Calculation Pricing Policy | Page 16

NAV Calculation - Pricing Matrix

Asset Type Primary Source Secondary Source Tertiary Source

Cash
Repurchase Agreements FX Spot FX Forward Long Dated FX Forward Exchange Traded Futures Exchange Traded Options

OTC Options CFDs

Interest Rate Swaps Credit Default Swaps Variance Swaps NAV Calculation Pricing Matrix | Page 17

NAV Calculation - Directors

The Board of Directors has ultimate responsibility for the valuation of the Fund. The Board delegate this responsibility to an Administrator. Documented pricing procedures should be approved by the Board in advance of the Fund's launch and should be disclosed in the Fund's prospectus. The Investment Manager and the Administrator must also ensure compliance with the valuation provisions disclosed in the Fund's prospectus. Regular and timely communication between parties on valuation issues is essential A formalised process for reporting valuation issues (for example, stale pricing, liquidity, price override, difficult trading markets, illiquid assets, side pockets or subjectivity) to allow the Board to delegate the responsibility but also to fulfil the requirement that there is adequate oversight and supervision. A clearly stated Pricing Policy, together with clearly stated procedures, should be agreed between the Board, on behalf of the Fund, the Auditors, the Investment Manager and the Administrator and it should be signed off by the Board, the Investment Manager and the Administrator.
NAV Calculation - Directors | Page 18

NAV Calculation - Reconciliations

Critical step is a full daily reconciliation of cash and trading positions to the prime broker, custodian and other counterparties ideally, on a traded and settled basis
All assets held by the fund should be reconciled between the administrator's records and all relevant third parties and should include assets or collateral held with: prime brokers, futures brokers CFD/Swap counterparties OTC counterparties custodians Specialised counterparties

All material differences and breaks understood and documented prior to NAV calculation. The reconciliations should encompass nominal holdings, value and transactions entered into during the period.

Three-way reconciliation is now more common (administrator, prime broker and fund manager)
Critical Drivers: Automation, Speed of Breaks Escalation & Resolution NAV Calculation - Reconciliations | Page 19

NAV Calculation - Expenses

Creation of an expense ladder/expense budget/expense schedule that will include all fees and accruals/payment frequency Many funds and administrators will agree this expense budget in advance of fund launch to govern the accrual process. The annual budget should be agreed with the client at the start of each fiscal year.
All known variable and fixed fees including management; administration; custody; performance; audit fees; listing expenses; establishment costs; legal expenses and directors' fees need to be accrued.

Of these expenses, potentially the most complex fee is the performance fee, which can be calculated using multiple different methods.
Critical Drivers: Advance planning, performance Fee Calculation Capability
NAV Calculation - Expenses | Page 20

NAV Calculation & Reporting

The final step in calculating the NAV of the fund is to calculate the NAV per share of each class in issue. In order to do this, the administrator will typically do the following:

calculate the allocation ratio for each class in issue allocate the income, expenses, gains and losses for the fund based on the above allocation ratio; adjust for any share class specific items, such as any hedging gain/loss, new issue profits, differing management and performance fees; calculate the NAV per share; agree the NAV with the fund manager; and distribute the NAV.

Additional steps can be added depending on the fund characteristics: multi class/multi currency processing and hedging some hedge funds may offer shares at a discount or premium, arising from fees or charges; and if the fund is subject to adverse or unusual market conditions, additional market or valuation provisions may be required.

NAV Calculation & Reporting |

Page 21

NAV Validation Process

DAILY ACTIVITY FLOWS RESPONSIBILITY

Functional groups complete Specified functions Fund Accountant process incoming activity

TRADES

INCOME CORP ACTIONS REVIEW

EXPENSES

RECON

ASSET PRICING
Reviewers signoff at each stage

ASSET PRICING VALIDATION

FUND PRICING VALIDATION

JPMORGAN HEDGE FUND SERVICES

Fund Accountant calculates NAV & deals with client queries

NAV PREPARATION SIGN OFF

NAV signoff before release

RELEASE

NAV

NAV Distribution & Reporting

22

Custody

Depositary / Trustee
In general, across all laws and structures the depository is required to know where the assets of the fund are at all times and how they are being held (Segregation & Title)
This involved oversight monitoring of trade settlement, income and corporate action processing and free cash and stock movements within the funds, which is undertaken on a daily basis. An annual on site due diligence visit is also conducted at the Transfer Agent when required by law. Investment guidelines and legal restriction checks could be carried out by the depository in some jurisdictions for some structures
Depositary / Trustee | Page 24

Depositary for Hedge Funds

Governance of the Delegation of safekeeping to a/multiple Prime broker(s) Tri-Partite Agreement Sub-Custody Agreement
Due Diligence & Monitoring on Prime Broker(s) Network Management approach Credit Monitoring + regular check on CDS Spreads Access to Prime Broker(s) systems (Website) Segregated Custody Accounts to be opened for each fund as a prudential measure in case of recall of assets
Depositary for Hedge Funds | Page 25

Prime Brokerage

What is Prime Brokerage?

Securities
Cash Contract

Research Provider

Client Hedge Fund

CSA Pool

Executing Broker

Prime Broker

Derivatives Commodities F&O Swaps & Others

Repo Desk

Stock Loan Desk

What is Prime Brokerage? |

Page 27

What is Prime Brokerage?

Bundle of services offered by Investment Banks: Custody and Clearing of Assets Financing Securities Lending Technology Cash & Liquidity Management Operational support Capital Introduction Business Consulting Other Services
What is Prime Brokerage? | Page 28

Conclusion

Conclusion
HFAs are not born equal - Devil is in the details HFA SLA, KPIs and Administrator Report are key governance tools Valuation Policy is compulsory Ask questions to your Hedge Fund Administrator and Depositary

Conclusion |

Page 30

THANK YOU
alain.guerard@mplgroup.com