I got a snapshot of where hedge funds stand as far as outsourcing key operations during a panel discussion at FTF’s HedgeOps New York conference last month. It appears that there are some key do’s and don’ts emerging for external providers such as fund administrators and IT outsourcers. Firms are also developing more nuanced strategies for farming out operations.Overall, hedge funds have to understand that they are outsourcing functions but not the responsibility for them, say panelists. It may not be a good idea to outsource shadow accounting, for instance, and then blame the provider for bad NAV numbers, for instance.
“Most of the restatements we’ve seen have come from those guys that have outsourced [their shadow accounting],” the panelist says. “That doesn’t really fly.” The better strategy for many hedge funds large and small is to keep shadow accounting in house as a control over farmed out, primary accounting services.
The panel also suggests that hedge funds should outsource IT when possible but verify.
One panelist recalled a situation where a new fund manager a firm took a fresh look at the firm’s portfolio line by line and found five bonds had defaulted nine months earlier, which constitutes a material P&L difference that would require a restatement. The problematic bonds had been flagged by the external administrator but the internal accounting staff and an auditor failed to catch the bond defaults and take corrective action. This example is an anomaly, the panelist adds, as the firm had four chief financial officers in two years. Yet the example underscores the point that hedge funds need to maintain an active role in overseeing their external administrators and outsourcers — even after the due diligence phase.
The upside to farming out a lot of the operational grunt work is that internal staff can focus on the industry issues and trends that are likely to determine the fate of the firm, another panelist comments. “By getting a lot of the grunt work, so to speak, out of our hands, we are able to build the strength and education of our people so they can think of things differently—more big picture,” the panelist says.
Conversely, hedge funds can look to third parties for external expertise such as the ever-growing need for compliance consulting and legal help with new areas of securities trading and finance, according to the panel.
While hedge funds are formulating major strategies, they have to keep in mind that they must never assign fund administration and IT management outsourcing charges to the fund, according to all members of the panel. “The key thing is that you can’t charge it to the fund,” a panelist warns. “Outsourcing is a management company issue so you’re going to pay for it yourself.”
Paying for IT outsourcing is a given for hedge fund startups that may have an advantage over larger firms when it comes to cloud computing, the panel says.
While the startups are already acclimated to the usage of third parties and are open to the cloud, larger firms have to contend with an incumbent IT infrastructure. Even though large firms are exploring the cloud and other outsourcing options, “larger managers won’t look to completely outsource [IT management],” says a panelist. The virtualization that is inherent in a cloud computing infrastructure is appealing because hedge funds can pay for the CPU cycles and platforms they need on an as-needed basis and yet move to a smaller IT footprint internally.
“If you already have servers in your closet, now you’re thinking of the pros and cons of cons of converting to the cloud or not,” says a panelist. “How long are these servers going to be good for? When is the insurance no longer available on them? That’s the tougher decision.”
Another consideration is that the relatively new field of cloud providers will require extra due diligence particularly as they are likely to provide disaster recovery services. “There definitely were cloud-based solutions that did not fare well during Sandy,” says a panelist. “There were people that weren’t really backing up in the way they said they were going to. And there were some that were fine.”
Other challenging situations for IT outsourcing include the service level agreements required, especially for highly sensitive data about funds and clients, says a panelist. Hedge funds also have to foster the strictest accountability among their outsourcing providers via effective standard procedures, agreements and documentation.
The panel also stresses that as they engage outsourcing and other external support, hedge funds should also consider:
- Letting their investors know about the outsourcers, administrators and prime brokers they are using or will be moving to;
- Moving to off-the-shelf solutions that are much more easily supported than proprietary order management systems and customer relationship management applications with complicated liquidity modules, for example;
- Rethinking their providers if they have a heavy reliance upon Microsoft Excel spreadsheets to communicate key data; hedge fund staff members should also move away from an over-reliance on spreadsheets;
- Understanding completely the corporate governance and stability of their external suppliers, including knowing liability caps, exclusions for gross negligence, access levels to clients’ data, and the policies and procedures for former employees privy to confidential information.
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