Starting a hedge fund

Starting a hedge fund:
How to establish a foundation for
success in a challenging marketplace
Spring 2016
Contents
3 Introduction
5 Raising capital in today’s financial environment
8 Sustaining profitability in the face of increasing regulations and
declining fees
11 Organizing the fund for tax efficiency
14 Conclusion
Introduction
Being a hedge fund manager isn’t easy, even if it can pay well.
2015 was an exhausting year for many of the approximately 9,000
hedge funds operating in the U.S. Although the stock market
has shown some improvement with the Dow Jones Industrial
Average crossed the 18,000 threshold for the first time in nearly
nine months, 2016 is unlikely to be much easier, judging by
certain macroeconomic challenges out of the gate, such as market
turmoil in China and the Greek debt crisis. This uncertainty
comes on top of woes for money managers in 2015, with the
devaluation of the Chinese yuan in August, and market upheaval
after the International Monetary Fund declared the yuan a
major global currency in November. Risk tolerance has fallen
among investors as energy commodities and equity continue
to decline, and the oil industry took a beating. One bright spot
was the Federal Reserve’s slight rise in interest rates at the end
of December, which caused some celebration on Wall Street and
among some hedge funds.
Even so, between performance pressures, competition for funds,
erosion of fees, market volatility and regulatory hurdles, hedge
fund managers are in a challenging spot. Many hedge funds
performed poorly in 2015, posting average returns of 1.45%, the
lowest since 2011. North American hedge funds posted their
lowest returns since 2008, down 0.55%.
At the same time, compliance costs have soared, driven by the
Dodd-Frank Wall Street Reform and Consumer Protection Act
(Dodd-Frank), signed into law in 2010 with the objective of
preventing the excessive risk-taking that led to the financial crisis
of 2008. Title IV of Dodd-Frank makes a number of changes
to the registration, reporting and record-keeping requirements
of the Investment Advisers Act of 1940. Now, advisers to most
private funds (hedge funds and private equity funds) must register
with the SEC, provided they are above a certain threshold, a
requirement from which they had been exempt in the past via the
private adviser exemption.
With SEC registration comes the many complexities of SEC
control and disclosure reporting requirements. Even the SEC
examinations that assess hedge funds’ compliance with these
requirements are a continued source of concern and still more
costs for hedge fund managers. Ensuring transparency in these
funds is a high priority among the SEC examiners. Among other
examination priorities are complicated fee structures that are hard
for investors to understand, and complex and illiquid investments
that can make it hard to measure fair value. It is important
for hedge funds to regularly review and update their policies,
procedures and business activities to reflect SEC priorities so they
can strengthen their business practices and prepare for potential
exams. For related content, see SEC, FINRA Release 2016 Exam
Priorities for Asset Managers, originally published by
Grant Thornton LLP on Feb. 10, 2016.
The poor performance and new regulatory hurdles drove
many high-profile hedge funds to close their doors or liquidate
certain funds in 2015, including JAT Capital, Everest Capital,
Fortress, Bain Capital, Comac and Cargill’s Black River Asset
Management. Among those winding down funds, many high net
worth fund managers returned investors’ money and converted
their operations to family offices, where they manage their own
money and that of relatives and friends, while avoiding the
regulatory requirements of Dodd-Frank and the demands of
investors regarding performance and fees.
Another response to the pressures on hedge funds has been
increased consolidation. Recent deals include Affiliated Managers
Group purchasing a minority stake in Systematica, KKR buying
a 24.9% stake in Marshall Wace LLP and Julius Baer upping its
stake in Kairos Investment Management from 19.9% to 80%.
Blackstone Group, Goldman Sachs and Credit Suisse have
raised money and/or staffed up for future asset management
acquisitions. For related content, see Plan Now: Don’t Let
Your Books and Records Stall the Sale of Your RIA, originally
published by Grant Thornton on Jan. 27, 2016.
