Risk Without Reward

Rethinking Fund Administration 1.5

In one of our last posts, we began a series of comments discussing the current state of the hedge fund administration industry, with a particular focus on valuation.  We promised that our next post would address some solutions to the "valuation dilemma", and we will return to this topic shortly.

However, we were interested to read the new version of the AIMA Guide to Sound Practices for Hedge Fund Administrators, published in September (available here).  This includes, as would be expected, commentary as to the role and responsibilities of the administrator regarding valuation.  

Before we go to our second post on solutions, we thought that it would be useful to make some comments on the AIMA paper - which holds itself out as the central benchmark of administrator "sound practice" - as an addendum to our prior post.  We hence have some comments on rethinking hedge fund administration 1.5.

The point we would like to make is to compare what AIMA now say in 2009, with what they used to say in the first version of the administrator sound practices guide, which was published back in September 2004. 

In Section 3.2, Security Pricing, the "Old Guide" stated:

Security pricing is a high-risk area for administrators, managers and prime brokers. It requires high quality data feeds, automated price validation systems and highly experienced staff. The risk of applying the wrong prices to a fund is ever present and extreme care is required to avoid this and any consequent reputational damage to the manager, administrator and prime broker.

It is also vitally important to consider the independence of the pricing process. Wherever possible, the administrator must independently price the assets of the fund. This is essential to preserve the actual and perceived independence of the NAV process and to protect the manager from accusations of bias. If the pricing environment of the fund is not rigorous, then the investors could be exposed to the risk of incorrect pricing.

However, there will be occasions when valuations of certain instruments can only be made by the manager and the issuer of the instrument, or by the manager alone. In such situations, it is important that the method of valuation is agreed with the administrator and the auditor before the fund is launched and that there is some way for both of them to check the pricing of the instruments during the life of the fund. The administrator should be able to assess the “reasonableness” of the manager’s and/or product issuer’s price.

We would completely agree that it is "vitally important to consider the independence of the pricing process".  Moreover, even for the hardest to value securities, AIMA's 2004 guidance states that the administrator (and auditor) must find "some way for them both to check the pricing of instruments during the life of the fund."

When getting to the very hardest to price securities, the Old Guide states:

In some cases, the administrator may be required to rely on prices determined by the manager, using its own pricing model for some specific complex derivatives instrument, for example. Although this is not desirable, there may be no alternative. In such cases, the administrator should:

1. ensure that the valuation procedure whereby the administrator is obliged to value the fund’s portfolio on prices based on the manager’s pricing model or formula is fully disclosed in the offering documents and the administration agreement;

2. ensure that the manager discloses both to the administrator and the fund’s auditor how the pricing model works and permits the auditor to carry out spot checks from time to time, to verify correct application of the pricing model; and

3. if possible, install the pricing model on its own system so that it can check the prices provided by the manager.

Armed with their own sources and the counterparty’s valuation, the administrator should be in a position to value the OTC position competently.

These provisions, therefore, provide specific guidance to the administrator when looking at OTC trades and, overall, create a "do as much as you possibly can" mindset.  The guide continues:

Security pricing is a highly skilled area, requiring highly trained and knowledgeable staff. It should not be done by “part-timers” nor should there be duplication of effort. Ideally, each security should be priced once for all funds holding that security at that time. Control of this function is one of the central obligations of the administrator, who should be employing common pricing procedures across all of the funds it administers.

This again suggests that there is a clear responsibility for the administrator to both disclose any manager pricing and, moreover, do all that is possible to derive independent valuations.  We particularly like the comment that "control of the [pricing] function is one of the central obligations of the administrator."  Moreover, the Old Guide makes it clear that this work should be supported by suitably skilled resources within the admin's organization.

Well, what a difference five years makes.  These are the key comments on valuation from the New Guide:

In all cases, it is important to consider the independence of the pricing process. Wherever possible, but subject in all cases to the fund’s pricing policy, the administrator should seek independent sources for the valuation of the assets of the fund. However, there will be occasions when valuations of certain instruments can only be made by the manager and the issuer of the instrument, or by the manager alone. In such situations, it is important that the method of valuation is documented, checked where a secondary source is available and reported to the pricing committee or board, periodically.

