Has third party administration become a necessity?

Investor driven demands for increased operational infrastructure grew exponentially with the decline in assets across the hedge fund industry. 2008 was a rapid turnabout as funds which had set high minimum investments, high fees, or had been previously closed to new investments found themselves agreeing to investor demands in the hopes of stemming redemptions and the dreams of securing allocations. As the year closed out with the revelation of the Madoff fraud, one of the objects investors focused on with laser-like intensity - was demanding hedge funds have independent, third-party administrators.

According to research firm Carbon360, which publishes the Fund Administration Fact Book, the traditional role of the hedge fund administrator is to provide back-office support by taking responsibility for operational, accounting, and regulatory tasks, thereby allowing hedge fund managers to focus on executing their investment strategies.Source In addition to these responsibilities, administrators also provide NAV estimates which have grown from monthly reporting to weekly and even daily reporting; communicating with investors via statements preparations, takes responsibility for antimony laundering services; process subscriptions and redemptions; ensuring compliance with domicile regulations; maintain statutory books and records and conduct annual shareholder meetings; amongst many other responsibilities. Although this outline of responsibilities seems clear, the relationship between hedge funds and independent administrators is a complicated one, fraught with both dependence and disdain. “98% of all hedge funds view administrators as a waste of money and a necessary evil that they are forced to use because of their investors,” says Jason Scharfman, Managing Partner at Corgentum a hedge fund due diligence consultancy.

Often, firms that started managing only internal assets have built their own administration systems and view changing to a third party as a cost-incurring requirement to secure outside investments. On the other end, administrators balance the need to serve two masters; the hedge funds who hire them and the investors they need to protect. But the tension of this relationship may in the end serve to strengthen the industry as a whole.

At launch, when investor numbers and budget constraints are on a lower scale, managers often look to administrate in-house. Others, such as quant funds act as their own administrators because of the amount of trading they do. “Many have spent millions on their administration systems,” says Christopher Kundro Co-Chief Executive Officer LaCrosse Global Fund Services.

LaCrosse had its own beginnings in this way. Cargill Global Capital (which became Black River Asset Management) began an administration platform when they were unable to find one that could adequately handle the many asset classes the fund was trading. LaCrosse finally spun out of the firm in 2007 to become its own, separate entity.

Are third party administrators necessary?
In the wake of the Madoff scandal institutional investors (with UBP leading the way) ramped up their demands for funds to secure third party administrators or risk redemption. Opalesque reached out to US institutional giant CalPERS to see if this policy had taken hold as a general standard. The CalPERS hedge fund program makes investments in 26 US based hedge funds and 9 international fund of hedge funds.

Since launching their Risk Management Absolute Return Strategy in 2002, the pension fund has invested in hedge funds without having a specific policy requiring third party administration. Instead, a CalPERS spokesperson told us “We work very closely with our external funds and have a very fine-tuned due diligence process for a few funds, that we may add to the program from year to year.”

While CalPERS has the resources to do their own, continual, in-depth due diligence, investors in hedge funds are being advised by many different industry groups to press for third party administrators. AIMA recently released their Guide to Sound Practices for Funds of Hedge Funds Managers that recommends FoHF managers require “independent and reputable third party administrator” of underlying hedge funds.

It also advises FoHFs to encourage their own investors to communicate directly with the administrator/custodian for the FoHF with respect to each investor’s own transactions.

Hedge funds such as UK-based commodity fund Ebullio Capital Management, which has successfully raised funds during the past few months acknowledge the change in investor attitude towards operational due diligence. “Due diligence is much harsher and much more rigid. They look a lot deeper than they did historically.”

Ian Tracey, co-founder of Acceleration Capital, a firm that works with both managers and seeders confirms that for investors, “Triangulation of oversight facilitated by third party administration is paramount.” The requirement has become enough of an industry standard that seeders looking to maximize their own return on investment by helping funds reach AUM goals will almost always require a fund have a third party administrator in place.

In the recently released San Francisco Opalesque Roundtable (Source), the value of third party administrators arose several times. Administrator importance was cited directly in reference to fundraising activities, to which hedge fund consultant Bucky Isaacson, of Futures Funding said, “I also tell people who call me for advice to pick their attorney and administrator very carefully. Of course most of the professionals can do a competent job, but part of the benefit an attorney can give you is networking with potential capital sources. And the better they are plugged in, they may be able to give you some referrals, and the same refers to the administrators.”

Mitch Levine of Enable Capital Management used his own experience as a startup manager (in 2003) who began with $1.1m in assets and a plan for track record to eventually lead to capital raising. The plan worked, as five years later Levine was managing $450m in assets, but in addition to track record he attributes this asset raising directly to the third party service providers the firm employed.

“So it can be done, but it can’t be done without first-rate service providers, which gave us much-needed credibility. Let me come back quickly to the position of a start-up manager. Running the business of being a hedge fund is so complicated, so convoluted and most founders, including me, are money managers and might not have the capability to manage a business. Fortunately, now six years later, I think I have a good idea of how to do it, but not without our administrators who are there every step of the way,” he says.