The Role of Investors in the Hedge Fund Service Model

Oct 23 2015 | 5:00pm ET

Editor’s Note: Investors have been at the forefront of the evolution in hedge fund administration, demanding greater transparency, diligence, data and regulatory expertise. However, at the same time, funds continue to push for lower fees. Custom House Fund Services CEO Mark Hedderman explains the changes underway in this industry and how the discerning fund manager can partner with an administrator to make the investment process more secure – and thus more attractive – for investors.

The Role of Investors in the Hedge Fund Service Model 

by Mark Hedderman, CEO of Custom House Fund Services

As the hedge fund administration landscape continues to rapidly evolve with recent divestures of several bank-owned administration businesses, the relationship between the investor, the manager and the hedge fund administrator needs to be reexamined, with all parties taking on new responsibilities and coming together to provide a new service provider model for the industry that is shaped with the best interest of the investors at the center. 

From the investor’s perspective, they firstly need to see segregation between the fund administrator, the custodian and the prime broker. Every part of the relationship between service providers and hedge fund managers needs to be independent. It’s a core value, back-to-basics functionality of the investment process that the market needs to understand is becoming a deal maker or breaker.

Investors can take the lead. They can play a more critical role in the current relationship between hedge fund managers and their service providers. Institutional investors that understand how important it is to know where the responsibilities lie within an investment management firm in which  they have allocated funds are starting to take a proactive role both in the selection of the fund administrator and how a fund is serviced.

To this end, we would encourage investor activism, in which due diligence is an important part. Before investors allocate to a fund manager, they should pay particular attention to how the service provider model was set up and how it runs. Investors can visit the offices of the fund administrator, carry out detailed testing on procedures for consistency, meet with the accounting teams conducting NAVs and ask some fundamental questions such as: 

  • What is the service provider model?
  • Is it a blue chip service provider with a recognizable name? 
  • What are the components of the process? Are there any shortcuts being taken?
  • How does the manager handle relations with the  investor
  • What are the valuation and pricing models?
  • Who are the directors, and do they have the right expertise?

Investors should be wary of fund administration fees that are too low. When a manager enters into a fund administration relationship based solely on fees, first of all, you can be sure that the account is not going to be treated with any degree of priority. The account is likely to have been handed off to junior or inexperienced staff, and has potentially been assigned to locations with less expertise, oversight or controls, or inadequate infrastructure. 

Part of the blame here, however, lies with managers expecting administrators to provide them with premium services at highly reduced fees. That’s why investors need to check on the fund service model to ensure shortcuts have not been taken and the manager has not put together a model where there is clearly an inability or unwillingness to service the client – both manager and investor. The best way to service the hedge fund investment process is to recognize this should be a service-led discussion, not just a price-led discussion. 

Whether a fund has $1 billion or $100 million under management, the steps that go into valuation are the same. Fund administrators need the same amount of infrastructure, oversight and people power. Administrators can’t run a business with low profit margins and then expect to be able to re-invest in the business, have the most up-to-date technology, hire and retain the best people, or keep abreast of all the latest regulation and compliance. It’s not sustainable from a business growth perspective.  

However, there are fair fee levels that can be arrived at through partnership and transparency.  A critical feature of many of today’s relationships is that they are, unfortunately, dictated by price without an initial core understanding of whether there can be a proper service relationship.  No matter what the fee is, if the service is poor it will never be cheap. Similarly, good service does not have to be expensive.  

Administrators also need to be able to support investors from a regulatory perspective. Recent regulatory changes such as FATCA, Dodd-Frank and AIFMD all have real impact on investors. The administrators are the knowledge center for the data that is required to meet regulatory and compliance standards, obligations and laws.  Managers are not thinking about the latest regulation and compliance as part of their daily investment process, so investors need to ensure the administrator has sufficient expertise, technology and systems to fulfill regulatory and compliance demands. 

The increases in cost associated with meeting these new regulatory and compliance requirements is something that investors need to be aware of and should take into consideration.  There is a battleground evolving among service providers as to where these costs should fall, not only in who should do what, but also where the overall cost should be parked. There can be pressure placed upon service providers to cut fees to offset increases elsewhere and thereby preserve total expense ratios.

This is a very murky area. The pressure to perform and offer returns is being made increasingly difficult by the price of play, and the ensuing search for a home for this extra cost can cause friction. Investors should educate themselves as to the solutions their funds have in place to accommodate these changes, and make sure that there is a clear and transparent assignment of responsibilities. Due diligence is again key in this context, and investors should educate themselves as to the impact these changes have had on their service partners.

A hidden advantage of the administrator is that it has the ability to provide investors with increased intelligence behind the fund data that they receive. The days of people just accepting the performance as the ultimate reporting barometer that made you happy or not are gone. People want to understand the reasons why certain events happened, what are the controls in place that ensure that this final number is correct. Rather than a “fly-by” monthly NAV, investors are looking for more substance and more of an understanding into the control environment, the role each participant plays and where the segregation or Chinese walls exist between the participants. 

The discerning manager will offer increased transparency to investors on pricing, valuations and, ultimately, NAVs. An administrator can partner with the manager to deliver this transparency as well as independence and robustness, making the investment strategy and process more secure for the investor and more likely they will allocate more money. 

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