Fund administration and audits: when a deal needs them

A single-property syndication can be administered simply: one property, a defined set of investors, a competent accountant, and honest books. A fund is different, and as it grows in investors, in deals, and in complexity, the informal administration that worked for one deal becomes inadequate and eventually dangerous. This article is about two functions, third-party fund administration and independent audits, that start as optional niceties and become, past a certain scale, both a practical necessity and a signal in their own right.

On a small deal, no administrator is normal. On a large fund, no administrator is a question the investor should ask out loud.

What a fund administrator does

A third-party fund administrator is an independent firm that handles the operational back office of a fund: maintaining the books and records, calculating each investor’s capital account and ownership, processing subscriptions and distributions, producing investor statements, and keeping the whole ledger of who owns what and who is owed what. The key word is independent. When the sponsor keeps the books itself, the investors are trusting the sponsor’s own accounting of the sponsor’s own performance and the sponsor’s own fees, which is a conflict, however honest the sponsor. An independent administrator separates the record-keeping from the party being measured by it, so that capital accounts, distributions, and fee calculations are maintained by someone with no stake in flattering them. For a fund of any real size, that independence is worth the cost, and its absence means the investors are relying entirely on the sponsor’s self-reporting.

What an audit adds

An independent audit goes further: a qualified outside accounting firm examines the fund’s financial statements and opines on whether they fairly present the fund’s financial position. Where the administrator maintains the records, the auditor tests them. An audit is a real check on the accuracy of what investors are being told, and in some structures it is required, a fund relying on certain regulatory positions, or one whose investors or lenders demand it, may need an annual audit as a condition. Even where it is not required, an audit on a substantial fund is a meaningful protection, because it puts an independent professional’s judgment behind the numbers the investors receive.

The structuring consequence

The scale determines the need, and the need is also a signal. On a single small deal, running the administration in-house with a good accountant is normal and no cause for concern. On a large fund with many investors and multiple assets, the absence of a third-party administrator and, where appropriate, an audit is itself worth questioning, because at that scale the informal approach is not thrift, it is opacity, and it leaves the investors dependent on the sponsor’s unchecked self-reporting for everything from their capital account to their share of a distribution. For the sponsor, adding independent administration and audit as the fund grows is both good practice and good relations, because it tells investors the numbers they receive are not just the sponsor’s word. For the investor, the question scales with the deal: on a small syndication, in-house administration is fine, but on a large fund, ask who keeps the books and who audits them, because at that size the answer separates a professionally run vehicle from one asking for an unusual amount of trust.