Hedge Funds in Asia

A Guide to Operational Due Diligence

Asia is a dynamic part of todays hedge fund industry.

The growth of China and the Asian economies over the last decade
has brought benefits throughout the region, whether it is the trading
economies of Hong Kong and Singapore or the resources-driven
economy of Australia. Other emerging market jurisdictions have
also faired well and niche funds have emerged investing in the
ASEAN region as well as other smaller capitalized markets such as
the Philippines and New Zealand.
Investing in Asian hedge funds presents a
number of challenges. For North American and European investors, distance is an
obvious impediment, which makes Asian
funds harder and much more expensive
to diligence than managers in New York and
London. Each market presents local legal
and regulatory issues, managers are generally smaller with fewer assets and fewer
employees, and service providers may be
region or country specific. It is also notable
that Asia has also not been immune from
managers suffering from strategy failure
(such as Basis Capital) and outright fraud
(such as Charles Schmidt)1.
Castle Hall Alternatives and Select Fund
Services work together to help global investors complete operational due diligence on
managers throughout Asia. Each review
is conducted using OpsDiligence, our proprietary due diligence framework, which

1- Information on more than 500 cases of hedge fund operational failure available to subscribers in OpsFraud, Castle Hall
Alternatives proprietary database of hedge fund fraud and
operational loss.

allows Asian funds to be subject to the

same defined and consistent due diligence
process already applied across more than
1,000 funds worldwide. Equally, our due
diligence benefits from an on the ground
team with deep and seasoned knowledge
of market conventions across Asia. This
helps avoid the check the box mentality
which can result if due diligence does not
take account of the unique characteristics
of the Asian marketplace.

AN OVERVIEW OF
HEDGE FUNDS IN ASIA

allocate to smaller managers in any case,

preferring the closer relationship and
enhanced transparency that can often be
available from a smaller firm.

EurekaHedge recently estimated assets

managed by the Asian hedge fund industry
to total $134bn2, represented by more than
1,200 individual funds. HFR reports the
number of Asia-focused hedge funds to be
1,067, representing more than 10 percent
of the global industry3. In terms of location,
HFR shows increasing manager numbers in
mainland China (PRC) and Singapore, offset
by some contraction in Japan and Australia.

Given the large number of managers with

more modest assets, investors building a
portfolio in Asia are likely to have at least
some exposure to smaller manager organizations. Unavoidably, these smaller firms
have fewer operational resources and a less
developed operational infrastructure. While
these factors can increase operational risk,
an investment in effective due diligence can
give investors the confidence they need to
allocate to a younger, more nimble manager.
A deeper dive can identify managers who,
while small, do have acceptable operational
controls and could have the potential for
very attractive performance.

THE SIZE OF THE MANAGERS

The hedge fund industry as a whole has
seen a flight to size, with investors
worldwide showing a preference for the
perceived safety (whether justified or
not) of managers with established track
records and higher assets under management. Manager concentration is also
a key trend in Asia, with 62% of capital in
Q2 2011 invested with the largest firms
(assets in excess of $500 million) according to a recent Bloomberg article4. This
statistic is further reinforced by Business
Insider, which recently reported that the
top twenty percent manage eighty percent
of the total assets5. However, while a relatively small number of managers dominate
current AUM, Asian focused strategies
often face capacity limits: this creates an
opportunity for new managers to gather
assets as existing leaders become capacity
constrained. Other investors may prefer to

A final characteristic of the Asian industry

is the large number of managers with current assets of less than $20 million. This
suggests that barriers to entry (including
key costs such as salaries and office rental)
can be lower in Asia-Pacific countries than
the US or UK. While these firms may currently run small portfolios, this dynamic
pool of early stage managers will be the
source of the next group of industry leaders over the coming years.

2- Bloomberg http://www.bloomberg.com/news/2011-08-24/
asia-s-hedge-fund-assets-to-grow-may-reach-180-billioneurekahedge-says.html
3- http://www.hedgefundresearch.com/pdf/pr_20110809.pdf
4- http://www.bloomberg.com/news/2011-08-10/asia-hedgefund-startups-fall-38-as-investors-seek-pedigree-.html
5- http://www.businessinsider.com/here-are-the-emergingtrends-to-watch-in-asian-hedge-funds-2011-5#ixzz1VoDqihCU

OPERATIONAL DUE
DILIGENCE
ON ASIAN HEDGE
FUND MANAGERS
Investors looking to Asia face a diverse group
of markets, domiciles and regulations. Due
diligence can be challenging for all investors,
be they an allocator considering a first fund
in Asia, or a more experienced investor with
an established Pan Asia portfolio. As markets
continue to evolve, we have highlighted four
issues management and operations, legal and
regulation, tax, and service providers which
impact an effective due diligence program.

