by Paula Schaap ,Senior Reporter , August 16, 2010

The word is out on The Street.

Hedge funds are coming back.

But just how far they are coming back from the bleak days post-Lehman bankruptcy and post-Bernard Madoff can be hard to tell.

Except there is a reliable way to gauge the health of the asset class: through talking to those who know hedge fund firms’ strengths and weaknesses most intimately: third-party administrators.

It’s the administrators who see asset flows of the vast majority of the hedge funds and funds-of-funds. Administration firms are also the first to know what investors and managers are demanding when it comes to due diligence and reporting.

Although things have improved in 2010, markets are still volatile. The HFN Aggregate Index is up 1.89% year-to-date.

That didn’t stop investors from putting their money into hedge funds.

With 61 administrators reporting, the 2010 Q2 HFN Hedge Fund Administrator Survey put hedge fund assets under administration at about $2.4 trillion. Funds-of-funds assets under administration were about $900 billion.

The average growth rate of the top 20 firms reporting hedge fund assets under administration for the first half of 2010 was 4.65%. For funds-of-funds assets the average growth for the top 20 firms was 1.39% during the same period.

All that growth augurs well for the hedge fund administration business.

Paul Timmins, managing partner and cofounder of Gravity Financial, says the demand for third-party administration, as well as outsourced chief financial office services the firm offers has been fueled by the smaller fund launches that are the hallmark of the recovering asset class.

“These funds have fewer assets at launch, so the managers are looking for high quality, high-touch fund administration services, but at a lower cost,” Timmins says.

Equinox Alternative Investment Services Chief Executive Officer Stephen Castree believes the recovery calls on administrators to be more creative in their service offerings.

“Existing managers are looking to right-size their fixed cost base now that they’re performing again after suffering a drawdown in their assets,” Castree says. “The way to look at it is by evaluating what they can outsource and then negotiating a contract where the fee structure is variable.”

With hedge funds and their investors keeping a close eye on their bottom line, there is pressure to adjust downward, says Joe Holman, Columbus Avenue Consulting’s chief executive officer.

“The problem is that they are also trying to push down services just when the investors want the service level to increase,” Holman says, “so there’s a disconnect there.

Those services include not only the usual demand from managers, but also increased involvement and oversight from investors, especially the big institutional investors.

Mike Sleightholme, Citi’s Head of Hedge Fund Services, says one thing his business has seen over the last six months is that the very largest fund managers are trying to re-engineer their operating models.

“There are two key drivers for that: one is investors pushing for independence of service providers,” Sleightholme says. “The other is that managers are looking for internal efficiencies in order to improve overall efficiency or scalability or to allow them to expand into new product areas or geographies.”

Sleightholme also says he has seen an increase in fund launches in bank debt and distressed debt spaces.

The big news in the first half of 2010 was, of course, financial reform, specifically the Dodd-Frank bill with its hedge fund registration requirement plus the Volcker rule, which will require banks to limit their proprietary trading and their stakes in private investment firms.

But most of the provisions of the bill, which was signed into law in July, take months to go into effect. Plus, there are many aspects of the bill that require agency regulation and rulemaking, a process that is also likely to take months.

But Paul Chain, president of AIS Fund Administration, says the limit on proprietary trading at the big banks could have a salutary effect on the hedge fund business and, concurrently on administration.

“You may have someone who was in a proprietary desk environment, where they didn’t need an auditor and an administrator,” Chain says. “All of a sudden you could see demand by people who probably will get funded, as opposed to others who are struggling to get funded.”

Another issue facing hedge funds are the greater availability of the newer retail products, such as UCITS funds, ETFs and, even, mutual funds.

Within the last few months, Paulson & Co. has been reported to be considering a UCITS fund product, while Ramius is offering a mutual fund.

Equinox, which has offices in Ireland and Bermuda, is watching the dueling United States-European Union proposed hedge fund regulations closely, according to Castree.

The EU put off until September regulations that would restrict the ability of U.S. funds to offer their products unless they have an EU domicile.

“Both jurisdictions are equally at risk of applying potentially protectionist rulings that will bifurcate the market,” Castree says.

Sleightholme says that while there hadn’t been “a stampede by any stretch of the imagination,” the trend of hedge funds launching retail products is happening.

“We may see more of it as more managers are pushed down the registration street anyway, so it isn’t such a big leap to take it a step further,” he says.

The trend of investors, especially big institutional investors, driving demand for more administration services has only increased in 2010, administration executives agree.

“We’ve seen a lot more demand toward transparency,” Holman says, “But not in the traditional sense. What we’ve seen is investors wanting to know what percent of their portfolio is market quote, what is modeled and what is private?

“Also, they want to know what percentage of the portfolio is at how many counterparties,” he says.

With the future of the U.S. and global economy still uncertain and with regulation ready to go, but still not quite there, hedge fund administrators were cautiously optimistic about what to expect from the asset class.

“The one thing you’re starting to see as money gets allocated to hedge funds,” Chain says, “is that it goes to the big established players first and then works its way down the chain.”

“I think we’re at the very early stage of that healing,” he says.

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