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04 Jun 2002
Getting the most from your service provider
This presentation was given during the 9th Annual Hedge Fund Forum held at The Russian Tea Room, New York City on Tuesday, 4th of June 2002
Good afternoon, Ladies and Gentlemen
Best Practices in Making Your Service Provider Selection
I am going to address this topic from the point of view of selecting an Administrator.
Before you can select an Administrator, you must have an absolutely clear understanding of your requirements – what you want, or, perhaps more to the point, what you need. This comes down to “What to Look For” and “What to Ask”. Before you can make any decision on these, you must carry out your own due diligence.
It is extraordinary to me how many, Investment Managers, when acting as promoters of funds, still do not carry out even the simplest due diligence when selecting an Administrator, other than getting a fee quote.
Let me be quite categoric – due diligence is essential when choosing an Administrator. To do this, you need to ask the candidate Administrator to complete a detailed Questionnaire – but I will come back to that later.
If, having received and reviewed the Questionnaire, you decide that a potential candidate is still in the running, you then need to carry out further checks and assessments including:
- Take out references from existing clients and, particularly, from clients using the same services, operating in the same manner and trading in the same instruments as you;
- Ask your prospective Prime Broker all about your prospective Administrator and vice versa, including checking that they can communicate electronically; and
- Check with their regulator that they are in good standing.
When you get references, be clear about what the references say – and what they don’t say. I have told this story before, but I think it bears repeating. When I first moved to Ireland, I was looking for someone to work at my home. My lawyer at the time, who was a canny old bird, told me to look out for what was missing from a reference – what was written may not be quite so relevant as what was not. For example, if the reference didn’t say that the person I was considering employing was sober and honest, then that probably meant that he was a drunken thief.
You should look for similar clues.
Sadly I have to say that almost every reference you get, will probably say that the referee does not accept responsibility for what the reference says, but occasionally you may get a reference from somebody saying, directly, or between the lines: “I wouldn’t touch this company with a barge pole” and that, of course, would be quite useful. In fact I believe that when getting a reference, it is often better to call the referee, because they may say something “off the record” that they would not commit to writing.
Next, as a trader, you would normally “check your market”. Do the same when selecting an administrator. That is to say, look at more than one administrator – hold a beauty parade – find out what they offer. And how they can add value to your product.
- You should visit their offices and see what they do and how they do it.
- Speak to the actual people on the floor who will be providing the service – don’t rely on the sales person, or front man like me
- Get your IT systems guru to talk to their IT systems guru;
- You should, quite soon, have a pretty clear idea whether they are able to offer a personal service and whether you are going to be allocated one named person as your account executive (preferably backed up by another named person), or whether you will be an anonymous account. Remember, if you have a query, you need know you only have to ring up “Joe” to get a quick answer – and not find yourself floating around the Ethernet, wandering from extension to extension, ending up with someone saying “I can’t help you, because the person who did that last week has gone fishing.
Basically you have got to find out if you are going to be treated as a person or as a number.
- Ask the Administrator how many clients they have in total and, more importantly, how many clients do they have that invest in the same asset classes, sectors or disciplines as you do.
- If you are dealing in an exotic instrument, and the Administrator has never handled that instrument, then you must ensure that it is capable of doing so. The fact that it hasn?t handled the instrument doesn’t mean it can’t, although it would be added comfort if you know, from day one, that the Administrator has other accounts that deal in the same instruments as you do.
- Review the Administrator?s standard agreement and get a detailed procedures manual – a term sheet if you like – to explain exactly what the Administrator is going to do and (and this is very important) who is responsible, in which office, for each specific task.
- Find out what are the qualifications of the Administrators’ staff – how many professionals do they have – previous employment history etc.
You should be aware that the Administrator also has certain fiduciary responsibilities to investors, for example overseeing and verifying valuations and being able to justify them. Find out if they are capable of carrying out esoteric valuations, if required.
- The Administrator has similar responsibilities with regard to ensuring compliance, by the fund and the Board of Directors, with relevant regulations and, particularly, anti-money laundering regulations. Find out how they handle this.
