Technology can help to address the risks of reporting failures

The alternative investments industry has now woken up to the new world order of increased regulation and reporting requirements. These new and stringent demands have become a major driver for firms of all types and sizes involved in hedge fund operations, and those who ignore the implications of this do so at their peril.

Regulators have become far more stringent about the regularity and detail of the reporting they expect to see, and errors in this process can be met with more robust fines. Combined with the challenge of dealing with multiple regulatory regimes, the risks are very real.

Professionals working in fund servicing, including custody and administration, transfer agents, and COOs at investment management firms, now face a situation where their careers and professional credibility lie in the hands of regulators. To keep costs contained as much as possible, financial services firms have to address their operational environments, including the way data and reporting are managed.

This mission can be a complex and costly exercise, but convenient out of the box solutions, such as those launched by Comada this year, can help investors and hedge fund managers to meet regulatory reporting requirements, including under FATCA and AIFMD, without the cost and disruption of a major revision of compliance programmes.

Better integration, cost-effectively

Comada has long been a strong advocate of better integration of reporting processes with pricing data and transactional information. Importantly this needs to create an environment in which live data can support more comprehensive and automated reporting activity.

Comada’s M.A.T.ware technology replaces legacy services, bringing to our clients a secure Cloud-based integration platform with more flexible connectivity.

Using the technical road map we have developed, transaction and pricing data and account information can be easily harvested from disparate reporting lines and systems to build a more comprehensive picture of such critical information as dynamic cash and liquidity in alternative portfolios.

M.A.T.ware is designed to meet the complex requirements of the alternative investment industry, and supports the reporting needs of even the largest organisations, integrating and then delivering the requisite data where it is needed. This includes information that it would be difficult and costly to incorporate otherwise, but which regulators are now asking for.

As the regulatory environment becomes stricter, solutions like this will be essential for firms that wish to continue to operate cost-effectively while meeting their reporting obligations.

For further information on how Comada can support your regulatory reporting, please contact Dave Shastri (North America) – ds@comada.com / +1 212 880 4245 or Stuart Fieldhouse (Europe) – sf@comada.com / +44 (0) 20 7043 1480.

This is the second in a series of articles from Comada on the subject of custody risk.

The challenge for custodians in safekeeping alternative assets like hedge funds is that there is no Central Securities Depository they can rely on. For conventional securities, CSDs exist to help investors and custodians by providing an easily accessible record of securities owned. Historically, the CSD would take delivery of physical share certificates – today an electronic registry is maintained which allows investors and company registrars to keep track of who owns what.

For the vast bulk of hedge funds, which are not actively traded on stock exchanges, there is no CSD. Nor is there a broker to broker network like the Depository Trust Company’s National Securities Clearing Corporation. Custodians are therefore forced on a monthly basis to request statements of hedge fund holdings from the transfer agents who maintain funds’ registers of shareholders. The problem with this is that there is a large universe of TAs in the market, each acting for only a small portion of the total universe of hedge funds.

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Today’s liquidity-aware fund investor is still seeking the appropriate solutions for cash flow monitoring within alternative portfolios.

Investors in alternative funds are managing far more diverse portfolios than they used to. And even within the hedge funds universe, they are grappling with wildly different structures and liquidity terms. Investors are set to increase their overall allocation to alternative investments, a trend that was already becoming established prior to the financial crisis, but by doing so they are creating some immediate operational challenges when it comes to monitoring their critical cash picture.

Fund allocators embrace new conditions of risk when they invest in alternatives. From an operations perspective, one of the key obstacles is the implementation of appropriate technology within the business that will allow for the effective management of alternative portfolios alongside other investments like long only funds and ETFs, where liquidity timelines and redemption conditions are very different. It is not unusual to have a UCITS fund with daily dealing sitting in the same bucket as a conventional hedge fund with monthly liquidity or a private equity or real estate fund with even longer liquidity time frames.

We are now living in an environment where more emphasis is being placed on internal risk controls and the quality of real time reporting is an important part of the overall risk management package. Portfolio managers and risk officers within investor organisations need to make sense of and fully understand the divergent cash flow and liquidity picture. Failure to do so will only create further pain for the organisation when another disruptive market event occurs.