001 MANAGEMENT
AND OPERATIONS
AND
002 LEGAL
REGULATION
003 REGIONAL
TAX ISSUES
PROVIDER
004 SERVICE
DUE DILIGENCE

Given the large number of small, early

stage managers across Asia, the management of a fund especially in terms of
personnel and resources - are often significant due diligence issues.

001

Key Man: An obvious concern is key man

risk related to the founder or CIO of a small
organization. As with any fund, investors
should look for reasonable key man protections, including a key man clause in the
offering document to waive lock ups and
other redemption restrictions, perhaps supported by side letter provisions. Investors
may also wish to discuss
key man triggers in ISDA
MANAGEMENT
AND OPERATIONS agreements for funds
which are material derivative users, and more
broadly consider business management
issues such as key man insurances. For
larger managers, more formal succession
planning could be discussed: we recognize,
however, that the hedge fund industry as a
whole remains remarkably undeveloped in
this area. Very few firms worldwide have effectively formalized the process to transfer
active businesses from the original founders to the next generation of leaders.
Access to Talent: A broader question is
whether the manager has access to an
adequate pool of professionals to sustain
growth, whether in the front or back office.
Compared to the now mature hedge fund
industry in the UK and US, Asias smaller
hedge fund sector can make it more challenging for managers to identify and recruit experienced staff. More recently, the
number of high quality professionals has
risen as regional staff gain experience and
as professionals have been attracted to relocate to Asia from other financial centers.
Even so, while the talent pool has increased,
so has the number of managers competing
for top tier employees.

key professionals who do not have an operations, accounting or legal background,

and instead come from brokerage, sales or
other front office positions. This can create more variation in COO / CFO skill sets
than would be typical in the US or UK, with
back office leaders holding differing levels
of technical operations knowledge. Face
to face due diligence, where investors can
meet the key professionals and assess their
capability and contribution, is key. A careful
review of the resumes of all operational staff
is also important to ensure all staff have the
requisite experience for their roles.
Segregation of Duties: Given the number
of smaller firms in Asia, segregation of duties can be a frequent due diligence issue.
While many managers have established a
baseline of controls, we have found some
Asian managers to be less conscious of the
importance of segregation between front
and back offices. For investors, a careful
review of controls around the life of a trade
can identify any weaknesses, from trade authorization through execution, to confirmation, settlement and reconciliation. If due
diligence does identify issues, constructive
feedback to the manager is important and,
we have found, well received by virtually all
Asian managers.
Spin Outs: Finally, a number of Asian hedge
funds have been formed as a spin out of a
trading team from an existing financial institution or another hedge fund. In these cases, the dynamic of the new structure needs
to be evaluated carefully: these new firms
can no longer rely on the infrastructure support of a parent, and must create their own
business structure sufficient to meet the
operational demands of the strategy.

Relevant Experience: It is also important to

consider the background and qualifications
of back office staff at each level of the organization. Again, given the younger hedge
fund industry in Asia, it is more common
to find Chief Operating Officers and other
5

In Europe, London is the dominant hedge

fund centre and the NY/Connecticut corridor is the nexus for hedge funds in the
US. Across the Asia-Pacific region, hedge
funds are dispersed between Singapore
and Hong Kong with smaller, but important,
centers in Tokyo and Australia. Each location has advantages and disadvantages,
but the favourable tax and regulatory
environment in both Singapore and Hong
Kong have proved attractive for managers.
Australia has built its own industry, with
a number of new fund launches by well
regarded professionals.

002

Singapore: In Singapore, the Monetary Authority of Singapore (the

MAS) has traditionally
adopted a light touch regulatory regime
for exempted, international hedge fund
managers. However, it is notable that the
MAS conducted, with help from two major
audit firms, on-site visits to every hedge
fund manager in Singapore in the wake of
the Madoff scandal. This demonstrated
that the regulator has the reach and resources to inspect every hedge fund manager, whether regulated or exempt.