4  Starting a hedge fund: How to establish a foundation for success in a challenging marketplace
Amid these many concerns and pressures, attracting investors
and raising capital are harder than ever. Investors have grown
more vigilant in delving into all aspects of a fund’s operations
to safeguard their assets and minimize exposure to operational
risk. And it should not come as a great surprise that it’s a highly
competitive marketplace. This paper provides an overview of
three fundamentals today’s hedge fund managers need to master:
• Raising capital in today’s financial environment
• Sustaining profitability in the face of increasing regulations
and declining fees
• Organizing the fund for maximum tax efficiency
Raising capital in today’s
financial environment
Despite the disappointing performance and heavier compliance
burden, worldwide hedge fund assets under management (AUM)
continue to grow. Roughly 10% of the 9,000 hedge funds
operating in the U.S. start new funds each year, while an average
of 500 to 700 funds close. For example, 2014 witnessed 731 U.S.
fund closures. Hedge fund closures in the first nine months of
2015 totaled 674, compared with 661 during the same period the
previous year.
As always, the biggest challenge for most new funds is finding
and raising capital. A startup often begins with $10 million to
$30 million — not enough to make any money, but sufficient to
establish an investment track record, which is key to the fund’s
marketing efforts. Much of the initial capital will come from the
fund manager, ensuring that the manager’s interests align with
those of other investors and the fund overall. Family and friends
typically form the next ring of early investors.
Performance last year was dismal, but fundraising and
investments continue unabated. In fact, some hedge funds
performed so poorly that they sent apology letters, and at the
same time asked investors to pony up for new funds. Investors
poured $38.2 billion into hedge funds in 2015, compared with the
$18.8 billion recorded in 2014. Hedge funds are expecting to raise
a significant amount of capital in 2016 and beyond. This should
be made somewhat easier by the prospect of continuing increases
in U.S. interest rates, credit defaults and volatility, which make
hedge funds an attractive investment option.
At this point, many hedge funds seek out a strategic partner from
a broader mass of potential investors, including high net worth
individuals, family offices, institutional investors (e.g., pension
funds and foundations), hedge fund seeders and funds of funds.
This seed investor typically will provide an influx of capital in
exchange for some sort of economic participation in the fund,
whether reduced fees or another incentive.
“A seed investor can help a startup hedge fund attract additional
outside capital, but keep in mind that it comes with certain
complexities,” says Michael Patanella, Grant Thornton Audit
Services partner and Asset Management leader. “If that
seed investor pulls out without sufficient warning, it can be
disastrous.” He advises fund managers to make sure the terms
of the seed investment are viable. For instance, how long is the
seed investment locked up? What revenue share is the hedge
fund expected to pay to the seeder, and for how long? What is
the buyout clause? Patanella says: “These are important issues
to address upfront. It’s also important to address confidentiality
expectations with seed investors, since future investors often want
to see the terms of the seed investment. If these terms are bound
by confidentiality, it’s problematic.”
Institutional investors contribute a larger share of hedge fund
investments than ever, which brings different challenges. For
the industry as a whole, about 60% of capital now comes from
institutional investors. Consequently, many hedge funds are
rethinking their products, fees and fund strategies to attract these
institutional investors, particularly pension funds. At the same
time, pension funds are changing their investment criteria and
objectives, creating new demands on hedge fund managers.
Unfortunately for new funds, tapping institutional investors is
something of a Catch-22: Funds have to have substantial capital to
get institutional money, but institutions won’t invest with those
funds unless they have substantial capital. Smaller funds that are
exempt from SEC registration face an especially difficult struggle
to attract the interest of institutional investors.
6  Starting a hedge fund: How to establish a foundation for success in a challenging marketplace
Kunjan Mehta, Grant Thornton Asset Management partner,
says: “Due diligence is still extremely cumbersome and timeconsuming, with no guarantees of additional money to fund
managers after the process is complete. There are extensive
background checks and a significant amount of paperwork. A
process that used to be two or three months now often takes six
months to a year.”
Potential investors are closely examining hedge funds before they
invest, checking out their business plans, strategies, exposures
(both investment and operational), policies and procedures. And
they’re also taking a long, hard look at the team the fund has in
place, both internally and externally, to do the job. It’s helpful to
prepare by obtaining one or more due diligence questionnaires
and being able to answer all the questions.
Patanella says: “Fund managers need to be prepared for close
scrutiny from investors. Transparency around exposure to risks
and sources of returns will be more important this year than
ever. Investors will want to understand the economics of your
business. What is your plan beyond trading? Who are you going
to hire? Who is going to do your compliance?” He adds that
institutional investors, in particular, are going to be looking for
pedigreed managers and top-tier service providers, including
accounting, legal and prime brokers.
