Alternative Investment Operations
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Alternative Investment Operations

Hedge Funds, Private Equity, and Fund of Funds

Jason Scharfman

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eBook - ePub

Alternative Investment Operations

Hedge Funds, Private Equity, and Fund of Funds

Jason Scharfman

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About This Book

Alternative investments such as hedge funds, private equity, and fund of funds continue to be of strong interest among the investment community. As these investment strategies have become increasingly complex, fund managers have continued to devote more time and resources towards developing best practice operations to support the actual trade processing, fund accounting, and back-office mechanics that allow these strategies to function. Representative of this operational growth, estimates have indicated that fund managers have seen increased operating budgets of 30% or more in recent years.

In today's highly regulated environment, alternative investment managers have also increasingly had to integrate rigorous compliance and cybersecurity oversight into fund operations. Additionally, with recent advances in artificial intelligence and big data analysis, fund managers are devoting larger portions of their information technology budgets towards realizing technology-based operational efficiencies. Alternative investment fund service providers have also substantially increased their scope and breadth of their operations-related services. Furthermore, investors are increasingly performing deep-dive due diligence on fund manager operations at both fund level and management company levels.

This book provides current and practical guidance on the foundations of how alternative investment managers build and manage their operations. While other publications have focused on generalized overviews of historical trading procedures across multiple asset classes, and the technical intricacies of specific legacy operational procedures, Alternative Investment Operations will be the first book to focus on explaining up-to-date information on the specific real-world operational practices actually employed by alternative investment managers. This book will focus on how to actually establish and manage fund operations. Alternative Investment Operations will be an invaluable up-to-date resource for fund managers and their operations personnel as well as investors and service providers on the implementation and management of best practice operations.

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© The Author(s) 2020
J. ScharfmanAlternative Investment Operations
Begin Abstract

1. Introduction to Alternative Investment Operations

Jason Scharfman1
Corgentum Consulting, LLC, New York, NY, USA
Jason Scharfman
Alternative investmentsHedge fundPrivate equityFund of fundsMutual fundChief investment officer
End Abstract


The term alternative investments lacks a single universally accepted definition. Additionally, there is not a uniform legal or regulatory definition for the term. There has been debate about even whether or not alternative investments are their own distinct asset class or rather a subset of existing asset classes. Others take the position that alternative investments are indeed their own separate asset class. Regardless of which position you take, alternative investments are generally classified into five types: commodity and managed futures, credit derivatives, corporate governance, hedge funds and private equity.1
In this book, we will classify hedge funds and private equity not as direct alternative investments themselves, but as types of fund managers . At its most basic level, a fund manager is a type of investment structure whereby investors give capital (i.e. money) to an individual to invest on their behalf. Alternatively, the term “fund manager” can also be used to refer to an entire firm consisting of multiple individuals and entities that manage capital. In practice, a number of different terms are utilized interchangeably with term “fund manager.” For the purposes of this text, we will employ these conventions as well and a fund manager may also be referred to as an alternative investment firm, alternative investment fund, capital management firm, fund management firm or simply a firm.
Fund managers usually adhere to specific investment strategies. Hedge funds and private equity fund managers adhere to certain alternative investment strategies. In this way, hedge funds and private equity can be thought of as having a dual role both as alternative investments themselves and, more practically, as fund managers of capital that allocate to alternative investment strategies. Alternative investment can be distinguished from the so-called traditional investments such as long-only mutual funds.

Classifying Fund Manager Activities

The functions of an alternative investments firm can be widely classified into two categories. The first category would be the investing activities of the firm. The investment function is typically led by an individual holding the title of Chief Investment Officer or Portfolio Manager. In many cases, investment decisions at alternative investment firms are reviewed by a group of investment professionals within a firm known as an investment committee. The investment-related tasks performed by the investment function include developing and managing the following:
  • The investment strategies of the funds managed
  • The investment theses behind the implementation of those investment strategies
  • Investment risk management framework and restrictions applied
The second category, and the focus of this book, is the operational activities of the fund manager. Broadly, operational activities can be defined as everything else not directly involved with the investment management function of the firm. Specific areas covered within the operational function of a firm include fund accounting, trade operations, compliance, and information technology.

Comparing Investment and Operational Functions

The investment and operational functions of a fund management firm operate with both the same goal of promoting the profitability of the firm and its investments. Each function goes about accomplishing this goal in different ways. As we outlined in the previous section, the investment function is focused on allocating and investing capital. The operational function is not directly involved in these functions, but instead supports the work of the investment function. Despite its supporting role, this does not make the work of the operational function any less important. Without the operational function, the investment function could not operate.

