Hedging forward

The disasters of 2008 made operational risk a prime concern for hedge fund investors.What can we expect in the short-term future? Here is a 10-point outline for a new consensus

By Christopher J. Addy
Illustration: Jud Guitteau

Hedge funds have moved into the mainstream of institutional investing. Just 10 years ago, they were still largely the “secret club of the super-rich” but now, pension funds, sovereign wealth funds and large endowments embrace the absolute return and diversification benefits available from hedge funds. Retail investors are also exposed to them as never before: your corporate pension very likely has hedge fund exposure, and, more generally, the movements of both stock and bond markets are now heavily influenced by hedge fund investment decisions and capital flows.

Undeniably, however, 2008 was the annus horribilis of the hedge fund industry. Evidently, the funds failed in their central premise to generate absolute returns irrespective of market direction. According to the Credit Suisse/Tremont index, the average hedge fund returned -19%in 2008. While this compared very favourably with the -38.5% drop in the S&P 500, 2008 destroyed the myth that hedge funds had somehow discovered the secret of alchemy and could always deliver positive performance.

Two further factors combined to rein in the industry during 2008. Toward the end of the year, funds worldwide took advantage of the fine print on their prospectuses to impose gates and suspend redemptions. While market conditions following the collapse of Lehman Brothers were unprecedented, events nonetheless highlighted structural weaknesses in many hedge funds, notably the trend to place ever more illiquid assets into what is still an open-ended investment vehicle. By the end of 2008, many funds simply declared themselves unable to give investors their money back, at least in the short term.

The other factor, of course, was the colossal fraud perpetrated by Bernard Madoff. To be precise, Madoff did not offer a hedge fund; rather, he was an institutional money manager offering clients private, managed accounts. However, his hedged strategy, and the large number of hedge fund investors involved, profoundly shook the confidence of investors worldwide.

It is against this background that the discipline of operational due diligence for hedge funds has come into renewed focus. The idea of completing a review of the accounting controls and business operations of a hedge fund manager is not new — it has been around for more than a decade. However, due diligence practices across the industry have been very mixed. While some investors have conducted thorough operational reviews for some time, others have continued to consider only performance.

In practice, a number of issues combine to make hedge funds unduly exposed to operational risk. At their heart, hedge funds are a paradox: while they may trade large volumes of extremely complex securities, most hedge funds have fewer than 50 staff. As a result, investors cannot rely on the depth of resources — or deep pockets — that can be taken for granted at a major asset-management institution. Moreover, many hedge fund managers, while skilled traders, may not be effective business managers (many fund managers launch their own firms to escape the bureaucracy of a large investment bank). Finally, there remains a complete lack of standard business practices in the hedge fund industry. Operational practices vary widely from fund to fund, particularly in critical areas such as valuation and administrator oversight.

Given the painful experiences of 2008, operational risk is now a central concern for all hedge fund investors. Many new topics are on the table, including transparency, fee structures, managed accounts and outsourcing. It will likely take some time for a new consensus to emerge and, in practice, the industry will likely continue to offer a range of alternatives rather than a standard solution.

As the dust settles, however, we can outline a 10-point framework that will impact the world of Hedge Funds 2.0.

10. Operational due diligence is about more than operations
Many investors have traditionally viewed operational due diligence only as a defence against fraud and other catastrophic loss. Due diligence procedures have, therefore, tended to focus narrowly on accounting controls and procedures if being conducted by an accountant — or legal terms and conditions when conducted by a lawyer.

While any due diligence review will consider the risk of a blow up, effective due diligence provides a much broader insight into the overall quality of each manager’s business, including each firm’s culture and operational philosophy. Indeed, business risk due diligence is probably a more helpful description than a more limited operational due diligence framework.

Managers who fail to make an appropriate investment in people, systems and other infrastructure will unavoidably fail to deliver optimal performance. The purpose of operational due diligence, therefore, is as much to assess the risk of a drag on performance due to a poorly run business as it is to identify outright fraud.