An outstanding investment track record, of course, offers a
big boost. But historical performance, no matter how stellar, is
not enough to convince investors that a firm’s strategy works
long term. It will be dissected to determine whether its past
successes can be duplicated in different economic and regulatory
environments, and whether it will continue to perform for that
fund as it grows and changes. Moreover, most hedge funds
haven’t performed optimally over the past few years, making this
a harder sell.
In addition to the business plan, a well-conceived marketing plan
is a must. This plan must address a number of questions:
• What types of investors is the fund going to approach?
• How will the fund reach these investors?
• What story will the fund tell them?
Advertising is also an option. The ban on general solicitation and
advertising for hedge funds was lifted in September 2013 as part
of the Jumpstart Our Business Startups Act. The SEC now allows
funds to advertise through a wide range of media, including print
publications and TV. A company’s website, which had been a
mostly password-protected tool for current investors, has been
positioned to become a much more robust promotional medium.
Given its ability to reach a greatly expanded universe of potential
investors, advertising is certainly something startups will want
to consider. One challenge for hedge funds is that advertising
requires a set of marketing skills and capabilities that is unlikely
to reside at smaller funds. Another is that most of those reached
through advertising will have far fewer assets than traditional
hedge fund investors. That means a lot more of them will be
needed to achieve a critical mass of capital.
Eager to ensure that the new investors are indeed high net worth
individuals, the SEC has issued stricter guidance for determining
investor suitability; self-certification by the investor through
simply checking a box is no longer sufficient. The fund now bears
the burden (and associated costs) of ensuring that all the money
it gets comes from accredited investors or qualified purchasers.
(There is grandfathering for existing investors.)
The investors attracted by advertising are also likely to be new
to hedge funds. They will ask more questions and need more
personalized attention, which raises administrative costs, or at
least increases the burden on current staff.
Finally, firms must file a Form D before a general solicitation
begins, and an amended Form D when it is completed. The raised
profile that advertising brings to the fund may come at the price
of increased regulatory scrutiny. The firm must be careful to
avoid making statements of material fact that could be perceived
as misleading, because performance results are especially likely to
receive close examination.
Sustaining profitability in the face of
increasing regulations and declining fees
Hedge funds are under margin and performance pressures.
They’re squeezed between reduced fees and higher costs,
especially when it comes to compliance, and in many cases are
under fire from investors due to poor results. Is it any wonder
that an average of 500 to 700 U.S. funds close each year? While
fees used to be ample, they have been eroding for a number of
years, particularly as performance has faltered. The traditional
two and twenty fee structure — management fees at 2% of
AUM and performance fees at 20% of investment returns — is
becoming less common as investors increasingly push back.
Moreover, smaller firms are getting heated competition from big
funds and are trimming fees to compete.
The use of hurdle rates (i.e., benchmark levels of return that a fund
must clear before performance fees kick in) has also become more
common. Moreover, investors willing to lock up their money for
several years, make a big investment or put money in a new fund
can get even better deals on already reduced fee schedules.
Yossi Jayinski, Grant Thornton Audit Services partner, says:
“When investors believe performance has been poor, it’s not
surprising that they scrutinize fees. We’re seeing fees continue
to come down in response to investor pushback. Management
fees are now between 1% and 2%, and for a small fund trying
to attract new clients it might be even less than that.” New
hedge funds are charging average performance fees of 14.7%,
a sharp drop from the 17.1% typically charged in 2014.
8  Starting a hedge fund: How to establish a foundation for success in a challenging marketplace
At the same time, an onslaught of new regulations — SEC
registration for advisers stemming from Dodd- Frank, the
Foreign Account Tax Compliance Act (FATCA), anti-money
laundering (AML) requirements and other regulatory regimes —
is raising compliance costs sharply. SEC registration also comes
with significant new disclosures.
In general, the SEC is focusing more closely on disclosures,
and identifying and monitoring risks of registered investment
companies and registered investment advisers, in light of the
growth of new and more complex investment products and
strategies, like those of hedge funds. Compliance and expertise of
in-house or outsourced compliance arrangements are a growing
area of scrutiny from the SEC, with proposed changes to the
Form ADV requiring hedge funds to disclose details of their
outsourcing arrangements for compliance.