LEGAL AND
REGULATION

Singapore overhauled its regulatory regime in 2010 with a view to introducing

capital adequacy and closer regulation of
larger hedge funds. Prior to recent regulatory changes, the exempt fund manager
status was seen to a straightforward hurdle
when establishing a manager organization.
Given new capital adequacy rules, due diligence practitioners should consider, for example, the implications of maintaining free
cash in the management company. Looking forward, some commentators have

suggested that changes to the MAS rules

could raise the threshold level of assets
needed to run a financially viable hedge
fund, with a potential impact on smaller
Singaporean funds. Summary details of a
managers regulatory status are also available from the MAS via their website, which
is a useful due diligence resource.
Hong Kong: Hong Kongs burgeoning
hedge fund community also benefits from
lower tax, although Asset Management Licenses have always been slightly more difficult to obtain due to the requirement for
the recipient to sit exams. Hong Kong has,
however, recently moved to simplify certain
aspects of its regulatory regime, including
granting an exam exemption for seasoned
investment professionals. License approval
times in Hong Kong have also been reduced
to 10 weeks according to the Securities and
Futures Commission (the SFC).
Given Hong Kongs licensing regime, the
due diligence review should consider the
type of license required by the manager and
the whether their licence accords with the
investors understanding of that requirement. Hong Kong also has taken an active
role in respect of targeting insider trading
in the local market, with some high profile
cases widely reported in the press. An individuals disciplinary records are available
through the SFC website and occasionally
make interesting reading.
Importantly, neither Hong Kong and Singapore are subject to the same prescriptive
rules on soft dollars as the UK, making it advisable to study the usage of soft dollars by
funds. Conventions are changing, however,
and some managers have adopted stand-

ards set by the FSA in the UK following pressure from investors to ensure soft dollars
are only used for appropriate purposes.
Australia: In Australia, lifestyle benefits can
be an important factor in choosing to locate in Sydney or Melbourne. However, the
regulatory licensing process is lengthy and
document intensive. Managers without the
necessary citizenship status may also have
to set aside additional capital to meet immigration requirements to establish a business in Australia.
Finally, regional regulators are working with
the EU in respect of the Alternative Investment Fund Management Directive. The
implementation of this directive should be
monitored by investors as it will have an effect on the regions hedge fund managers,
particularly if equivalence requirements
come into force.

The large number of potential markets

within a Pan Asian mandate inevitably
exposes funds to different tax regimes. As
a first step, investors should look for the
manager to engage effective service providers to access appropriate tax guidance
and accurate tax accounting. The PB /
custodian, auditor, administrator and legal
advisor all play important roles in tax planning and compliance.
FIN 48: For US investors subject to US
GAAP financial reporting, two Asia markets,
China and Australia, raise particular issues
in relation to FIN 48,
accounting for uncerREGIONAL
TAX ISSUES tainty in income taxes.
In China, current rules
related to the treatment
of Capital Gains Tax (CGT) are fluid, with
some variation in the policies adopted by
different institutions acting as the Qualified
Foreign Institutional Investor (QFII). The
prevailing view is that the collection of the
PRC taxation of capital gains on A Shares
is presently unclear and fund directors, in
conjunction with the relevant QFIIs, have to
exercise their judgment on the Funds potential liability for any CGT obligations. Due
diligence should establish each funds tax
position which may differ by counterparty and monitor ongoing developments in
Chinese tax rules.

003

In Australia, uncertainty regarding taxation has led to growth in the swap market
for trading Australian shares by offshore
funds. In particular, an investor based in a
non-treaty country (e.g. a hedge fund based
in the Cayman Islands) investing in shares
listed on the ASX has faced some risk that
income could be subject to Australian taxation, if considered to be Australian sourced.
Recent updates to Australian tax law are increasing clarity on this issue, but we would
still recommend a detailed tax discussion
as part of each due diligence review of an
Australian manager.

004

Administrators: Virtually all hedge funds

in Asia have appointed a third party fund
administrator from inception, meaning that
issues of self administration and lack of
external oversight are rare. The majority of
Asia funds are serviced by administrators
from offices in the region, with the result
that fund admin market share is somewhat different to the global industry. Asian
administration is still dominated by three,
long standing vendors: HSBC (having purchased the traditional regional leader, the
Bank of Bermuda, back in 2003), Citco and
Credit Suisse (formerly
Fortis Prime Fund SoluSERVICE PROVIDER tions). Moreover, the
administration service
DUE DILIGENCE
model for the majority of funds remains
traditional, focused on month end NAV
accounting and reporting. Aside from a few
large funds, there is less focus on hiring an
administrator to be an outsourced back /
middle office: smaller AUM and emphasis
on equity strategies reduces the need for
administrators to assume the heavy lifting
of complex derivative portfolios.
Fund administration continues to evolve,
however. Some administrators, notably Citco in Singapore and HSBC in India, are expanding in Asia to add lower cost resources
(and take advantage of round the clock time
zone benefits) to service their North American and European clients. M&A activity continues, with a recent example being Apex
Administrations purchase of an Australian
fund administrator business. A final trend is
the emergence of businesses which can offer a plug and play back office infrastructure for small, early stage managers.
For investors, due diligence on administrators can raise region specific issues. Global
administration firms may issue a single
SAS 70 report across their entire organization, but distant offices across Asia may be
scoped out or, even if included, will likely not
be subject to on the ground SAS 70 work
every year. Investors should be conscious
that regional offices of the fund administrators may have specific issues that may not

