Even Fund Administration in Crypto is NOT BORING
Overview
Several weeks ago, Valmar touched upon the state of banking in the crypto industry in the United States, addressing viable solutions. In a hedge fund’s “service provider stack”, a strong banking partner adds stability, security, and credibility for an investment manager. Likewise, in that stack, a fund administrator ensures fund governance and certain fundamental back-office activities. And on the surface, while fund administration may not seem like the sexiest topic, fund administration is necessary for a legitimate hedge fund, and a good fund administrator may just end up being a hedge fund’s best friend. Let’s delve into it.
A bit of a history trip first. Fund administration for hedge funds has evolved significantly over the years. In the early days of hedge funds, fund managers often handled administrative tasks themselves. However, as the industry grew and became more complex, the need for specialized professionals to manage fund administration became more evident. Then, in 2008, everything changed. At the end of that year, in the middle of the Great Financial Crisis, the infamous Bernard Lawrence Madoff was arrested and charged with securities fraud, having defrauded investors via a $65 billion Ponzi scheme. How could this happen? Well, documentaries have dived into the full complexity, but certainly a major contributing factor was the lack of accountability and oversight (not to mention the ineptitude of the SEC’s officials that had conducted several examinations on Madoff’s fund without raising major red flags). Specifically, Madoff and his operation were able to falsify trading and investor reporting documents, enabling them to report “unusually consistent” annual returns of around 10% year after year, which persuaded his clients to continue to participate in the fraud. With Madoff, the world learned a lesson about the undeniable importance of true third-party verification of trading and reporting activity. Since then, no credible fund would ever be able to run without an independent fund administrator at its side.
Back to 2023 and with the emergence of a new digital asset class, transparency and strong governance are as important as ever, especially in the wake of well-known industry frauds over the past year. Furthermore, launching a hedge fund is a difficult and time-consuming endeavor, and a streamlined process with a high-quality fund administrator allows a fund greater time to focus on the core aspects of its business: generating yield, managing risk, and raising capital. With superior fund administration, essential functions like investor reporting, back-office operations, internal checks and balances, and regulatory and compliance activities are simplified and strengthened. It is important to delve into each of these areas in some level of detail, considering the unique complexities introduced by crypto investments. A manager’s final agreement with a fund administrator will specify all duties and responsibilities.
Investor Reporting
A primary function of the fund administrator is to calculate the net asset value (“NAV”) of the hedge fund and its individual investor accounts. The fund administrator tracks the fund’s income, expenses, and pricing of trades and transactions, maintaining full visibility into these activities. The NAV is then used to calculate individual investor returns, and it is the fund administrator’s duty to independently distribute those returns to investors. Investors typically receive investor reports monthly, so accurate, timely, and consistent calculations from the administrator are critical. When a manager presents returns to existing or potential investors, those returns should be consistent with the NAV of the overall fund. Additionally, returns are typically displayed net of fees.
Back-Office Operations
Behind the scenes, a fund administrator executes a myriad of essential and less-than-glamorous back-office operations for the fund. While not an exhaustive list, fund administrators: onboard new fund investors, facilitate redemptions of exiting investors, prepare regular reports for the Board, handle the payment of fund expenses, track investor complaints, conduct all core fund accounting functions. These activities involve a significant amount of paperwork, which the fund administrators diligently completes and reviews. A strong working relationship with a fund administrator involves ongoing conversations about expectations and process control. Effective communication and collaboration between the fund manager and the administrator are key to ensure the smooth execution of all back-office operations, and once a good rhythm is established, for the most part, they should become mostly automated.
Automation and efficiency, in turn, depend on the strength of the technology used by the administrator. Advanced software systems can automate many of the manual tasks, enabling the team to handle larger volumes of data and transactions. In the crypto hedge fund space, blockchain technology presents opportunities for fund administrators, because the distributed ledger technology can streamline the recording and verification of cryptocurrency transactions, increasing transparency and reducing the risk of fraud. All in all, it is crucial to thoroughly evaluate the systems used/developed by an admin, and how native they are to the crypto ecosystem.
