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Hedge Funds Must Maintain Oversight, Set Standards When Outsourcing

MIAMI-Hedge fund advisors that believe registration has benefits are quickly learning compliance brings plenty of headaches, too.

And while for a small shop, outsourcing tasks, especially those related to reporting to regulators, may be attractive, it's no easy remedy, experts warned.

"There is a lot of concern in our business, but not a lot of consensus," said Linda J. Hoard, senior vice president and general counsel at PFPC in Boston.

For hedge fund advisors, choosing to remain registered opens the door not only for inflows from institutional investors, but also for examinations from regulators, Hoard said.

"The number one advantage of registering is credibility. It says to the world out there, Look, I have a good record, a clean business and nothing to hide,'" she told an audience at The National Investment Company Service Association's 25th Anniversary Annual Conference & Expo here last month.

"The disadvantage is you will be subject to [Securities and Exchange Commission] exams. Hedge funds are really under a microscope now, and those exams will be rigorous," she said.

For smaller hedge fund complexes, that may be daunting because while managers looking to grow may want to attract institutional assets, they may be unaccustomed and ill equipped to comply with the various accounting and reporting requirements set forth by the SEC.

Outsourcing those tasks offers an alternative-but it comes at a cost.

"You need a recordkeeper, and they don't come cheap," Hoard said.

Still, hiring outside help has its advantages. For example, service providers have expert know-how that may take years to develop in-house. In some cases, freeing up staff to focus on the core operations of the fund is well worth the cost of paying someone else to handle details, she added. Service providers also often have better infrastructure, technology and resources for complex tasks like recordkeeping, Hoard added.

Especially in the still somewhat uncharted waters of hedge fund reporting, service providers can offer a perspective about how others in the industry are tackling certain problems, she said.

But outsourcing is no panacea, she warned.

"If you are a control freak, outsourcing might not be an option," she said. It's important to know the team with whom you will be working, and to set standards.

Vendors aim to please, so most will be willing to negotiate the terms of a contract and customize their service for each client, she noted. At the same time, however, clients must realize that vendors may have scores of clients just like them, and may not always be a provider's top priority.

Clients should set up metrics by which they judge their providers. Hoard suggested tying compensation to performance. For example, if a recordkeeper falls below 98% accuracy, the contract would stipulate that the client would pay less for that period.

Clients should also take time to select the right provider, and establishing a strong contact within the company, so that when there is a problem, it can be remedied quickly.

C. Steven Crosby, a managing director with PricewaterhouseCoopers of New York, warned that even with such firm contact in place, hedge funds especially must keep close watch over their service providers.

"You can't delegate your regulatory responsibility," he said. "They may be preparing the paperwork, but it's you who's responsible for it, and with a hedge fund, that's a massive consideration," he said.

In the long run, outsourcing may not save money after all, Crosby noted. First, outsourcing a straight business function, such as providing back-up network storage, is one thing, but funds should be especially cautious of sending "knowledge processes," such as financial reporting, fund accounting and reconciliations, outside. "In these cases, a closed-loop decision takes place with the service provider, and never comes back to the Mother Ship for approval," he said. Funds quickly lose track in such cases, and find themselves with little defense if something goes awry.

Second, clients should be especially careful about allowing tasks to leave the country. While India, China and the Philippines may offer low-cost, highly skilled labor, they don't offer the basic protections guaranteed by companies operating in the United States. In India, for example, there is no credit bureau, Crosby noted. This is especially risky because some service providers outsource certain functions themselves, without ever disclosing this third-party contract to the hedge fund. That means that while the fund may have vetted their service provider, information and sensitive data might be taken and resold by another party altogether.

"Valuable assets in an uncontrolled environment get sold," he said.

"Ask your board, Do you know where your data is? I mean, do you know right now?'" Crosby said. "If you've just outsourced something, you've just changed the DNA of your organization," he said.