OK.  So now it is "important", not "vitally important" to consider the independence of the pricing process.  There is also a big difference between "wherever possible, the Administrator must independently price the assets of the fund" (which means that the administrator's prices would be used in the NAV) and "wherever possible, but subject in all cases to the fund's pricing policy, the administrator should seek independent sources for the valuation of the assets of the fund."  Note also that we are now in a world where there "will", rather than "may" be occasions where valuations can only be made by the manager.  We continue:

The pricing policy document should be approved by the board or governing body of the fund on a regular basis (annually or when altered).

It should be noted that while some HFAs have people, teams and service models which are capable of, and expert in, the calculation of recommended prices for individual securities, many others are not. A hedge fund manager or investor should not automatically assume that the HFA offers this service, employs this expertise or takes this responsibility.

Particular attention should be given to the governance aspects of the AIMA Guide to Sound Practices for Hedge Fund Valuation, as the observance of their principles should avoid any misunderstanding or lack of clarity around pricing and responsibility.

The Guide notes that the area of valuation has been topical and, in some cases, controversial. The role of the HFA has regularly been questioned and many investors and other industry participants have asked: “Is the HFA responsible for valuations?”

The Guide notes (and agrees) that both the AIMA and IOSCO documents suggest that it is the governing body that is ultimately responsible for the valuation of assets. In most cases, this is a board of directors or a general partner. Typically, the board will set a pricing policy.

The main thrust of the new document, therefore, is to revert attention to the pricing policy (and how many funds actually have one which really is detailed and comprehensive?) and place the administrator in a secondary, reactive role.  The guidance is much more vague, and there is certainly not the same emphasis on the "essential" need for administrators to "independently" value assets.   Moreover, there is now room for "many" administrators not to be "capable" and "expert" in the calculation of recommended prices for individual securities.  

Our biggest comment though, is one we have made before.  It remains utterly, utterly and utterly ridiculous to suggest that a Board of Directors comprised of two gentleman in the Cayman Islands with corporate secretarial backgrounds, who serve on the boards of hundreds of other hedge funds, can be "ultimately responsible for the valuation of assets" and "set a pricing policy".  For investors who allocate tens of millions - or hundreds of millions - of dollars to individual hedge funds, this comment can best be described as disingenious fallacy.  In fact, it is an insult to the intelligence of everyone concerned.

We would also point out that investors can pay the administrator millions of dollars per year for their services on some larger funds, while the average Cayman director gets $5-10,000 per fund.  That would seem to place some framework around who has the better knowledge and who is better placed to get involved. 

Perhaps the best comment, however, is the final "sound practice" guideline.

The governing body and the HFA, together with the investment manager, will then agree on how that pricing policy is to be executed. There may be specific responsibilities placed on the HFA in the execution of this policy but investors should not automatically assume a standard model.

AIMA, therefore, leaves us in exactly the same place as our own experience of current administration servicing.  While some administrators do complete thorough and robust servicing, including detailed pricing, many do not.  The message from the industry to investors, though, appears to be fairly casual - don't take anything for granted, or "automatically assume" a standard model.  In other words, caveat emptor.

The real issue here - and one that must be addressed, sooner rather than later - is that post Madoff, post financial crisis, and post the greatest stress period the hedge fund industry has ever seen, hedge fund investors have increasing, not decreasing, exposure to managers pricing their own securities.  We would have thought that all this pain would leave us with more protections - but no, we continue with all the evident risks that go along with managers marking their own books.  Moreover, everyone concerned - managers, administrators, auditors - seem to assume that this is an entirely satisfactory state of play and, indeed, is "sound practice".  

As the boy said to the naked emperor, it is not.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence 

Rethinking Fund Administration: 1

Our comments on Risk Without Reward have frequently touched on the role, responsibilities, advantages and disadvantages of third party fund administration.  As a starting point, all of Castle Hall's partners have experience in the offshore hedge fund community, the traditional "home" of administration servicing ever since the days of the 10 commandments.  Given our backgrounds, we have always been very strong proponents of the value of third party oversight over hedge fund accounting and NAV calculation.  We continue to believe that effective administration servicing is universally the hedge fund investor's best protection against loss caused by operational failure, from honest mistakes to the worst case of dishonest fraud.  

We do, however, see a number of emerging trends in the administration industry which are gradually "changing the game".  Some developments in the administration servicing model, notably better application of technology, can be strongly positive for investors.  Other trends, however, appear to be less beneficial, with changes taking place outside the scope of investor input or intervention.  It is against this background that we would like to comment, in a series of posts, on areas where investors, managers and the administrators themselves could usefully rethink the third party oversight model.

