Introduction—What Is Fund Administration and Custody
Fund administration and custody are generic processes that all funds whether retail products available to all investors or what have become referred to as alternative investment funds (AIFs) which are restricted in terms of the type of investor.
There are many tasks and functions that will be carried out by teams under the services of administration and custody.
Some will be common across funds and others will be quite bespoke to particular types of fund.
Common tasks and functions will include for the administrator areas such as
1. Fund set up
2. Fund records
3. Pricing and valuation of assets
4. Compilation of the fund accounting records
5. Production of the audit file
6. Calculation of the Net Asset Value (NAV) of the fund
7. Dealing with investors subscriptions and redemptions
8. Communication with investors
9. Secretarial services
10. Reporting
The precise workflow will be very much dependent on the fund and is determined by things such as the investment products and strategies used in the investment process. In addition the regulatory requirements will affect the work the administrator is involved in and the level of work will vary from lightly (relatively) regulated funds like AIFS to the heavily regulated retail funds. Of course, there are also unregulated funds, which have very little associated work.
Custodians will have common services they provide to funds in particular the following:
1. Safekeeping of assets
2. Managing the asset settlement process with the market infrastructure
3. Managing activity in securities lending and borrowing
4. Managing activity in corporate actions
5. Dealing with withholding tax (WHT) reclaims
In terms of the bespoke services that the administrator and custodian offer this is perhaps more prevalent in the context of the alternative Investment funds which in general terms comprises Hedge Funds, Private Equity Funds, and Property Funds as well as perhaps Commodity funds and those investing in specific alternatives.
The administrator is in effect, the management of the Fund in virtually all aspects of the day-to-day operations of the Fund, except the actual investment of the assets, which is the responsibility of the investment manager.
As a result, the administrator is always answerable to the Board of Directors, General Partner or Trustee and does not have any actual senior management control. In simple terms, an administrator is responsible for ensuring the efficient operation of a fund leaving the investment manager free to concentrate on the portfolio of investments.
Some funds are listed on exchanges and if this is the case, the administrator will ensure that the company and the directors comply with the ongoing obligations of the relevant stock exchange.
Agreements
Both administrators and custodians will sign an agreement with the Fund that will cover the relevant topics listed earlier.
Depending on the terms of its agreement, the administrator may also be responsible for ensuring that the Fund complies with the terms of its offering documents such as Offering or Placement Memorandum, Prospectus, Scheme Particulars etc.
Advantages of 3rd Party Administrators and Custodians
The market crash and aftermath left investors disillusioned and destroyed the trust between the Fund and the investor. Regulators and investors both see comfort in having key operational aspects of the fund carried out independently.
This includes pricing and valuations of the assets and the safekeeping of the fund’s assets.
It is important of course to recognize that the majority of directors and general partners of funds maintained complete and accurate records and the value of the fund was likewise accurate.
Assets were recorded and safely kept in the records of the custodians, however as noted in the Preface, the environment today is one of caution and prudent management of risk and so independence and transparency are key issues.
The size as well as the activity and complexity of the assets and strategies employed by the investment manager will have a significant impact on the workload and difficulty of the task for both administrator and custodian.
Retail funds can have billions of dollars or pounds or euros under management whereas many AIFS can be far less than 500 million.
Also retail funds are mostly open-ended meaning that subscriptions and redemptions take place frequently, possibly daily whereas a lot of non-retail funds are closed with less activity in this area. Naturally, the frequency of subscription and redemption affects cash flow and therefore portfolio activity.
Fund Relationship Structure
There are several key parties in the fund structure as the Diagram 1 shows.
Diagram 1 Fund structure. (Source: The DSC Portfolio Ltd.)
They range from the parties who own the fund and have governance responsibilities to institutions, which provide access to markets and services.
Also of course, there are the investors in the fund providing capital as shareholders or unit holders. Unit Trusts have unit holders whereas companies and partnerships have shareholders.
