Operational Diligence

Who Does What: Manager, Administrator, Auditor, and Custodian

Operational failures, not investment losses, are behind many of the worst outcomes in private fund history. The service provider map is where diligence should start.

Copernicus Partners LLC · Educational article

Investors spend most of their diligence effort on strategy. That is understandable, but the historical record is awkward: a substantial share of catastrophic private fund outcomes involved not bad investing but bad infrastructure — assets that were not where they were said to be, or valuations nobody independent ever checked.

The fund administrator

The administrator is the independent record-keeper. It calculates net asset value, maintains capital accounts, processes subscriptions and withdrawals, and produces the statements investors receive.

Its independence is the point. When the manager both makes the investment decisions and reports their value, there is no external check on the most consequential number in the relationship. An independent administrator means the performance figure an investor receives has been produced by someone with no stake in it being flattering.

The independent auditor

The auditor examines the fund's financial statements annually and issues an opinion on whether they fairly present the fund's position under the relevant accounting standard.

Two things worth checking. First, whether the audit is performed by a firm with genuine private fund experience — this is specialised work. Second, whether the fund has ever received anything other than a clean opinion, and if so, why. Ask for the most recent audited financial statements; a fund that will not provide them to a prospective investor under NDA is telling you something.

The custodian

The custodian physically holds the fund's assets. The reason this matters is uncomfortable but simple: if the manager has direct custody of client assets, the manager can move them. Separating custody from management removes an entire category of risk that no amount of investment skill compensates for.

The prime broker

Funds that use leverage, short positions, or derivatives typically engage a prime broker for financing, securities lending, trade execution and consolidated reporting. Not every fund needs one; a long-only fund built from ETFs may have no use for prime brokerage at all. Its presence or absence tells you something about the strategy.

Legal counsel and compliance

Fund counsel drafts the offering documents and advises on securities law — the exemption relied upon, the verification obligations, and the marketing rules governing how performance may be presented. Advisers subject to the SEC's marketing rule face specific constraints on advertising, including requirements that performance be presented fairly and that material claims be substantiable on demand.

An operational diligence checklist

1. Who is the administrator, and how long have they served this fund?
2. Can I receive statements directly from the administrator rather than from the manager?
3. Who audits the fund? May I see the most recent audited financials?
4. Where are the assets held, and who has authority to move them?
5. Who values any position that is not exchange-traded, and how?
6. Has any service provider been replaced in the last three years, and why?

That last question is often the most revealing. Service providers are changed for perfectly ordinary reasons — cost, service quality, scale. But a pattern of auditors or administrators resigning is a signal that deserves a thorough, unhurried explanation.

The underlying principle

Good structure will not rescue a poor strategy. But a good strategy inside a poor structure exposes an investor to risks that have nothing to do with markets and cannot be diversified away. Both halves need to hold. Operational diligence is how you check the half that most people skip.