Internal Checks and Balances
Due to the fund administrator’s unique positioning to view full fund activity, the fund administrator additionally serves as a backup set of eyes for the fund and the manager of that fund. As noted in the investor reporting function, a fund administrator prices fund trades and transactions daily, establishing its own set of records. The other set of trading and transaction records is of course maintained by the manager of the fund. As good practice, a manager can and should reconcile fund activity maintained by the fund with the activity maintained by the administrator. Reconciliation can be a manual process, an automated one, or a combination of both. It requires discipline and regularity but can troubleshoot small fires before they become larger ones. Proactive reconciliation helps a manager avoid valuation/transaction errors, internal fraud, and balance sheet mistakes.
Regulatory and Compliance
Last week, we provided some insights on recent regulatory action in the United States. Regardless of jurisdiction, a legitimate fund is beholden to some regulatory and compliance regime, and accurate reporting to that jurisdiction is mandatory. A fund administrator prepares vast amounts of information for regulatory filings, reports, and audits, and by ensuring accurate investor reporting and internal fund accounting, the fund manager can have confidence in these proceedings. Insufficient books and records are a major red flag to regulators, and so an administrator’s books and records should be thorough and complete.
Further, an administrator can be engaged for anti-money laundering and Know-Your-Client (“AML & KYC”) functions ensuring that a fund is not laundering or managing money for bad actors. To perform that function, the administrator conducts proper ID, and background checks are run on fund investors.
Selecting a Digital Asset Fund Adminstrator
While traditional hedge funds have long relied on established fund administrators such as SS&C, State Street, and Citco, it has become evident that these incumbents are ill-equipped to handle the unique challenges presented by the crypto industry. Some traditional administrators may also lack interest in an opportunity that has yet to reach enough scale to move their needle. Consequently, a new wave of specialized fund administrators has risen to the forefront, demonstrating their expertise and commitment to serving the needs of crypto hedge funds. In the United States, NAV Consulting, MG Stover & Co., and Formidium have emerged as such leaders, though we expect that new options will continue to emerge.
When considering options and conducting appropriate due diligence around digital asset fund administrators, key considerations/questions include:
What is the history of fund administrator, track record, and general understanding of digital assets?
What is the market reputation of this fund administrator? Does the administrator have experience in digital assets and with similar-themed strategies (market direction, style, and frequency)?
How well does the administrator understand and integrate with the key counterparties within digital assets? Are they able to integrate and pull transaction history from all counterparties used?
How knowledgeable is the fund administrator with respect to DeFi (if appropriate) and are they able to reconcile DeFi transactions efficiently?
How does daily pricing of trading work? Is this consistent with how the manager prices its trading activity?
Is the administrator appropriately staffed to manage all of the back-office accounting and functions while remaining responsive and in regular communication? Does the staff have the appropriate expertise to conduct thorough accounting practices?
Will the administrator offer daily/weekly (depending on strategy) trading activity reconciliations?
Will the administrator handle AML & KYC functions?
Has the administrator provided information for the regulatory body/bodies that the fund/firm reports to? Has the information provided been deemed sufficient?
Are there other managers in your industry willing to offer a reference?
Conclusion
The game of a hedge fund is simple in practice: gather assets and manage those assets for yield, risk, and volatility. But that’s a lot like saying, the key to winning a race is a performing car and a great driver. To get that car to run correctly, there are quite a few intricate systems under the hood, and for hedge funds, top-quality fund administration is an imperative one. Reporting, operations, regulatory, reputation; a fund administrator feeds into all of it, and this is not an area for corners to be cut (not that you would ever do that). Don’t unknowingly let history repeat itself; get a great fund admin.
Valmar is excited to watch the growth of the fund administration space and the coming innovation that seems to be advancing in it month-by-month. At this stage and after its own deep diligence process, Valmar favors fund administrators that have established business both in traditional finance and digital asset sectors. We have found that administrators with dual functionality possess the highest level of expected business and accounting practices and have the most experience with investors (all levels) and regulators. Of course, each firm and fund must and is responsible for conducting its own due diligence. Please contact Valmar if we can make useful fund administrator introductions for you or provide more information.