When you talk about a fund, what is the topic of conversation? Is it the legal, regulatory and tax environment affecting the fund? Perhaps it’s the valuation methodology? Maybe it’s about information security and the importance of having robust controls in place? Of course not. What people want to know about is the front office activity – the investment strategy, the acquisitions, the capital raised and the exits.
Yet, none of this just happens. It’s the middle and back office activity that ensures the front office can generate the headlines. Every fund needs a suitable structure, investors need to be on-boarded and managed, financial and tax reporting needs to happen, cash needs to be in the right place at the right time and legal, regulatory and compliance obligations must be met.
In many ways a fund is similar to an iceberg – the fundraising and the deals are the visible part, but so much of running and operating a fund goes under the radar. It’s not the attention-grabbing stuff, it rarely makes the news, but without it the fund wouldn’t function.
And just like fund managers who need to be nimble and flexible so they can capitalise on new investment opportunities, the middle and back office team, whether it be in-house or outsourced, have to be ready to evolve and adapt to industry developments that can impact the day-to-day running of a fund.
As a specialist alternative fund administrator, we’ve experienced both the opportunities and challenges that these developments can bring, particularly on the technological, legal and regulatory fronts. Here’s our view from the middle and back office, or rather the submerged part of the iceberg, on how some of them can be managed or, indeed, exploited…..
Understanding what’s below the surface
We have a rather unglamorous view of a fund! We see it as a complex web of legal structures and entities, serving a number of purposes and often spread across several jurisdictions. Every fund needs a vehicle, such as a limited partnership, that glues the investment, investor and operational components together, carry vehicles to compensate, holding companies to structure the investments – the list goes on.
What most managers don’t have at their disposal is an off-the-shelf solution. Every fund will have its own unique DNA in terms of its investments and investors, and that DNA will determine where, for example, the fund and its holding companies should be located in order to deliver operational and fiscal efficiencies. Factors such as the volume and sophistication of the investors involved will also help to determine domicile and whether lighter touch regulatory regimes, such as the Jersey Private Funds regime or the Luxembourg RAIF, are an option.
Without labouring the point, establishing a fund is a highly complex process with a lot of variables in play. Of course, the structuring itself is very much the domain of the legal and tax advisors, but when everything is in place, the middle and back office needs to step forward. It’s their job to run the sometimes complex structure which has been established.
And that’s equally as challenging. Each jurisdiction has their own legislation governing the operation of a fund, with their own unique reporting, filing, tax, compliance and other administrative requirements.
It’s up to the middle and back office to ensure they not only have a strong understanding of the different regulatory environments, but can operate the various entities and ensure that those operations are managed and conducted in a uniform fashion across all jurisdictions.
That’s ultimately one of the core advantages of outsourcing – the manager will have a middle and back office team that already has a presence across the leading jurisdictions, with the accompanying expertise and experience, and processes and procedures in place to ensure there’s consistency in approach.
Finding the right navigation system
Many of us will still remember the corridors of paper files, the rattle of numbers being punched into a calculator and computers being used for very little other than word processing. Thankfully, things have moved on since then. Today, everything from financial reporting, payments and distributions to record keeping, investor communications and even board packs utilise technology in some way.
In fact, not only has technology enabled us to get things done far more efficiently, but it has helped improve accuracy and reduce the impact of human error. It’s also brought about more control and structure to our activities.
But while there’s no question that technology has revolutionised middle and back office functions, it’s also presented some challenges, particularly from a resource and cost perspective. Technology isn’t static. Fund managers who want to take advantage of the latest technological developments will need to invest in more than the system itself, but the configuration of that system and any relevant training requirements.
That’s why outsourcing is the preferred route for many managers because the cost of technology will effectively be shared across a wide client base, meaning no significant outlay for any one manager. The outsourcing partner is also likely to have their own in-house systems team who will tailor the system to the manager’s requirements, drawing on their experience of supporting other clients with similar operating models.
Cost aside, perhaps the most notable downside to technology, and our dependence on it, is the information security threat. We’ve all read the recent press coverage and understand the damage that can be done both from a reputational and financial standpoint of sensitive information falling into the wrong hands. The threat is made worse by the fact that fraudsters and hackers have evolved from rogue individuals into sophisticated extra-national organisations.
A robust risk management framework, with clear controls, policies and procedures in areas such as transactions, communication and information management, is an absolute must to counter the threat. Accreditations and certifications such as ISAE 3402 and ISO 27001, which represent the gold standard in quality control and information security respectively, should be sought.
Specialist outsourcing providers typically have dedicated information security professionals in situ, who will not only put in place the right measures, such as encryptions, penetration testing and access controls, but help create a culture of vigilance and awareness regarding the risks through training and education.
Entering choppy waters
One of the biggest shake-ups to the middle and back office world in recent times has been the growing regulatory reporting burden. FATCA and CRS are good recent examples of major regulation to have impacted our industry, with MIFID II having come into force and GDPR just around the corner. That’s even before you take into account the stringent compliance and reporting requirements now in play at a jurisdictional level.
This presents a number of challenges for fund managers, among which is the increased cost burden and professional training attached to such regulatory complexity.
The Common Reporting Standard (CRS) is undoubtedly one of the most high profile regulatory developments over the last couple of years. Driven by the OECD in order to introduce greater cross-border tax transparency, signatories to CRS are required to obtain information from their financial institutions and annually exchange that information with other participating jurisdictions.
In force since 2016, it’s been far from plain sailing. The problem lies in the lack of a common framework, which is perhaps ironic given its name. To give you a couple of examples of this; you have Luxembourg which requires full details of the person submitting the information, whereas Guernsey and Jersey require only registration numbers. Cayman and Bermuda stand alone in asking for institutions to submit multiple CRS returns using jurisdictional basis. Then you have the different deadlines, with some jurisdictions flexible on dates and others being far more rigid.
The easy answer to how such regulatory developments should be dealt with is to be as proactive as possible. That means monitoring developments and asking questions at the earliest opportunity, enabling any necessary system or process enhancements to be introduced and the right external advisors engaged in a timely manner.
In reality, regulatory reporting and compliance have become such specialist areas that many managers see that handling it in-house represents a risk. Indeed, in our experience, fund managers want their outsourcing partner to be able to handle the regulatory reporting and compliance components as an integral part of their offering.
So, who’s going to steer the ship?
Hopefully, this article has provided plenty of insight into what goes on below the surface and the crucial role the middle and back office plays in ensuring the fund is a success. To flip my analogy around, what the front office captain needs is the right helmsman to steer the ship – one who knows their way around the regulatory, legislative and technological icebergs and can ensure it remains on the right course. A specialist outsourcing partner might just be the right answer.
This feature article appears in the February 2018 edition of Private Debt Investor.