Best Practices for Third-Party Hedge Fund Administrators

Third-party hedge fund administration is now the focal point of discussions between hedge fund managers and their investors.

High-profile hedge fund fraud has changed the level of due diligence key investors will perform prior to making significant allocations to single manager and fund of hedge fund managers. Industry best practices have always stressed the need for alternative investment managers to engage a reputable third-party administrator. Today, there is increased scrutiny on ensuring the administrator is performing the necessary level of service to meet investor demands and promote confidence that the fund manager is in line with industry best practices.

We are experiencing a shift in the nature of what constitutes hedge fund best practices in the areas of fund administration. The recent fraud cases are pressuring hedge funds to engage third-party administrators to provide a more comprehensive fund administration services. The objective is to instill investor confidence through working with a reputable service provider that is independently reconciling activity, substantiating fund assets and pricing fund assets. Hedge fund managers and their investors are looking to perform more detailed due diligence on third-party administrators to ensure the service provider has the ability to provide required level of service to meet best practices.

The core services most fund administrators offer involve the following:

• reconciliation and substantiation of cash, trades and positions to all prime brokers and other counterparties
• pricing of holdings including OTC derivatives
• fund level accounting and striking of NAV on dealing dates
• maintenance of investor registry, preparation and distribution of investor statements
• performing AML/KYC for onshore and offshore entities on investor base

The functions listed above are dependent on a host of operational workflows needed to be executed properly on a daily basis. As complexity increases, these workflows can become quite onerous, especially in the areas of reconciliation and fund-level accounting. For example, how many side pockets does a master fund have or how many OTC counterparties does the administrator need to reconcile to in addition to traditional prime broker relationships?

As recently as a few months ago, the industry deemed it acceptable for hedge funds to self-administer or engage a third-party administrator to perform a water downed version of administration such NAV Lite. Clearly, the investor community is now questioning these once accepted practices. Hedge fund managers are reacting quickly and forming strategic partnerships with third-party administrators to expand the scope of services provided to their funds. Self-administered funds are now performing more detailed due diligence prior to selecting an administrator.

This can start with analyzing the financial strength of the administrator and its culture around fostering a strong control environment. Managers and investors are examining whether the administrator’s financial stability is viable to mitigate any risk of having to convert the books and records due to the insolvency of the administrator. One element that receives particular attention is the control environment and the framework around how business risks are managed. This goes beyond merely confirming the administrator has a SAS 70 in place. Managers and investors have begun to interview accounting, operations and investor services managers in an effort to understand how client deliverables are prepared, reviewed and distributed to clients. In addition, it is critical to understand how key operational functions, such as cash movements at the fund level are originated, validated and confirmed.

A major concern for self-administered funds is releasing or “losing” control of many core processes, especially in the area of investor services. To address this concern fund managers can agree a “responsibilities” matrix in partnership with the administrator to clearly define what tasks will remain with the manager and what will be outsourced to the administrator. For example, performance-related questions, or investor inquires regarding the monthly statement, in many instances are directed to the manager and not the administrator.

The fund manager should be focused on identifying how the administrator is organized functionally and who it will be interacting with on a daily basis—meaning, are there multiple points of contact or a single contact for escalating any service-related issues. In addition, the managers are increasingly reviewing the profiles of the individuals that will be assigned to their relationship. To ensure work experience and tenure within the industry is adequate to meet service-level requirements specific to the hedge fund manager.

From an infrastructure and technology perspective, self-administered funds typically will look to continue to run most functions in-house and run a parallel set of books and records. As hedge funds move away from a self-administration environment, it is important to understand how the administrator will capture trading activity, reconcile data and also source pricing. The manager should strive to leverage existing infrastructure and create workflows that can assist the administrator in increasing the ability to STP most trading activity on a daily basis. Engaging a third-party administration relationship should be considered a partnership. In essence, the administrator is truly an extension of the client’s middle and back office, and the ability to leverage respective technology platforms can improve the monthly frequency of NAV turnaround.