Risk Vs. Cost: How Hedge Fund Managers Can Engage The Right Mix Of Internal, Outside And Shadow Administration by New York Hedge Fund Roundtable

Risk vs. cost

Hedge funds are back. Total assets under management (AUM) have strongly recovered and are already higher than they were in 2007. In addition, many new funds are launching, particularly smaller managers with AUM of under $100 million. At the same time, managers are feeling pressure to cut fees, while compliance and regulatory costs continue to increase dramatically—and could rise by as much as 20% over the next three years.

A real opportunity to manage costs

Emerging funds are looking closely at how best to meet regulatory requirements without overspending. Top of mind: fund administrative costs. For efficiency, most funds engage a third-party administrator to manage and maintain all or part of their books and records, while also keeping in-house resources to shadow the outside resources. Because of the expense of duplicating these tasks, each fund must make a decision as to where they fall on the spectrum of cost versus risk when engaging the right mix of resources.

“Large multibillion-dollar hedge funds often use a different model, which includes both an outside administrator and a full in-house shadow function that completely duplicates the outside administrator’s work,” comments Michael Patanella, National Asset Management Sector Leader. “Although much costlier, the resulting risk reduction means this is a trade-off they are willing to make.”

Says Kristin Castellanos, global head of product management at Deutsche Bank Fund Services: “Fund managers who adopt a full in-house shadow approach often find that having a dedicated team under their roof helps to align fund operations and portfolio management. The downside is scalability; there is a fixed cost associated with this approach that may be problematic in periods of declining assets.” Adds Patanella: “Funds who opt to use this model should consider that costs may be allocated to the fund group as a result, rather than the management company. Such a shift in fee structure may require a conversation with investors, depending on the fund’s governing documents.”

For the large fund, another advantage is the ability to exactly duplicate the administrator’s work, ensuring the accuracy of trading data, portfolio management, regulatory compliance and investor communications.

Risk Vs. Cost

Emerging managers won’t have the same budget options as a larger fund, so a well-considered administrator choice is one of their most important decisions. An administrator with a flexible technology platform may allow an emerging manager to leverage external analytic tools that they might otherwise have to source themselves. There is also an opportunity to maximize the budget by selecting an administrator that can provide bundled services such as regulatory reporting and/or depositary services. Administrators that have invested in a consolidated technology platform should be able to repurpose data and provide these services at a lesser cost than an additional provider, which has to duplicate the administrator’s books and records. “Leveraging a third-party independent administrator can help emerging funds achieve economies of scale,” comments Fred Jacobs, managing director of global business development for alternative investments at SS&C GlobeOp, a fund administrator. “At the same time, third-party administrators can improve the manager’s ability to set themselves apart in an environment of stringent investor and regulatory due diligence requirements.”

Evaluating your operating model

Emerging funds have usually grown quickly, with a heavy focus on sales and marketing. When the fund gets to a large enough level, it’s a good time to take a fresh look at administrative costs, agreements and structures. To guide the evaluation process, consider the following areas:

  • Administrative costs — List all vendors and their costs.
  • Administrative data — Determine how much of your vendors’ data needs to be collected and collated for investors and regulators (e.g., brokers,trustees, custodians, risk data providers and market data providers).
  • Outsourcing agreements — Collect all agreements and develop a matrix based on costs and deliverables. Once you have a matrix in place,look for redundancies and cost disparities.
  • Deadlines — Create a matrix of regulatory and/or compliance deadlines.
  • Mix of service offerings — Once you are aware of your regulatory deadlines, ensure your vendors can provide the services you need to meet your growing regulatory obligations in a way that is cost-effective.
  • Data access — List the dates (or real time) that investors, internal departments and/or external vendors need access to fund data.
  • Vendor qualifications — Examine whether vendors are up-to-date with technology, processes,and communication deadlines and protocols.

This review process should reveal some key changes that need to be made to keep costs low and risk at a level acceptable for your fund.

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