“Hedge funds need to give serious thought to their compliance
function and how it meets the needs of their business,” cautions
Patanella. “The fastest way to repel capital is to have an SEC
investigation finding or fine.”
For related content, see SEC Seeks to Modernize Investment
Reporting and Disclosures, originally published by Grant
Thornton on July 20, 2015.
The Dodd-Frank Act
Hedge funds are now required to provide information on Form
PF as follows:
Adviser registration
• Gross and net assets of each private fund
The Investment Advisers Act of 1940 included an exemption
from registration for an investment adviser — including those to
hedge funds — with fewer than 15 clients within the preceding 12
months, and which did not hold itself out to the public as such.
Under Dodd-Frank, that sweeping exclusion has been eliminated.
Hedge funds with more than $150 million in regulatory assets
under management (RAUM) in the United States now have to
register. (There are additional requirements for venture capital
funds and foreign private advisers.)
• The aggregate notional value of the fund’s derivative positions
• Performance
• Counterparty credit risk exposure
• Trading practices
• Percentages of fund ownership
• Financing (including secured and unsecured positions)
Among the requirements of a registered investment adviser (RIA)
filing with the SEC are:
• Valuation and methodology
• Filing disclosures on Form ADV
• Portfolios of insiders
• Designating a chief compliance officer
• Maintaining financial books and records to facilitate
SEC examinations
• Keeping client assets with a qualified custodian
Form PF
Form PF is a joint initiative of the SEC and the Commodity
Futures Trading Commission (CFTC). Its purpose is to allow
the Financial Stability Oversight Council to monitor risks to the
U.S. financial system. Private fund advisers have to file an annual
Form PF if they advise private funds with more than $150 million
in RAUM.
A hedge fund is defined for purposes of Form PF to be generally
“any private fund that has the ability to pay a performance fee
to its adviser, borrow in excess of a certain amount, or sell assets
short.” Large hedge fund advisers above the $1.5 billion RAUM
threshold have additional reporting obligations, including
quarterly filings for some data.
• Liquidity of holdings
Such an abbreviated listing understates the complexity of Form
PF, which requires extensive data identification, collection,
verification and aggregation. Much of the information has never
been required on any form, and simply locating and gathering the
data has been a major challenge for some funds.
AML
The Securities Industry and Financial Markets Association
(SIFMA), an association of several hundred securities firms,
banks and asset managers, has released a suggested AML due
diligence practices guide for hedge funds. The SIFMA document
prescribes two regimes — simplified and increased — of
procedures based on the level of risk, adherence to an equivalent
AML regime and other factors.
Blue sky laws
Hedge funds also have to make blue sky filings in each state
where they have investors. Blue sky laws are state regulations
designed to protect investors against fraudulent sales practices by
requiring sellers of new issues to register their offerings. These
generally run no more than a few hundred dollars, but in the
case of New York, where a filing is required before the initial
investment, the cost is over $1,000.
Additional regulations
Other regulatory regimes that affect hedge funds include:
• The Financial Crimes Enforcement Network’s (FinCEN)
proposed AML rule applicable to SEC RIAs remains on track
to be finalized in 2016. This proposed rule would extend the
Bank Secrecy Act, AML and suspicious activity reporting
(SAR) regime to investment advisers. FinCEN proposed the
rules in part to address its concern that individuals would use
advisers to launder illicit proceeds and terrorist funds. Hedge
funds will be required — like banks, brokerages and mutual
funds — to file SARs with FinCEN.
• The CFTC issued new rules that went into effect in 2012,
requiring hedge funds or hedge fund advisers who previously
were exempt from the CFTC’s registration requirements to
register as a commodity pool operator (CPO) or a commodity
trading adviser (CTA). Even those who are exempt need to
file an annual notice that they continue to qualify for the
exemption. The CFTC is, in part, aligned with the SEC. For
example, CFTC registration requirements may require funds
to complete Form CPO-PQR, which is the counterpart of the
SEC’s Form PF. Hedge funds would also be subject to rules
in markets regulated by the CFTC, such as swap transactions.
• FATCA requires all non-U.S. hedge funds to report
information on their non-U.S.-based clients.
• The Alternative Investment Fund Managers Directive
(AIFMD) has rules that apply to any fund, no matter where
it’s based, if it takes any money from an EU-based investor.
These rules went into effect for AIFMs on July 21, 2014.
