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3 Tips for Performing Fund Administration Due Diligence

April 12, 2013

A combination of marketplace volatility and hedge fund scandals has propelled investment practices onto center stage. Regulatory agencies that include the U.S. Securities and Exchange Commission (SEC), Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency, and the Financial Industry Regulatory Authority (FINRA), have become more vigilant in their oversight of the front, middle and back office functions of hedge funds.

Both regulatory agencies and investors want more efficiency and transparency, especially in the fund administration function. Consequently, more funds have made the strategic decision to outsource administrative activities to an independent third-party fund administrator.

The task of evaluating fund administrator firms goes beyond simply getting the best fee quote for services. The selection process requires solid and deliberate due diligence designed to ascertain the quality of the operational infrastructure and increasingly more important the level of service and responsiveness from each contender.

Here are three tips for implementing a selection process that will assist fund managers in determining what they need to know and what to look for when selecting a third-party administrator:

Due Diligence

1) Develop due diligence guidelines

Prepare a due diligence questionnaire or assessment form that includes the most critical components of the fund administration function to be outsourced. The document can serve as a guide to ensure all critical areas for the evaluation get addressed.
The forms should include the following sections:

· Size and structure of the organization
· Ownership and management financial information
· Talent and experience of operational and technical resources
· Regulatory compliance and oversight controls
· SSAE16 Type II compliance (SOC, SAS70)
· Fund accounting
· NAV calculation/valuation procedures and controls
· Payment and signatory procedures and controls
· Client relationship management – procedures and controls

Design questions for each section that will ferret out the information you need. The best place to obtain much of this information will be at the business offices of the fund administration companies under consideration, RFP, or conference call.

Some other areas of concern the form should address include: other service lines (e.g. separately managed accounts) stability and financial soundness, business continuity plan and information technology (IT).

2) Narrow the list of candidates

The next step in the due diligence will require management to further streamline the list of candidates using the information accumulated from the questionnaire. Focus on companies with clients who used the same services, operate in the same manner or trade some of the same financial instruments as your firm.

Perform a thorough background check with regulatory bodies to ensure the candidates’ are in good standing. Primary brokers are good sources of information about fund administration candidates. When speaking to a candidate's references, it is essential to gain a clear understanding of what is being said by the source.

Try to conduct reference checks person-to-person because sources have a tendency to be more forthright with their responses.

Another key determining factor to consider is the service level and flexibility of the fund administrator. Many fund administrators will provide only canned reports and will take a what-you-see-is-what-you-get approach. In an ever changing regulatory environment with increasing investor demands, a higher emphasis needs to be placed on service and focus on hedge fund manager needs as opposed to a one size fits all approach. Directing questions around service level and expectations will provide a clearer sense on this key input.

3) Final evaluation of third-party administrator

After considering the candidate’s talent, experience, certifications and other background, hedge fund managers must weigh the specific requirements of their products and consider the candidates’ staffing efficiency and administrative capacity.

The administrator's standard agreement should spell out in detailed and clear language what the third-party administrator is going to do. The contract needs to contain information on the responsible party, in which office and for each particular task outsourced by the fund manager.

Conclusion

Operational due diligence requires an in-depth investigation of all candidates capabilities, experience, and service level. The company selected to run the fund administration operations must have the institutional risk controls and best practices necessary to make a seamless transition or launch. They must manage this critical back office function smoothly and in a cost-effective manner that yields a competitive advantage for the hedge fund and investment manager not only today, but in the future as well.

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