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A Guide to Outsourcing The Administration Of Hedge Funds: Part 2: Self-Administration versus Outsourcing

February 3, 2006 at 6:13 am

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The second of a six-part series by Dermot S.L.PARA_BREAK_SENTINEL_9f8e7d6c

The second of a six-part series by Dermot S.L. Butler, Chairman of Custom House Administration & Corporate Services Limited (Custom House).

2. Self-Administration versus Outsourcing - The Pros and Cons
This debate comes down to two questions: 'Is there any value added?' and, 'What are the costs? - which are not the same thing.
In the Hedge Fund industry, the main advantage that the third party Administrator brings to the table is the comfort that is provided to investors, if the administration of a Fund, and particularly the calculation of the net asset value (NAV) of that Fund, is being carried out by an independent third party (that is independent from the Fund's Manager), using independent prices and transaction data sources when calculating the NAVs.
The majority of Hedge Funds, of which there are now several thousand, are established in the United States as Limited Partnerships. The General Partner is usually the Hedge Fund Manager and also, usually, handles the administration of the Fund and produces all of the partnership accounts, reports and statements. In the vast majority of cases, there is nothing wrong with that and, historically, the vast majority of US Hedge Fund accounts and reports have been spot-on.
Investors now want to see that the Funds they invest in are administered by an independent third party Administrator. The appointment of a third party Administrator can add immeasurable value to a Fund, if it means that it will retain investors in the Fund or, indeed, attract new investors to the Fund.
For a small or emerging Hedge Fund Manager, setting up his first fund, the cost advantages of appointing a third party Administrator can be easily demonstrated, but it is not just a matter of pure dollars and cents.
Until the Fund grows in size to, at least USD 50 million, or even USD 100 million, which is above the average size, the actual cost of setting up an administration facility - (which involves renting more space, employing qualified staff, acquiring the specialised technology and providing the managerial resources required to ensure the efficient self-administration of the Fund) - can be almost prohibitive and unlikely to compare favourably with the fees charged by many of the specialist Hedge Fund Administrators - or at any rate those Administrators who will accept the smaller start-up Hedge Funds.
Obviously, once the Fund has reached a critical mass, the cost ratios change and the attraction of a third party Administrator may decline. However, it is also likely that, as the Fund grows, the fees charged by the Administrator will also be volume sensitive.
So, it can be seen that the decision to use a third party Administrator is not necessarily cost driven and can be swayed by other considerations, such as the perception of independence previously mentioned, and risk transfer (transferring the risk, and resulting liability, represented by, for instance, the possibility of expensive administrative errors, from the Fund Manager to the third party Administrator - or that Administrator's insurance company).
One area where dollar costs can be a serious factor is when a Fund Manager, who has hitherto administered the Fund that he manages, decides, perhaps because of investor pressure, to appoint a third party Administrator.

In these circumstances, the Manager will already presumably have made a substantial capital investment into his own administration department and that department and the technology purchased, may have proved very efficient. In choosing to outsource the administration, the Manager may, on top of paying the new administration fees, have to decide to write off the capital investment and let some staff go. And, as we all know, that can be a very expensive way to cut costs.
Often in these circumstances and in order to avoid these write-offs, the Fund Manager may decide to continue preparing the Fund's accounts and calculating the NAV.
However, the Manager will try and appoint a third party Administrator to fulfil the function of 'verifying' the figures produced by the Fund Manager and, of course, to do that for a nominal cost. This is what is known in Hedge Fund circles as 'NAV Lite'. Obviously, this is, potentially, a very dangerous area for an Administrator and any Administrator who agrees to 'verify' such numbers and be described as 'The Administrator' in the Fund's documentation, should, in my view, still replicate the whole accounting process, in-house, using independently sourced data, which, of course, cannot be done for a nominal cost.
Having said all that, in many jurisdictions, it is now a requirement that an independent Administrator is appointed for most Funds, perhaps excluding those managed by the larger Fund Managers who have their own separate administration company.
Dermot S.L. Butler is Chairman of Dublin-based Custom House Administration & Corporate Services Limited ("Custom House"), a company that specialises in assisting clients in the organisation, establishment and administration of alternative investment and hedge funds. Custom House is regulated by the Irish Financial Services Regulatory Authority ("IFSRA"), and authorised under Section 10 of the Irish Investment Intermediaries Act, 1995.
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