Expense allocation is the process by which the various expenses incurred by a fund manager are divided among various funds. These expenses can include everything from trading and system costs to conference and legal fees.
One of the most important questions posed during the expense allocation process is “Who should pay for this expense, the fund manager or the funds?” The significance of this question has increased in parallel with the costs of operating a hedge fund. There is no straightforward answer, and it is generally determined by the legal documentation pertaining to the fund manager and the funds. There is also no specific guidance provided by the SEC on how to allocate various expenses due to the large variety of expenses that can be incurred. This is why the expense allocation process attracts such heavy scrutiny from both investors and regulators.
For all of these reasons, it is critical for asset managers to be transparent about expense allocation. Transparency helps ensure investors understand how their money is being used so they can make informed decisions about their investments.
Hedge funds typically use a few different methods to allocate various types of expenses. Four of the most common methods include:
1. Pro Rata Allocation: Expenses are divided among the funds based on their NAV or AUM. This is the simplest method of allocation, as it does not require any additional calculations or assumptions. Pro rata allocation is generally used in cases where a common service, system, or product is used by the asset manager for the proper operation of all the funds it manages.
2. Deal-Based or Investment-Based Allocation: Expenses are allocated to all funds that invest in the deal according to ownership percentage. This method is used for expenses incurred for a specific deal, such as T&E, general legal services, and advisory fees.
3. Fund-Specific Allocation: Expenses are allocated to a single fund and may include expenses related to consulting, incorporation, compliance, and due diligence.
4. Other Methods: Some fund managers use other methods of allocation, including:
a. Allocation to funds based on partial capital investment: These can include tax return preparation and tax consulting services in one region. In this case, the capital invested will be calculated based on the investors in that region only.
b. Allocation to funds based on the issuer of security: Expenses are allocated among funds based on the number of securities, the funds own.
c. Allocation across all funds by strategy or segment: These allocations can be done based on AUM, NAV, or capital commitment.
Using an expense allocation solution for private equity and hedge funds is especially important because it makes it easier for managers to keep a close eye on expenses and find ways to reduce them where possible. This can help improve the fund’s overall performance and increase the return on investment for investors. For example, the solution can:
1. Automate the expense allocation process, which speeds up the process and allows more time for handling exceptions.
2. Remove employee discretion in allocations by setting up a process that determines allocation rules automatically (rather than relying on each employee’s memory), which helps reduce errors.
No matter what kind of fund you manage, an expense allocation solution is important and can have a significant impact on both fund performance and investor returns. Deploying an expense allocation solution enables fund managers to maintain transparency and be mindful of expenses, ensuring the best possible outcomes for all stakeholders.
The IVP Expense Allocation Solution for private equity and hedge funds not only helps fund managers stay compliant and improve transparency but also allows them to automate the expense allocation process and improve efficiency.
Expense Allocation Solution
This expense allocation solution helps asset managers improve accuracy and efficiency, reduce the risk of errors, and guarantee compliance. It ensures that in-house teams can process most allocations swiftly, allowing them to focus more on exception handling. Accounts payable and expense allocations are also tracked by the platform through customizable reports. Additionally, it offers easy-to-set-up invoice approvals and maintains a detailed audit trail for approvals, rejections, and changes.
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