Our first topic is, unsurprisingly, valuation.  In Castle Hall's recent white paper on hedge fund operational failures, "From Manhattan to Madoff" (available here) we noted that "misvaluation of fund assets is the most significant, unresolved operational risk for hedge fund investors."

Our particular concern was "the ongoing ability of some managers to price securities themselves."  We continued that "this practice is not in any way universal, but, unfortunately, becomes progressively more prevalent as instruments become more complex and harder to price.  It goes without saying that it is precisely those instruments which are the most difficult to value which are the most susceptible to pricing fraud - it is obviously very hard to fake the price of IBM common stock."  

We then commented on what appears to be a growing "expectations gap" in the administration industry, noting:

"Today, hedge fund investors continue to expect - rightly in our view - that third party administrators paid by investors to calculate a hedge fund's net asset value should independently value security positions.  However, many of today's administrators argue that they have no responsibility for pricing and that the administrator's role is limited to that of a 'verification' rather than 'valuation' agent. Indeed, we see an increasing trend for administrators to accept manager prices for hard to value securities without further checks."

It is against this background that we were interested to see GlobeOp's settlement with a hedge fund - which the Wall Street Journal and other news sources identified as the UK based Regents Park - related to "mis-priced position values provided by a principal of the hedge fund's investment manager."

According to GlobeOp's statement on interim results issued on August 27th:

"We have settled a long-standing claim brought in arbitration

by a former hedge fund client. The claim relates to GlobeOp's

obligation to calculate and distribute the net asset value of

the fund and the impact on that of mis-priced position values 

provided by a principal of the hedge fund's investment manager. 

The arbitration will be terminated and a settlement agreement 

was signed. GlobeOp expects that the cost of this settlement

will be approximately $27 million, net of $16.5 million

of applicable income tax benefits. The amount of the 

settlement is $43.5 million, with $20 million paid at 

settlement and the remainder paid over time with interest

equal to the U.S. prime rate. The last payment will be 

February 2011. The settlement will be paid out of existing

cash resources and will be a tax-deductible business

expense during the year in which each payment is made.

GlobeOp has no further liabilities outstanding in relation

to this matter and the issue will have no impact on

current and future clients. 

Regents Park itself was named by the UK FSA back in 2006 (see FSA news release here).  As an aside, it's interesting to see how the FSA can conduct an investigation which, at the time, did not involve "any finding of misconduct or breach of the FSA's rules" which nonetheless leaves the admin on the hook for nearly $50 million - we guess that's a different issue.  

The point of our discussion here is not to take GlobeOp to task with respect to whether they did or did not perform services in accordance with their contract with the Regents Park fund.  (We have not completed due diligence on Regents Park and, therefore, cannot comment on the specific administration servicing with respect to that fund.)  In this particular case, it is evident that GlobeOp have settled claims and have made a substantial payment to resolve the issue.

Rather, our observation is more general and is directed at the administration industry as a whole: it is self evidently a really bad idea to accept prices for securities that will be used in a hedge fund's monthly NAV calculation, when those prices have been provided "by a principal of the hedge fund's investment manager".  Guys, you need to check prices, and you need to check them independently.  As we have said before, a copy of Adobe Photoshop only costs a few hundred bucks if you happen to be a hedge fund manager who is keen on changing that broker quote which will then be forwarded to the admin.

Our next post in this series will consider some of the potential solutions for the valuation dilemma - our starting point is clear and transparent disclosure so it is at least evident what the administrator has priced and what they have not.  We will also touch on the use of third party valuation agents separate from the traditional administration companies: we see potential value in bifurcating the accounting function from the valuation process.  And, of course, we'll also say that investors will have to pay more money, including to the admins themselves, if we really want top tier servicing.

However, we do have one final observation in this post.  Anyone who completes due diligence on a reasonable number of hedge funds is familiar with the administration industry's attempts to avoid responsibility for pricing.  This is evident in the legal blurb now included in many fund offering documents, together with the pages of disclaimers in typical administration agreements (we particularly like the legal provisions stipulated by those administration companies owned by prime brokers, who are usually very clear to point out that they have absolutely no responsibility for pricing, even when a hedge fund uses prices different from what the same pb uses in its own businesses.)

