LatAm has a 3% share of the global hedge fund market and growing. The region is home to 330 funds with more than $60 billion in assets under management, according to EurekaHedge. The vast majority of these funds are located in Brazil, where 80% of fund managers in the region can be found, followed by Argentina (7%) and Chile (1%). Managers located in the US and Europe with funds trading in the region account for the remaining 12%.
There are seven key operational requirements to starting a fund in the region. The list is intended to cover the whole region, taking into account that Brazil is the flagship market.
1) Design the optimum vehicle based on key fund attributes, local regulations and tax efficiencies.
The type of investment strategy and instruments that the fund trades can result in varying degrees of taxation. The type of funding (local versus external) and the fund’s structure (leveraged versus unleveraged) can also result in serious tax consequences and should be weighed to maximize returns.
A manager operating an offshore fund can operate onshore in Brazil directly through a prime broker or via a 2689 account which allows nonresidents to invest. Trading activity via a 2689 account in equities, cash dividends and venture capital is usually tax-exempt in Brazil.
2) Design a master-feeder structure and then choose the optimum domicile.
A master-feeder structure is typically used to capture a pool of assets in a tax-efficient way. Onshore and offshore feeder funds are established and invest directly into the master fund, where all trading activity takes place. US investors place assets in the domestic feeder while non-US and US tax exempt investors utilize the offshore feeder.
When seeking the optimum location to domicile the fund, it is important to recognize that one jurisdiction may be more advantageous than another, depending on the country where trading will take place. One domicile can be more convenient in tax terms than another, so it is important to explore several options.
According to Brazilian legislation, if a fund manager chooses to domicile the feeder in one of these traditional tax havens, or a country where taxes are lower than 20%, the investment will be taxed as a local investment without taking out the tax benefit derived from the 2689 mechanism. For this reason, the most common domiciliary jurisdictions for funds trading in Brazil are Delaware and Uruguay.
3) Analyze the cost of maintaining back office in-house versus outsourcing.
Traditionally, everything from trading to back office support was performed in-house. This concept has evolved as fund managers seek the most convenient and cost-effective structure. Using an independent fund administrator for these services can help reduce cost and provide institutional investors with a greater level of comfort. Depending on the fund’s size, outsourcing is usually a more cost effective model, particularly as assets under administration grow.
4) Appoint key service providers: fund administrator, prime broker, lawyers, external auditors, custodians and IT providers.
A fund wishing to operate in LatAm must conduct an exhaustive due diligence examination of any service provider it seeks to partner with. Additionally, there are a number of factors that need to be considered that are unique to funds wishing to operate abroad. Time and language differences are important. Local expertise and knowledge of domestic instruments that a provider can offer may be even more desirable.
Selection of an administrator is critical as it interacts with investors, banks, prime brokers and other service providers with a high level of impact. The administrator should have extensive trading experience and an established presence in LatAm. It should be able to offer personalized, quality service and broad geographic coverage on a global scale. It should also have capacity to efficiently service new business and have the appropriate systems and infrastructure in place to support the fund.
5) Implementation of fund structure.
The fund manager should work with lawyers to set up the fund’s structure while the administrator ensures that the structure is operative by opening cash and custody fund accounts with banks, brokers and custodians. In addition, the manager will look for office space, determine staffing requirements, and complete all other logistical and administrative tasks needed to establish an asset management company.
At the same time, the fund manager will work with lawyers to draft the fund’s offering memorandum, including investment policies and internal risk management procedures. It should also draft the fund’s compliance manual, service level agreements and all other related documents.
In order for a fund operating in Brazil to operate through the 2689 mechanism, the fund manager must select a local administrator, responsible for reporting to local authorities while interfacing with the custodian and counterparties. Depending on the fund structure, if a fund manager in Brazil wishes to trade offshore (current regulations permit a fund manager to invest up to 20% of a fund offshore, 100% if it accepts investments from qualified investors only), it can designate a separate administrator for the offshore portion of the fund.
6) Due-diligence and anti-money laundering.
Fund managers will need to be prepared for due diligence reviews by potential investors. All policies and procedures should be clearly documented and implemented including a clear anti-money laundering procedure for investors as specified in the compliance manual. It is important to note that some investors will include the fund administrator in their due diligence review.
7) Research and understand all local valuation and accounting issues.
Depending on strategy, a fund and its administrator will require local accounting and valuations expertise. Some investors have specific requirements that need to be complied with. For example, depending on where the investor is located, the accounting will vary from US GAAP to IFRS. Several LatAm financial instruments have specific peculiarities – the way they are marked to market, settlement standards, margin allocation controls in clearinghouses, etc.
Looking at Brazil, for certain local instruments, the fund manager also needs to ensure that the selected administrator has the capability to deal with products on a 252 day-per-year basis. LF