By Jason Scharfman Esq., CFE, CRISC, CAMS, CAIA Managing Partner, Corgentum Consulting
As an operational due diligence (ODD) professional who performs ODD reviews of alternative investment managers on behalf of institutional investors and family offices, I have noticed a recent increase not only in the number of ODD reviews investors ask me to perform., but also the level of detail in which I perform it. A common question that clients ask is “if an investment manager is profitable and has already been subjected to dozens of previous ODD reviews, does the so-called “quality” of their operations actually matter?” Said another way, if a fund manager has raised a lot of capital and continues to be in good standing with regulators, then shouldn’t his operations be “good enough”? Furthermore, if a fund manager’s operations are acceptable to existing investors and regulators then why should investors continue to devote substantial resources towards understanding fund operations?
Standardization or Commodity?
In many ways, many elements of alternative investment fund operations have become standardized.[i] For example, it is currently very common for a hedge fund manager to use a third-party administrator. Rather than opting for self-administration, managers and investors have decided that the practice of having a third-party overseer is no longer an option but, rather, a necessity. Risk avoidance has been a key motivator in promoting the elimination of hedge fund self-administration. This is because self-administration indicates that a fund has less oversight on operational procedures comparable to that of a fund with a third-party administrator. This lack of added oversight also equates a fund having weaker operational governance and therefore higher operational risk[ii]. Therefore, investors have decided that the overall benefits of third-party administration far outweigh the additional expense.
This contrasts with the practices of private equity, where it is far more common for funds to self-administer. Even in cases where a private equity general partner does utilize a third-party administrator, the types of services provided by administrators differ from hedge funds because they are often much more limited in scope. For hedge funds, the two categories of services commonly provided by administrators are shareholder services and fund accounting. The bulk of private equity administration work is centered around shareholder services. As part of the fund accounting procedures, administrators usually source independent prices for the more liquid positions held by hedge funds. Then, they utilize these to verify the marks provided by the fund and prime brokers. In the private equity space however, the positions are illiquid and third-party administrators cannot perform these position checks because prices cannot readily be sourced from third-party data feeds or brokers.
The agreement among investors, fund and service providers regarding what constitutes standard industry operational practices should not be equated to such practices as being a commodity. A great deal of variation can exist within the parameters of what is considered minimum standard practices versus best practices.
As an example, each fund administrator is unique, and therefore brings both benefits and drawbacks, including differing levels of experience across investment strategies. For instance, an administrator with expertise in traditional equities, options and fixed income may not have experience with other types of instruments such as loan securities which offer various types of interest payouts at irregular time intervals. The same is true in illiquid securities, as those administrators typically specialize in venture capital and private equity investments, while others may have more familiarity dealing with the cash flows from real estate properties.
Furthermore, smaller administrators may not have the capabilities to support fund managers who have large AUM bases. And, smaller administrators may not have undergone more robust operational audits such as System and Organization Control (SOC) reviews which are performed by third-party auditors to validate the performance of internal controls.[iii] These SOC reviews are often important considerations for funds and their investors when evaluating the overall operational strengths and weaknesses of an administrator.
Even with a single fund administrator, the level and quality of service can vary widely. This depends on a number of factors, including the administrator’s experience with different asset classes, the robustness of their information technology architecture, the scope of services for which the administrator has been engaged by the fund, and the tenure and experience of the fund accounting and shareholder services teams in place for a specific fund relationship. This is not to say that many small to medium size funds should avoid smaller fund administrators. For some managers, the smaller client-base, coupled with more affordable cost structures, makes smaller administrators more attractive to nascent strategies and smaller hedge funds.
