Section 28(e) of the US 1934 Securities and Exchange Act provides a well known "safe harbor" for soft dollar usage, which is also applicable to hedge fund managers. Section 28(e) provides that, per the SEC, "a person who exercises investment discretion with respect to an account shall not be deemed to have acted unlawfully or to have breached a fiduciary duty solely by reason of his having caused the account to pay more than the lowest available commission if such person determines in good faith that the amount of the commission is reasonable in relation to the value of the brokerage and research services provided."
Expenses paid through soft dollars which do not fall within the definition of "brokerage" or "research" services fall outside the safe harbor. This is not to say that hedge fund managers cannot use soft dollars for other items: the manager must, however, disclose the nature of the items involved. In general, investors are not happy to see a manager paying unduly high commissions so part of these fees (paid by the fund and therefore borne by investors) can go to items such as rent, IT or even salaries. As the industry has matured, it has become increasingly rare to see a hedge fund firm seek to make extensive use of soft dollars outside 28(e).
While the passage of time has reduced the abuse of soft commissions, we see a countertrend: "other expenses" charged to the fund in addition to the management and incentive fee have become far more significant.
It is obviously the case that any hedge fund, be it an offshore corporation or an onshore partnership, will bear some unavoidable expenses. These include the cost of the audit, filing fees with the incorporating jurisdiction, and, in the offshore world, (reasonable) directors' fees.
But - when is an expense too much? We see a growing trend for hedge fund managers to push the envelope as to what internal costs are allocated as a fund expense and therefore paid by the shareholders. To illustrate the trend, we'll take three examples - research related travel, IT and technology, and administration expenses. Our takeaway is that practices vary widely (very widely) and that investors need to ask careful questions during their due diligence process.
Firstly, let's say I'm a long short equity manager and need to visit the CEO of a potential investee company in Idaho. If I travel to that meeting and bring my junior analyst, who should pay - my management company or the fund investors?
In practice, there's no universal answer. In our experience, a majority of hedge fund firms say that travel costs associated with the research process is a management company expense. After all, that's what the fixed 2% management fee is for - to enable the manager to manage the portfolio.
A substantial minority, however, do charge research related travel to the fund - led, we are often told, by each fund's ever resourceful attorney drafting the offering documents (by the way, the small print in the offering document which reminds investors that legal counsel has been engaged by the manager and the fund, and that there is no separate counsel to represent the interests of investors - that's very, very true.)
Let's take this a step further. Suppose that my hedge fund manager wants to travel to a number of investee companies in the Mid West, and it is really tricky to find a good flight schedule on Delta. Wouldn't it be better to charter a private aircraft? And, in fact, if you charter an aircraft a few times, wouldn't it be cheaper to buy a fractional ownership? It is possible to justify even this expense within the catch all of "research related travel".
Let's turn to IT expenses. A hedge fund firm needs research tools such as Bloomberg, and will often pay for these using soft dollars. What about other systems however, say an order management system or a portfolio accounting system that could cost several hundred thousand dollars? What about hardware, network support, even the internet connection? We have seen hedge funds charge all of these items as fund expenses in addition to the management fee.
In our mind, at least, a company's IT platform is a cost which should be borne by the manager: again, this is why investors pay 2% to cover the fixed costs of running an asset management business. To give another perspective, if you take your car to be repaired, you would probably be pretty unhappy to find that the mechanic had charged you an extra 25% to pay for his tools.
Which leads us to the 800 pound gorilla of "other expenses" - administration expenses, or more specifically outsourced mid office services.
We are extremely strong proponents of the value of effective independent administration and firmly believe that good admin servicing is the single, most effective control available to protect investors' interests. Investors will also pay for good servicing - we always note that it's much better to pay 10 basis points now than lose 10,000 later on.
Equally, we grew up in the offshore world (and that was before the repeal of the 10 commandments!) and have a traditional view of the administrator's role. The purpose of the administrator is to maintain the official books and records of the fund, independent of the investment manager, and calculate the net asset value which will be used to facilitate subscriptions and redemptions and pay managers their incentive fee. The manager, from their side, will keep their own records of trades and transactions, creating a best practice control environment: the administrator and manager can reconcile their records together which protects against accounting error on either side, but the final books of account are prepared by an independent party which provides the best safeguard against fraud.
The problem with "traditional" fund administration is that it's not, quite honestly, very sexy. It has also over time been subject to fee pressure - what used to be a 12-15 basis point business is now 6-10.
Unsurprisingly, the administration companies have sought a more lucrative business, and have now turned to outsourced middle office services. In these models, the administrator books daily trades, often handles settlement and margin procedures, and produces daily P&L. As a quick rule of thumb, the fees are usually 2-4 times "traditional" servicing.
We'll just touch on one implication of the outsourced middle office model as it doesn't involve fees - if you only have a single set of books with no parallel accounting by the manager, you are vulnerable to accounting error as there is no system of checks and balances. The well known case of the Archeus Animi fund illustrates the worst case outcome.
With respect to the fee issue, however, is daily P&L and transaction processing really a cost which should be paid by the investors? We're happy to pay for the independent, safeguard check of a third party NAV, but do we have to pay for day to day trade processing as well?
In our travels, we have come across a small handful of managers who have asked their administrator to divide the fee schedule between mid office processing and "traditional" fund administration - mid office is paid by the manager, admin by the investors. To us, that's very logical and very fair, and we'd like to see this approach become far more common.
To put these issues in perspective, the basis point impact of these items (especially on a manager posting good numbers) may be minimal. Plenty of investors may not care for a second as long as net returns are good. Other investors, however - notably fiduciaries - are far more sensitive to these items and recoil from the idea of giving a manager a blank cheque.
As some suggested solutions, all investors should ask for more information about "other expenses". Investors should review the offering documents to see what can be charged, discuss with the manager what actually is charged, and review the financial statements to see the dollar cost incurred. Changes year to year are particularly interesting.
Also, is there a budget? Who sets it, and is it approved by anyone? Does the manager (or will the manager) agree to cap "other expenses" to a particular basis point threshold?
Expense practices also represent one window into the broader culture of the management company. Firms which eat these items, or firms which recharge as much as possible, each send their own signal of how they approach the business of money management.
Excellent article re soft or CCA.
Posted by: salvatore patanio | October 21, 2007 at 01:09 PM
As far as I can tell there is a absolutely nothing you can buy with soft dollars you can not buy cheaper somewhere else. As long as this is so, I see no reason for any soft dollar purchase at any time. If the hedge fund manager thinks this service or that service is important, let him pay for it. If he can’t afford it let him increase his fees—if he dares
Posted by: Fred Gehm | October 25, 2007 at 10:50 AM
As far as I can tell there is a absolutely nothing you can buy with soft dollars you can not buy cheaper somewhere else. As long as this is so, I see no reason for any soft dollar purchase at any time. If the hedge fund manager thinks this service or that service is important, let him pay for it. If he can’t afford it let him increase his fees—if he dares
Posted by: Fred Gehm | October 25, 2007 at 10:52 AM