Seven useful tips for starting up a hedge fund in Latin America, especially Brazil.
BY GUSTAVO RODRIGUEZ PONTI
Latin America has emerged as a region with enormous potential for growth. Currently holding a 3 percent share of the global hedge fund market and growing, the region is home to 330 funds with more than USD60bn in assets under management (EurekaHedge, February 2008). The vast majority of these funds are located in Brazil, where 80 percent of fund managers in the region can be found, followed by Argentina (7 percent) and Chile (1 percent). Managers located in the U.S. and Europe with funds trading in the region account for the remaining 12 percent.
If you are interested in starting your own fund in the region, this list of important operational requirements for setting up and supporting a hedge fund in Latin America will help you prepare and build the necessary infrastructure. 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
Once a manager has identified the key fund attributes and the instruments to be traded, it is important they fully understand all local regulations and taxation requirements. The type of investment strategy and instruments that the fund trades such as futures, equities, derivatives, etc., 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 in order to maximize returns.
Should a manager operating an offshore fund choose to operate an onshore vehicle in Brazil, they can do so in two ways: directly through a prime broker or via a special account known as a “2689 account.” which allows nonresidents to invest in financial and capital markets in Brazil. 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 for the fund
A master-feeder structure is typically used to capture a pool of assets in a tax-efficient way from hedge fund investors based inside or outside the U.S. Onshore and offshore feeder funds are established and invest directly into the master fund, where all trading activity takes place. U.S. investors place their assets in the domestic feeder while non-U.S. and U.S. tax exempt investors utilize the offshore feeder.
When seeking out 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 a number of options.
According to Brazilian legislation, if the fund manager chooses to domicile the feeder in one of these traditional tax havens, or a country where taxes are lower than 20 percent, 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 a back office in-house versus outsourcing to a third-party
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 to support their fund. Using an independent fund administrator for these services can help reduce costs and provide institutional investors with a greater level of comfort.
LaCrosse Global Fund Services, with its strong operations and middle-office capabilities, can help a fund manager focus on investments and trading by eliminating the need to create a costly in-house structure to provide information to investors and authorities. 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 Service providers
It is important that a fund wishing to operate in Latin America conducts an exhaustive due diligence examination on 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 and that may not be covered during the due diligence process. Time zone differences (appoint service providers that can handle information and support a fund manager at the necessary time) and spoken languages (Spanish and Portuguese for Latin America) are both important. The local expertise and knowledge of local instruments that a provider can offer may be even more desirable. Ultimately, a fund should have a full understanding of the service providers it chooses to partner. This ensures the administrator can effectively offer the services a fund requires and that it provides the fund with a good cultural fit.
The 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 Latin America. They should be able to offer personalized, quality service and broad geographic coverage on a global scale. They should also have the capacity to efficiently service new business and have the appropriate systems and infrastructure in place capable of supporting the fund.
5) Implementation of the fund structure
The fund manager should work with its 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 in the local market.
At the same time, the fund manager will work with the lawyers to draft the fund’s offering memorandum, including the fund’s investment policies and internal risk management procedures. They 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 percent of a fund offshore, 100 percent if they accept investments from qualified investors only), they 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 the 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 Latin American 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 needs to ensure that the selected administrator has the capability to deal with products on a 252 day-per-year basis.
Gustavo Rodriguez Ponti is the head of LaCrosse Global Fund Services’ Latin American operations. Prior to joining LaCross, he worked for Cargill and Black River Global Fund Services.Rodriguez Ponti graduated from the University Argentina de la Empresa in Buenos Aires in 1983 with a B.S. in Business Administration. He is a member of Consejo Profesional Ciencias Economica, Argentina, a financial and accounting association.