- Can the Administrator handle Equalisation?
But I am getting ahead of myself: As I have already suggested, as your first step, before you do all of the above, should be to send a detailed Questionnaire to your shortlist of Administrator candidates, which should ask many of the questions that I have highlighted above, as well as many more.
I now propose to put on my AIMA hat.
As some of you may know I am the Deputy Chairman of AIMA ? the Alternative Investment Management Association – which is an international association targeted purely at alternative investment and hedge fund management and the participants in those industries. The primary function of AIMA is the education of potential corporate and institutional users of the markets as to the value of those markets, and they do this in many ways. For
I am currently the Chairman of AIMA?s Due Diligence Committee and, last year, AIMA produced a series of illustrative questionnaires for the due diligence of Managers, Prime Brokers, and Administrators and, in the context of Funds of Funds, Custodians. Unfortunately, these illustrative questionnaires are only available to members of AIMA, therefore, if you would like one and you are a member, please contact Emma Mugridge at AIMA (Tel: +44 (207) 659 9920; e-mail: firstname.lastname@example.org). If you are not a member, please then also contact Emma and she will assist you to become a member.
For the purpose of this presentation, I will just give you a brief synopsis of the Questionnaire, designed for Managers seeking an Administrator for a Hedge Fund, excluding Funds of Funds.
The Questionnaire has twenty-two sections, under the following headings:
Details of the Administrator
Client Relationship Management
Payment and Signatory Procedures
Pricing and Valuations
Fund Systems Audit
Corporate Secretarial and Director Services
Business Continuity etc.
This synopsis just gives the Bullet Points, highlighting each important area to be explained in the due diligence process. It goes without saying that under each bullet point there are, in the actual Questionnaire, several additional questions designed to “ferret out” as much information as possible. Thus, results of the Questionnaire will not tell you whom you should select, but it will definitely indicate whom you should not select and that is the first, and a very important, stage in the process of elimination. The answers to your Questionnaire and the visits and other recommendations that I have made, should enable you to select the winner of the beauty parade.
One final word on the selection process – when you have done all of this – finished the beauty parade – don’t go for the cheapest, go for value.
Remember, an Administrator should add value to a fund, and the more you want your Administrator to do, then the more it will cost. Even in today’s high-tech environment, administration is a labour intensive business and everywhere that Administrators operate, labour costs are rising. There is a great tendency to assume that Administration is a simple bookkeeping task and that the Administrator that can do it cheapest, is the one you want. Rest assured that this would almost inevitably turn out to be a totally false economy. That old clich? if you pay peanuts, you get monkeys – is very apt in this context.
What is the Administrator’s Role?
“Administration”, in the context of Hedge Funds, means, in effect, the management of the Fund in virtually all aspects of the day-to-day operations of the Fund, except the actual investment of the assets, which is the responsibility of the Investment Manager. In this role, the Administrator is always answerable to the Board of Directors or Trustees of the Fund and does not have any actual management control.
In simple terms, an Administrator is responsible for ensuring the efficient operation of a fund, whilst at the same time relieving the Investment Manager from having to do all the boring stuff, such as:
Calculating the NAV and the NAV per share or unit, as often as may be required by the Fund or it’s Board. That may be daily, weekly, monthly or quarterly. Usually Hedge Funds have monthly valuations, however, as institutions become more and more involved in these markets, so does the demand for more frequent valuations;
- Keeping the accounts and financial records;
- Preparing the annual audit file and liaising with the Auditor;
- Liaising with prospective investors and sending out the offering documentation;
- Calculating, confirming and arranging payment of all subscriptions, redemptions, fees and expenses, and arranging for the payment of all dividends or other distributions, if required;
- Often the Administrator will also act as Registrar & Transfer Agent, handling the registration of shares and liaising with shareholders with regard to subscriptions, redemptions and transfers;
- The Administrator will maintain a copy of the Share Register at it’s office and, if the Administrator is not resident in the domicile of the Fund, ensure that the original Share Register is held in the Registered Office in that jurisdiction;
- Carry out anti-money laundering due diligence with regard to investors;
- The Administrator may also act as Company Secretary – and will therefore be responsible, amongst other things, for arranging Board Meetings, calling the AGM and preparing Board Minutes;
- Maintain the statutory books and records;
- If the shares of the Fund are listed on a Stock Exchange, ensure that the Company and the Directors comply with the ongoing obligations of the relevant Stock Exchange;
- Be the interface between the Manager and Investors;
- The Administrator is also responsible for ensuring that the Fund complies with the terms of its Offering Memorandum in many ways, including, in some cases, reviewing the management of it’s investment portfolio with regard to, for instance, investment restrictions and diversification requirements.