Most UK- and Europe-based hedge fund managers are now
AIFMD-compliant.
• When the SEC lifted the ban on hedge fund advertising, it also
issued regulations that disqualify felons and other so-called
bad actors from participating in hedge fund offerings. Bad
actors are primarily officers, 20% beneficial owners and fund
managers who have engaged in disqualifying events, including
criminal convictions, court orders, final orders and other
orders in connection with violations of securities laws.
10  Starting a hedge fund: How to establish a foundation for success in a challenging marketplace
With expenses rising and fees dropping, hedge funds have their
work cut out to maintain profitability. Jayinski says: “The
current cost structure of the industry is tough on smaller funds.
Firms need to grow — whether organically, raising new funds or
through consolidation — so that they generate sufficient income
to remain profitable. But cost-cutting has to be done with a
scalpel, not a saw: Choosing bargain-basement services and staff
may initially help the bottom line, but in the long run it can hurt
the firm’s reputation and back-office operations.”
Organizing the fund for tax efficiency
When setting up a hedge fund, there are many factors to consider
from organizational, regulatory and tax standpoints. Organizing
a hedge fund for maximum efficiency is a task of considerable,
sometimes enormous complexity.
Grant Thornton Tax Services Partner Brian S. Moore says:
“While never the most important part of launching a new venture,
managers need to pay particular attention to the tax structure of
new funds. It can impact the ability to attract and retain certain
classes of investors. Most sophisticated investors are acutely
aware of the tax implications of certain structures, and want to
ensure that they are receiving income from funds in the most
tax-efficient manner possible, as it will impact their overall rate of
return on the investment.”
The following is a brief overview of tax structure considerations.
Tax status of investors
A key factor in organizing and structuring a hedge fund is the tax
status of the investor the fund seeks to attract.
• Individuals and for-profit institutions based in the U.S.:
They pay U.S. taxes based on their worldwide income.
• Tax-exempt U.S. investors, including pension plans and
charitable entities: They do not pay U.S. income taxes.
Importantly, a U.S.-based nonprofit cannot invest in an
onshore hedge fund without addressing the unrelated business
taxable income.
• Nontaxable offshore investors (i.e., individuals and
institutions not based in the United States): They do not pay
U.S. income taxes.
Common hedge fund structures
Master-feeder funds
Master-feeder is the structure most often used by hedge funds.
Investors put their money in feeder funds, which in turn supply
it to a master fund. All the investing and trading is done by the
master fund, which is typically an offshore corporation taxed as a
partnership — a flow-through entity — for U.S. tax purposes.
Usually, the master fund receives capital from:
• A U.S. domestic feeder (typically a partnership called the
onshore) with funds from U.S. taxable investors
The master-feeder fund structure (and mini-master fund structure)
Master-feeder funds consolidate trading activities into a single
portfolio, while allowing managers to accumulate funds from
U.S. taxable, U.S. tax-exempt and foreign investors. This
commonly used structure creates a critical mass of tradable
assets, improves the economies of scale and helps reduce costs.
This structure features:
• Management fee
• Onshore feeder
• U.S. investors
• An offshore feeder (usually a corporation) with funds from
U.S. tax-exempt and nontaxable offshore investors
• Investment manager
The master fund is often incorporated in places friendly to
alternative investment entities, especially the Cayman Islands,
Bermuda and the British Virgin Islands, although there are
numerous locations outside the Western Hemisphere. These
jurisdictions, where offshore funds represent a significant part of
the local economy, offer well-established investment laws, a strong
infrastructure of service providers, and no- or low-tax favorable
tax treatments — investors are taxed where they live. Regulatory
bodies, such as the Cayman Islands Monetary Authority and
the Bermuda Monetary Authority, maintain strong policies
and guidelines. Investors see these regimes as underpinning risk
management, and managers accordingly select these jurisdictions.
• Performance fee
12  Starting a hedge fund: How to establish a foundation for success in a challenging marketplace
• Master fund
• General partner (GP)
• Offshore feeder
• Foreign or U.S. tax-exempt investors
Single domestic hedge funds
Incubator hedge funds
Most U.S. startups begin with investors solely from the U.S.,
so the hedge fund may be structured as a U.S.-based limited
partnership (LP) or limited liability corporation (LLC).