Above, however, we have a case where a leading administrator did need to settle a case related to allegations of mispricing.  In GlobeOp's case, the $43.5 million settlement (pre-tax) needs to be set against the fact that the firm's revenues for the six months to June 30, 2009 were only $79.2 million. (GlobeOp, as a public company, does need to disclose its financial performance - as well, of course, as the terms of the settlement itself.  Privately owned administrators do not need to provide such disclosures, which makes it easier to shield such mishaps from public view.)

Taking a step back from all of this, what really strikes us is the huge business risk much of the administration industry seems to be taking each and every time they take a price from a manager without properly checking it.  

There are two potential problems.  Firstly, all an admin company needs is one of the firm's several hundred hedge fund clients to blow up due to faked valuations, and the financial impact could potentially be threatening to the entire administration firm.  We agree that the admins have sought to protect themselves with tight contracts which disclaim responsibility, but would a court of law actually uphold all of those terms?  We would expect that there is at least some chance that a court, dependent on the facts and circumstances involved, could find that an administrator did at least have some baseline duty of care to check for valuations which were clearly incorrect.  We remain puzzled as to why admins would accept the risk that one bad apple could wound - or even kill - the entire firm.

Secondly, the administrator's greatest friend is the investor, who continues to push for third party oversight.  Many managers, however, would quite happily operate without an admin if they had the choice and didn't face investor pressure.  Administrators, therefore, need to keep the investor community convinced that their servicing is valuable and worth the money.  

The risk here is that, if there was a significant hedge fund failure caused by mispricing, the administration industry would not make friends if their response was "ah, but we did not actually have any legal obligation to check prices and were entitled to rely upon information furnished to us by the investment manager."  The worst case scenario for the administration industry as a whole would be a loss of investor confidence, should investors be faced with a fund failure where it would seem that the admin got paid but didn't do their job.  A lack of investor confidence in such an outcome - which we certainly hope will not arrive - would hardly help anyone.

Again, our next post will examine some of the potential solutions here, with a focus on short term initiatives which could better clarify the role and limits to current admin servicing.  In the long term, however, the "expectations gap" remains.  Ultimately, if you don't price the portfolio yourself, you have not calculated the NAV.  That is the 800 pound gorilla at the back of the room for all administration service providers.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

 

How will the credit crisis impact the administration industry?

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.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

Hedge fund assets approach $3 trillion

Following on from our recent comments on the Hedgefund.net administration survey - which showed industry assets at $2.759 trillion - the FT reports today on a further administration survey, this time by HFM Week, which puts industry assets at $2.9 trillion.  We await the first survey which puts industry assets above the $3 trillion bar.

In fact, we may well be over $3 trillion already: the Hedgefund.net survey did not include the substantial assets administered by Fortis and IFS which amount to at least $300 billion.

Aside from the question of industry growth, one other comment in the FT caught our eye.  Providing a description of hedge fund administrators, the paper commented:

"They are used by almost all European hedge funds and an increasing number of US funds, who are under pressure from investors to provide independent valuations."

Readers of this blog will be familiar with our opinion that today's hedge fund administrators increasingly provide less and less oversight over valuation (as our prior post, "should administrators stand behind their work" discussed.)

One of the biggest fallacies in the current hedge fund industry is the ongoing assumption by far too many investors that, if a recognized administrator has been appointed, that administrator will calculate the NAV and price the portfolio.  As we have discussed before, most administrators are emphatic that they are not responsible for security valuation (although exactly who is responsible for pricing remains a legal game of musical chairs).  We then have all the variations of NAV Light and, even on full service engagements, the increasing trend for administrators to accept manager marks for that portion of the portfolio which is truly hard to value.  It goes without saying that it is precisely these challenging instruments where investors have the greatest need for independent oversight and control.

We continue to believe that effective, vigilant oversight from an independent administrator remains by far the most effective - and cost effective - protection investors have against manager errors, be they honest or dishonest.  Investors need to focus their due diligence, however, to determine which administrators meet these objectives, and which do not.  After all, if the administrator does not compute an independent NAV, exactly why are investors footing the bill?

Latest administration survey

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:

Citco:  $482bn

Citi:  $227bn

HSBC: $217bn

Goldman: $211bn

BoNY: $149bn

CACEIS: $136bn

UBS: $82bn

GlobeOP: $78bn

PFPC:  $71bn

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.

Review of the Cayman administration industry

Hedgeweek has posted a new summary of the Cayman administration industry.  The page includes an article including comments from UBS, Fortis, Admiral, EY and Walkers, together with a link to the full quarterly survey.