This is not an exhaustive list of an Administrator’s duties – but should give you a reasonable idea of what is involved.
In summary, as I said, an Administrator should be responsible for making sure everything is done to enable the fund to run efficiently in all aspects, except the management of the assets – that is the Investment Manager’s task. Thus an efficient Administrator will enable the Investment Manager to sit in his ivory tower and make pots of money, without distraction.
Why do you need an Independent Administrator?
In the Hedge Fund industry, I suggest that the main advantage that an independent Administrator brings to the table is the comfort that is provided to investors, if the administration of a Fund, and particularly the calculation of the net asset value (“NAV”) of that Fund, is being carried out by an independent third party (that is independent from the Fund?s Manager), using independent prices and transaction data sources when calculating the NAVs.
If you are not familiar with Hedge Funds, this comment may seem rather extraordinary and perhaps, even offensive to those of you who work for major financial institutions, that administers their Funds “in house”.
So I should briefly explain – the majority of Hedge Funds, of which there are now several thousand – some estimate close to 10,000 – are established in the United States as Limited Partnerships. The General Partner is usually the Hedge Fund Manager and also, usually, handles the administration of the Fund and produces all of the partnership accounts, reports and statements. In the vast majority of cases, there is nothing wrong with that and, historically, the vast majority of US Hedge Fund accounts and reports have been spot-on.
However, as those whose knowledge of this market is based on the somewhat sensationalist, and, frankly, ill-informed, articles in the press over the past couple of years (including, rather disappointingly, recent articles, both in the Financial Times and The Economist, both of which should know better) will know, there have been a number of scandalous frauds mostly involving US Hedge Funds during the past couple of years. I would point out, in passing, that these frauds represent a tiny percentage of the universe of Hedge Funds there and an even smaller percentage of the asset pool invested in those Hedge Funds. Unfortunately, these small percentages seem to be in inverse proportion to the column inches that the scandals apparently merit in the press.
Be that as it may be, the reports of these scandals have honed investors? senses and, because the majority of these frauds involved self-administered US Funds, those Investors now want the Funds they invest in to be administered by an independent third party Administrator. Therefore, I suggest that the appointment of a third party Administrator can add immeasurable value to a Fund, if it means that it will retain investors in the Fund or, indeed, attract new investors to the Fund.
For a small or emerging Hedge Fund Manager, setting up his first fund, the cost advantages of appointing a third party Administrator can be easily demonstrated, but it is not just a matter of pure dollars and cents.
Until the Fund grows in size to, at least fifty, or even one hundred million dollars, which is above the average size, the actual cost of setting up an administration facility – (which involves renting more space, employing qualified staff, acquiring the specialised technology and providing the managerial resources required to ensure the efficient self-administration of the Fund) ? these costs can be almost prohibitive and are unlikely to compare favorably with the fees charged by many of the specialist Hedge Fund Administrators ? or at any rate those Administrators who will accept the smaller start up
The economics of introducing an independent Administrator to an existing self-administered fund, where the Manager has already invested in an in-house administration system is more problematical ? and becomes a marketing cost
Obviously, once the Fund has reached a critical mass, the cost ratios change and the attraction of a third party Administrator may decline. However, it is also likely that, as the Fund grows, the fees charged by the Administrator will also be volume sensitive.
