Finding the right partner

Selecting a fund administrator from the perspective of a hedge fund or fund of hedge funds is a complex and challenging task. As more funds look to administrators to provide additional outsourcing functions, Kris Devasabai discusses the challenges.

Investor concerns about potential fraud and a lack of transparency from hedge fund managers have underscored the importance of appointing an independent administrator. However, finding the right administrator for a hedge fund is more complex than it might first appear.

According to experts in the field, there are over 75 companies around the world offering administration services to hedge funds. The landscape is diverse. Fund administrators cover the spectrum from small boutique businesses to multi-jurisdictional investment banks and everything in between. This means selecting the right administrator for a hedge fund can be a complex and time-consuming task.

Before attempting to select an administrator, the fund manager must first establish the fund's operations strategy and clearly define the requirements of the business, says John Hamrock of Kinetic Partners, a consultancy company specialising in advising asset managers. "The manager has to understand his needs before he can begin to assess the administrators in the market. This will narrow the field and make it much easier to find an administrator that is a good fit for the fund," he says.

Once the requirements have been agreed on, it should be possible to identify potential candidates. Administrators interested in bidding for the contract are usually asked to complete a written due diligence questionnaire. This will at the very least help the manager to eliminate unsuitable candidates with the minimum of fuss.

The Alternative Investment Management Association (AIMA) has produced illustrative questionnaires for due diligence on fund administrators which can help the manager to create their own versions. Managers must carry out thorough due diligence including on-site visits on the final short list of administrators that meet their basic requirements before making a final choice.

The reputation and brand of the administrator does not in itself guarantee good service, cautions Glen Griffin, chief financial officer (CFO) of Concordia Advisors, a multi-strategy hedge fund manager with locations in Bermuda, London and New York.

Griffin advises hedge fund managers to look beyond headline figures like assets under administration (AUA) and focus on the experience and service model of the administrator. "The salespeople know all the buzzwords but you need evidence that the company can actually provide the service that is being promised. It is always a good idea to contact some of the administrator's existing clients for references," he says.

An administrator may have sizeable AUA but if its clients are mostly funds of funds, then it may not be the best fit for a complex multi-strategy fund or one that trades exotic instruments, notes Griffin. He says managers need to get to grips with the capabilities and background of the administrator as part of the due diligence process. "The ideal scenario is to find an administrator with a client base that is similar if not identical to your business," he says.

New York-based multi-strategy Diamond Notch Asset Management grappled with many of these issues in 2007 when it searched for a company to provide administration and middle- and back-office services for its funds. As a multi-strategy fund manager, one of the main challenges for Diamond Notch was finding a company with experience of processing and valuing the wide range of instruments and geographies traded by the firm, says Steven DiNunzio, CFO of Diamond Notch.

"Fund administration is fairly commoditised if you are talking about vanilla strategies like long/short equity. But if the strategies and instruments being traded are more complex, it becomes that much harder to find an administrator that can provide a good service," says DiNunzio.

The search eventually resulted in the appointment of LaCrosse Global Fund Services, which launched earlier that year. LaCrosse was a spin-out of the back office of Black River Asset Management, the hedge fund subsidiary of Cargill. Although it had yet to establish its reputation in the market, DiNunzio was impressed with its capabilities and its history as the back office of Black River.

Diamond Notch outsourced its fund administration and middle- and back-office functions to LaCrosse when it launched in December 2007. That choice has worked out well, says DiNunzio. "Working with LaCrosse has meant we have the benefit of their infrastructure and experience, while keeping things lean and flexible on our side," he explains.

Outsourcing its middle- and back-office requirements has allowed Diamond Notch to concentrate on developing its asset management business without the distraction of building a complex operations platform, says DiNunzio.

Outsource wisely

Deciding on services to be outsourced to the administrator is a strategic one for the fund manager. The basic service provided by the administrator includes independent reconciliation and valuation of positions, net asset value (NAV) calculation and the processing of subscriptions and redemptions. Most administrators also offer a wide range of additional services covering everything from back- and middle-office outsourcing through to capital introduction and marketing support.

One service that is attracting interest in the current environment is enhanced risk reporting for investors. Administrators are in an ideal position to provide this type of information to investors because they have access to the reconciled positions of the fund.

"There is a growing demand among investors for greater transparency and reporting. A manager with a small number of clients can probably handle this in-house, but as the fund grows, it could make sense to outsource some of this work to the administrator, leaving the manager free to focus on the portfolio," says William Lloyd, managing director of Coral Bay Capital, which gives strategic advice to investment managers.

