Historically the offshore funds landscape was dominated by traditional funds.
Historically the offshore funds landscape was dominated by traditional funds. Much of the administration process was paper-based, and few traditional fund service providers were involved in administration of hedge funds.
Today strategies have become more complex and the typical investor profile has shifted from high net worth individuals, who in general were content with monthly or quarterly NAVs and mainly paper-based reporting, to institutions that require electronic and web-based reporting, more frequent NAVs and above all transparency.
The administration process has historically been paper-driven, with technological developments mitigating some of the operational risk. However, many alternative funds still rely heavily on manual processing, which can be a major risk factor for complex fund structures.
Increased use of derivatives and illiquid assets increases the complexity of the administration process and creates system challenges – hence the need to build up specialist back-office staff capable of understanding the legal documentation governing the investments, the terms of clearance and settlement, and the valuation of the fund’s instruments.
By their nature, funds of hedge funds are people and paper-intensive, with a very manual administration process. Administrators rely on estimates of prices, custodial records and information on trades from the investment manager, with most activity happening at month-end.
By contrast, hedge fund administrators rely on details of trades from the investment manager, along with reconciliations to the assets and cash reported by the prime broker. Levels of automation and pricing complexity can vary according to the fund’s strategy, but administration still remains typically people-intensive.
The model for administrators is a combination of the right people, the right technology and the right processes. The key is to reduce reliance on manual processes and find technological solutions wherever possible. Ongoing review of all the processes to value and administer funds is necessary to refine and produce efficiencies in the process. Without significant continued investment in technology and refinement of processes, administrators may find themselves overtaken by others quicker to respond.
Independent and timely valuation of illiquid securities and complex instruments remains an ongoing challenge, requiring administrators to recruit specialist staff that understand the instruments and the alternative asset space.
Capacity issues are critical, with skilled staff in high demand in the alternative investments sector and administrators having to compete with capital markets firms and prime brokers for talent. In some offshore centres, the availability of skills may not be sufficient to go round.
Administrators must improve service, create capacity, reduce process risk and improve operational efficiency. Merely increasing staff numbers to deal with a large number of manual processes is no longer viable, but while investment in people will not stop, substantial spending on technology is required to replace manual processes. Processes that cannot be fixed by technology may eventually migrate to lower-cost or higher-capacity jurisdictions.
The impact of these changes on the audit process should not be underestimated. More complex alternative investment funds may require much more audit effort and skill due to the nature of the strategies and instruments used. The impact of manual processes, the nature of operational risk and the growth of automation are all issues to which the audit process must adapt as the alternative investment industry faces up to its challenges.
Heather MacCallum is an executive director with KPMG Channel Islands in Jersey