Should administrators "stand behind" their work?

Financial Alternatives published an article a couple of days ago on the custody and fund administration industry. The article is somewhat confused - the role of the custodian and the fund administrator, very different things, are sometimes used interchangably - but it is nonetheless a very useful read.

The author's basic point is the view that the administration industry is under threat from litigation from failed hedge funds. Referring to the case of the Archeus Animi fund, who sued GlobeOp, the article's author notes: "The dispute was settled out of court, but it set alarm bells ringing throughout the fund administration industry. Anxious to recover losses and keen to blame anyone but themselves, hedge fund managers were happy to sue their administrators in the event of a failure."

Now, anyone who has read the Archeus claim against GlobeOp (we refer interested readers to Greg Newton's excellent blog, NakedShorts) might take the view that saying that hedge fund managers are "anxious to blame anyone else but themselves" is a little strong. Similarly, we expect that investors in the failed Philadelphia Alternative Asset Management Co, now suing UBS Cayman (NakedShorts also has great information on this one), Lancer's liquidator suing Citco or Manhattan's investors who, many moons ago, sued the Bermuda administration arm of Ernst & Young, might also disagree with the notion that the administrators in question were entirely innocent bystanders.

The article then quotes Tim Keaney, the global co-head of asset servicing at Bank of New York Mellon (currently the tenth largest admin company, according to a recent survey).

"Those responsibilities are beginning to weigh heavily on administrators." notes the author. "Keaney said he can foresee a need to change the way in which administrators and their clients work together: “If we are asked to stand behind our valuations, regardless of the source of pricing, then we will be taking on much greater responsibilities and risks.

“We will need to change the way in which we charge for this service to cover those increased risks.”

Hang on, let's just repeat that one. "If we are asked to stand behind our valuations, regardless of the source of pricing, then we will be taking on much greater responsibilities and risks". Sorry to ask the obvious question, but what exactly is an administration company paid for if not to "stand behind its valuations"?

In many ways, this quote encapsulates all the weaknesses and contradictions in today's hedge fund administration model. In our opinion, these weaknesses have become ever more pronounced in recent years, as we will discuss below. The end result can be deeply unsatisfactory for hedge fund investors.

A little history is helpful to put the role of the administrator into context. The admin industry grew up due to the US ten commandments, which created the need for the official books and records of early hedge funds to be maintained offshore. What emerged was the "traditional" model of hedge fund administration, whereby the hedge fund manager ran the portfolio and kept their records, but the official accounting and calculation of each NAV was handled by the administrator, an independent third party.

How times have changed.

The biggest issue is a 180 degree shift by much of the administration industry on the fundamental question of who is their client. We recently attended a conference on hard to value securities and asked a representative from a leading fund administration firm who they viewed as their client. The answer was instantaneous - the hedge fund manager. Not, readers should note, the fund and not, readers should definitely note, the investors.

One part of the administration servicing model, however, has remained constant - who pays the administrator's fees. All administrators are paid by the investor (fees are charged to the fund, not paid by the manager). In fact, let's repeat that point - administrators are paid by investors, not managers.

Call us traditional, but there is certainly an inconsistency if the administration industry considers their client to be with the hedge fund manager, yet it is the investor who pays the admin's bills. Exactly what are we paying for?

As we think about this topic, we have a number of observations to make on the overall picture of today's admin industry.

1) If the investor pays the bills, then the investor is the client. This goes to the central question of what is the role of the administrator. In the "traditional" model, the administrator is an independent watchdog, hired by investors, tasked with independently calculating each net asset value and ultimately preventing fraud. In today's model, the client is the manager.

2) Outsourced back office is not fund administration. "Traditional" fund administration is, we wholeheartedly agree, not a sexy business. It is also something that has come under fee pressure - what used to be a 12 to 15 basis point business has now become 4-10 basis point work. In response, several administration companies now provide outsourced mid and back office processing, and outsourcing is definitely the current trend. We have discussed this issue in an earlier post, but our view is that back office servicing is an expense of the management company and should not be charged to the fund as an administration service.

Aside from the fee issue, outsourcing also has two problems. Firstly, if a manager has no means of checking the work of the third party, there is no way to catch errors if something goes wrong. Irrespective of who was at fault, this is certainly the lesson of Archeus Animi. Far more fundamentally, however, in the outsourcing model the administrator is now emphatically working for the manager, and the end of the month process to calculate the shareholder's NAV rapidly becomes a minor add on service. This is, obviously, not what investors want to pay for.