Hamrock says it is worth looking at the full breadth of services offered by the administrator even if the contract will initially be limited to traditional services. As circumstances change, the administrator could become a valuable source of operational support, he says, pointing to the risk-reporting services provided by hedge funds as one example.

"That type of service could become very important if some of the regulations currently under consideration are enacted," he explains. The proposed EU directive on alternative investment fund managers includes a requirement to appoint an independent risk evaluator. "If that comes into effect it could be useful to have the option of outsourcing that to the administrator," says Hamrock.

Listen to investors

In the current environment it would be foolhardy to ignore the perceptions of investors when selecting an administrator. It has become standard practice for investors to carry out reviews of the administrator as part of the due diligence process. This has taken on added significance in the wake of the Madoff fraud, to the extent that the quality of the administrator has a significant influence on the eventual investment decision.

Appointing an administrator with an established brand and reputation in the industry could be a smart move, even if it comes at an added cost. "The objective is not simply to appoint an independent administrator, but one that investors are actually going to be comfortable with," says Lloyd.

Having an administrator with name recognition might give investors an additional note of comfort, says Lloyd. Reputation is an important consideration, agrees Hamrock, but that does not mean the search needs to focus exclusively on the biggest players.

The larger administrators have minimum requirements for AUA which exclude most start-up managers and smaller fund groups from becoming clients, notes Hamrock. "Look for companies that are growing and have a reputation for administering the type of strategy that you are running. The hedge fund world is very diverse, and some smaller administrators may have a better reputation than their larger competitors in certain strategies and markets," he says.

The main concern when selecting an administrator is the avoidance of conflicts of interest, according to a source at Conrad Capital Management Consultants, who declined to be named. To perform its functions effectively, an administrator needs to be impartial and independent. This raises concerns about the appointment of administrators affiliated to the prime broker of the fund.

According to Conrad Capital, the central function of the administrator is to verify information independently about unlisted and illiquid investments. This information is typically supplied by the fund manager and the prime broker. He questions whether an administrator affiliated to the prime broker is likely to critically assess and challenge this data.

"There should be a clear separation between the roles of the fund manager, the prime broker or custodian and the administrator. But the reality is the administrator is often hired on the recommendation of the prime broker, and they will always seek to push their own services," says the source.

For the most part, investors have been in the dark about the inter-relationships between the people safeguarding their assets, he adds. This is slowly changing. "Pension funds are going to start insisting on a clear separation between the administrator and prime broker. Funds which currently rely on their prime brokers for administration services may be forced to appoint an independent third party to verify those assets. Fund managers should take steps to avoid such a situation from the outset," he adds.

Hamrock advises managers to talk to others in the industry to get a sense of the credibility of different administrators in the market before making a selection. Fund managers, prime brokers, audit firms, lawyers and consultants can all provide some useful insight into the market, Hamrock says. "Wherever possible you should speak to some of the existing clients of the administrator and find out how satisfied they are with the service."

Other areas that need to be carefully examined as part of the selection process include the technology platform and service model of the administrator and the experience of its staff members. Hamrock says it is possible to differentiate between service providers on these factors.

"Companies are moving at different speeds," he says. "The big banks entered this business through acquisitions a few years ago. The key issue here is how these businesses have been integrated within the bank and the service model that has been created around that. The other main differentiator between administrators is the level of commitment to technology. Administrators that have invested in improving their technology are in a better position. Given the complexities of the hedge fund business, automation is a distinct advantage."

Technology was among the main factors considered by Rose & Sky Investments when it decided to outsource its middle- and back-office functions to PNC Global Investment Servicing earlier this year. Based in Switzerland, Rose & Sky specialises in market neutral strategies.

One of its key requirements was that the administrator should be able to support the daily redemption cycle of its fund. PNC was selected because it was able to provide a seamless system for the daily processing and reporting of fund information, says Anthony Lombardi, chief operating officer (COO) of Rose & Sky Investments.

Lombardi found all the administrators he looked at "could perform 75% of the services to the same high standard". But there were differences elsewhere which helped Lombardi to settle on PNC.

"One was a willingness by very few to look outside the box and do something differently. And the way they dealt with ideas. It has been a great learning experience for both of us. They are very professional and they are not rigid. These guys work terribly hard; they are willing to look at an equation from all sides," notes Lombardi.

He says fund managers should look to the long term when selecting an administrator. "Ideally pick where you want to be in five years," he says.

