By reviewing critical aspects of back office processing and focusing on the common troublesome areas described below, many of the typical operational risks can be mitigated. Furthermore, implementing one of the new solutions available on the market can provide a comprehensive view of investor accounting, unifying both partners and shareholders into one offering, and largely eliminating exposure to restatement risk.
The supervision of both the allocation of income to investors and the subsequent calculation of performance fees has been a particularly vexing problem in the industry. Offering documents continue to devise more ingenious ways of charging investors and equitably distributing income at the expense of back office procedural complexity.
First, the process of allocating income needs examination. Most of the time income allocation isbased on investors’ capital but there are many instances when this is not the case, such as income related to new issues. Certain investors, due to their relationship with broker dealers and other hedge funds, are precluded from participating in new issue income. Problems will arise if during the month-end processing all income is blindly allocated based upon capital without any consideration to the eligibility or ineligibility of the investor.
To mitigate this risk a review of the composition of the monthly returns must be done. For each category of income, determine if it pertains to all investors or just a subset. This study will reveal whether a portion of income needs to be specially allocated, as well as determine the participating group of investors.
After the review of income composition is the analysis of the fee calculations. Although the fees might appear simple, say 20% of income, this calculation can be deceptively complex. It is common for funds in their start-up phase to waive or reduce fees to attract initial investors. Combining those tranches of investors with the most basic loss-carry forward provisions and a simple 20% calculation falls beyond the capacity of most hand-held calculators.
For management fees, make sure the correct rate for each class of investor is used. Also confirm the date methodology used to pro-rate the fee. The most common are either 30360 or actual/actual. One surprising industry mistake is to calculate a fee as 30365, thus ensuring that the manager loses five days of fees every year.
For performance fees, review all the components of the calculation including: Has all the income been included in the base? Is the rate correct for the investor class? Was an existing loss-carry forward taken into account? Was any claw back properly applied?
Continuing the focus on possible performance fee miscalculation, a review of all investor withdrawals should occur. It is a typical practice to charge a pro-rata portion of the accrued performance fee on investors in corporate feeders while not charging investors withdrawing from the partnership. If the fund has a loss-carry forward, make sure a portion of the carry forward is reduced proportionally to the capital being withdrawn.
There are two areas of exposure that usually can only be controlled through a review of the actual investor statements. The first is the verbiage used on the statements. Unfortunately, statement preparers can get creative when drafting headings and notes. Headings such as ‘Final Statement’ or ‘Fund Collapse’ (trying to describe the typical yearly shares series roll up) are two examples of such creativity that ultimately lead to investor anxiety.
The second exposure that can only be addressed through manual review of the statements is the performance returns that are commonly presented. Most accounting systems just display the investor’s income and capital balance and only show the performance on the statements themselves. The entire workflow can proceed without anyone verifying the performance shown on the statements.
Another error prone area is subscription prices, which actually relate to the start of the period, rather than at month’s end. The most common industry practice is to use the prior month’s gross price per share for new subscriptions.
Unfortunately, between the net prices and multiple share classes, an administrator has many prices to choose from for these new subscriptions. While choosing the wrong share price will merely alter the number of shares subscribed to, it can also force a reissuing of statements and damage investor confidence. It is not completely surprising that many organisations have resorted to using the initial share price from the offering memorandum in an effort to simplify the process.
Finally, the yearly process of generating tax returns should be taken into account. Many times tax processing is only considered as an after thought, though mistakes on the tax returns willcause tremendous frustration for the investors. Although a detailed discussion in tax preparation is beyond the scope of this article, suffice it to say, it should be given the consideration worthy of its potential exposure.
The hedge fund industry continues expanding, with over approximately 9,000 funds surpassing US$1.1 trillion under management. This growth is driving the need for more sophisticated back-end infrastructures and processes.
Back-office processes are critical functions for any fund, especially now that more and more investors are asking about them. Investors are realising that monthly reports are a potential exposure issue if information is incorrect, so they are demanding to see more overall control. The good news is that in addition to being vigilant about overseeing these processes, there is a hope on the horizon for managing investor reports. New software is available to automate these month-end tasks, which eliminates some of the re-occurring issues mentioned earlier.
Incorporating technology alongside a fund’s best practices reporting greatly reduces the back office exposure to operational mistakes. Technology and business vendors are working to better tailor software solutions to meet the demanding investor and monthly reporting activities for hedge funds. These software offerings combine the best of the old partnership and shareholder systems, and have rule based defaults so workflows become more systematic.
While back office risks will not cause regulatory issues or violate the fund’s offering memorandum (like trading and front-office exposures), they can lead to the revision of the monthly statements and a loss of investor confidence. Maintaining the reputation of a fund is crucial to its longevity. Losing the trust of the investor base is a sure way to a fund’s early demise.