Funds Must Reassess Back-Office Controls
June 8, 2009
Thanks to shady money managers like Bernie Madoff who ruined it for everyone, the lucrative and surreptitious heydays of hedge funds may be gone for good.
Tenacious regulators and spurned investors alike are demanding more transparency of their investment holdings, and hedge fund and mutual fund companies alike will need to beef up their back offices to meet this new demand.
"We are entering a new era of back-office administration," said Kirk Botula, chief operations officer at Confluence. "Firms that thrive will optimize people, processes and technology."
The traditional response to increased back-office demand has been to add staff members. Prior to the recession, the industry's biggest challenge in this area was finding enough talented people who could fill these roles.
All this has changed. Firms have been slammed with budget cuts and have been forced to make staff reductions. The new challenge is meeting operational demand without adding new people, according to a recent whitepaper on hedge fund reporting by Confluence.
"Fund administrators will look to technology to reduce both costs and risk," Botula said.
In many cases, the back-office workload has increased, but the budget for new hires has not. Now, after several painful waves of staffing and expense cuts, firms are discovering they can do more work with fewer people.
Computers will never replace the excitement and emotion of a well-populated back office, but Botula said well-designed technology can be used to reduce costs and errors, increase scalability and elevate service levels.
"The biggest problem in the back office is control," said Scott Powell, senior market analyst at Confluence. "These problems are only getting worse with the new standards."
Powell said most mutual funds and hedge funds are way too reliant on spreadsheets. Back-office reporting processes that rely on spreadsheets and manual processes will become inadequate in the new world of hedge fund administration, the Confluence report said.
"The problem with collecting data is ensuring its accuracy," he said.
Reduce Spreadsheet Errors
"Spreadsheets were never designed to be enterprise-level applications, but the growing use of complex and user-defined functions, lengthy macros and links to other spreadsheets and systems has led to the development of highly complicated applications," according to a separate whitepaper on spreadsheet risk management by the consulting and internal auditing firm Protiviti.
Spreadsheets have exploded in popularity among the back-office and accounting worlds for the easy and efficient way they can be used to organize data into little boxes and rows, but they also have many drawbacks.
As spreadsheets become more complicated, they become more prone to errors, protiviti said
"Over 90% of spreadsheets larger than 100 rows contain at least one error," Botula said. "They are a suboptimal use of staff expertise. Spreadsheets are just a glorified replacement for paper and filing cabinets. They don't create a vision for the future."
Many companies rely on spreadsheets to support essential operational and financial reporting processes, as well as to perform complex modeling for trading decisions, accounting reconciliations and calculating employee bonuses, the Protiviti whitepaper said.
"A fundamental problem with spreadsheets is that untrained users tend to place undue trust in the integrity of the analysis that is prepared in them," Protiviti said.
Botula said Confluence's Unity platform eliminates this over-dependence on spreadsheets by automating and integrating back-office processes to solve fund administration problems ranging from investment performance measurement to customized reporting for mutual funds, hedge funds and other financial instruments.
By putting all the spreadsheet information into a central data repository, approximately 90% of the information can be repurposed, Botula said.
"This way, information actually becomes an asset," he added.
The Unity system uses several layers of safeguards to ensure that only authorized users can access and manage data, Powell said, and it has a tracking tool that shows who accessed what file when. There are hundreds of opportunities to make mistakes throughout the life of a project, he said, including when the company is assembling the completed report.
"Edits are recorded to provide an audit trail of changes," Powell said. "We don't replace the accounting system, but integrate with it."
Bracing for Regulation
Spreadsheet misuse has been linked to numerous high-profile, multimillion-dollar fraud cases in the past few years. Companies that can't control their use of spreadsheets have been forced to file material weakness and deficiency claims with the Securities and Exchange Commission, and this likely to continue, Protiviti said.
"The pressure for greater flexibility and control will only increase with the adoption of additional reporting rules, and challenge current processes even more," said Charles Plaveczky, a principal at the hedge fund accounting and auditing firm Rothstein Kass. "As the April 30 hedge fund financial reporting cycle clearly demonstrated, prevailing error-prone manual processes for hedge fund reporting are far too brittle and inflexible. They lack the scalability to meet increasingly complex reporting requirements."
As hedge funds deal with a variety of reporting requirements, administrators will need to develop processes to maximize accuracy, efficiency and control in the reporting process, in areas such as FAS 157 fair value reporting, FAS 161 disclosures about derivative instruments and hedging activities, and how new International Financial Accounting Standards from the International Accounting Standards Board will challenge existing back-office reporting processes.
"Multiple stakeholders are demanding greater reporting diligence from hedge funds and their administrators," Botula said. "Regulators are clearly focused on greater transparency, investors are demanding additional disclosures and more frequent reporting, and accounting and auditing firms are mandating improved process control and documentation. Hedge funds must consider how technology and automation can improve their reporting processes in order to provide the speed, control and flexibility needed to weather a new era of reporting transparency and control."
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