2006 Alpha Awards - Top Accounting Firms

Subscribers, click here to view the winners.

Not a subscriber? Subscribe now to view the winners of the Alpha Awards.

The revelation a year ago that Bayou Management — a onetime $450 million Stamford, Connecticut, hedge fund firm — had for years been fabricating independent auditor reports from a fictitious accounting firm shocked many investors. Although the firm’s co-founders, Samuel Israel III and Daniel Marino, have since pleaded guilty to fraud charges and are awaiting sentencing, the impact of Bayou’s alleged Ponzi scheme is still being felt, especially among accounting firms.

“Since Bayou we find we are receiving more inquiries to confirm if we are the auditor [to a hedge fund client],” says Robert Castro, managing director, financial services, for Chicago-headquartered accounting firm BDO Seidman. “These questions are coming from current investors, prospective investors and outside consultants to firms.”

The Bayou scandal highlights the importance of outside auditors in legitimating and verifying the practices of their hedge fund clients. Investors, keen to ensure that the auditors of their hedge funds are not acting like a rubber stamp, are pressuring their managers to use respected, well-known firms, says Castro, who works out of BDO Seidman’s New York office.

Although the flight to quality by investors has undoubtedly helped win business for the Big Four — Deloitte Touche Tohmatsu, Ernst & Young, KPMG and PricewaterhouseCoopers — smaller firms like Castro’s have also benefited. BDO Seidman is the No. 1 accounting firm in this year’s Alpha Awardsª, handily unseating 2005 winner Rothstein Kass & Co. of Roseland, New Jersey. BDO Seidman is the only firm in this year’s survey to finish first in each aspect of service on which we asked clients to rate it. The firm’s clean sweep includes Alpha Awards in audit, client service, hedge fund expertise, regulatory and compliance, and tax.

Of the Big Four, only Deloitte Touche ranks among the top five overall winners. Castro suggests that more-specialized accounting firms tend to fare better among hedge funds because the managers, especially during the start-up phase, need more-personalized support. “The reason you see smaller firms and local firms doing well is that many of these hedge fund managers got their start in large capital markets firms as traders and money managers,” he says. “They are new to running a business and tend to require more hand-holding.” Once managers get used to that level of service, Castro adds, there’s no going back.

Like those of other hedge fund service providers, the job of auditors is becoming more challenging and varied. Institutional investors, regulators and others are paying greater attention to hedge funds’ books — looking not only at the accuracy of the accounting but also at the valuation of securities. The latter is becoming increasingly important as hedge funds invest more in hard-to-value asset classes.

“The biggest accounting and auditing issue is the valuation of illiquid securities and exotic derivatives,” says Castro. In cases of hard-to-value assets, his firm often outsources the valuation work to experts such as Standard & Poor’s to ensure its accuracy.

Howard Altman, co–managing principal and head of the hedge fund practice of second-place Rothstein Kass, says that having the right valuation procedures in place is critical. “Funds need to understand that valuation policies and documentation are required not only for the annual audit, but should be a part of the monthly closing process to document performance,” says Altman. “In the wake of noted investment fund failures, investors don’t want to get caught again.”

As hedge funds become more global in their investments, they are turning to their accountants for international tax advice and assistance in setting up foreign operations. BDO Seidman, for example, is helping hedge funds to navigate private equity transactions in India and China. For a midsize firm, BDO Seidman is in a unique position; through BDO International it has more than 600 offices worldwide and access to local expertise in most markets. More typical is Rothstein Kass, whose only non-U.S. presence is a small office on Grand Cayman island. “There is enough growth in our U.S practice in the near term that we are comfortable where we are as a business,” says Altman, who adds that his firm has no immediate plans to open other offices overseas.

The Big Four, of course, all have major international operations. Of the 80 partners working with hedge funds at PricewaterhouseCoopers, 30 are based outside the U.S. The Big Four fare better in our ranking when counting just the votes of the biggest hedge funds. No. 9 PWC moves up to No. 3 among the Hedge Fund 100, our list of the world’s biggest single-manager hedge fund firms. Ernst & Young, No. 8 in the overall ranking, jumps six places, while Deloitte Touche, No. 3 overall, moves up two, to first place. (Neither BDO Seidman nor Rothstein Kass garners enough votes among Hedge Fund 100 firms to be included in that ranking.)

For the Big Four accounting firms, catering to multibillion-dollar hedge funds makes economic sense. Samuel Cole, chief operating officer of New York– and London-based credit hedge fund BlueMountain Capital Management, which has $3.3 billion in assets, says his firm has been pleased with the service it has received from Ernst & Young. “We have a very good relationship with the senior partners,” he says. “They do a very good job of auditing the firm.”

One problem that plagues both big and small accounting firms is turnover. Well-heeled hedge funds and funds of hedge funds are snapping up good auditors. Fund-of-funds firms in particular can benefit from an accountant’s expertise. Four years ago, New York–based Blackstone Alternative Asset Management hired away accountant Brian Gavin from Arthur Andersen. Today, Gavin heads up BAAM’s operational due diligence team, which carries out extensive background checks on every manager the firm considers. Having the eyes of a trained auditor on the books can help investors avoid the next Bayou.