The buzzword when investors are conducting due diligence on a hedge fund today is “Institutional.” Funds strive to appear institutional when they present their back office operations to investors. Investors meet with hedge funds to determine if the manager is institutional enough to entrust with their money. Appearing institutional is fairly clear cut when a fund has $10 billion in assets under management, but what does it mean when you are a manager with $500 million or less under management? What does it mean to be institutional when you don’t have 100 people running operations, your systems are not so robust that you are considering selling it to other funds and each back office function is not performed by a separate person?

When asked this question, a leading fund consultant responded by saying, “smaller funds by definition cannot be institutional.”

Their smaller size prevents them from establishing all the controls and a separation of duties necessary to be institutional. What the investor looks for with smaller firms is whether they have applied the controls and practices that are in the spirit of being institutional. They seek to understand if the manager is aware of the risks and taking steps to minimize these risks within their smaller framework.

Appointing a fund administrator is consistently identified as an operational requirement and a risk mitigant for smaller managers. Investors want to know that a reputable third party is independently verifying the positions held by a fund on a daily basis and valuing the positions on a monthly basis. When a fund administrator is performing a significant number of operational functions for a fund, how much of this can be outsourced?

“Investors can gain comfort with outsourcing back office responsibilities as long as a manager has solid controls over what the fund administrator is producing,” Samer Ojjeh, a principal in Ernst & Young’s in financial services asset management group, said. “The manager should have a robust shadow model.”

Ojjeh also points out that while a manager can outsource back office functions, they still have a fiduciary responsibility to the investor over the aspects of their business outsourced to the fund administrator.

The investor does not expect the manager to re-perform all of the operational functions of the administrator, however, they want to know that the manager has sufficient in-house support to analyze the work of the administrator on a daily basis. Investors want managers who understand the importance of reconciling discrepancies in a timely manner and is in control of that process. They want a manager who retains the responsibility for catching errors because that can mean preventing money lost by the funds.

The consensus seems to be that it is acceptable for a small fund not to purchase accounting software and to rely on the administrator’s accounting systems. It is also not a requirement that a manager purchase a front office system. Many prime brokers offer order management systems or tools as part of their platform to their hedge fund customers that can route orders as well as aggregate and disseminate transaction information to the fund’s back office on a daily basis.

Through the due diligence process, investors seek to understand if the fund has maintained sufficient oversight of the process. That they understand and are maintaining responsibility for the fund’s books and records and managing the transactional activity while utilizing third party vendors and systems to minimize costs.

While dependence upon third party systems has its benefits, it also can have its drawbacks.

As assets under management increase, the manager will face the need to transition to more robust systems to maintain the same level of necessary oversight that they were able to provide on a smaller scale.

It should also be noted the costs of accounting and front office systems for hedge funds have decreased significantly and are now much more accessible for smaller and start up funds than in the past.

“Establishing a strong and integrated infrastructure speaks to a firm’s scalability,” said Amit Malhotra, chief financial officer at startup firm RoundKeep. “It answers the question of a fund’s ability to effectively manage growth of assets under management and the addition of new strategies with complex investment products. Integrated systems and sound practices allow for a control over the consistency and accuracy of information that spreadsheets cannot provide.”

Compliance, irrespective of a fund’s size, has become an important component of an investor’s due diligence process.

Asked why there has been this increased focus, Alan Fish, a Partner at Ernst and Young, said: “Most investors are aware that the compliance world is changing. They understand that a manager will eventually have to register and a governance model that lends itself to registration is key.”

Fish is not alone in this line of reasoning.

“Investors want to see that a fund manager is not going to struggle to meet the requirements of registration,” Ojjeh said. “They will verify that operational processes are documented and that responses provided in due diligence questionnaires are accurate.”

Investors also want to understand that even at a smaller fund, there is a sophisticated level of oversight in the management of the business. When conducting due diligence, a fund consultant typically has a view on the market standard for controls, prime broker diversification, trading and financing terms, NAV triggers, lockups, valuation policies, etc., that are available to a fund in the context of its size and trading activity. They want to understand that the fund is obtaining the protections and establishing the controls that are available for a fund of that size. A smaller fund manager does not have the resources to hire in­house experts to manage all of these issues and investors are more assured when the fund seeks and utilizes reputable service providers.

The takeaway by the investor is that the fund is receiving the necessary market color and representation made available to them through the service providers that is not available in house. Investors see this as an investment by the manager in infrastructure and a commitment to the growth of the business. There is also value placed on a manager’s ability to attract reputable prime brokers and service providers.

Finally, it comes down to the people at the firm. They define the process and are key assets for any fund. Individuals are expected to wear multiple hats at smaller funds, and duties and functions may not be as bifurcated as they are at larger funds. However, it is important to clearly establish responsibilities and controls in the management of the fund because investors want to see responsibilities broken out in a manner that mitigates risk.

For example, investors want to see the transfer of the end of day file from the executing party to another person within the firm for verification with a counter-party.

Another example is multiple layers of approvals for wire transfers. Investors want to know a manager understands the importance of securing cash under management. Some managers even remove themselves from the wire authorization process by ceding control to the administrator. Once you introduce the administrator into the process, collusion becomes much more difficult.

Investors want to see knowledgeable people at the helm of a firm who understand and instill a culture of accountability and consistency. Investors look for leaders who can build a growing business and are sophisticated enough to be aware of the relevant issues and risks that occur with growth. They want to see the appointment of a strong COO or CFO who understands the importance of instilling the necessary controls and can effectively manage the business.

Whether a manager has $5 billion or less than $500 million under management, investors are asking the same questions and reviewing the responses within the context of the fund’s size and trading activity.

Funds should seek to instill the confidence that they are aware of the risks and are utilizing resources, systems and processes and executing controls in the spirit of being institutional.

Published on with permission by Devi Koya.

Copyright © Devi Koya

Devi Koya is a partner at the law firm of Baker & McKenzie. She focuses her practice on negotiating derivatives, prime brokerage, clearing, and trading agreements, as well as counseling clients on managing their trading operations.

The views expressed in this guest column do not necessarily reflect the views of

Download file

Copyright © 2023 Koya Law LLC®. All Rights Reserved.