9. Due diligence requires judgment, not a scorecard
Judgment is critical in the due diligence process. There is an enormous variety of hedge fund operating models across different strategies and jurisdictions, meaning that the typical hedge fund structure is far from one size fits all. While some due diligence practitioners use a rigid, predefined list of criteria to determine an overall score, effective due diligence must combine a consistent process with subjective opinion.

In our experience, yellow flags and warning signs are as likely to be subjective impressions as they are objective facts. Perhaps a manager is a little too aggressive in passing through research or spurious back office costs to the fund; perhaps the firm’s compliance procedures spend more time on justifying exceptions than on enforcing rules; perhaps the manager has gone above and beyond to ensure that the fund’s offering documents allow flexibility “in the sole discretion of the investment manager.” Individually, these issues may not be overly significant, but collectively they can be important signals to help investors understand how managers view their business and their relationship with investors.

8. Due diligence is just as important on the biggest and the best funds
The Madoff fraud was astonishing, not only in terms of the sums involved but also because of the number of years over which it was sustained. Madoff was, unfortunately, able to take advantage of a perfect confluence of circumstances — he conducted his crime in an industry that not only had enormous sums of money, but was also prepared to accept that certain managers didn’t have to explain what they were doing.

The lesson for investors is obvious: irrespective of the manager in question, it is emphatically necessary to complete robust, detailed due diligence. It will no longer be possible for any investor to have a list B of certain managers who, because of tenure, reputation or length of personal relationship, are allowed to provide less information. Going forward, this also means that all managers — even large and successful ones — will need to provide a new degree of operational transparency. This will require a marked change in attitude for some larger firms that, to date, have pushed back on investor requests for better information.

7. Ongoing due diligence is vital
One of the biggest errors in operational due diligence is to review a manager only at the time of initial investment. Once a fund has passed due diligence, investment teams have often been quick to assume that all operational issues have been resolved and that once a fund is in the portfolio, only performance matters.

In practice, systematic, ongoing due diligence is as important as the initial review. Events of recent months have demonstrated how quickly the operational rules can change. Going forward, many managers face entirely new business challenges due to new regulations, redemption pressure and lack of opportunity to earn incentive fees if they are under their high-water marks. How these managers will run their business to navigate the coming 12 to 24 months is just as important as their investment thesis.

Even when times are more stable, on-going due diligence is essential. Every hedge fund faces a constant challenge to keep up with new trading technology, adapt for new instrument types, and match the ongoing evolution of industry best practices.

Funds also update their offering documents, change service providers and experience turnover in key roles such as the CFO and COO. Each of these events must be evaluated on a timely basis.

6. Investing is a partnership: good managers accept advice
Operational due diligence is an important touch point in the relationship between manager and investor. Many managers appreciate comments and perspective from a seasoned due diligence team; while managers may know their own organization in minute detail, they have much less knowledge of the practices adopted by their peers and competitors.

The attitude of the manager during the due diligence process can also give valuable insights. At one extreme, some managers may view due diligence as a mundane necessity, adopting a bored attitude when answering investor questions. At the other, we consistently find that the more capable the CFO, the more quickly he or she will ask for feedback and suggestions about how controls and procedures could be improved. A commitment to continuously improve the hedge fund organization sends a strongly positive signal regarding culture and business philosophy.

5. Remember that the administrator, directors, auditor and law firm are paid by the investor, but hired and fired by the investment manager
External service providers perform important functions to support a hedge fund and, in theory, safeguard investors. However, service provider relationships are often imperfect due to the unavoidable tension between the interests of the in-vestment manager — who is the day-to-day client and has the power to hire and fire the service provider — and those of third-party investors. For investors, service providers must be independent and above all, work to protect their interests rather than those of the manager.

In the legal area, the redemption crisis of late 2008 has created a strong backlash against the efforts of hedge fund lawyers to insert ever tighter disclaimers, exclusions and waivers into fund offering documents — despite all the legal bills being charged to the fund and paid by investors. Going forward, we expect investors to be far more active in negotiating changes to the fund prospectus to derive more balanced terms.

