Outsourcing the Administration of Alternative Investment and Hedge Funds

A presentation by Dermot S. L. Butler
to the Mastering Investments and Offshore Funds Conference
held at The Hilton Hotel Dublin on 28th of November, 2001

Good morning Ladies and Gentlemen.  I am going to talk about Outsourcing the Administration of Alternative Investment and Hedge Funds.  I have broken this down into several topics  the first of which is : -

1.         What is Administration

Administration, in the context of Alternative Investment and Hedge Funds, (which I will refer to collectively as Hedge Funds in this presentation), 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 its 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 liasing with the Auditor;

-   Liasing with the Investment Advisor, the Custodian, the Brokers and other service providers;

-   Liasing 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;

-   Maintaining the statutory books and records;

-   Often the Administrator will also act as Registrar & Transfer Agent, handling the registration of shares and liasing with shareholders with regard to subscriptions, redemptions and transfers; and

    Carry out 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.

-   The Administrator will maintain a copy of the Share Register at its 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;

-   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 the management of its investment portfolio with regard to, for instance, investment restrictions and diversification requirements.

This is not an exhaustive list of an Administrators 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.

The next topic is:

2.         Self-Administration versus Outsourcing  The Pros and Cons

This probably comes down to two questions:  Is there any value added, and what are the costs  which are not the same thing.

In the Hedge Fund industry, I suggest that the main advantage that the third party 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 Funds 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 administer 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.

Please remember that I am talking about Hedge Funds, which  are, on average, very much smaller than the average retail fund.  Very few Hedge Funds are over half a billion dollars.  This is because many, if not all, Hedge Fund strategies are capacity sensitive.  The other day I heard a UK Fund Manager described as small, in the context of the European retail market, at ten billion dollars  I would be surprised if you needed more than two hands to count up the number of Hedge Funds Managers with over one billion, let alone ten billion, dollars under management.

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, a recent article in The Economist) they will know, there have been a number of scandalous frauds 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 to see that the Funds they invest in are administered by an independent third party Administrator.  Therefore, I believe 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 Hedge Funds.

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.

So, it can be seen that the decision to use a third party Administrator is not necessarily cost driven and can be swayed by other considerations, such as the perception of independence that I have already mentioned, and risk transfer.  By this I mean transferring the risk, and resulting liability, represented by, for instance, the possibility of expensive administrative errors, from the Fund Manager to the third party Administrator  or that Administrators insurance company.

One area where dollar costs can be a serious factor is when a Fund Manager, who has hitherto administered the Fund that he manages, decides, perhaps because of investor pressure, to appoint a third party Administrator.  In these circumstances, the Manager will already presumably have made a substantial capital investment into his own administration department and that department and the technology purchased, may have proved very efficient.  In choosing to outsource the administration, the Manager may, on top of paying the new administration fees, have to decide to write off the capital investment and let some staff go.  And, as we all know, in Europe at any rate, that can be a very expensive way to cut costs.

Often in these circumstances and in order to avoid these write-offs, the Fund Manager may decide to continue preparing the Funds accounts and calculating the NAV.

However, the Manager will try and appoint a third party Administrator to fulfill the function of verifying the figures produced by the Fund Manager and, of course, to do that for a nominal cost.  This is what is known in Hedge Fund circles as NAV Lite.  Obviously, this is, potentially, a very dangerous area for an Administrator and any Administrator who agrees to verify such numbers and be described as The Administrator in the Funds documentation, should, in my view, still replicate the whole accounting process, in-house, using independently sourced data, which, of course, cannot be done for a nominal cost.

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 administration company  DMG, Citigroup, Barings all spring to mind  and, of course, those companies also act for both their own in-house funds and outside funds.

My third topic is:

3.         The Complexities of Administering Hedge Funds

There are a number of areas in which the administration of Hedge Funds differs from the administration of the more traditional Mutual Funds or Unit Trusts.  These include: the range of investment instruments; and the strategies used to exploit these instruments; the ability to go short; leverage; fee structures, including incentive or performance fees; and equalisation.

The traditional Mutual Funds or Unit Trusts are, for the most part, retail funds with quite restrictive investment policies  which include: very broad diversification; no short selling; no leverage; and derivative trading limited to Efficient Portfolio Management, which is a Euro euphemism for hedging, but very targeted hedging.

