In 2007, hedge fund managers administered roughly 75 percent of U.S.-based hedge funds in house. Today – for reasons including the credit crisis, high profile frauds
and the institutionalization
of the hedge fund investor base – the majority of the hedge fund industry outsources to administrators in some capacity. But outsourcing of administrative functions in the hedge fund industry is not like outsourcing in any other industry. A typical outsourcing arrangement is a classic division of labor: Party A pays Party B to perform specific tasks because Party B can perform them more cheaply or efficiently, or because Party A’s time would be spent more productively on other tasks. See “Primary Legal and Practical Considerations for Hedge Fund Managers Looking to Outsource Their Operational Functions
,” Hedge Fund Law Report, Vol. 4, No. 33 (Sep. 22, 2011). By contrast, outsourcing of administrative functions in the hedge fund industry is not so much a division of labor as a duplication of it. To a degree that likely would surprise observers outside of the industry, hedge fund managers often continue to perform administrative functions even after those functions are outsourced to an administrator. In hedge fund industry parlance, this duplication of administrative efforts is known as “shadowing.” According to a recent Ernst & Young survey, shadowing is “expensive and unique to the hedge fund industry,” widespread and “a business model that might not make economic sense.” See “Ernst & Young Survey Juxtaposes the Views of Hedge Fund Managers and Investors on Hedge Fund Succession Planning, Governance, Administration, Expense Pass-Throughs and Due Diligence
,” Hedge Fund Law Report, Vol. 5, No. 1 (Jan. 5, 2012). So why do hedge fund managers shadow their administrators? That is the fundamental question that this article addresses. In particular, this article discusses: what hedge fund administrators do; what administrator shadowing is; the functions most commonly shadowed by hedge fund managers; reasons why managers shadow their administrators; the benefits and costs of administrator shadowing; whether funds or managers typically bear the costs of shadowing; the circumstances that make shadowing of an administrator most attractive for managers; the different methods managers can use to shadow administrators; and the challenges managers face when shadowing their administrators.