Due diligence ‘critical’ for hedge funds selecting administrators

Apex Fund Services (US), a hedge fund administrator, has paid $350,000 to settle charges by the Securities and Exchange Commission (SEC) that it failed to spot red flags and correct faulty accounting by two of its clients, in what one expert says should heighten due diligence by managers on their service providers.

The SEC found that Apex “missed or ignored clear indications of fraud while contracted to keep records and prepare financial statements and investor account statements for funds managed by ClearPath Wealth Management and EquityStar Capital Management,” read the SEC statement. Both organisations have since been charged with fraud by the SEC. Apex neither admitted nor denied the charges but will retain an independent consultant.

“It is critical that fund managers conduct thorough due diligence on their service providers more broadly and understand who their clients are lest there is a potential reputational fallout. I would argue this is something that is particularly true when conducting due diligence on small fund administrators,” said one hedge fund manager, speaking anonymously.

There are pros and cons to appointing small versus large fund administrators. Smaller hedge fund administrators point out they offer bespoke and enhanced client services, and can often focus on niche product sets or markets. Conversely bank backed administrators tend to have greater scalability and can offer a multitude of services including collateral management, custody and depositary. The bank model is also preferred generally by institutional investors – such as pension funds –due to their balance sheet strength. Such a model can also offer better pricing for various services through cross-subsidisation although counterparty risks can be heightened if only one service provider is used for these critical functions.

The hedge fund manager added that small administrators offering depositary-lite services under the EU’s Alternative Investment Fund Managers Directive (AIFMD) were also an area of concern. “Depositary-lite has a lot of parallels between that of a full-scope depositary bank, but does not take on the strict liability if assets go missing or are stolen at the custodian or sub-custodian. Part of the depositary lite’s role is to ensure safekeeping of assets and oversight of the fund as well as its cash-flows,” said the hedge fund.

Many small administrators have set up depositary-lites as entirely separate subsidiaries with different management and corporate governance structures. Nonetheless, conflicts of interest are a risk in this set-up as depositary-lites have to monitor the work and processes at the fund administrator. It is also a potential risk at banks although larger institutions tend to have established Chinese walls and depositary experience servicing their UCITS business. Some may feel the risk of conflicts emerging at depositary-lites is heightened at smaller institutions.

Irrespective, many fund administrators with depositary-lites may have to rethink their business strategies when national private placement regimes (NPPR) expire. This may be a refocus on offshore clients with no EU interests or looking at becoming a full depositary institution if they want to preserve their EU clientele. Others may look to consolidate to create economies of scale. However, NPPR is unlikely to expire in 2018, and many expect it to continue in its current form until the early 2020s even.

In its statement, the SEC said Apex failed to act appropriately after detecting undisclosed brokerage and bank accounts, undisclosed margin and loan agreements and inter-fund transfers made in contravention of the fund offering documents at ClearPath. Apex itself failed to correct previously issued accounting reports and capital statements and provided materially false reports and statements to ClearPath and its independent auditor. These false reports were used by ClearPath to communicate financial positions and performance to its investors.

In regards to EquityStar, Apex accounted for more than $1 million in undisclosed withdrawals by the fund’s owner Steven Zoernack, despite no evidence he was able or willing to repay the withdrawals. Apex confronted Zoernack and concluded he was unable to repay the funds, but did not account for the withdrawals despite them comprising more than half of the net asset value (NAV) of one fund. Apex also sent monthly account statements to investors that it knew or should have known materially overstated investors’ true holdings in the funds.

Apex has also seen some people changes over the last few months. Reports said that Bill Salus, its chief executive officer (CEO) had left after joining the firm back in August 2014 from BNY Mellon where he was managing director for asset servicing. The same reports said Apex founder Peter Hughes was now chairman and CEO and had relocated to Bermuda from the UK.