Audit fees have skyrocketed for some small-fund managers over the past few months, as the slew of new regulations and pending litigation puts the squeeze on small shops' already stretched budgets - forcing them to consider dumping their existing auditors in favor of less expensive ones.

Those audit fees, which all mutual funds incur when they hire accounting firms to provide their SEC-mandated annual financial audits, have risen by double digits, said fund managers of single-fund or small fund complexes.

In some cases, audit fees have soared 20%, 30% and as much as 60%.

One New York-based fund group president explained her recent shock at being told audit fees for her plain-vanilla fund complex would ratchet up almost 60%, despite assurances that her fund group has been an outstanding client. In the best interest of investors, she and the board's audit committee bid out the funds' audit work to other accounting firms and are considering these firms' proposals.

Another single-fund manager in Maryland is also feeling the squeeze from the auditor price vice. "There is a smaller group of auditors [we] are being forced to consider," he said.

Take a Walk'

The existing auditors are basically asking you to take a walk, he added.

Representatives of all four major audit firms, Ernst & Young, Deloitte & Touche, KPMG and PricewaterhouseCoopers, had either not responded by press time or were unavailable for comment.

Despite the frustrations of the number of small fund managers that MME contacted, mega audit fee increases aren't being universally force-fed to all small mutual fund sponsors. Some managers who preside over diminutive funds have noted that while fees have grown, their shops haven't been slapped with huge fee increases at all.

The $1.3 billion Hennessy Funds group, managed by Hennessy Advisors, Novato, Calif., has used KPMG as its fund auditor for a long time and hasn't been on the receiving end of a whopping audit fee increase, said Neil Hennessy, president and portfolio manager of the fund group. He points to his funds, which, at most, hold only 50 securities at a clip and aren't difficult to audit or price.

Likewise, Don Yacktman, president and chief investment officer of Yacktman Asset Management of Chicago, which employs PwC to audit its two funds, hasn't seen killer increases.

"Ours [audit fees] are not going up dramatically," he said. While he concedes that higher audit fees are the norm now, driven by droves of new SEC requirements that layer on costs, his audit fees are not "out of this world."

Thinning of the Herd

That fee disparity points to audit firms increasingly cherry-picking which mutual funds they want to keep as audit clients, on the one hand, and which low revenue producers they hope to cut free, on the other, said industry insiders.

The ones that aren't lucrative enough from the accountants' perspective are being hit with large fee increases in order to voluntarily drive them away or, alternatively, forcing them into contracts with mega fees. "The Big Four are willing to keep the smaller funds, [but only] if they are willing to pay up," said one fund industry executive, on condition of anonymity.

As a result, the industry is increasingly seeing an auditor polarization. The Big Four accounting firms, which have traditionally provided audit services to larger mutual fund groups as well as a smattering of small ones, have been divesting themselves of at least some small funds or complexes, industry insiders confirm.

At the same time, single or smaller fund groups are now actively seeking the assistance of a growing group of smaller but growing accounting firms that are happy to cater to the little guy and are billing themselves as the "alternative" audit firm to turn to.

Classic Strategy

It's a classic business strategy, said Mike Boyle, partner with Briggs, Bunting & Dougherty (BBD), a Philadelphia audit firm that caters to fund startups, small and mid-size funds. The firm has seen its fund audit business double over the past year, with a dozen clients defecting from the Big Four.

"There's a lot more work for accountants to do now," Boyle conceded. For the Big Four, it's a matter of good business sense. "You raise your fees on your lower revenue clients," he added.

"We've gotten plenty of calls within the last year from clients of Big Four firms that are seeing audit fees that are 20% to 30% higher," echoed Bill Kouser, another BBD partner. The eight-year-old firm now provides audit services to 92 clients with more than $9 billion in collective assets.

Big Four's 99% Market Share

Now that public accounting firms have divested themselves of their consulting practices, they are paying a great deal more attention to their core audit practices, said Burton J. Greenwald of B.J. Greenwald Associates, the consulting firm in Philadelphia. In the past, if auditing services for a small fund complex was part of a relationship with a $30 billion, or $40 billion client with lucrative tax work or consulting projects to offer as well, the accountants were happy to allow those auditing fees to be loss leaders. But those days are gone.

"There are no concessions to those smaller funds anymore," Greenwald said. "The whole audit process is under strain and they [accounting firms] have to pay up to attract and retain talent in addition to the added pressure on their expenses," he added.

The Big Four accounting firms are definitely a force to be reckoned with in the fund industry, as well as in the larger corporate world. The folding of Arthur Andersen produced a flurry of defections among mutual fund clients that gravitated to other audit firms.

Recent reports have noted that even the Securities and Exchange Commission has expressed concern that the loss of another of the largest accounting firms could seriously impact audit services in all industries.

According to data from Lipper of New York, of the more than $8.7 trillion that mutual funds and variable annuity portfolios collectively hold, the Big Four are responsible for auditing almost 99% of the total assets.

PriceWaterhouseCoopers currently audits more than 55% of the industry's assets, with Deloitte & Touche auditing just over 20% and Ernst & Young auditing over 13% of those dollars. KPMG comes in fourth as the auditor of less than 10% of the industry's assets.

That leaves the smaller audit firms, including BBD, Tait, Weller & Baker of Philadelphia, and Cohen McCurdy of Westlake, Ohio, to compete for the other 1%.

But those smaller firms don't necessarily want to be seen as the low-cost provider, which carries the connotation of lower quality. BBD's partners believe their fees are intrinsically lower than the Big Four's audit fees because of significantly lower overhead.

Joining the 100 Club

There is also another challenge to smaller audit firms that may be the beneficiary of funds defecting from the Big Four auditors. The Public Company Accounting Oversight Board (PCAOB), which was created through the passage of the Sarbanes-Oxley Act of 2002, mandates that audit firms with fewer than 100 registered clients be inspected triennially. Those with 100 or more registered clients must be inspected by the PCAOB annually. That added level of scrutiny has caused some small but growing audit firms to reconsider how big their client list becomes.

(c) 2005 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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