Operations Role in Facilitating Investment Procedures

To best understand the role of operations in facilitating the investment procedures of a fund manager, let us consider a straightforward example of an alternative investment fund seeking to make an investment in a publicly traded stock. The job of the investment function in this case would be to determine initially which stock to invest in. Then the investment function will next make a series of determinations relating to the purchase of this stock. These can include the following:
  • At what price, or price range, should the stock be purchased at?
  • Are there any restrictions regarding the purchase—such as if all of the desired quantity cannot be purchased, then none is to be purchased (i.e. all or nothing)?
  • When to purchase the stock?
As is common in practice, the stock in our example will not be the only investment the fund manager makes. Instead, it will be part of a series of investments that will be held together in a portfolio or portfolio of investments. In practice, a portfolio of investments is also referred to as a fund. When an investment is part of a portfolio, the specific answers to the questions above will often depend on a number of other considerations that relate not only to the specific characteristics of the particular stock. Portfolio management considerations, such as the amount of capital being managed, view about how this new investment in the stock will influence the overall larger portfolio and macroeconomic views about the larger market. After the portfolio manager has developed answers to these questions, the fund would then seek to purchase the stock.
Up until this point in the process, the operational function has not been engaged. Once the decision is made to make an investment, and the investment function has developed a set of rules or guidelines surrounding the way in which the investment is to be made (i.e. how much to invest, when and what other restrictions may be in place), then the operational function takes over to implement the investment function’s instructions. The first step in this process would be for the operations function to proceed to place the trade in the requested stock via a process known as execution . The trading process is discussed in more detail in Chap. 2. After execution and the remainder of the trading process is complete, then the appropriate cash needs to be transferred to fund and settle the trade. The cash management process is discussed in more detail in Chap. 3. Additionally, the operations function will perform certain pre-trade and post-trade compliance checks to ensure that any specific regulatory of fund-specific compliance guidelines has not been violated. The compliance processes of the operational function are discussed in Chap. 4.
A number of third-party vendors, commonly referred to as service providers , may also be involved in several aspects of the trading process including facilitating the actual execution of the trade, the compliance oversight of the trade and processing the accounting for the trade after execution. The role of service providers in alternative investment fund manager operations is discussed in Chap. 5. The information technology supporting the phones, computers and relevant software need to be operational to process the trade, and follow up on post-trade procedures must also be working properly to support the entire trading process. The information technology process is discussed in Chap. 6.

Dependency of the Investment Function on the Operational Functions

There are a number of similarities between the investment and operational functions of alternative investment funds. Firstly, we have already introduced the concept that both the investment and operational functions have the same broad goal of promoting the profitability of the firm. Beyond that, the investment and operational functions share a number of other similarities. This is by design due to the fact that they are complementary functions. One cannot operate without the other, and both the investment and the operational functions need to be aware of what the other is doing in order to function effectively. In this way, the operational and investment functions are similar in that they both overlap in a number of different areas. Consider the previous trading example outlined in the previous section. Without the appropriate guidance from the investment function, the operational function would have no trade to execute, and no trading-related compliance activity to oversee.
To be clear, this relationship is not a one-way street and the investment function is not always leading the operational function. The activities of the investment function may be dependent upon the capabilities of the operational function. For example, consider the situation where the investment professionals at a fund manager have previously only traded US equity securities but based on recent changes in market conditions have now decided that they want to start trading in Korean securities. The operational function at the fund manager, however, may not be at all capable of supporting this activity. Alternatively, if the operational function might be eventually capable of supporting trading in Korean securities, they might not be set up to start doing so immediately. The reasons for this could include the following:
  • The fund manager’s trading systems may not be configured to interact electronically with Korean securities exchanges.
  • The firm may not have in place the appropriate agreements and contracts to deal with Korean trading counterparties.
  • The compliance function may not have yet had a chance to evaluate to implement procedures to comply with relevant compliance and regulatory requirements that may be in place when trading Korean securities.
In this case, therefore, the investment function would have to simply wait for the operations function to implement the appropriate protocols prior to beginning trading in Korean securities. On the other hand, if the investment function had given prior notice to the operations function that in the future they would likely want to start beginning to trade in a new market such as Korea, then the operational function could have made the appropriate preparations so that trading could commence once the investment function wanted to begin trading.
Another example of the ways in which the investment function may be dependent on the operational function would be if, instead of seeking to enter a new position, such as in the Korean securities example above, the investment function sought to gain more information about their options prior to adding to or exiting their position. One common piece of information investment professionals would wish to review in this case would be what is known as an exposure report . These reports can show a wide variety of information about the various exposure...

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