In theory, launching an investment fund is a straightforward process: start at square one, follow a logical series of steps, and arrive at the winner’s circle. In reality, the process can resemble the classic board game, Snakes and Ladders. ‘Snakes’ are setbacks that hold up progress and potentially delay a fund launch or cause operational problems; ‘ladders’ are steps that boost the likelihood of a successful product.
In the credit space, the recent surge of allocations to alternative strategies has led to some interesting dynamics in the asset management industry. Fund managers well-versed in fixed income have extended their scope to syndicated bank loan and illiquid private originated debt. Firms that have focused for many years on alternative strategies like mezzanine funds are moving into more liquid loan trading strategies that look like credit hedge funds. Often, this involves crossing the operational divide between commitment-based closed-ended funds (zero investor liquidity with a finite lifespan) and the more prevalent open-ended funds (no fixed end to the fund lifespan with regular investor subscription and redemption and fluctuating fund size). In any of these situations, the investment manager has to adapt to a broader landscape of requirements, market norms, and service providers performing tasks less familiar to the manager.
Avoid the Snakes: Match Investor and Investment Liquidity
A fundamental decision managers need to make when structuring a new fund is to match the liquidity provided to investors (i.e., how frequently, if at all, investors can buy or sell interests or shares in the fund) to the liquidity of the fund’s target investments (i.e., how quickly investments can be liquidated to pay investor redemptions).
In Europe, UCITS funds need to fulfil liquidity criteria for their investment portfolio to match the daily, weekly, or bi-weekly liquidity provided to investors. Non-UCITS alternative funds generally fall under the AIFMD regime, and managers have much more flexibility to structure their funds’ liquidity terms.
Economic or political shocks like Brexit expose the inability of poorly matched funds to fulfil large volumes of redemption requests, which damages the reputation of both the fund manager and the product. What seems like a ladder to boost revenues can become a snake that sets the manager back in the long term.
The graphic below illustrates areas of alignment in green and areas of misalignment in red.
Climb the Ladder: Manage Investor Expectations
Balancing investor requirements with the cost of running a fund is an art form in itself. Fund structures are most successful and sustainable when there is close collaboration between front office negotiations with investors and middle- and back-office teams that need to deliver after launch.
Asset managers need to balance the relative flexibility in alternative funds to design unique economic terms and features, with operational discipline on fund structures. Alternative fund structures often include a main flagship fund for multiple investors and a number of separately managed account vehicles for large single investors. Feeder fund vehicles (that invest in a single holding of a master fund vehicle) are comparatively easier and cheaper to run than parallel master fund vehicles (that each hold a proportion of the underlying investment portfolio). If the various fund vehicles replicate the same key terms, even complex layers of funds can be relatively straightforward to run. However, in an age when a high degree of customisation is expected, managers need to be aware of how far their operating models can flex before they break, and how expensive specially negotiated terms can be to the overall operating model in the long run.
Closed-Ended Funds vs Open-Ended Funds
In drafting the key economic terms for a new and unfamiliar fund product, care must be taken to understand the operational realities they conjure, particularly in the current cost-conscious environment. Closed-ended funds, for instance, behave very different from open-ended funds: what is straightforward for one can cause complications in the other. For example, multi-currency feeder fund vehicles are common with fixed income and syndicated loan funds. Since these are liquid investments, they are usually in fund structures that provide daily or monthly liquidity to investors. Private originated debt is illiquid and is usually held via closed-ended fund vehicles.
Offering multi-currency interests to investors is more complex to manage for closed-ended funds. The incentive fee calculation usually includes a cash internal rate of return (IRR) element that tracks the time value of every cash movement since inception. The incentive fee calculation for open-ended funds is usually based on comparing the valuation of the fund at two discrete points in time, which requires different systems capabilities to calculate.
Alternative fund terms can vary a great deal. Fund documentation legalese needs to make common sense, so, in order to climb the ladder, the right operating expertise must be brought in at the right time in the launch process, ideally between drafting the term sheet and finalising the offering document. Working out the operational kinks in the key terms before launch is usually a much cheaper exercise than doing so after launch.
For example, credit shops with an operational set up geared for daily net asset values and daily processes will need to think through how a closed-ended fund with quarterly reporting cycles will actually work within their environment. Systems and processes that are designed for straight-through processing of high-volume trades need adjustment to work with complex multi-layered fund structures holding low volume and bespoke private deals that are priced manually, and vice versa. Specially-negotiated incentive fee calculations need to be evaluated on day one to ensure the right level of transaction detail is captured for the calculations to run correctly.
Holding a pre-launch workshop with operational teams to walk through their day-to-day processes can minimise the headache of learning things the hard way, re-working an operating model and unintended costs on all sides.
Time to Market
As with anything complex or new, asset managers need strong project management skills to ensure all the moving parts come together efficiently. Over and above securing investor commitments, launch logistics for an alternative fund can be a lengthy, iterative process taking six to twelve months or more. For master-feeder fund vehicles in multiple jurisdictions, a manager would typically liaise with a number of advisers and service providers:
- Onshore and offshore legal advisers for fund documents and regulatory approvals
- Tax adviser
- Fund administrator for fund services
- Depositary in Europe for AIFMD requirements
- Corporate services provider for satellite and investment holding company corporate vehicles
- Listing agent for listed fund vehicles
Structural and operational design does not stop with the launch of the first fund vehicle. New feeder, parallel, or alternative vehicles are often introduced for new investors or unique investment opportunities. Stopping to think through the operational implications of how each vehicle will work within the overall operating model can save a lot of headaches caused by unintended consequences. Again, this requires strong communication between the front office teams negotiating the new terms and the back office teams that need to deliver on the day-to-day operations.
THE WINNER’S CIRCLE
Stretching into new products and fund types is becoming more commonplace amongst asset managers, particularly as large investors develop deeper and fewer relationships with managers. Being alert to the pitfalls that snakes create and opportunities that ladders bring will separate those who meet their fundraising and return targets and those who do not.
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