A related issue is corporate governance. There is now an increasing awareness that billion-dollar hedge funds need meaningful, independent boards able to consider the interests of investors as well as the manager. Unfortunately, most hedge fund boards today are comprised of the manager plus representatives from offshore corporate secretarial firms who often act as directors for tens, if not hundreds, of other hedge funds. Going forward, investors will push for more involved and investor-focused board members.

Perhaps the most important service provider, however, is the fund administrator. We are strong proponents of the need for effective administration, which, in our view, is investors’ best defence against fraud and malfeasance. However, investors should be conscious that not all fund administration is created equal. For example, some administrators take accounting information from the custodian/prime broker and then complete an entirely circular reconciliation back to the same custodian, without any effort to obtain trade information from the fund manager. The lack of a thorough, three-way reconciliation (manager to administrator to prime broker) significantly reduces the value of third-party oversight.

The biggest issue in the administration industry is, however, valuation. Many investors continue to assume that an administrator hired to calculate a fund’s net asset value must also independently value the portfolio. Unfortunately, this is not the case: the administration industry typically seeks to disclaim legal responsibility for pricing and, ever more, limit its role to one of price verification, where that verification can be selective and in accordance with widely varying tolerances. As such, today’s investors face a confused and unpredictable array of administrator pricing, which varies from strong to entirely ineffective. In particular, for hard-to-value securities — which are self-evidently those instruments where fraud is most likely and third-party pricing oversight most important — we see an alarming increase in the number of hedge fund administrators who are prepared to accept manager valuation marks without any form of independent verification. Careful due diligence is required and investors should emphatically not assume that top-tier administrators will always provide top-tier servicing.

4. Beware of conflicts of interest
Conflicts of interest are also a lingering issue within the hedge fund industry. Fee breaks, retrocessions, side letter agreements and other behind-the-scenes deals all merit careful attention. There can be conflicts allocating trades between hedge funds and other investment products in larger investment houses that also offer traditional funds. Service provider conflicts can also be present: some funds own their own administrator, and the situation where a prime broker also owns its own administration is also not conflict-free. As always, investors should examine and consider each potential area for conflict and decide if it represents a material due diligence issue.

3. Be prepared to ask tough questions — even when you are making money
Madoff reminds us that every Ponzi scheme exploits a fatal flaw in investors’ psychology: there always seems to be less appetite to ask tough questions when investors are making money. Madoff and his lesser imitators show how important it is to focus just as much on strong performers as on the laggards on the watch list. It is precisely the fact that a fund has reported great returns that could be the clearest sign that all is not well.

2. If it looks too good to be true, it probably is
While some investors are more skilled than others and some managers have better resources and infrastructure, no one has discovered the secret of alchemy. Despite investors’ enduring optimism, it is simply not possible to design an investment strategy that, over time and under all investment environments, will always generate consistent, positive returns. Investors should be conscious that a high proportion of hedge funds that did turn out to be frauds offered some combination of unreasonably high returns, unreasonably low volatility, or a minimum guaranteed return.

1. Be prepared to say no
Our final comment is perhaps the most obvious but, all too frequently, can be one of the most difficult. Very few investors can truly remove emotion and the human element from investment decision-making. Sometimes the effort expended in researching a new fund can create almost unstoppable momentum to get the fund approved and into the portfolio. There can also be strong peer pressure to take scarce capacity in well-regarded funds: after all, the argument goes, if everyone else has already invested, the fund must be safe.

The role of investment teams and advisers is to identify funds that will generate good risk-adjusted returns, to focus on what the reward will be if all goes according to plan. The role of operational risk due diligence, however, is to worry about what can potentially go wrong. This creates an unavoidable trade-off: what happens if a fund has strong performance but is operationally weak?

Given these issues, the real lesson of Madoff is that investors do need to be pre-pared to say no, and recognize that not every investment will meet their investment criteria once the risk/reward profile includes operational factors. In our view, a consistent and comprehensive due diligence process allows better investment decisions: investors will be better informed to reject those funds that do have deficient operational controls, and have more confidence to invest with those firms that genuinely do have a top-tier business infrastructure.

Christopher J. Addy is president and CEO of Entreprise Castle Hall Alternatives Inc., a specialist provider of operational due diligence services to global hedge fund investors with offices in Montreal and Halifax