The decline of hedge fund administration
The Financial Times reports that the hedge fund industry has seen a recent outflow of assets of more than 30% last year, with the closing of at least 150 European based hedge funds. No news there. But, the article goes on to detail the troubles this has caused for hedge fund administrators, and this highlights an interesting point.
Hedge fund administrators, in their most basic form, traditionally provide independent valuation services to mark-to-market the portfolio holdings of a hedge fund. Some even have departments that assist in the valuation of less liquid instruments. Administrators often offer these hedge funds a much wider variety of services including shareholder services, accounting services, cash oversight, custody etc.
As the Financial Times suggest, hedge fund administration companies and hedge funds themselves are, in economic terms, compliments. They are not perfect compliments (i.e. – a hedge fund can self administer) but nonetheless, the fate of the two industries is inextricably tied to the other. In light of events such as Madoff more administrators are likely being pressured to demonstrate (and heaven forbid even practice) enhanced vigilence and independence in pricing. At the end of the day, such increased oversight comes at a necessarily increase expense – and the hedge funds are the ones holding the purse strings. This seems to me to be an inherent contradiction.
I have been quoted as saying, “98% of all hedge funds view administrators as a waste of money and a necessary evil that they are forced to use because of their investors.” Assuming I am correct, then a hedge fund manager has every incentive to hire a top tier (and very expensive) administrator, but not enough incentive to really ensure that they are kicking the tires very hard. The likely answer in this environment is somewhere in the middle. It should be noted that, this is not even to suggest any fraudulent activity but rather a general attitude of letting the hedge fund manager oversee their own business (and give the administrator enough information to keep it, and investors, at bay).
The Financial Times article also highlights a continued wave of consolidation in the hedge fund administration industry as less administrators stay in business as global hedge fund assets decline. Such a decrease in the number of administrators will be like pouring gasoline on a fire for hedge fund investors. If only a few very large administrator remain, this will necessarily greatly increase the counterparty risk of hedge funds to these limited administrators. As such an investor allocating to a portfolio of hedge funds may very well see those hedge funds only using one or two administrators. This reduces overall operational diversity and increases the risk of operational contagion should something go wrong at one of these administrators.
The hedge fund industry, and its investors, are quickly becoming captured by the administration industry. Consequently with the inevitable wave of further pending consolidation approaching, it is now more important than ever for investors performing operational due diligence, to take a close look at their hedge fund administrators.
Any rigorous operational due diligence program should include a review of a hedge funds service providers but sometimes the administration function can slip through the cracks. Investors should take care to review not only the valuation policies in place at the hedge fund level, but review the interaction between the hedge fund and the administrator.
Other key areas worth covering with your hedge fund’s administrator include:
1) timing of NAV’s
2) valuation sources utilized
3) personnel continuity (and turnover) at the fund accounting level
Integrating such an administrator review process into the investor operational due diligence process will certainly yield a more comprehensive operational due diligence review. This will also allow investors to have more or less conviction in the growing administrator counterparty risk they will invevitable face as increased consolidation continues.
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Valuation, like administration, is more art then science these days – such is case is Russia and Ukraine but also global hedge funds