Administration Structure
A full service administrator will involve the three key areas shown above and can often include the services of the fund Secretary, provision of Directors and assistance with risk management and compliance (Diagram 2).
Diagram 2 Administration workflow. (Source: The DSC Portfolio Ltd.)
Comparison With Retail/Mutual Funds
The term Mutual funds is widely used globally whereas in Europe the term Retail Fund also used. In the rest of this book, we will mainly use the terms Retail and Alternative Investment Funds. There are a number of areas in which the administration of alternative investment funds like Hedge Funds differs from the administration of the more traditional Retail/Mutual Funds or Unit Trusts. These include the range of investment instruments in the portfolio; and the strategies used to exploit these instruments; the ability to go short; leverage; fee structures, including incentive or performance fees; and equalization. A process that seeks to ensure each investor pays the correct amount of any performance fee due to the investment manager. The traditional Mutual Funds or Unit Trusts are, for the most part, retail funds with quite restrictive investment policies, which include:
• very broad diversification;
• no short selling;
• no leverage; and
• derivative trading limited to Efficient Portfolio Management, which is a term that refers to hedging risk
Hedge Fund strategies can utilise a vast range of derivative instruments, which can introduce pricing problems for the administrator as many of these products have bespoke bilaterally negotiated terms with no independently published value unlike listed products. These instruments range from the relatively straightforward exchange traded commodities, financial futures and options contracts, to highly complex derivative products, which include swaps and swaptions, as well as contracts for difference (CFDs), currency forward contracts and a wide variety of customised instruments created by major banks and financial institutions and sold on the Over the Counter or OTC market. We will become familiar with many of these instruments as the book progresses. Hedge Fund portfolios, which have these “exotic” investments in the portfolio, are not inherently difficult to administer or account for, providing, and this is the key, the Administrator is able to obtain a reliable and verifiable price for the investments, upon which that Administrator can base the NAV calculation. Funds that operate in these bespoke OTC products must have a clear valuation policy that is disclosed in the offering document. Where possible, an independent price source must be used. If that is not possible, for some reason, a reasonable, practical pricing formula must be agreed between the Investment Manager, the Administrator, and preferably the Auditor, before the Fund is launched and incorporated in the pricing policy and the offering documents.
Fund Set Up
Many administrators offer services related to setting up a fund in a jurisdiction.
This is of particular value for a promoter setting up a fund in an offshore jurisdiction. Here the knowledge of the local regulatory environment enables the administrator to compose and file the necessary application forms, provide the reference and provisional appointments for the key support services etc.
Custody and Depositary Services
Custody services are either on a direct basis between the fund and a custodian in various jurisdictions that the fund may transact asset activity or on a Global Custody basis whereby the fund appoints a single custodian who will manage the services across various markets centrally.
The way in which the custodian operates in the market infrastructure is shown below:
What is the Role of a Depositary?
A depositary is required under the regulations for some types of fund.
In Europe this relates to retail and non-retail structures under the UCITS and AIFMD.
Depositaries have specific roles including those related to the oversight of cash management process, the safekeeping and verification of assets and the valuation of assets, all of which are also services that a traditional custodian offers.
We will look at this role more closely in Part 2 of the book.
Types of Fund
Administration and custody will vary across different types of fund.
Traditional retail or mutual funds will generally have high levels of activity in both assets and subscriptions and redemptions whereas AIFs such as hedge funds, private equity funds and property funds will have often much less activity in both areas. Valuation, reporting, and fund records are of course common across all funds but the degree of difficulty and challenge for the administrator will again vary depending on the assets and strategies employed by the investment manager.
In this book, we will be looking at both retail funds and AIFs.
Summary
The fund support process can be extensive, occasionally complicated and involves a high degree of effective communication, knowledge and system capability in its provision.
Above all the administrator has a very significant relationship with the investment manager, the senior management of the fund and through the transfer agency services, the investors in the fund.
In this book, we will look at how the fund operates and how the administrator and custodian play a major role in that operation.
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