Generally, each fund will have its own management company and
GP; the manager establishes an LLC to serve as the fund’s GP.
Onshore funds are usually domiciled in Delaware, because of the
state’s long tradition of well-developed and generally businessfriendly corporate laws.
As the name implies, an incubator fund provides a controlled
environment for investment managers to test out strategies
and show what they can do before hiring an administrator and
launching the actual fund. The incubator fund has a simple
organization structure, usually comprising: (1) an LP or LLC for
the fund, and (2) an LLC as the investment manager/GP of the
fund (or managing member if the fund is an LLC). An incubator
doesn’t provide all the offering documents of a traditional hedge
fund, and it is usually only open to the actual managers of the fund.
Single foreign hedge funds
An offshore hedge fund, such as a foreign corporation that trades
securities for its own account, is not considered to be engaged in
a trade or business in the U.S., thus its investors are exempt from
U.S. taxes. For a few select funds in their initial stages, this may
provide a less costly solution than the more complex masterfeeder and side-by-side structures.
The manager invests for six to 12 months, sufficient time to
create a performance history and to cultivate investors. If there’s
sufficient interest, the fund can take the next steps to establish
itself as a full-fledged fund.
Side-by-side structures
In a side-by-side structure, a single management company
manages an LP, organized in the U.S. for U.S. investors, and an
offshore corporation, organized overseas for non-U.S. investors.
Both funds typically have the same trading strategies, and trade
tickets are allocated to each entity. But because the onshore and
offshore funds are two separate entities operating independently,
the fund manager can better accomplish tax efficiencies for U.S.
investors while seeking the best returns for investors not subject to
U.S. taxation. The negatives are increased administrative costs as
well as decreased leveraging power because assets are in two pools.
Conclusion
The hedge fund industry is in the midst of significant change.
Regulations are driving up costs. Traditional fee arrangements are
being renegotiated. Competition for capital is fierce. Many funds
— particularly those just starting out — are more than willing to
cut fees to attract money. Investors across the board are much
more skittish about safeguarding their money, giving rise to a due
diligence process that is increasingly quantitative and complex.
Fund performance is under increasing pressure, and the investor
base is shifting. Institutional investors, especially pension
funds, are becoming the primary investors in lieu of high net
worth individuals. These types of investors tend to prefer
well-established funds with a long history of high returns over
newcomers lacking committed capital. Consolidation among
funds is taking place at a fast pace, especially among smaller funds
that are aligning with one another to expand their AUM and,
thereby, are better positioned to attract institutional investors.
Hedge funds that plan to be successful in this marketplace
will need a creative sales and marketing strategy in order to
raise assets, a robust compliance program that goes far beyond
dotting i’s and crossing t’s, strong relationships with their service
provider partners, and a well-planned tax strategy that maximizes
efficiency and minimizes risk.
14  Starting a hedge fund: How to establish a foundation for success in a challenging marketplace
How Grant Thornton can help
If you are considering starting a fund, Grant Thornton can help give
your firm the critical edge. Our firm can advise on fund formation
and structuring, and assist throughout the initial fund launch.
Our specialists have real-world industry knowledge, and as
your fund grows from a startup with less than $150 million
in AUM to an SEC-registered business, we can address the
day-to-day business situations you may encounter. We can
provide assistance with matters such as audit, tax and regulatory
compliance; investment adviser registration readiness; internal
control and risk management reviews; operational and
performance evaluations; IT strategy and effectiveness analysis;
and litigation support services.
As hedge fund industry thought leaders, we regularly publish
white papers, articles and other communications designed to keep
emerging managers abreast of industry issues. In addition, we
collaborate with various trade organizations and key influencers
to host a variety of educational events for our clients, including
industry hot topics symposiums, roundtables, webcasts and
networking events. Visit grantthornton.com/assetmanagement for
more information about our asset management practice.
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Michael C. Patanella
Audit Services Partner
U.S. Asset Management
Sector Leader
T +1 212 624 5258
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Yossi Jayinski
Audit Services Partner
Asset Management
T +1 212 624 5548
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Joseph Magri
Audit Services Senior Manager
Asset Management
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Sean Matthews
Audit Services Senior Manager
Asset Management
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Kunjan Mehta
Audit Services Partner
Asset Management
T +1 212 624 5259
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Brian S. Moore
Tax Services Practice Leader
Asset Management
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