Today’s institutional allocator will have a number of alternative funds within their portfolio:

• Onshore hedge funds, including Limited Partnerships
• Offshore hedge funds, usually employing a unitised holdings model including series of shares or equalisation allocations
• Private equity investments, again with a Limited Partnership structure with a commitment and funded periodically on a capital call basis
• Real estate funds
• Alternative UCITS with daily or weekly dealing
• ETFs used as indexed hedges of based on alternative markets (e.g. based on commodities futures)

There is a need for a diverse range of alternative investment funds to be managed and analysed via a single platform, particularly when a portfolio manager requires accurate reporting on cash flow and liquidity terms. Managers of alternative fund portfolios now need to see all the way out the liquidity curve, to a year or more if needed. Private equity cash flows, for example, are much less frequent than conventional funds and need to be accounted for efficiently if the investor is going to ensure sufficient cash is on hand to meet PE commitments.

How can daily cash flow commitments to alternative investment funds be monitored on a forwards basis out to 12 months?

Proper cash flow management within the alternative portfolio in this challenging environment goes beyond normal accounting requirements. There is a need to budget and estimate both future commitments and withdrawals, taking into account actual and anticipated liquidity terms. Accurate risk management and forecasting can be managed on a dynamic basis from a single point, but not with an Excel spreadsheet. The sophisticated cash flow requirements of today’s industry go beyond what is economically achievable with Excel.

Today’s portfolio management solution needs to take account of a range of varying factors – liquidity terms of a hedge fund, or a particular side letter for example.  It has to be sufficiently customisable to dynamically track commitments over time, and provide an accurate picture of cash and asset positions, on a daily basis if necessary. To do this manually seems a reckless waste of man hours at a time when many investors are very conscious of both the lack of effective reporting on their portfolios and the costs they already incur in their operations.

The typical institutional fund portfolio will hold a range of assets with varying liquidity terms that will behave very differently under liquidity stress test scenarios:

Managing the balance between longer and shorter dated assets

It is important that, as the investment manager maintains his own diversification between different asset classes, he also keeps a clear picture of the pricing and liquidity terms of the portfolio of funds. This can even change several times a day. Juggling the short and long term liquidity picture simultaneously without appropriate monitoring can be like driving a car at midnight with no headlights. An Excel basic road map may help you, but you are still placing yourself at risk.

In addition, today’s portfolio manager will also need to model liquidity scenarios on an allocation-by-allocation basis, including hypotheticals. This can have an increasingly important bearing on decisions to allocate in the first place. The biggest variable, however, is the cash flow picture.  Is the manager overweight on monthly dealing funds? Can liabilities be met without altering exposures? Can they monitor and transact on both manager and client portfolio liquidity dynamically?

During the credit crunch of 2008, managers of alternative investment portfolios were forced to turn to their most liquid investments to access cash in the shortest possible time. Sometimes this meant liquidating holdings with some of the better performing fund managers. It is an experience that has created more emphasis on controlling and diversifying the underlying portfolio liquidity picture across sophisticated hybrid portfolios. Doing this effectively without resorting to manual and error-prone Excel-based processes is another matter.

A detailed liquidity report of an underlying portfolio of hedge funds, one that could be dynamically updated, was the Holy Grail for many funds of funds in the dark days of 2008. Proper liquidity reporting is underpinned by effective data and tools. It requires a degree of investment in technology that can be proactive, agile and responsive.

One of the real tests of any portfolio management system occurs when things go wrong: in the world of money management, operational failures, for instance on the part of a business further down the service provider chain, can force the portfolio manager to re-evaluate retrospectively. Can he be sure that such revaluations are being consistently applied, especially if multiple individuals within the same firm are juggling dozens of spread sheets? Once mistakes creep into the historical portfolio picture, they can be difficult to track down and correct, and they can continue to have an unforeseen impact on reporting further down the line.

Beyond the problems of effective performance tracking, investors in hedge fund portfolios today want to feel they have a better grip on what is happening in underlying hedge funds. This means being able to view a more complete operational picture. Their questions cover key issues relating to fund liquidity, including whether funds have the ability to gate withdrawals, whether gates have been initiated, the expiry of each tranche lock up, and what the options are to reduce lock ups and when. Better information on the liquidity scenario can deliver important additional advantages to the portfolio manager.

It all comes down to a question of confidence: can an investor feel confident that a trade has been properly executed? Has it been confirmed by the relevant custodian and underlying transfer agent? How long does it take to receive the estimated and real NAVs? Do they always come in on time? Are communications with relevant parties secure and dynamic enough to process real-time information flows?

With a more detailed picture comes a higher degree of confidence in the underlying investment and a superior level of reporting to end investors when required. This also helps the portfolio manager to allocate further funds more efficiently.