Any change in the administrator, lawyer or auditor of the fund will have to be reported to the regulator and may raise eyebrows among investors, so it is not an appointment that should be made lightly. "It is not a penny-pinching exercise. You have to have someone who is good, not someone who is the cheapest," adds Lombardi.

Keep an eye on costs

However, cost is clearly one of the major considerations when selecting an administrator. The decline in assets under management has hit the hedge fund industry hard and keeping operational costs low is a priority for many managers. Fund administrators have felt the pressure too and many have taken steps to reduce their cost base.

The quest for economies of scale has led many of the larger administrators to adopt a factory model. Functions like reconciliation, accounting and transfer agency are concentrated with specialist teams. In some cases certain functions have been offshored to low-cost locations like India and Poland. "That type of model makes sense from a business perspective, but the administrator needs to bring it all together on the client service side," reminds Hamrock at Kinetic Partners.

The solution is to have a single point of contact for client relationship management who can work internally to resolve issues on behalf of the manager, says Hamrock. "It can make a big difference, particularly with the larger administrators. Otherwise you can find yourself going around in circles trying to find the answer to even the simplest of questions," he says.

Diamond Notch carried out extensive due diligence on the administrators it was considering for selection. Experience and expertise were the top priorities, but DiNunzio and his team at Diamond Notch also looked at the business model of the administrators in the market.

"A lot of the big administrators were off-shoring parts of the operations to places like India and de-skilling each function. That did not appeal to us. We trade a lot of esoteric products, so it is important for us to be able to pick up the phone and talk to someone who understands those products and is able to explain the issues," he says.

Another factor DiNunzio paid particular attention to was staff turnover. "Some administrators had massive turnover. But we did not want to be in a situation where our contact at the administrator would change every few months," he says.

LaCrosse had offices all over the globe but its operational hub was in Minnesota, in the American Midwest. This appealed to DiNunzio. "Their employees had strong backgrounds and many of them had previously worked in London and New York. The Minnesota connection meant that many of them had returned home to settle down. We felt that would help to keep turnover at a minimum," he says. That has proved to be the case. DiNunzio says Diamond Notch has had the same people servicing its operations for the past two years.

For Griffin at Concordia Advisors, the quality of people employed by the administrator is perhaps the top concern. "The administrator may have a robust platform and strong backing at the organisational level, but ultimately it comes down to the quality of personnel assigned to your account," he says.

Check the staff

He advises fund managers to really dig into the staffing policies of the administrator before making a selection. "Who are they employing to do the work? Are they all qualified accountants? The experience of the team is very important," says Griffin. He says it is important to meet with and get to know the people that will be working on the account before making the final choice of administrator.

He also highlights staff turnover and the work environment at the administrator as other areas worthy of further investigation. "It is important to have some comfort that the staff assigned to your account will be around for a few years. You don't want to be in a situation where every few months you have to educate their employees about your fund and your account," says Griffin. The quality of service can fluctuate markedly if there are frequent changes in personnel, he adds.

In August, London-based Islandbridge Capital appointed Quintillion to provide administration services for its Islandbridge Multi-Manager Fund. The company scored each administrator it considered according to a matrix of around 15 criteria, ranging from size and service to IT infrastructure, market reputation and price, says Joseph McCarthy, managing director and founder of Islandbridge Capital.

"There were big differences in the culture of the various administrators and the product offering did differ when you got under the bones of the service. There was a difference between the bigger administrators that were part of banking organisations versus the independents, but some played to their strengths and weaknesses better than others," says McCarthy.

The final decision to appoint Quintillion was based on the strength of its technology, the general sophistication of the team and its approach to client service, says McCarthy. "We felt we would be treated well as a start-up," he adds.

Before making the final decision, McCarthy canvassed opinions from other funds, lawyers and investors. His advice is to take nothing for granted. "Ensure the administrator assumes responsibility for their role and takes seriously their independence. Be careful of firms with high staff turnover. Get to know who will be your day-to-day contact," he says.

A final factor that managers ought to consider is the balance sheet and financial strength of the administrator. Administrators have seen revenues fall as a result of the contraction in hedge fund assets over the past 18 months, and Hamrock believes the sector could shrink by more than 30% in the foreseeable future.

"A number of administrators are likely to be acquired in the near future. That is not necessarily a bad thing for clients. Being acquired by a larger entity could lead to a broader product offering and more investment in technology, but it is certainly an issue that needs to be raised during the selection process," concludes Hamrock.