Top four fund-admin mistakes

There are so many ways to mess up the complex task of fund administration. Here are four big ones.

Take it from the pros – administering a private equity fund is hard work. Mistakes happen, and these bloopers are made by both internal professionals and third-party administrators alike.

The demand for quality fund administration is on the rise, as evidenced by private equity firms staffing up the finance and operations functions, and by the use of outsourced providers.

On the latter point, a recent survey by International Custody & Fund Administration of 27 companies – including State Street, Citco Fund Services, UBS Global Asset Management and JP Morgan – found that the participants were currently administrating around $838 million for private equity firms and $830 million for funds of funds. Although this represented a decline from last year, several of those surveyed said they believed an increase in demand for transparency by investors and the likelihood of additional regulations would lead more firms to outsource areas such as deal confirmation and workflow, investment accounting, compliance monitoring and risk reporting.

However, while using a third-party administrator can take some of these pressures off the firm, even the best providers can make mistakes from time to time, just like internal staff. According to both a fund administrator and a controller for a private equity firm, there are several common mistakes occur all too frequently:

Mistake No. 1: Born under a Bad Sign
The purchasing of a new investment can lead to errors around how it is booked depending on its complexity and how it is structured to meet the needs of various types of investors. “We very clearly see errors around the recording of a particular type of investment either when it was originally recorded, or, secondarily, when there was a capital restructuring of the portfolio company,” said James Hutter, global business executive for JP Morgan Private Equity Fund Services. “Obviously in this environment there are more capital restructurings going on and so it is important to not only book and report it right the first time, but to have ongoing vigilance.”

He adds that having an automated system rather than using something like Excel can help guard against this. “Excel won’t be able to keep up with the complexity of the investment structure; it’s too easy for something to be forgotten,” Hutter said. “The second area is having the right people to book the entry in the first place. You need to hire trained accountants who have experience in private equity. If you don’t get the reporting and recording right, what tends to happen is that when you sell that investment in, say, six years, you only then realise you’ve been booking it wrong and then you have to unwind that whole structure.”

Mistake No. 2: Waterfall folly
Application of the fund waterfall distribution formula is another area that presents challenges to administrators. “If you have a pretty canned waterfall model that follows all common convention, then you should be all right because [fund administrators] have some experience with that,” the controller for a private equity firm with $8 billion under management said. “But the second there is a little twist in the partnership agreement or something different, they are difficult to adapt to that.”

Hutter says problems sometimes crop up when the waterfall calls for opt-out cases – such as an investor having a side letter saying that they cannot invest in certain countries or industries.

More basic though is the possibility for misinterpretation. “There will be those occasions where that fund wasn’t set up correctly,” he said. “If JP Morgan, for example, assumes administration responsibility we make sure that both our client and their legal counsel signs off, just to make sure that the interpretation of the intent is accurate.”
Hutter also says that the use of recycled proceeds is sometimes an area where mistakes are made: “In this day and age, as we see more players moving into different kinds of securities, some funds are now buying and selling more frequently, so it requires even greater understanding of the recycled proceeds provisions. If the whole underlying accounting of the fund waterfall is not right, it’s unlikely that the recycled proceeds are going be right.”

Mistake No. 3: Mangled pie slices
Fund administrators should be careful that an institutional investor’s interest is transferred correctly. This becomes particularly hard in the case of a default. “[The GP] may transfer after the end of year two, for example. You may have a case where a limited partner defaults on their capital call. You then need to follow that through the legal document so that’s appropriately allocated,” Hutter says. “Private equity is an industry with a lot of allocations, and ultimately it is making sure that the pie is sliced appropriately. We see that that doesn’t always happen.”

Mistake No. 4: Ugly reports syndrome
Finally, general sloppiness can crop up when sending statements out to investors. “I don’t think there is the same level of care around reporting to investors, and formatting is not as nice as it could be,” the controller said. “I think you are restricted a bit by the medium and mode in which things get delivered. Whether certain administrators only allow faxing of statements when people just don’t use faxes anymore, or when statements are off by a penny or two because it is in some sort of automated system.”

The controller says such issues can pop up due to high rates of turnover for administrators like fund accountants. But while he stresses the importance of maintaining good relationships with quality administrators, he adds that managers should in the end be the “owners” of the information, as they the ones who will be held responsible if it is wrong.

“Owning that process in-house just makes you more comfortable because there are too many little idiosyncrasies in issues like waterfalls, how things need to be written, how you have to apply offsets and other things that to get to the same level of detail you need to do a full review,” he said. “There is so much that can go wrong with that process and you need to own it so that you are confident in the information being right.”