3. Anything other than full service administration is not administration. Our target here is the nonsensical practice of "NAV Light", whereby the administrator performs some sort of check on the work performed by the manager (again, see our earlier post). As an example, the same administrator representative at the conference we mentioned above noted how some clients were now engaging the admin to "selectively verify" prices. No prizes for guessing that, in most cases, the administrator's "selective verification" is only for the easy stuff - we need help with distressed debt, not IBM stock. 

We are always left with the feeling that NAV Light is really a marketing trick to let funds "tick the box" when investors ask if an administrator is in place. We certainly hope that investors will become far more vocal to prevent their assets being spent on this process.

4. Administrators owned by the fund's prime broker are not independent. This may be one of the biggest trends in the industry, but the evident independence issues are rarely mentioned. Is administration servicing being thrown in as a loss leader to attract far more profitable prime brokerage business? And, far more importantly, how do firms handle the potential conflicts when, let's say, the admin division is unhappy with prices in a month end NAV, but the hedge fund is a $20 million revenue PB client?

5. And, last but not least, valuation. This is clearly the biggest issue at stake in the world of fund administration and the hardest for everyone concerned.

Taking a step back, calculating a NAV involves just two issues - existence and valuation. In other words, do I own what I say I own, and is it worth what I say it's worth. Against this background, many investors continue to make the naive assumption that it's pretty hard for an administrator to calculate a NAV unless they have also priced the portfolio.

Not so. Current fund offering documents universally allow the board of directors, "in consultation with the investment manager" to price some or all of the instruments in a hedge fund's portfolio. Administration agreements, in turn, seek to disclaim virtually all liability of the administrator related to pricing information provided by third parties, including the hedge fund manager: typically language will say something along the lines of "the administrator is entitled to rely upon, and will not accept responsibility for the accuracy of, information furnished by pricing vendors, prime brokers, market makers, the Board of Directors and the Investment Manager and shall assume no liability with respect to usage of such information."

(As an aside, a trend in the past couple of years has been for administrators to place confidentiality clauses in administration agreements in an attempt to prevent investors having access to the agreement in the first place.)

The rationale for ever tighter legal language is that hedge funds can hold hard to value instruments and that it is unfair to impose a duty of care on an administrator to price complex, illiquid securities. For certain instruments, it is argued, the manager is the only party who has any information as to the potential value of portfolio securities.

Fair enough, but in our view this lets the (well paid) admin off the hook far too easily.

Again, we start with the question of who is paying the administrator. If admins are to be paid by investors, then the reasonable expectation is that administrators will, consistently and vigilently, do the maximum to independently price hedge fund portfolios. "Get out of jail card free" clauses which enable admins to accept manager marks with no further verification are deficient but, increasingly, standard.

We completely agree that administrators usually perform some sort of verification against different types of pricing support, including manager marks. Some, despite restrictive liability clauses, do so very carefully and have robust internal procedures. Others do not, however, and we consistently find that procedures vary enormously across the industry (and can vary widely even within the same admin firm.) In plenty of cases, little to nothing is done to vouch manager marks (why is it, for example, that many administrators will accept copies of broker quotes provided by the manager rather than received independently, despite the evident risk of manipulation - it only costs $500 for a manager intent on fraud to buy a copy of Photoshop). It is also the case that tolerances for checking manager marks can be so wide that they end up as essentially meaningless.

Where does this leave us? As a due diligence specialist, we have always been vocal that the single, most effective control available to protect the interests of investors is effective fund administration. As a control concept, this remains undeniable and, encouragingly, we continue to have conversations with fund administrators who still follow the "traditional" model. As one senior executive at a Dublin based admin recently told us, "it takes 15 years to build a reputation in this business, but 15 seconds to lose it". This firm emphatically said that they would never accept manager pricing and independently verify 100% of prices for all client funds. If you don't do this, the exec commented, "how can you calculate the NAV?"

Unfortunately, this viewpoint is now very much the exception to the rule. In our thinking and our conversations with our clients we're getting closer to a tipping point - can we maintain our confidence, and our universal recommendation that funds hire an administrator, in the face of more and more examples of weak servicing and attempts to restrict administrator liability. We expect that other thoughtful investors are thinking along the same lines.

