Hedgefund.net has published a new survey of fund administrators as of Q1 2008. Usefully, the survey breaks our AUA ("assets under administration") between single manager funds and fund of funds: total single manager AUA is stated as $2.759 trillion (representing over 13,000 individual funds), while fund of funds held $1.389 trillion.
Per HFN, the largest single manager administrators are, of course, the usual suspects:
There are some issues with these statistics, however, as there are some very notable absences. Fortis is not mentioned; neither is State Street. The latter have combined their IFS outsourced back office business with Investor Bank and Trust's Investors Fund Services admin group and, per a HFM Week survey as of Q3 last year (see our earlier post), would have had over $300 billion on a combined basis. We wonder if Fortis and State Street simply declined to respond to this particular survey.
This point makes us think of several issues investors should consider when reviewing this type of information about the administration industry.
1) As above, the surveys may have respondent bias: certain firms may choose not to respond.
2) As we have often discussed, not all administration servicing is created equal. There are enormous variations in detailed accounting and, particularly, valuation practices between funds serviced by even the same administrator. Due diligence is always required.
3) Certain administrators continue to focus on the unwelcome practice of NAV Light (under this process, administrators do not maintain their own accounting records, but simply check - to varying degrees - the manager's own NAV calculation.) We continue to believe that the main reason for the popularity of this service is that it allows funds to "check the box" and tell investors that they do have an admin, notwithstanding that there is no full administration servicing. Some investors have policies whereby they will not invest unless an administrator is in place: NAV Light allows funds to meet this criteria, if only on paper.
On this point, investors need to become more discriminating: the point of paying for an administrator is to pay for effective, independent oversight. Investors should not be satisfied with restricted, NAV Light procedures.
4) Certain administrators' businesses have grown more by concentrating on outsourced back office services than fund administration servicing. Running a manager's back office is not the same as acting as a fund administrator: in one situation, you are an outsourced provider for the manager, in the other you are an independent watchdog tasked with protecting investors and ensuring an independent, accurate NAV calculation.
Investors should always ask their administrators a very simple question - who is your client? If the client is the manager, then it goes without saying that the admin's fees should be paid by the manager, not the investor.
5) Consolidation has brought an increase in the number of administration firms owned by prime brokers. This raises two issues: firstly, PB owned firms, in our experience, have the widest exclusions of liability and may accept absolutely no responsibility for pricing, for example. A recognized name does not necessarily mean more comprehensive service.
Secondly, how effective are the Chinese Walls between the admin group and the bank's sales desk? There is an obvious and material conflict of interest if an admin group is cutting a NAV of a fund holding a book of, say, CDO positions which were sold (very lucratively) by the same bank's sales desk. If a fund generates very significant commission and sales revenue, what would happen if the administration group had a significant disagreement with the manager over pricing? Investors need to ask specific questions as to the management of conflicts of interest.
Overall, we continue to believe in the value of effective fund administration. That said, the evolution of the industry is causing us great concern: we see administrators aligning their businesses and services increasingly towards the manager, not the investor, and have noted a very rapid decline in administrator oversight over valuation. These are topics we have discussed before, and, we are sure, are issues to which we will return.
We recently commented at length on the issues which arise when traders and portfolio managers are put in charge of pricing their own portfolios. In particular, we highlighted that the the institutional world has already given us plenty of examples of what could happen in a hedge fund if the PM's are in charge - notably Credit Suisse's multibillion dollar loss related to CDO valuations.
As an addendum to our comments, we were unsurprised to see the same thing happening again: this time it's Merrill Lynch. According to Bloomberg, the bank is "probing one of its trading desks in London and has suspended a trader after discovering he may have overstated the value of some of the bank's equity derivatives." The damage? Just about 10 million pounds, or $20 million.
Interested readers may also want to check Greg Newton's post on the same topic at NakedShorts. As Greg says, how many times does this has to happen before someone...
One of our beefs has always been the lack of any material investment restrictions in hedge fund PPM's - typical offering documents are drafted so broadly that any potential investment is permissible. Common language will often say something along the lines of "The Fund has maximum flexibility to invest in a wide range of instruments including listed equities, sovereign and corporate debt, other collective investment schemes, options, warrants and other derivative instruments. Derivative instruments may be exchange traded or over-the-counter." Some documents are explicit to note that the investment manager has absolute discretion to pursue any investment opportunity.
As an aside, this is the basis of the case between some investors and the defunct Amaranth fund - the investors are suing the fund on the grounds that the portfolio had become unduly concentrated and was hardly the diversified "multi strategy" product they had been promised. The fund, meanwhile, is defending itself with the argument that its offering documents fully disclosed its unrestricted ability to make any type of investment. In other words, whatever we do, you can't sue us.
Against this background, we often made the joke that hedge funds could probably buy a racehorse if they wanted to and still follow an investment strategy "in accordance with the terms of the PPM." Well, it appears now they can.
"International Equine Acquisitions Holdings hopes to form a publicly traded company and a hedge fund, both of which would seek to marry two worlds that can be full of hard luck.
The group's value could increase dramatically Saturday if one of the two Kentucky Derby contenders that they co-own -- morning-line favorite Big Brown or Court Vision -- wins the classic. The value also could jump tomorrow if Pure Clan wins the Kentucky Oaks. IEAH has a stake in the filly.
"Basically it would be an investment in a portfolio instead of in an individual horse," said Michael Iavarone, one of the principals. Owners could get in or out at any point."
We await the fund's valuation policy with interest.