'40 Act funds advised to tread cautiously with turnkey platforms
Hedge fund managers launching regulated products, such as ’40 Act funds, have been advised to tread carefully when using traditional turnkey platforms that offer outsourced back office and legal services.
“Turnkeys provide a relatively quick and easy way for regulated alternatives managers to outsource a lot of the work, but those managers can rapidly lose control of their products. Turnkeys are often bureaucratic and inflexible, particularly around corporate governance as the board of directors is appointed by the turnkey’s administrator,” said George Silfen, partner at Kramer Levin Naftalis & Frankel, a law firm.
Silfen also criticised turnkeys for being inflexible. “These boards will meet on a fixed basis and are often not always in tune to real-time events happening at the managers. This would not happen in the offshore world, where directors will meet ad hoc or if there is a crisis situation,” he added. He continued managers could also be subject to the reputational risks of unaffiliated funds on the same platform.
A number of service providers are bullish on the future of liquid alternatives. Citi Prime Finance itself said it expected $939 billion of the $12.8 trillion in retail assets available to flow into liquid alternatives by 2017. Meanwhile, McKinsey & Co estimated retail assets had grown by 21% annually since 2005 with the sector now managing around $700 billion.
Other service providers highlight turnkey solutions are viable. “A lot of managers launching regulated vehicles today are using turnkey solutions. These solutions, which we currently offer though trusts with over $20 billion in assets, are also far from inflexible. The boards are highly experienced and it is not a bureaucratic process of getting them to meet. If anything, there is a higher level of oversight with a turnkey solution than what managers would get with an offshore governance provider. Furthermore, turnkey solutions have rigorous internal controls and regularly ensure managers operate accordingly,” said Phillip Masterson, senior vice president and managing director of SEI's Investment Manager Services division in London.
Several brand name private equity and hedge funds, most notably AQR, Blackstone and Apollo Global Management have recognised the potential distribution opportunities, and developed vehicles aimed at retail, with minimum investments as low as $2,500 in some cases. AQR has been one of the biggest enthusiasts for retail alternatives, having launched 20 mutual funds which are now running $9.2 billion in Assets under Management (AuM).
One of the key investor targets among managers running regulated alternatives is the Defined Contribution (DC) pension plan market. A report by SEI said 60% of the DC plan market’s $5.1 trillion in assets were parked in mutual funds, adding this investor class had historically been averse to alternatives. Nonetheless, the report added plan sponsors had become emboldened and were increasingly investing in real estate, inflation protected treasuries and commodities in search of greater yield.
Nonetheless, ’40 Act hedge funds are not without their challenges. While the distribution benefits are hard to falter, 40’ Act hedge funds are subject to onerous restrictions. The absence of leverage (capped at 33% of gross assets), lack of performance fees (with a management fee of between 70 bps and 1%), restrictions on investing in illiquid assets (capped at 15% of AuM), rigorous corporate governance standards and mandatory third party custody will all lead to higher compliance costs, at a time when profits are rapidly receding. These costs could also make it unsustainable for smaller hedge funds to launch regulated products.