On the other hand, Hedge Fund strategies utilise a vast range of derivative instruments, which can introduce pricing problems.

These strategies range from the relatively straightforward exchange traded commodities, financial futures and options contracts, to highly complex derivative products, which include swaps and swaptions, as well as CFDs, which are Contracts for Differences, currency forward contracts traded on the Interbank market and a wide variety of customised instruments created by major banks and financial institutions and sold on the Over the Counter or OTC market.

Hedge Fund portfolios, which have these exotic investments, are not inherently difficult to administer or account for, providing - and this is a big providing - the Administrator is able to obtain a reliable and verifiable price for the investments, upon which that Administrator can base the NAV calculation.

Most Hedge Fund strategies are, essentially, quite simple long-short strategies, from the obvious long-short equity fund, through merger arbitrage, commodities, futures, options and bonds and none of these present a problem, if they are traded on a recognised exchange and a liquid market.

The problems come with illiquid assets and esoteric derivative products, created by and sold by just one financial institution, which is the only valuer of those assets.  Again, no problem in liquid high volume markets, but if markets fall dramatically and volumes shrink, God help you, if you expect the institutions to look after Number Two  you.

They will inevitably look after Number One - themselves.

What is essential is that a clear valuation policy is disclosed in the offering document and some fallback plan is in place, in case the unthinkable happens, - which it inevitably will, if you dont have any fallback plan.

Where possible, an independent price source must be used.  If that isnt possible, for some reason, a reasonable, practical pricing formula must be agreed between the Investment Manager, the Administrator, and - this is important - the Auditor, before the Fund is launched and, as I say, some fallback plan, in the event that market circumstances change, is also agreed.

Of course, the volatility of the Fund can be exacerbated by leverage and this can bring its own valuation problems, particularly if leverage is provided by utilising an option or other derivative instrument.  Of course, the ability to go short is, itself, a form of leverage and, in some arbitrage strategies, a dramatic change in market conditions, or even just market sentiment, can decimate the relationship between the two arbitrage components, which is essentially what happened to Long Term Capital.

Just a quick word here on the complexities of fees and, particularly, performance fees and equalisation.

Basically, all I am going to say about this subject is that the manner in which management and performance fees for Hedge Funds are calculated, can be very complicated and is certainly never standardised, unlike Mutual Funds, which are, for the most part, charged on a standardised basis.  For instance, management and/or performance fees can be charged on a monthly, quarterly, half-yearly or annual basis, but they must be accrued for at least monthly. 

-   They may be charged, on the opening NAV at the start of the period, the closing NAV at the end or, on the average, during the period.

-   They may be charged before all other fees, or after all other fees.

-   They may be subject to a benchmark, or a hurdle, which could be a market index, such as the S&P500, or a specified fixed return, or a variable rate  say three month LIBOR.

-   The accrual of these fees, including the calculation of the performance fees, after allowing for the benchmark, then has to be adjusted in the event of a redemption, because, even if the rest of the Shareholders arent due to pay their performance fee yet, the redeeming Shareholder will have to pay any performance fee due on its investment.

-    All this is a relatively complicated accounting process, but can be achieved automatically, if the Administrator has the appropriate system.

The real problems occur in this area with Equalisation, which is the term used to describe the various accounting processes designed to ensure that the performance fee due to the Investment Manager is allocated fairly between all Shareholders.

Most people assume that Equalisation is only needed in order to ensure that the Investment Manager receives the full performance fee due to him and that an investor who buys on a dip does not get a free ride.  Let me briefly explain:

-    If a Fund starts trading at $100 per Share and the market rises to $120 at the end of an accounting period, then an incentive or performance fee will be paid, which, if it is a 20% incentive fee, would be $4.

-    The Investment Manager would not receive any further incentive fees until the NAV per Share had reached $120 again  the High Watermark.

-    Let us assume that the Fund suffers a drawdown to US$90 per Share, at which point a new investor subscribes.

-    If the value of the shares now rise from $90 to $120 at the end of the fee payment period, the $30 profit made by that Shareholder would not incur an incentive fee, because the Investment Manager would not be entitled to claim an incentive fee, until the NAV had reached $120.  So that Shareholder would receive a $6 (20% of $30) free ride.

Equalisation eliminates this anomaly.

