IN THE MONEY : Hedge Investors Trust But Verify

Dow Jones News Service

The financial crisis has raised the profile of a previously obscure realm of the hedge fund world: Third-party administrators who verify the performance of fund managers. Third-party administrators, like Bank of New York Mellon Corp. (BK) and GlobeOp Financial Services SA (GO.LN), are like outside auditors. They perform tasks from verifying stock trades to calculating net asset values to mailing out client statements. The financial crisis and scandals, like the Bernard Madoff swindle, have set hedge fund investors on edge and many now demand independent administration, says Kenneth Heinz, who runs Chicago-based Hedge Fund Research. “Institutional investors prefer the integrity of a third party,” said Heinz, whose firm estimates that about 70% of all hedge funds now use one of the 50 largest outside administrators. Other funds either self administer or rely on one of a growing number of start-up administrators.

The growing use of third-party administration is the latest in a series of changes shaking up hedge fund practices amid a push for more transparency in a world known for secrecy. Spurred by criticism they attacked publicly traded companies during the crisis and condemned for missing return targets, many hedge funds have altered their fee structures, relaxed withdrawal terms and focused on soundness rather than eye-popping returns. The changes are likely to help the industry regain investor confidence, which sank after many hedge funds failed to deliver during the bear market. Now, that’s starting to change: Assets managed by hedge funds climbed to nearly $2 trillion in 2009, close to pre-recession levels. Hedge funds are limited to wealthy individuals, foundations and endowments.

After years of self administration, hedge fund D.E. Shaw Group hired Citco Fund Services of the Netherlands last year to handle the task of verifying the value of the $24 billion it manages. At about the same time, Caxton Associates, which manages $8 billion in assets, hired State Street Corp. (STT) to administer some funds. Similarly, roughly third-party administrators around the world are trying to offer more. In December, State Street expanded its administration business by buying Channel Islands-based Mourant International. Citco is the largest with 16% of the market. Opus Fund Services, with offices in Bermuda and three U.S. cities, saw its business grow four-fold in the last half of 2009, says Robin Bedford, chief executive of the firm. Business is driven in part by the Madoff scandal, which demonstrated how easy it is for a fund manager to control his fund’s details, he said. “With high-profile problems, such as the Madoff episode, investors are looking to third-party administrators” for proof of performance,” Bedford said. Opus receives a file of trades from the fund manager, reconciles it against holdings at a prime broker or custodian and values it. Reconciliation usually occurs daily, Bedford says, and clients receive performance statements monthly, directly from Opus on Opus letterhead. For small funds with little infrastructure, these are demanding tasks, Bedford says. But even for larger firms the administrative burden takes time and technology that independent administrators can better provide. “You can’t do this on a spread sheet,” Bedford said.

Steven D. Jones is one of five In The Money columnists who take a sophisticated look at the value of companies and their securities and explore unique trading strategies. He can be reached at 360-834-1865 or by email steve-d.jones@dowjones.com