In the past two weeks, Fortis has been rescued not once, but twice. While hardly at the top of the priority list in times of global economic meltdown, it's still an interesting question to ask what would have happened to Fortis' administration business if the bank had ceased operations.
Thinking of a different point, it's also ironic - and fortuitous - that Lehman was one of the few of the prime brokers which had not decided to create a fund admin sideline to help attract managers to the firm's PB services.
In this environment, however, both hedge fund managers and investors need to evaluate the stability and viability of fund administration entities. There is both a possibility of direct bankruptcy and also a risk that a parent entity in financial distress could decide to close a peripheral admin business in short order.
We can immediately think of several issues:
1) If the administrator goes bankrupt, do funds have a contingency plan in place to enable them to continue operations? Do hedge funds have copies (ideally electronic) of the administrator's accounting which could be given to a new provider?
While audit firms in the US may not agree with us (they tend to audit the manager's accounting and largely ignore the admin), the offshore administrator's accounting forms the official books and records of a hedge fund. If the administrator is no longer in business, does the fund have a contingency plan to recover those records so that the next NAV can be struck on a timely basis?
2) Administrators usually control cash movements for subscriptions, redemptions and fund expense payments.
Do these cash movements pass through a cash account within the administrator? This would, of course, expose a fund to loss if cash is sitting in an account at the time of bankruptcy.
More discreetly, does the administrator use some form of commingled Escrow account to receive incoming subscriptions and perhaps hold cash until anti money laundering procedures have been completed? Are hedge funds sure that these assets are properly segregated and controlled?
Separately, if the administrator is the only one with signing authority over the offshore bank account, can the manager withdraw any residual cash and process new redemption and expense payments if the signatories are no longer available?
3) If administrators complete anti money laundering and know your customer checks, does the hedge fund have access to these records to prove that AML has been performed in the event that the admin is bankrupt?
4) Does the hedge fund have access to the full shareholder's register / list of partners capital accounts to identify all investor balances in the event that the administrator is bankrupt?
More generally, it's worth noting that many administration companies are small, independent firms which may not be well capitalized. In an environment which sees a sharp fall in hedge fund assets through both negative performance and net redemptions, administrators' fees will also fall. Administrator financial viability is, therefore, a real issue for both managers and investors as we navigate the coming year.
Hedge Fund Operational Due Diligence
Interesting post. The answer to points 3 and 4 will be no in those jurisdictions that have bank secrecy laws. Luxembourg is one of these, and I suspect Cayman may be as well.
However, what is the risk that an administrator stops functioning from one day to the next? Even in bankruptcy, there will be a period, before employees are fired / start leaving, that will allow some sort of organised handover to new administrators to be carried out.
Posted by: European Bear | October 14, 2008 at 01:31 PM
Two questions to add to that admin DDQ: "Is the administrator profitable?", and, "Does the administrator have any debt?".
Remember, fund admin was a low margin business in the BEST of times...
Will this set off another round of admin M&A for 2009?
Posted by: The Optimist | October 21, 2008 at 04:48 AM