Every hedge fund investment manager will, at some point, face the critical question of selecting an administrator to whom to award the administrative mandate for the funds.
Nowadays, finding the appropriate solution to this question is not always a straightforward task and many fund managers struggle to identify the best possible deal. As the demand for hedge and alternative investment products grows, so does the need for fund administrators capable of providing innovative outsourcing solutions and supporting increased product complexity and sophistication.
Recent years have witnessed a rapid increase in the choices available to hedge fund managers. Traditional financial institutions have expanded their administrative service offerings beyond traditional bond and equity funds. In addition, the industry has seen the growth of independent third-party fund administrators, specialising in supporting hedge funds and other alternative investment products.
A low fee schedule is no longer a discriminating criterion when selecting the most appropriate fund administrator since the increased pressure from fund managers to reduce costs and maximise returns has, in general, pushed administrative fees down. The consequent compression of profit margins and the need for greater volumes have shifted the focus of the contest between fund administrators towards qualitative elements of the relationship such as noteworthy expertise, diversified capabilities, use of advanced technologies, cross-border coverage and superior quality of services.
In this competitive and dynamic environment, the assessment of the "fiduciary risk" component of an administration mandate becomes a key element for the hedge fund managers in establishing successful business relationships with their service providers. This "fiduciary risk" can be thought of as the fund administrator's ability to preserve its client's trust by meeting their expectations.
In response to this need, Moody's has developed Management Quality (MQ) ratings for administrative service providers. MQ ratings offer fund managers a facility to enable them to differentiate among global administrators. They also provide administrators with a tool to meet the growing demand from fund managers and other market participants for transparency and disclosure. The first MQ rating to an administrator was assigned in December 2002 to Custom House Administration & Corporate Services Limited, a Dublin-based administrative service provider for hedge funds.
Rating the fiduciary profile of an administrator
The objective of an MQ rating is to present third-party users with an independent ranking of a fund administrator's ability to provide services to clients. In other words, the rating is an opinion of the administrator's "fiduciary risk profile" regardless of size, ownership structure and scope of operations.
The analytical approach supporting the MQ rating is based on the assumption that fund administration is a fiduciary business in which the fiduciary responsibilities extend to every activity of the administrative mandate. An assessment of the fiduciary risk profile of an administrator can thus be seen as equivalent to judging the overall quality of the organisation, its management characteristics and operational practices.
The analytical process
The rating assessment begins with a review of the organisational structure of the administrator. This helps identify the firm's overall ability to exercise proper control over the diverse activities involved in executing its obligations in a timely, systematic and orderly manner. It is important for the fund administrator to have adopted an organisational infrastructure that allows it to carry out these functions without making any serious omissions and to operate in accordance with fiduciary standards, internal guidelines and all applicable laws and regulations. Of course, structures may vary widely from one fund administrator to another, ranging from the small, less formal specialised firm operating from a single location to the more articulated and geographically diversified organisation serving multiple products. As a result, we adjust our analysis to accommodate such differences.
The evaluation of the fiduciary risk profile of an administrator also requires a review of the management's professional skills, its record of achievements in meeting past business plans and its level of awareness of major trends in the fund industry. Particularly in the hedge fund business, which is characterised by rapid products and service evolution, an assessment of the management quality helps measure the administrator's ability to achieve its goals, provide new services or modify existing ones and meet customer needs on an ongoing basis.
The loss of key personnel, particularly members of senior management and leading departmental heads, could have an adverse effect on servicing levels. Consequently, we also evaluate the firm's efforts to retain key staff and the potential impact of staff departures on the stability and performance of the firm.
Moody's analysis also endeavours to gain an understanding of the firm's franchise, business philosophy and strategies for development to determine its long-term feasibility.
Financial soundness is a key element in the successful operation of service organisations. We are particularly concerned with the administrator's ability to fund current operations and meet capital requirements - be it systems, people or capability to meet fiduciary responsibilities - in order to support current and future business activities.
The MQ rating assessment places considerable emphasis on the practices and procedures used by the administrator to manage the business risks associated with being a fund service provider. The review of the risk management process aims to ensure that risks are effectively identified, evaluated, monitored and managed at the appropriate levels within the company. More specifically, our analysis looks at how the administrator selects its service offerings (such as administration, accounting, transfer agent and shareholder services, and register and corporate secretarial services), chooses the products to support (e.g. on-shore and off-shore conventional and hedge funds, funds of funds, managed accounts, and investment companies) and assesses potential clients. We also review the methods that the administrator uses to evaluate the systems required by personnel to service its clientele and their products in an effective manner.
We recognise that, in an industry where pressure for automation is strong and growing, the failure of IT operations could threaten a company's ability to provide efficient day-to-day operations and adequate client services. For this reason, we also look at back-up systems and other failsafes.
Of equal relevance is the extent to which the administrator complies with local and international regulations, which can be ascertained by gaining an understanding of the company's sensitivity to such compliance.
Another factor in the definition of an MQ rating is the quality of operations and procedures. The objective here is to ascertain that the administrator will have continued ability to administer client assets, communicate information to clients, comply with internal/external securities laws and regulations, and maintain day-to-day servicing of fund portfolios. Moody's looks at elements such as the structure and support of the operations function, pricing practices for marketable and non-marketable securities, valuation procedures for different types of investment vehicles, client and regulatory/tax reporting. We also review the hardware and software capacity in the operations, the level of relationship with third parties (such as custodians, prime brokers and other fund administrators), the contingency plans and the output of internal/external audits.
Finally it is important to review client servicing in order to measure the general quality, transparency and timeliness of services. In general, site reviews and discussions with senior management and other appropriate personnel help us reach a fair opinion. We also seek access to internal information and reports dealing with the quality and timeliness of services and customer complaint records, along with observations of operations and activities.
Through site visits and in-person meetings with the entire organisation (from senior management to operational staff involved in day-to-day operations), we make a qualitative assessment for each component described so far. The final rating results from a weighted combination of the different conclusions according to the characteristics of the firm. All of these factors are equally weighted, however, we may modulate some to reflect the character of the firm or unit being rated. This may be based on; the jurisdiction of the administrator, assets under administration, number and type of product offerings or customer types. For example, a strict segregation of responsibilities and independence in such areas as risk management and compliance may not be possible in a small-sized firm with a limited number of individuals. However, this may be offset by the type and number of products offered, ownership structure considerations, nature of external audits, and the firm's operations practices and procedures.
In conclusion, MQ ratings are not intended to be a substitute for due diligence reviews by managers seeking administrative services. The scope of Moody's opinion is to complement the evaluations and any request-for-proposal process conducted by asset managers. As with any other rating, the final objective is to enable market participants to benefit from a globally comparable analytical tool in order to increase transparency and to communicate and improve the effectiveness of controls and procedures in the fund administration industry.
Management Quality Rating Definitions:
Entities rated Aaa(MQ) are judged to exhibit an excellent management and control environment.
Entities rated Aa(MQ) are judged to exhibit a very good management and control environment.
Entities rated A(MQ) are judged to exhibit a good management and control environment.
Entities rated Baa(MQ) are judged to exhibit an adequate management and control environment.
Entities rated Ba(MQ) are judged to exhibit a questionable management and control environment.
Entities rated B(MQ) are judged to exhibit a poor management and control environment.
Note: Numerical modifiers 1, 2 and 3 may be appended to each rating classification from Aa(MQ) to B(MQ). The modifier 1 indicates that the entity ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates that the entity ranks in the lower end of its letter rating category.