The real paradox is that investors will pay more for good servicing. Compared to 2 and 20, fund admin is a bargain, and if our insurance policy costs 20 basis points not 10, then so be it. That's still a lot cheaper than losing 10,000 basis points later on in a fraud.

At the moment, though, there are instances where investors would be better off paying nothing at all as the admin does not effectively protect their interests. In our mind, if the industry wants to raise its fees and protect its business, it should refocus on who is ultimately cutting the cheque. Wouldn't the best decision be to reorientate fund administration away from back office outsourcing back towards the traditional role of investor protection?

Administrator Survey - Once More

HedgeFund.net has just published a new survey of the administration industry.  Total assets under administration for single strategy funds is now estimated at  $2.6 trillion, with the administrators also reporting a further $1.3 trillion in fund of funds servicing.

The results remain consistent with our last post on the administration industry: Citco remain the largest, although their assets under administration now reach $436 billion.  That is, by the way, more than the estimated size of the entire industry just five years ago.

HFM Week Hedge Fund Administrator Survey

HFM Week has published a detailed, new survey of hedge fund administrators (available here).  The survey finds that the total assets of single strategy hedge funds under administration (so excluding fund of funds) was some $2.5 trillion as of April 2007. 

Some thoughts:

- Many US hedge funds are self administered (this includes a lot of small funds as well as some of the very largest).  The $2.5 trillion number hence excludes a lot of funds and must be an understatement - this survey becomes, therefore, another point of reference in the ever elusive search to confirm total industry assets.

- At the same time, not all the administrators provide full service administration - the $2.5 trillion includes a lot of share registration and NAV Light services.  In these arrangements, the administrator may be doing some work, but is not maintaining independent accounting records and is not cutting an independent NAV. 

Investors should always, always remember that not all administration is created equal.  We continue to be disappointed by managers who appoint administrators to perform less than "full service"; it also begs the questions as to why the firms themselves (as we have noted before) remain happy to be used as window dressing.

- Not all administrators on the list are independent - several are owned (at least partly) by hedge funds.  There is also the broader question of whether an administrator owned by a fund's prime broker can be considered independent, but we'll leave that thorny issue for another day.

- If we do assume that administrators now service $2.5 trillion, an average fee of 10 basis points makes the administration industry a $2.5 billion a year revenue business.  With that type of fee structure, I'm sure investors would like to see administrators continue to invest in technology.  Above all, investors want to see administrators make far greater investments in systems and people to enable independent pricing.

The full detail is in the HFM article, but for quick reference, the top 10 firms are now:

1) Citco - $390bn
2) HSBC - $175bn
3) Bisys - $170bn (since acquired by Citi)
4) IFS - $169bn
5) Goldman Sachs - $158bn
6) IBT - $154bn (since acquired by State Street, meaning that IFS and IBT combined administered $323bn as of April 2007, putting State Street in second place)
7) Fortis - $114bn
8) Caceis - $100bn (bought Olympia Capital)
9) GlobeOp - $100bn
10) BNY - $90bn

NAV Light?

The hedge fund administrator plays a critical role when thinking of the operational risk of hedge funds. One of the biggest lessons from our due diligence experience, though, is that not all administration servicing is created equal.

We will return to the question of the role and responsibility of the administrator regularly, but wanted to touch today on one of our favorite bugbears - NAV Light.

In a NAV Light, the administrator does not make any effort to account for a hedge fund's trades and keeps no accounting records themselves. What the admin will do, however, is perform some type of check on the NAV previously calculated by the hedge fund manager.

The snag is that checking someone else's work is obviously not the same as doing the work yourself. The only way to properly account for a hedge fund is actually to do the accounting: good, old fashioned debits and credits to track each trade.

Adding to the confusion is the complete lack of any agreed standard as to the checks an administrator should perform. Does the admin check the positions to prime broker statements to confirm that the month end assets actually exist? Do they check the prices? If so, how? Some administrators do quite a lot of work - some do virtually nothing.

It's hard to see NAV Light as anything more than an unsatisfactory half way house. Why bother at all, then? The cynical - and largely true - answer is that NAV Light lets the manager tick the box to say they have an administrator. At least some investors will take false comfort, not realising that the admin is doing much less work than they could - or should.

We are encouraged that at least one of the leading administration firms has exited the NAV Light business. We hope the others do too - let's not forget that it's the investors, not hedge fund managers, who pay the administrators' fees. If we're going to pay, we'd rather pay for someone to do a proper job.