EXPENSE ACCRUALS

Hedge Fund & Private Equity Fund Operational Due Diligence Since 2009

PRISM INSIGHTS #108

Fund expenses: timing of accruals and payments are relevant factors. 

MANY HEDGE FUND AND PE FUND MANAGERS ACT AS “PAYING AGENT” FOR FUNDS. THEY PAY VENDORS DIRECTLY ON BEHALF OF FUNDS AND SUBSEQUENTLY GET REIMBURSED BY FUNDS, CREATING A RELATED PARTY TRANSACTION.

Almost all institutional hedge fund managers use an independent fund administrator and a recognized national or global auditor. On the other hand, around half of institutional private equity funds use an independent administrator and close to 100% use a national or international auditing firm. Fund expenses: how they are paid, how they are allocated, and finally how and when they are accrued are a focal point of PRISM’s ODD reviews.Payment of fund expenses and wire transfer controls around fund cash have been a long time topic of ODD reviews; and still today should not go unvetted. In short, any bank, prime broker, or custody account should be required to have dual signatures or dual online authorizations. Even today, many reputable managers overlook the online LOA, because they are now accustomed to wiring online. However, it doesn’t mean that manual written LOAs are not permitted; and PRISM relatively often finds this gap at all types of managers. In short, investors want to ensure that the financial institutions holding the fund’s money cannot legally release fund cash without two authorized persons, in any cirumstance.Secondly, the allocation of fund expenses across funds is crucial because it is common practice for managers to allocate certain of their own operating expenses to its clients (aka the funds). Some types of these allocations include errors and ommissions insurance, software, market data, and research related travel. Another category of “expense allocations” is legal fees for deal due diligence and closings, and then there are also “broken deal fees”. For all of these moving parts, it is key to ensure that the manager has a robust allocation process in place to ensure that each fund is absorbing its actual portion of these charges.Lastly,a main point of this brief, is expense accruals. It is often that a manager (hedge or more common PE), will act as paying agent for the funds, paying the fund’s vendors, and subsequently be reimbursed by the funds. This is largely done to reduce the number of wires to one vendor (e.g. auditor, law firm), and to allocate manager originated expenses (e.g. insurance, research travel). The accrual process and timing is critical to ensure that the statement of income records the expenses, as incurred. The risk here is that a manager receives 2018 invoices in 2019, or decides later in a particular year that an expense will be charged to the fund, back loading charges into a profitable month. The allocation accrual process, if not done accurately and timely, could be used in a potential smoothing of earnings. PRISM notes that this is just another reason why a fund’s operational risks are lowered with the use of a qualified independent administrator.