Some private fund managers in alternatives may recall when a sound investment strategy, an established track record and a few key relationships with the right investors were enough to get fundraising. That's not to say raising assets was easy, or investor due diligence was less rigorous, but the industry was simply not as mature in its early days. During the past decade, as the industry has grown and become more institutionalized, the standards and practices of investors in alternatives have evolved.

According to a recent report by McKinsey & Company, "Money has continued to pour into alternatives over the past three years, with assets hitting a record high of $7.2 trillion in 2013. The category has now doubled in size since 2005, with global AUM growing at an annualized pace of 10.7% - twice the growth rate of traditional investments." The same study notes this trend is not a short-term phenomenon and represents a significant growth opportunity for asset managers.

INVESTOR CONCERNS

In order to take advantage of this opportunity, fund managers need to focus on more than the strategies they intend to execute. They must also structure their funds and organizations in ways that address both increasing regulation and investors' concerns about the safekeeping of assets.

Investors are more knowledgeable about alternatives and their risks, and are no longer content to accept assurances that operational systems are sound without confirming it themselves through a dedicated operational due diligence process. Meeting these standards doesn't just help fund managers avoid regulatory issues - it also plays a critical role in capital raising.

While it's true putting an institutional-quality infrastructure in place increases expenses, making this investment can prove invaluable over the long term. Independent oversight and a clear separation of duties between service providers and fund managers can reduce the risk of fines, fraud, misappropriation, errors and helps position the fund for future growth.

At the heart of fund operations lies the critical work of custodians and administrators. While both play unique roles and serve different purposes, fund managers are best served when each recognize their services are complementary, and collaborate accordingly. These symbiotic relationships are key, as fund managers look to develop, deliver, and service quality fund offerings. Achieving cohesive relationships between all parties is crucial in a world where institutional-quality infrastructure is, for all intents and purposes, a prerequisite for fund managers to raise assets.

QUALIFIED CUSTODIANS

Recently, there has been an outbreak of issues related to RIAs misunderstandings about the SEC custody rule, resulting in violations. The problem has been so pronounced that the SEC issued a Risk Alert in March 2013 related to compliance with the SEC's custody rule for RIAs.

Since the investment advisor is a fiduciary to the fund and responsible for any negative consequences as a result of a failure to comply with regulatory requirements, it is critical to understand the differences between the services offered to properly manage fund operations.

Both custodians and administrators provide services that are utilized in day-to-day fund operations. However, certain tasks, such as holding cash and assets on behalf of investors, fall squarely under the purview of qualified custodians as per the custody rule. Engaging with an independent, qualified custodian in tandem with an administrator creates independent checks and balances as well as operational efficiencies that provide additional oversight and benefits to investors and fund managers.

"The most common reasons to reject a manager are a lack of scalability on the business and investment side and structural weaknesses on the operational front," says François Bocqueraz of Chicago-based Amundi Alternative Investments. "There are custody rules but it will be important to know exactly where our risks are in terms of custody. Is it with the main custodian or is [it] with the sub-custodian or the prime brokers? How did they arrange their business between them? Who is taking ownership of the risk?"

KEY CHARACTERISTICS

Gregory Knapp, director of business development at Chicago-based Opus Fund Services, says there are several key characteristics of a sound, qualified custodian. Possessing superior communication skills top the list. The custodian must also be flexible when considering what duties are appropriate for each firm, he says, and open to ways to improve the relationship.

Also essential for custodians, Knapp adds, is that they provide timely and accurate reporting on cash holdings and actual portfolios at the end of each month, and that they can quickly respond to issues and know how to connect with an administrator's proper contacts.

"The trend in the industry now is to retain a qualified custodian in addition to the third-party administrator to gain that additional oversight," Knapp says.

Jeremy Christensen is senior vice president, Alternative Solutions Group, with the Millennium Trust Company, and Meg Zwick is senior vice president, Private Fund Custody Client Service, with Millennium Trust.

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