apply to other offices elsewhere in the world

and, as such, should be reviewed individually. Legal and contractual terms may also
differ: we recently encountered a regional
administrator which sought to limit liability,
even in the event of gross negligence, willful
default and fraud, to only the fees paid by
the fund in question.
Prime Brokerage: The PB business has
also expanded in Asia with most prime
brokers increasing their presence on the
ground in key Asia-Pacific jurisdictions. In
respect of China, the hedge fund managers
relationship with their PB will be important
in gaining access to A Shares through the
PBs QFII entitlement. Sub-custody is also
important with regards to the various Asian
markets and investors should pay attention
to the quality of those relationships with
domestic sub-custodians, especially in less
developed and frontier markets.
Auditors: The Big 4 audit firms are, of
course, represented in all financial centers
across Asia. The majority of funds prepare
their audited financial statements in accordance with IFRS (International Financial
Reporting Standards) which can create
some reconciliation issues for US investors: one key difference is the use in IFRS
of valuation procedures based on bid / ask
pricing which can create differences between the trading NAV (usually based on
last sale) and valuations reported in the accounts. It is also somewhat more common
to see Asian funds reporting to a fiscal year
end other than December 31, which can
also create audit issues for investors subject to US GAAP.
As a separate issue, investors should be
conscious that a number of recent frauds
have raised concern as to the quality of financial statement reporting and the associated audit process - in China. Cases
such as Sino Forest and Longtop, while not
hedge funds, highlight the risks involved
with private assets and other investments
not unambiguously held by a custodian in
safe keeping.

10

Looking forward, the

Asia hedge fund industry will continue to grow.
Regional investors will continue to increase
their wealth and consequent hedge fund
allocations, while global investors are
excited by the opportunity to access Asias
growth economies in a hedge fund rather
than long only format.

SUMMARY

For allocators, building a portfolio of Asian

funds presents two challenges. Firstly, in the
post Madoff environment, all hedge funds in
a portfolio must be subject to detailed due
diligence, consistently applied irrespective of strategy or location. Going forward,
allocations to Asian managers must be
subject to the same process and methodology as US or European funds, even if
travel and distance has, in the past, meant
that not all investors have conducted onsite
due diligence. Secondly, Asian funds oper-

ate against a backdrop of country specific

regulation, tax and service issues, some of
which we have described in this paper.
In our view, effective due diligence requires
deep knowledge and the information
advantage that comes from regional
specialism. Castle Hall and Select Fund
Services are proud to offer their clients a
dedicated due diligence focus across Asian
markets. Working together, we help investors identify those managers across Asia
who set the standards of operational best
practice.

USEFUL RESOURCES

Monetary Authority of Singapore:

>

http://www.mas.gov.sg/

>

http://www.mas.gov.sg/legislation_ guidelines/securities_futures/sub_
legislation/A_Practitioner_s_Guide_to_the_CIS_Regime_under_the_SFA.html

Hong Kong Securities and Futures Commission:

>

http://www.sfc.hk/

>

http://www.sfc.hk/sfc/doc/EN/speeches/public/surveys/11/Hedge%20
fund%20managers_201103.pdf

Alternative Investment Management Association

>

AIMA Hong Kong: http://hongkong.aima.org/

>

AIMA Australia: http://www.aima-australia.org/KnowledgeCentre.html

11

ABOUT CASTLEHALL ALTERNATIVES

AND SELECT FUND SERVICES
Castle Hall Alternatives and Select Fund Services provide their
clients a seamless, unconflicted solution to operational risk due
diligence across hedge funds, private equity and traditional
asset management structures.
Castle Hall, with offices in North America (Montreal, Toronto
and Halifax) and Europe (London) has completed comprehensive due diligence on more than 1,000 different fund structures
worldwide. With more than 20 professionals dedicated exclusively to operational due diligence, CastleHall deploys one of the
industrys largest and most experienced due diligence teams.
Select Fund Services, based in Sydney, Australia, is a leading
due diligence provider focused on the Asian marketplace.
Castle Hall and Select Fund Services collaborate to provide their
clients with detailed due diligence insights on managers based
throughout the Pan Asian region.

CONTACT
> castlehallalternatives.com
> selectfunds.com.au

NORTH AMERICA

EUROPE

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