All of this applies to both US partnerships and offshore funds, but having said all that, in many jurisdictions, it is now a requirement that an independent Administrator is appointed for most Funds, perhaps excluding those managed by the larger Fund Managers who have their own separate – and therefore legally “independent” – administration company – ABN-AMRO, Citigroup, Credit Agricole, Deutschebank and ING Barings all spring to mind – each of which act for both their own in-house funds and outside funds.
Getting the most out of your Administrator
You must develop a long-term relationship.
It goes without saying that long-term relationships between Managers and Administrators are built up over time and, I would suggest, are largely dependent upon the service provided by the Administrator. This essentially means the efficiency of the working relationship, in terms of the Administrator?s ability to produce the numbers and provide administration services and, particularly, Shareholder services, promptly and accurately and in the manner that the client wants.
But this is not a one-way street. The Administrator will be unable to provide a fully efficient service if it does not receive all of the information that it needs promptly and efficiently. In my opinion, the provision of that service and, therefore, the creation of a long-term relationship, is, itself, dependent upon three primary factors. These are:
- The Administrator’s technical capability;
- Its ability to communicate; and
- The personalities, involved on both sides.
It goes without saying that, for the Administrator to provide a good and efficient service, the Administrator will need to have the technical capability. By this I mean not just the technology, but the qualified staff who understand what they are doing and who understand what the Hedge Fund is doing. They don’t necessarily need to understand the minutiae of the actual investment strategy, although that would obviously help, but they do need to understand the instruments used and particularly the complex ones.
Of course, it won’t matter how technically proficient the Administrator is if the communications between the Administrator, the Hedge Fund Manager, as well as the Prime Broker, Clearing Broker or Custodian, are not up to par.
Ideally, the Administrator should be able to draw down all of the data that it requires from the Brokers or Banks electronically, so that it gets the information promptly and efficiently. But it is not just electronic communication that matters. The Hedge Fund Manager needs to be able to communicate with the Administrator and, for that to work efficiently, the Hedge Fund Manager needs to have a single person or team with whom the Manager communicates on a daily, or when needed, basis.
In this regard, I think it is important that the Hedge Fund Manager should visit the Administrator’s office and, if the account is big enough to justify the expense, we will often send the individual administrator, dedicated to a particular Fund, to visit the client’s office.
Getting to know people on a face-to-face basis always helps, unless there is a personality clash. One cannot plan, regulate or often, even predict, the chemical reaction between two individuals. It?s just one of those facts of life that occasionally you have a situation where two people just don’t get on and so the Administrator will have to appoint another account executive – it can’t replace the client! In my experience, that is a relatively rare occurrence, although we all know Managers who can be as volatile as the market and sometimes Managers can be, in my opinion, unbelievably and unreasonably picky.
I recall one instance when we had a disagreement with a Manager over a single penny difference in reconciliation. When we checked back, we found that the problem? if you would call it a problem ? the difference, was a rounding difference. By no stretch of the imagination is one cent a material discrepancy in a US$ 20 million Fund. A Hedge Fund Manager with that sort of obsessive personality can, of course, grind down a young administrator, who has got another six or eight funds to administer. It is important that the relationship is built up on mutual
Thankfully, these are rare instances and, on the whole, providing, on the one hand, the individual administrators realise that they are there to provide a good service and a personalised service, and can be seen to be striving to do that, and, providing, on the other hand, the Hedge Fund Manager realises that he is getting a good service and that even administrators are human (despite the fact that they are, for the most part, accountants), a good relationship can be built up over time.
But a lot of that, as I have already said, is communications. Errors will occur, delays will occur and these are aggravating to the Manager, but they become really annoying if the Manager doesn’t know what’s going on. Therefore, it is important that the administrator handling the account communicates with the Manager and keeps him informed in bad times, as well as good.
Dermot S.L. Butler is Chairman of Dublin-based Custom House Administration & Corporate Services Limited (“Custom House”), a company that specialises in assisting clients in the organisation, establishment and administration of alternative investment and hedge funds. Custom House is authorised by the Financial Regulator, (formerly the Central Bank of Ireland) under the Investment Intermediaries Act, 1995.