I came across another very good article which examines the new landscape of the hedge fund industry and brings up some pertinent points which both hedge fund managers and investors should be aware of. The issue is that many of the prime brokerage firms and very large global banks have established administration businesses to cater to the ever growing hedge fund industry. While this expansion gives managers more choices for administration (and arguably better service as admin and other back office functions, like banking, can be handled by one organization), it does create new risks that both managers and investors should investigate. This article details some of the issues which should be considered; these issues should probably be talking points between the manager and the administrator during the process of choosing an administrator. The original article can be found here: www.castlehallalternatives.com.
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.
HFLB note – other related articles include: