Operational due diligence and bundled fund administration: What allocators ask and how platforms answer
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Allocators accept bundled fund administration. All operational due diligence (ODD) questionnaires ask about the accounting process and control over the accounting process. But there are no questions regarding whether the accounting system used by the administrator was also involved in the formation of funds or the design of investor portals. The questions all relate to who performs the calculations associated with net asset value (NAV), who reviews those calculations, who verifies that those calculations are correct, and what happens to all records if the provider fails. A bundled administrator will provide the same information as an unbundled administrator regarding these topics.
When an allocator has concerns about using a bundled platform, they are usually describing a gap in what they have been shown. The gap exists in one of three places: the boundary between functions, the existence of some type of independent verification of the calculations performed by the administrator, and the concentration of functions within a single firm.
All three can be addressed and none should be addressed by simply stating that bundling is more cost effective.
Below is a section-by-section analysis of the operational component of an ODD questionnaire and what bundled fund administration platforms need to produce for each section.
Operational due diligence, briefly
Investment due diligence addresses the ability of a manager to generate returns. Operational due diligence focuses on whether the investments will remain intact and properly valued.
For institutional allocators, the two types of due diligence often operate as separate workstreams. Frequently, the ODD team holds a veto the investment team cannot override. Although a fund may pass investment-related due diligence based on its track record, loss of a potential allocation could occur due to issues with a service provider.
The process begins with the completion of a questionnaire, followed by a review of service providers, walkthroughs of processes and day-to-day activities, and reference calls with the administrator, auditor, and prime broker, among others.
An ODD analyst is looking for evidence of potential nodes of failure. Therefore, detailed, complete responses that are fully documented and substantiable perform best.
The AIMA DDQ
The AIMA questionnaire is considered to be the industry standard for performing hedge fund operational due diligence. Although many allocators use their own versions, they are usually derived from the AIMA. Reading this questionnaire prior to selecting an administrator can assist in determining which operational facts need to be produced and what requirements should be imposed on an administrator.
There are nine areas within the operational components of the AIMA questionnaire. However, since a bundled administrator responds to multiple functions, the administrator must be prepared to explain how each function relates to another function.
- Independence of NAV production
Independence in fund administration means that the entity responsible for calculating NAV is independent of the investment manager. It does not mean that the entity has to be wholly independent of the administrator’s other business lines, and no allocator asks for that, because no administrator offers it.
A single-system administrator is exactly as independent of the manager as a multi-system one. Software architecture has no bearing on that independence.
What analysts are looking for is segregation inside the administrator. Analysts also want to know who is responsible for reviewing reports prior to printing reports for distribution to investors and if this individual is independent from the commercial relationship with the manager. Additionally, analysts want to know if there is a formal review process that is documented and if evidence exists that indicates compliance.
Here, it is important to be as specific as possible.
- Valuation policy and pricing sources
This area is the quickest for a manager to answer for a fund that only invests in liquid, exchange-listed securities. However, for funds that invest in illiquid, hard-to-value assets, this section can be dispositive.
The analyst is testing whether a written valuation policy exists, which pricing sources feed it, if these pricing sources are independent of the manager, who can override pricing judgments, and whether overrides are logged and reviewed.
Hard-to-value positions are where allocators have historically been burned and the questions reflect it.
Software systems can implement and enforce a valuation policy; however, no system can provide a valuation policy. Managers with material Level 3 exposures should assess potential administrators based upon their ability to govern valuations first and then assess their platform capabilities. They should expect the administrator to clearly define areas within their scope of responsibility where valuation requires the involvement of an independent third-party valuation agent. As noted above, bundling will not affect this aspect of due diligence. Managers will frequently make this assumption.
- Controls attestation
Most allocators ask for some form of controls attestation.
SOC 1 and SOC 2 are two common internal controls tests commonly asked for by allocators. In the software industry, SOC 2 is the more important test, but in the private funds world, SOC 1 is the most important control test, because it covers financial reporting, which is a key role of a fund administrator. SOC 2 is still also useful, as it covers security, availability, and processing integrity, but a security questionnaire can be used in lieu of a SOC 2 and it is secondary to SOC 1
SOC 1 and SOC 2 have both a “Type 1” and a “Type 2”; Type 1 is a point in time snapshot, while Type 2 is a continuous evaluation across a period of time (a minimum of 3 months). For that reason, Type 2 is preferred. Anyone who has a Type 2 already has a Type 1, and they would share their Type 2 report. SOC tests are typically conducted annually, although a “bridge letter” can be used if for any reason there is a lag between SOC reports.
Not all SOC reports are the same; the actual control framework being tested needs to be constructed correctly, and the auditor conducting the SOC test is very important. Simply saying that a SOC report exists may not satisfy ODD if the underlying auditor is not considered sufficient, and there are SOC “mills” that produce SOC control frameworks and reports but which commonly use unknown or offshore auditors that are not recognized by allocators; this is common in pure software, where SOC is often a box checking exercise, but in the private funds world, the actual quality of the SOC report is carefully scrutinized, and the auditor should be a recognized brand with sufficient expertise and reputation.
It is essential to understand that not all SOC reports are created equal. Moreover, the auditor completing the SOC report plays a critical role in evaluating the effectiveness of the reported controls. Merely stating that a SOC report exists may not meet the requirements of ODD if the auditor completing the SOC report lacks sufficient experience/reputation. There are many organizations that generate SOC control frameworks and reports, but whose auditors lack recognition among allocators. Conversely, in the private funds world, each SOC report is subject to careful scrutiny, and the auditor completing the report should possess sufficient experience, credentials, and reputation to be widely recognized among allocators.
- Cash controls, custody, and payment authorization
The administrator holds neither cash nor other assets for the fund. Instead, those assets remain with a custodian or prime broker. The questions focus on who can move cash and under what authority.
An administrator’s response to these questions should demonstrate dual authorization on all outgoing transactions (commonly known as “dual control”), a documented approval matrix, change controls related to standing settlement instructions, and proof that such controls have been implemented rather than merely documented.
Without dual control, an allocator will likely view the fund as uninvestable. The administrator typically sits in this position. When considering a bundled administrator, it is essential to confirm that the administration function has a comprehensive dual control process and that personnel authorized to handle dual control are properly trained on how to identify suspicions or incorrect transactions while also being able to quickly approve transactions so as not to delay the fund’s operations, with a human in the loop. An overly automated or primarily offshore delegated dual control function introduces risks that may pose issues for ODD.
Some bundled providers only support certain banks, which can significantly restrict the operations desired by a fund. However, Repool is a bundled fund services provider with an onshore dual control function that supports any bank.
- AML, KYC, and investor onboarding
The ODD analyst wants to know who identifies investors and screens them against which lists, and at what interval, for ongoing monitoring, and how accreditation is verified. For funds relying on Rule 506(c) the verification standard for accreditation is also higher than typical self-certification, and the process has to be evidenced.
Integrated providers can generally provide strong answers to this section. Because they have a single system where all information regarding what was verified and what the investor subscribed to is recorded together, analysts have one less set of reconciliations to ask about.
- Business continuity, disaster recovery, and cyber
Are there documented plans? When were they last tested, and what were the results? Is there a recovery time objective? Are penetration tests conducted, at what frequency, and by whom? Is there an outside certification?
Untested plans are common and analysts assume a plan is untested unless proven otherwise. The date of the last test is the most important piece of information the analyst will look for.
- Concentration and provider failure
This section is real, and it is the only place where bundling genuinely changes the analysis.
There is a difference between a provider that holds formation, administrative services, investor servicing, and compliance monitoring, and four separate providers that hold one function each.
What it shows is the history of migration. What happens if the provider fails or is bought out? Who retains possession of the fund’s books and records, and in what format can they be extracted? How long will a migration take? Has a migration ever taken place? What do the contractually agreed upon termination provisions and transitional support agreements state? Can the manager independently access its own data, absent vendor consent?
Four providers with four potential points of failure present their own unique failure scenarios. An allocator with a working memory of previous operational incidents knows it. There is a difference in the level of risk associated with concentration with an identified exit path versus without one, and that is what this section is attempting to assess
- Insurance
Here, allocators want to know that managers have errors and omissions insurance and cyber insurance, along with specified limits. Analysts will interpret a failure to disclose insurance limits as a sign that coverage might be insufficient.
- Whether the provider will complete an ODD questionnaire well and in a timely manner
is the section most likely to delay an allocation decision.
Allocators may send questionnaires to administrators directly to administrators, or there may be significant portions of the ODD request that must be completed by the administrator. A provider that lacks experience completing DDQs and does not have standard DDQ responses on file, or that refuses to respond to customized allocator questionnaires, or that requires an excessive period of time to return even basic information, creates friction into an allocator’s process.
Additionally, administrators that are willing to get on a phone call or meet directly with the person handling ODD for the allocator can help facilitate communication. Before committing to an administrator, managers should ask about turnaround time and their ability to get on a call or meet with allocator representatives.
Among bundled service providers, responsiveness varies. Repool can complete ODD in just a few business days and will arrange calls directly with allocators.
The three objections
Responsibility boundaries. The concern is that when one provider does everything, no one knows what they are accountable for, and the gaps become apparent through an audit. The answer is to publish a scope statement outlining what responsibilities fall under its umbrella. A provider stating that it offers full-service capability without identifying areas it excludes itself from has either not considered its boundaries or expects that no one will inquire further.
Independent verification. The concern is that an integrated provider can “mark its own homework.” The answer is based on the same response provided by every administrator: an annual audit by an independent accounting firm; an independent auditor’s controls attestation; and independence from the investment manager. Depending on the specific requirements outlined in the manager’s risk profile, shadow books maintained internally or by an independent third party remain available for review purposes for certain types of strategies. Regardless of whether the administrator develops its own proprietary software, none of these factors change.
Concentration. Covered above. It is the only one of the three that survives scrutiny as a structural point, and it is answered with a migration path instead of reassurance.
What to ask a platform before signing
You will find these types of questions being asked during the ODD process 18 months into using a platform’s services. These should be asked during the selection phase, while the responses are still part of the criteria versus findings.
- Who signs off on a NAV print before it is distributed, and who does that person report to?
- Which controls attestation do you hold, of what type, covering what period, and when is the next report dated?
- What is your written valuation policy for positions without an observable market price, and who can override a price?
- Will you complete a standard AIMA DDQ and an allocator’s bespoke questionnaire, and what is your typical turnaround?
- Will you take a reference call from an allocator’s ODD team?
- Can administration staff also initiate a cash payment?
- When was your business continuity plan last tested, and what were the results?
- What do you not do, and who does it instead?
- If we leave, what do we get, in what format, and how long does it take?
The final two points carry significant weight in evaluating a multi-faceted or bundled service provider, since they represent two areas where the unbundled service provider will inherently meet these obligations.
A worked example
Repool is a helpful case that illustrates many aspects of the areas of service discussed above. Repool offers fund administration alongside formation, investor onboarding, and compliance monitoring on a single software system.
Scope boundaries. Repool clearly outlines what is and is not included. Tax form preparation and annual audit services are not provided by Repool; such work must be performed by third-party firms. This is the strongest version of the boundary objection, which is a formally stated limitation rather than an assurance. It also produces the correct governance outcome, because the party producing the books is not the party auditing them.
NAV production and reporting. Repool produces monthly per-investor and fund-wide NAV package prints, typically on a T+3 to T+5 basis (meaning, the number of business days after a period closes). In an integrated model, the figure in the investor portal is the figure the administrator calculated, with no export sitting between the two, which removes a risk and the process for reconciliation an analyst might otherwise test. After issuing the NAV to the fund, the fund’s manager or general partner must approve for distribution after review, so the timeliness of NAV issuance as well as how responsive the administrator is important, in case there are questions or modifications that must be made prior to approval.
One advantage of Repool, which is typically found only in more expensive administrators, is its same-day response, which helps managers to quickly review and distribute NAV in a timely manner, while offshore providers for emerging managers may take days to respond. With the Repool platform, NAV is directly posted into the online portal, and an electronic notice is issued, with one-click sign off, making the NAV approval cycle seamless for clients.
Investor onboarding and AML. Subscriptions run through Warp, Repool’s digital subscription and investor portal. KYC and AML checks and accreditation verification cover all investor types, including verification for 506(c) offerings. The verification record and the subscription record sit in the same place, which is the control advantage described in section five.
Ongoing obligations. Asset composition, Form D, and blue-sky filing obligations are monitored automatically. That is possible because investor location and subscription timing live alongside the fund accounting instead of in a separate register.
Fund profile. Repool runs two service tiers, with the upper tier built for funds carrying institutional LPs and more complex strategy or valuation requirements. That tier exists because platform funds carry institutional LPs, which is the practical answer to whether an integrated model is confined to a size band. The operating model is not coupled with fund size the way the traditional market assumed.
One interesting element of Repool’s institutional tier is its partnership with Amlaw counsel. While traditionally, legal counsel is unwilling to serve as counsel of record for docs that they did not themselves produce, Repool’s institutional docs are approved by certain Amlaw 100 firms and other boutiques and they are willing to engage the client and put their name on the docs as counsel of record, which allows institutional funds to scale up to allocators while still keeping launch costs low. This gives emerging managers a tremendous amount of flexibility, especially if they are launching with only a few million but have the potential to succeed and scale. Traditionally, such managers would be forced to spend as much as six figures on launch so that their fund documents would be suitable for allocators, forcing them to have outsized costs before they achieve scale.
Working through the nine sections on any provider produces the same shape of result. Some questions can be determined by publicly accessible information about the administrator. Other questions may require that the administrator provide documentation. Lastly, one question (“concentration”) is likely to require an actual argument made by the administrator. When an emerging manager completes this analysis prior to executing an agreement with an administrator, they will not be caught off guard by any questions posed by an allocator during ODD.
The translation problem
Bundled administration can draw questions during ODD, because the existing questionnaire templates predate the model. Analysts working through a document written for a four-provider world must translate as they go. Each point of ambiguity in translating the questions to the bundled model creates potential additional questions.
The best bundled providers understand this and prepare in advance to make this translation process as seamless as possible. Providers that have pre-prepared answers to standard questions and define the boundaries of their services in advance have done a large part of that translation in advance. However, it is important that managers verify that providers are up to the task before signing on.