Hedge Fund Investing Chapter 12 Part 2: Service Providers - Auditors and Tech

In the first part of Chapter 12, we covered fund administrators and prime brokers. Now we get into the other critical service providers: auditors, lawyers, and technology firms. These are less flashy but just as important. A hedge fund without a good auditor is like a restaurant without a health inspector. Maybe everything is fine. Maybe you don’t want to know.

Auditors: Trust But Verify

The audit firm provides two crucial functions for investors: validation and attestation. In plain language, they check that the fund’s numbers are real and sign off on them.

But auditors do a lot more than just the annual audit.

Scope of Services

• Audit and attest. Independent review of the fund’s books, performance calculations, and valuation methods. This is the core service.
• Tax services. Choosing optimal jurisdictions for onshore and offshore funds, minimizing withholding taxes, partnership accounting, K-1 preparation.
• Governance work. SAS 70 readiness reviews, anti-money-laundering process reviews, valuation models for complex securities, compliance manual preparation.
• Operations and technology support. Building due diligence questionnaires, helping select administrators or prime brokers.

A basic audit costs $50,000 to $150,000 per year. Additional services pile up fast. This is a long-term relationship. Changing auditors is expensive, takes time, and raises questions from investors.

Red Flags

Here is something Mirabile emphasizes. If a fund changes its auditor, treat it as a red flag. Investigate immediately. Too often, auditor changes happen because of disputes over valuation or tax risk between the fund and the auditor. The fund did not like what the auditor was saying, so they went shopping for a friendlier one.

Audit firms compete hard upfront to win hedge fund business. Once hired, there is very little turnover. So any change in auditor deserves serious scrutiny.

The Big Four

Most investors can feel comfortable with the Big Four audit firms: KPMG, PricewaterhouseCoopers, Ernst and Young, and Deloitte. Deloitte was ranked as the top hedge fund accounting firm among the Big Four for five years straight in Institutional Investor’s Alpha Awards. They placed first in client satisfaction, hedge fund expertise, and regulatory compliance for funds with $1 billion or more.

If a fund uses a lesser-known or cheap auditor, ask why. Sometimes there is a good reason. Often there is not.

Legal Counsel: The First Decision

Choosing a law firm is often the very first decision a new hedge fund manager makes. Before you trade a single dollar, you need lawyers to set up the fund structure.

What Lawyers Do

• Fund formation. Setting up the legal structure, whether it is a master-feeder, side-by-side, or umbrella fund structure.
• Offering documents. Drafting the paperwork that lets you legally raise money from investors.
• Regulatory advice. Securities and derivatives regulation, ERISA matters, tax optimization.
• Marketing arrangements. What you can and cannot say to potential investors.
• Trade documentation. Standardizing contracts for derivative trades and other complex instruments.

Legal services tend to cluster in major hedge fund centers. New York, London, the Cayman Islands. Each location has firms that specialize in hedge fund work and know the local regulatory landscape.

A top law firm adds reputational value, especially for new funds that do not yet have a performance track record. Investors see a name like Sidley Austin on the offering documents and it carries weight. The firm was ranked number one onshore U.S. hedge fund law firm in 2006 and 2007 by Institutional Investor’s Alpha magazine.

For offshore funds, firms like Walkers specialize in international financial center work. They have set up funds in virtually every known strategy and structure.

Technology: The Silent Infrastructure

This is the section where I feel most at home. Having worked in IT for decades, I can tell you that technology decisions are way more important than most people realize. And hedge funds are no exception.

Many hedge fund founders come from technology-rich banks. They are used to having Bloomberg terminals, proprietary trading platforms, real-time risk systems. Then they start their own fund and realize how expensive it is to re-create that environment from scratch.

What Tech Providers Offer

The list is long:

• Business continuity planning and disaster recovery
• Data backup and recovery
• Email and message archiving
• Connectivity to brokers, ECNs, and exchanges
• Cloud computing and data storage
• Networking and security
• Help desk and outsourced IT
• Co-location and server management
• Mobile computing solutions

Firms like Eze Castle Integration and Edge Technology Group built entire businesses around providing these services to hedge funds. Eze Castle had over 600 hedge fund clients managing more than $300 billion in assets. They offer everything from private cloud computing to disaster recovery.

Why Investors Care

Investors want to know their information is safe. They want to know the fund can still trade if the office floods or the Internet goes down. Standard due diligence questionnaires include multiple questions about technology and business continuity plans.

The Alternative Investment Management Association published a guide specifically for hedge fund business continuity. If a fund cannot articulate its disaster recovery plan, that is a problem.

Common Mistakes

Mirabile lists several technology mistakes hedge funds make:

• Working with generalists instead of industry specialists
• Underestimating how long setup takes
• Making decisions based purely on cost
• Overinvesting too early or underinvesting as the firm grows
• Keeping old hardware and software past their useful life
• Not training staff on the tools they already have
• Doing too many things manually when automation exists

Jim Nekos, CEO of Edge Technology Group, put it bluntly. The “year-one” objective of a hedge fund is to make it to year two. Funds that budget properly for technology tend to survive past five years. Those that do not will struggle in due diligence questionnaires and reduce their chances of raising capital.

Other Considerations

Beyond the big four service providers, hedge funds need payroll providers, record-keeping systems, real estate agents for office space, document storage and retention services. Funds with a proper C-suite (CEO, CFO, COO) can assign each of these to someone senior. Smaller funds with just traders and a receptionist have to lean on their lawyers, auditors, and prime brokers for vendor recommendations.

Industry associations publish best practice guides that investors can use to evaluate a fund’s operational setup. The Alternative Investment Management Association puts out “A Guide to Institutional Investors’ Views and Preferences Regarding Hedge Fund Operational Infrastructures.” It covers fund governance, risk, performance, terms, ownership, and operations.

The Bottom Line

Choosing service providers is a defining moment for a hedge fund. It tells the world who they are and what they stand for. Picking high-quality partners tells investors the manager is serious about the business and willing to pay extra for safety, transparency, and risk management.

Getting it wrong can be devastating. Getting it right the first time requires the same due diligence and planning that investors apply to picking the fund itself.

Service providers are not glamorous. Nobody writes articles about the best fund administrator. But when things go wrong, when Madoff happens, when Lehman collapses, when an audit reveals problems, it is the quality of these partners that determines whether a fund survives or goes down.

Previous: Chapter 12 Part 1 | Next: Closing Thoughts

This is part of a series retelling of “Hedge Fund Investing” by Kevin R. Mirabile.