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

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.

For the full guide to Outsourcing  the Administration of Hedge
Funds see the Dublin Fund Services Resource Area on
www.hedgeweek.com

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.