A Changing Operational and Regulatory Standard
While there are general industry standards of practices that are considered acceptable, designing, maintaining and evaluating an alternative investment fund manager’s operations is not a one-size-fits-all exercise. Furthermore, what were industry standard yesterday might not be suitable today or tomorrow. An example of changing standards is cybersecurity. Several years ago, cybersecurity was a relatively small consideration for most alternative investment fund managers. Today, funds devote considerable time, effort and financial resources to cybersecurity, which is now an even more relevant concern in the post Covid-19 world[iv]. This is not only because cybersecurity is prudent, but also because regulators are increasingly calling for it[v]. Over time, regulators revise the minimally required operational practices that funds must follow. For example, in 2011, the SEC adopted the requirement that Registered Investment Advisors who managed in excess of $150 million submit a new filing known as Form PF[vi]. Previously, RIAs were not required to track and collect all data necessary to complete the form.
Investors have also been key drivers of operational changes at alternative investment fund managers. For example, private equity funds have embraced the relatively new development of a governance mechanism in private equity funds known as a Limited Partner Advisory Committee (LPAC), which is driven by LPs.[vii] In hedge funds, risk-adverse LPs have steadily pushed for that increases in hedge fund operating budgets be devoted towards operational improvements. A key area of LP focus has been in ensuring that systems are in place to facilitate stricter controls over the management, movement and oversight of cash. The risks associated with poor cash management practices range from outright embezzlement and fraud, to processing redemption payments to the wrong LP accounts. Additionally, cash management is under increased scrutiny when trying to better address regulatory liquidity management concerns.[viii]
Instances of fraud leading to losses because of poor cash management procedures have become more newsworthy, which has therefore focused investors’ attention on this issue[ix]. In response, investors have broken their analysis of cash procedures into four categories[x]:
- Cash for expenses
- Cash to facilitate investing
- Cash flow to and from investors
- Unencumbered cash
Across these four categories, LPs have largely demanded a series of more rigorous controls such as dual signatures for all cash movements, differentiation between the initiator and approver of cash transfers, greater seniority of approval personnel for differing dollar amounts thresholds, and increasing security mechanisms around cash wires including call back procedures and the use of electronic encrypted security tokens.[xi]
Conclusion: The Only Constant in Alternative Investment Operations Is Change
Operations for alternative investments are not static and should be subject to constant scrutiny from investors and regulators. Fund managers must continue to re-evaluate their own actions to ensure that they are keeping up pace with the increasingly high operational expectations of investors. Investors must also keep focused on new industry developments and regulatory changes to ensure that their analysis remains relevant during ongoing ODD.
Staying current with operational best practices will allow for better planning for changes down the road, as opposed to playing catch up.
Jason Scharfman, Esq., CFE, CRISC, CAMS, CAIA is a Managing Partner, Corgentum Consulting. He is the author of the newly published Alternative Investment Operations: Hedge Funds, Private Equity and Fund of Funds (Palgrave Macmillan / Springer Nature, September, 2020). Corgentum Consulting is a specialist consulting firm which performs operational due diligence reviews and background investigations of fund managers globally.
[i] Guidelines that have been published that have advanced the convergence of standardized operational practices include the MFA’s Sound Practices for Hedge Fund Managers, the Standards Board for Alternative Investments standards, and the AIMA Guides to Sound Practices
[ii] For more information on the risk-return tradeoffs and governance implications of third-party administrations versus self-administration see Scharfman, J., Hedge Fund Governance: Evaluating Oversight, Independence, and Conflicts (Academic Press), pages 152 – 153, November 2014.
[v] See Rundle, J., “SEC Urges Better Cybersecurity Practices at Financial Firms,” The Wall Street Journal, January 28, 2020.
[vii] For more information on LPACs see Scharfman, J., Private Equity Compliance: Analyzing Conflicts Fees, and Risks (Wiley Finance), Chapter 3, September 2018. "Hedge fund liquidity Management Considerations," March 23, 2020.
[ix] See Chellel, K. “A London Hedge Fund Lost $1.2 Million in a Friday Afternoon Phone Scam,” Bloomberg, July 7, 2015.
[x] See Scharfman, J., Alternative Investment Operations: Hedge Funds, Private Equity and Fund of Funds (Palgrave Macmillan / Springer Nature), Chapter 3, September, 2020