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Over the hedge

Against the backdrop of a hedge fund industry that is estimated in 2008 to be worth $1.7 trillion, but has experienced probably its most challenging year, a number of issues face investors in the current environment.

"Gating", for example, has become a well-known term to many investors. Whilst the notice periods required for placing a redemption instruction are a familiar matter, with 90 days notice being common, the process involved when a gate is established, effectively blocking redemption proceeds flowing to investors, was not so familiar until quite recently. Gating is in fact notified to the investor's custodian with often only a few days notice prior to the expected trade date of the redemption order, the lack of predictability and advance notice potentially raising cash flow issues for clients.

Even where no gating is applied, indefinite delay can be imposed on the receipt of redemption proceeds by an investor. This can arise in one of two ways: either you are given a known trade price, but only a certain percentage of proceeds are paid out in the normal settlement time frame, with the remainder undetermined as to final settlement day; or your redemption may be placed in a "queue", whereby effectively a portion of your investment is dealt at the expected trade date and the remainder is "sliced" across future dealing dates until all queued redemptions are completed. The fund's prospectus will set out the method the fund will use in such circumstances.  

However, as many investors may not have focused on this aspect of things when initially subscribing, there is a need to become familiar with the process and give consideration to the implications should redemptions be disrupted in any of these ways.

A different but similar issue arises from the fact that funds often have the ability, under certain circumstances and usually with the proviso of protecting remaining shareholders, to introduce additional share classes during the lifetime of the fund without shareholder approval, re-allocating investments across these "locked up" classes, called side pockets. These typically contain the illiquid investments of the fund and the investor is effectively unable to establish a known date for realisation of this portion of the original investment.

Whilst a fund might commence with side pockets representing less than 10% of its portfolio holdings, this can and has deepened in some cases to as much as 50%.

With this backdrop of events in place, Karen Winter asked Sadie Podmore to discuss the challenges for a custodian.

"Communication and flow of information is key to maintaining service to all parties involved, including the administrators of the fund, the fund managers and paramount of all – the investor," said Podmore.

"Better information flow is obtained by a proactive stance on the part of the custodian.  From our experience in dealing with many of these complex issues, we have built up a strong understanding of the questions that need to be raised. It is not sufficient for the custodian to merely be a relay of information to the investor from the fund manager.

"A pro-active custodian will also review the fund documentation to see if the fund has Directors' discretion to vary any terms in certain circumstances.

"Another important consideration for clients who have pledged their portfolios to third-party banks as collateral for lending and treasury facilities is the issue of non-contractual settlement, which means that there is an inability on the part of the investor or the lending bank to rely on expected timing of receipt of funds, whilst in the meantime the pledged collateral is vulnerable to market price volatility.

"Custodians can be called on to provide reports of expected or estimated cash flows from settlement of redemption orders, as a tool for the lending bankers, with this sometimes needing to be updated daily. These are additional services, often not originally anticipated as being needed, and rely on a good working relationship between the custodian, the client and the lending banker."

Although not seen in great numbers, as funds decide to unwind voluntarily due to overall values being below that viable for management, holdings may also be distributed by way of in specie transfers to investors. What do you see as the implications of this for investors?

"Although it is usually straightforward for the custodian to receive in specie transfers in favour of their client, a client may have initially opted for a fund-based investment not only for investment reasons but also for structuring purposes to make the investment more tax effective for the client, subject to independent advice," said Podmore.  

"A direct holding may not, in fact, be suitable, impacting on the client's after-tax returns. One option for the client could be to take possession of the investment via a special purpose vehicle and custodians which are part of a specialist wealth management institution may be able to facilitate this within their fiduciary services division.

"Alternatively we may see a secondary market develop for the sale of total fund portfolios, which could mean that a client's investment becomes part of another fund, and their original share holding is exchanged for a holding in a larger, broader fund."

Looking back over the last 20 years what has been the biggest shift in the profile of a custodian?

"Custodians have to recognise the different skills and servicing elements needed today to deal with both market and non market securities. By the latter we mean most hedge funds, fund of hedge funds, private equity funds and other alternative vehicles.

"By their very nature, these require a high level of technical expertise, particularly in the application/subscription stages but also in handling disrupted redemption events as we discussed earlier. Only a certain degree of automation can be brought to some of these issues, placing an emphasis on the technical knowledge and experience of the custodians' staff.

"The changes in investment patterns over the last 20 and even 10 years has seen  a major swing towards these type of investments, which will remain with us despite the events of 2008."

What does the future hold for a custodian, to enable it to provide value to its clients?

"Firstly, to continue to build technical skill and awareness in the workforce, valuing experience: ongoing investment in training and a focus on staff continuity are key to this objective.
"Also, an emphasis on working with the client, understanding their current and future requirements and providing proactive advice on market developments as distinct from the more traditional trade processing role and reactive service posture of the past.

"We feel that to contribute effectively to the success of those of our clients which are family offices, it is very important to participate in regular meetings, including attendance at operational meetings with all the family office's advisors if possible, in order to enable knowledge to be shared across the advisor group supporting the family office and its activities." 

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