Custodian and Fund administrator in the alternative investments

20.10.2022

 

 

- Good day, Zhandos! We are pleased to introduce you to our audience. Could you please tell us about and explain to our readers what a custodian and fund administrator are and why they are needed in alternative investments?

 

- Good day, dear audience! Thank you for showing interest in this subject. Firstly, I would like to note that custodians and fund administrators are key participants of the global stock ecosystem as a whole, both in traditional and alternative asset classes.

 

To begin with, a custodian or custodian bank - is a financial institution that holds securities and other financial instruments of clients in electronic or physical form. It should be noted that custodians are usually large reputable banks, as they are responsible for the safety of their clients' assets, where amounts can vary from several million to hundreds of billions of US dollars.

 

The fund administrator - is a third-party service provider that independently records and values the assets of the funds and primarily protects the interests of investors. Generally, the administration of funds consists of two parts: providing accounting services and the activities of the registrar/transfer agency.

 

- Zhandos, what is the key role and main responsibilities of custodian and fund administrator?

 

- It should be noted that the main responsibility of the custodian is the record keeping of clients’ assets. Furthermore, custodians provide such services as trade settlements, collection of dividends, clearing, securities lending, and foreign exchange transactions. Moreover, custodians providing custody services for alternative investment accounts shall have competent professionals familiar with the nuances of keeping records of these complex asset classes. It is necessary to note that the activities of custodians are regulated by law and require a relevant license. In general, it should be noted that there are no significant differences in the functions of the custodian in alternative and traditional investments.

 

In turn, the fund administrator role may vary depending on the specific needs of the fund and assets class and, typically includes the following: providing accounting, calculation of returns, valuation of assets (NAV), preparation of financial statements, reconciliation of broker reports, custodian and fund manager. At this point, it should be necessary to note the significance of the fund administrator's role in alternative investments in comparison with traditional investments in stocks and bonds. Since alternative instruments are not publicly traded and therefore do not have available market prices, the valuation of assets is a more complex process. Besides, the main functions of the administrator are conducting compliance procedures in relation to investors and leading managers, keeping and storing all records and calculations, preparation of reports in accordance with the legal requirements and international reporting standards, payment of taxes, and preparation of tax documentation.

 

- Zhandos, please tell us more about the importance of conducting a thorough selection of custodian banks and fund administrators?

 

- In general, it is impossible to imagine the existence of an investment fund of the institutional level without custodians and administrators. In the first instance, in addition to conducting investment due diligence of the manager and the fund, investors need to evaluate the operational infrastructure of the manager, including the custodian and fund administrator. This analysis takes place within the framework of operational due diligence (ODD), which we have discussed previously. Insufficient evaluation of the importance of these institutions can lead to significant and sometimes irreplaceable losses. For instance, without proper due diligence of reliability and experience of custodian or fund administrator, chosen by fund managers, there is a risk of facing negligent record keeping, incorrect NAV calculation, as well as fraudulent acts. Unfortunately, cases of this kind have occurred in alternative investment history. As I mentioned before, one of the key functions of a fund administrator is the calculation of the NAV of the fund’s assets. The price of fund shares depends on this calculation, as per which investors may evaluate the profitability of the manager’s investment activities. Besides, a fee rate received by managers for results-based fund managing should depend on correct NAV calculation.

 

I should notice again that the procedure of calculating the NAV of alternative instruments takes quite a long time. Alternative instruments are not traded on public markets and have no accessible market quotations, therefore, most part of the administrator’s work is focused on the assessment of fund assets, accurately reflecting and accounting for all transactions. Administrators use different valuation methods, such as (1) Asset-based approach based on the valuation of assets and liabilities of objects often using a replacement method, (2) Market approach based on results of market transactions related to identical or comparable assets and liabilities, and (3) Income approach, that includes the forecasted and future discounted cash flows.

 

Additionally, many alternative investment funds, such as hedge funds and private market funds, choose and use custodian services, including to strengthen anti-money laundering (AML) compliance. Important factors when choosing a custodian are its financial stability, credit rating, and the size of client assets under custody (AUC).

 

- Zhandos, what is the fundamental difference between a custodian and fund an administrator?

 

- This is a very good question. Even though custodians and administrators perform related functions, they have some differences, one of which is regulation. Custodians undergo checks from bank regulators as part of the observance of legislative and regulatory requirements, and financial stability. Beyond that, a custodian if licensed by a US regulator should keep records of clients’ transactions in accordance with US Securities and Exchange Commission (SEC) and periodically submit the required reports to SEC. Moreover, custodians shall observe the specific rules and requirements such as the bank secrecy act, client’s identification program, anti-money laundering, and information security requirements while these requirements are not obligatory for administrators. Generally, custodians are nominal holders of clients’ securities, which is why they have to comply with considerably more rules than administrators.

 

- Zhandos, thanks for interesting and insightful conversation, and we wish you a successful work! We also thank our audience for the interest shown to us, and see you soon!

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