Evolution of fund administration – Is your administrator keeping up?
By Chris Meader, Formidium
Published: 28 November 2022
Fund administration services and associated technologies have evolved extensively throughout the years and are expected to continue to evolve as private funds’ needs increase in complexity. What started as an outsourced responsibility of the investment manager to maintain “books and records,” has evolved into a fully independent fund administration service sector with the technology capability to meet the modern needs of fund managers, investors, and regulators. Today, fund administrators are expected to be partners with investment managers, while also being cognisant of the best interests of the fund investors. Despite these additional responsibilities, service fees have been declining due to technology and increased competition. A long-short equity fund today pays half of what it would have paid 20 years ago and gets a significantly higher service level. Though a high touch service industry traditionally, automation and technology will continue to make it more efficient and less personalised.
To understand the evolution of fund services, it is important to first understand the evolution of the hedge funds industry itself.
Evolution of funds and fund administration prior to the 1990’s
While investment pools and trusts date back to the 1800’s, the 1920’s saw the first modern mutual funds established for outside investors. Following the heavy losses from the 1930’s stock market collapse, the Securities Acts of 1933 and the Securities Exchange Act of 1934 were enacted to protect investors from bad actors. The Acts required funds to register and disclose holdings, performance, and other items which were later expanded as part of the Investment Company Act of 1940.
In 1949 Alfred Winslow Jones started a ‘hedged’ fund for friends that reduced risk by combining the purchase of equities and short selling of stock. The fund was launched as a private limited partnership and not marketed, therefore able to avoid registration and disclosure requirements. Mr. Winslow utilised leverage, created the 2 and 20 fee structure to avail himself of a tax benefit, and did not disclose his positions. During this time, the recordkeeping and “administration” of funds was generally handled by the fund issuer, typically an investment house or bank.
Birth of offshore services
In 1968 the US Treasury introduced the ten commandments. The commandments were ten essential activities that foreign entities needed to perform outside of the USA to be considered foreign. Among these activities were the acceptance of new investors, providing ongoing performance communication with investors, and the maintenance of the books and records of the fund. As a result, any US managers managing non-US funds were required to find service providers outside of the US to fulfill these functions. They naturally looked to the same offshore jurisdictions where funds were being formed, consequently spawning the offshore fund administration industry. Most of these service providers were accounting or trust companies or other specialist firms.
US onshore services
In 1997 the Taxpayer Relief Act repealed the ten commandments allowing these activities to be performed within the US, which lead to many administrators scaling back or outright exiting offshore jurisdictions. Around this same time interest in hedge funds expanded to institutional investors, such as university endowments, family offices, and pension plans who began to enter a space that had been previously dominated by private, individual investors. Many investors recognised the risk of managers performing accounting and recordkeeping, and the importance of independence, further expanding the need for third-party fund administration.
Evolution of fund administration services
Self-administration and hired hands
Today there is no regulatory requirement for a private fund to utilise a third-party administrator and some hedge and private equity funds continue to ‘self-administer’.
Private funds were historically self-administered by the manager using an internal finance team, accounting firm, or some other specialist firm to assist. Aside from a lack of independence this led to non-standardised procedures. For example, some of these firms allowed the manager to adjust the books and records as they wished, while others were not independently pricing securities or reconciling trades, simply calculating NAVs taken from custody report balances. As funds evolved and the investor makeup and needs changed, so too did fund administration services. Fund administration evolved into a back-office necessity for many asset managers to maintain books and records and process investor activity.
Administrator as independent party
As institutional investors expanded into private funds, so did the scrutiny investors placed upon fund administrators with respect to independence and adherence to best practices. This led to an expansion of the expected services from fund administrators.
Today investors, funds, and fund sponsors expect administrators to be partners, assisting both manager and fund in adhering to regulations and requirements, all while remaining independent. Services have also expanded from accounting and investor record keeping, to now include technology that supports financial reporting, regulatory and tax reporting, investor tax reporting, AML compliance, company officers, investor relations, real time reporting, web portals, website design, white label marketing, etc.
Administrators as tech enabled service providers
The ‘lack of technology’ period
Prior to the 2000’s, fund administration technology was dominated by large mainframe operating platforms for accounting and databases for investor recordkeeping. There were little to no industry-specific tools and many administrators were utilising mutual fund platforms, front-end investment management platforms, or wealth management platforms.
Technology with significant gaps
In the early 2000‘s as hedge funds expanded in popularity, numerous technology firms entered the space with expanded offerings which only focused on basic accounting and investor services requirements. Many accounting platforms required workarounds or offline spreadsheets to support rapidly expanded trading across OTCs, derivatives, short-selling, multi-currency portfolios, allocations/waterfalls and more. Most of the investor services technologies were basic databases that could only support limited fund structures (partnership vs share issuance) or specific fund types (closed-end PE vs open-end hedge). Many lacked the capability to monitor investor requirements such as lockup periods, gates, side letters, etc. These accounting and investor support platforms were not integrated and required manual export/import or keying in of data.
In the decade to follow, technology evolved to address many deficiencies resulting from manual and disparate processes, yet shortfalls and workarounds remained pervasive. These problems were a result of antiquated infrastructure unable to support new functionality, as well as a lack of investment to automate further. While additional technology was introduced to deal with the ever-growing service requirements of funds, these continued to be stand-alone platforms centered around compliance, risk management, and reporting. Because each platform had its own data needs it drove the concept of a data warehouse to store, transform, and transmit data between these inter-connected platforms in a more structured manner. Managing vendors and a data warehouse presented unique challenges to administrators, such as vendor upgrades, which required significant efforts to identify upstream/downstream impacts.
Vulnerabilities in modern fund administration technology
Today many fund administrators continue to maintain a portfolio of third-party tools. The complexity of the technology stack leaves many administrators at the mercy of their vendors. Administrators that have developed in-house technology are better suited to manage upgrades, releases, and improvements while maintaining responsibility for security and development.
Many challenges with fund administration technology remain. Among them: industry technology is often built on older foundational code; many of the platforms are still not connected and require manual intervention to pass data; others still require allocations or some waterfall types to be performed in spreadsheets.
Key features of modern fund administration technology
Built correctly, technology exists to solve the needs of fund managers and clients. A modern fund administration technology offering should include at minimum, the following components:
- Multi-asset class & multi-currency investment accounting
- Native general ledger
- Web interface for report and data build and download
- Cybersecurity and safety features
- Open architecture to allow for integrations with external applications for a seamless experience
- Electronic subscription
- CRM/Investor communication
- Complete audit trail with internal controls, include SOC/ISO audits
- Integrated financial reporting
- Integrated tax/regulatory data preparation
Fund administration in the next decade
As the complexity of investment funds grow - with added expectations of lower cost - our conclusion is that fund administration will continue to evolve with even more emphasis on technology. Many of the processes and interactions of today will eventually be replaced by automated workflows. The ‘Great Resignation’ has contributed to acceleration of this trend. As Gen-Z start entering the fund management industry, their comfort with and expectation for more technology means we will likely see a newer generation of managers and investors who no longer view an administrator as a partner, service provider, or an intermediary, but rather as a provider of back-office technology solutions.
The adoption of technology enables significantly higher levels of internal controls as opposed to making subjective decisions. As a result, we believe such controls can be decentralised, ushering in tremendous efficiencies.
As for the fund service providers themselves, they should prepare for their new role in the era of a disintermediation of their core product. Much like how the ingenuity of AW Jones in 1949 birthed the modern-day hedge fund, to succeed fund administrators will be required to leave their comfort zone and think and act as much like technologists as they do as accountants.