As I said, most people think the free ride was the main reason for bringing Equalisation in and they are correct.  Undoubtedly, that is why Equalisation was introduced in the first place.  However, mathematically, it can be proved that, if investors subscribe into a Fund between performance fee payment dates then, regardless of whether the price of  the shares had risen or fallen in the meantime, some Shareholders will pay a proportionately lower incentive fee than they should, and so conversely, others will pay a higher incentive fee than they should.  Thus, unless Equalisation is applied all the time, some Shareholders are subsidising other Shareholders, to their own detriment.

I do not intend to go into the mathematics of Equalisation today, because it is a subject that could take up a session on its own, if not a morning, but if anybody would like to know more about this, then please give me your name afterwards and I will send you a copy of a brief explanatory paper on the subject.

My fourth topic is:

4.         How to go About Selecting an Independent Administrator
Due Diligence or What to Look For, What to Ask

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 that, whereas almost all Investment Managers would expect any sophisticated investor to carry out serious in depth due diligence, on the Manager, on the Manger's trading techniques, past performance, checking references, reviewing systems, in fact delving into everything, yet those same Investment Managers, when acting as promoters of funds, often 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 this candidate is still in the running, you then need to carry out further checks and assessments including:

-        Get references and be clear about what the references say - and what they dont 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 wouldnt touch this company with a barge pole" and that is 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.

-        You should visit their offices and see what they do and how they do it.

-        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 hasnt handled the instrument doesnt 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 Administrators 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, as I have already suggested, your first step should be to send to your shortlist of Administrator candidates, a detailed Questionnaire, which should ask many of the questions that I have highlighted above, as well as many more.

This presentation is not supposed to be a commercial for my company, and myself but I hope you will forgive a blatant plug for AIMA, of which I am Deputy Chairman.  AIMA  the Alternative Investment Management Association  has recently, last Friday, in fact, announced the publication of its new guidelines for Due Diligence Questionnaires for many different participants in the Hedge Fund industry.  These include suggested guidelines with regard to questionnaires for Administrators that might be issued by both Managers and Investors.  These and other Due Diligence Questionnaires, including questionnaires for Hedge Fund Managers, CTAs, Prime Brokers and Funds of Funds are available to members of AIMA so, if you are not a member, you should join now.

Commercial over.

The answers to that Questionnaire and the visits and other recommendations that I have made, should enable you to select the winner of the beauty parade.

Finally when you have done all of this - finished the beauty parade - dont go for the cheapest, go for value.

Remember, as I said before, 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.

The fifth topic is:

5.         Who is the Client of the Administrator  The Manager or the Investor

The answer is, of course, Both, but only so long as the Fund Manager is fulfilling its responsibilities to the Shareholders.  Ultimately, although the Administrator may have been selected by the Fund Manager, the Administrators contract is with the Fund.  Thus, the Administrator has been retained by the Board of Directors of the Fund to act for the Fund and, as such, the Administrator has a fiduciary responsibility to look after the interests of the Shareholders.

When it comes down to it, the Administrator has a variety of responsibilities, including, for example, seeing that the Fund complies with its investment restrictions and seeing that one Shareholder is not treated differently to another.  The Administrator, of course, has a conflict of interest here because it gets paid by the Fund and, if it takes a drastic step, that may upset the Fund Manager, then it could lose the contract.

But it is better to lose the contract than to lose your reputation.

We have, in the past, been instrumental in closing Funds where we thought that the investment strategy had got out of hand or, on a couple of occasions, where the Net Asset Value of the Fund had been decimated by trading  losses, with the result that the operating costs of the Fund were untenable.  We, therefore, took steps to persuade the Investment Manager to close the Fund.

I am glad to say this is a very rare occurrence and, for the most part, the Administrators responsibilities and duties to the Shareholder, coincide with the Fund Managers.  This is because the vast majority of Fund Managers are honest and have integrity, regardless of the impression you may get from the press and the Administrator and the Fund Manager are almost always able to work together in the interest of the Shareholders.

And my final topic is:

6.         Creating a Long-Term Relationship  Common Problem Areas

It goes without saying that long-term relationships 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 Administrators 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 Administrators 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 dont 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 wont 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 Administrators 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 clients 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.  Its just one of those facts of life that occasionally you have a situation where two  people just dont get on and so you have to appoint another account executive  you cant 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 a 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.  Thankfully, these are rare instances.

The most important factor in a long term relationship is mutual trust and understanding.

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, 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 doesnt know whats 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.