Much consternation has been given to expenses borne by hedge funds. In an industry where managers may receive 2% management fees and 20% of the annual profits, it may sound trivial to focus on a few basis points here and there as it relates to professional fees, overhead charges or other financial relationships with service providers. However, when applied properly, expense charges can be indicative of a true value proposition from an investor’s perspective.
Segregation of Duties and Independence...I’ve Got a Feeling
Perhaps the most valuable aspect of having expenses charged to hedge funds is the practical and perceived segregation of duties and independence. Most notable is the external administration fee. Over a decade ago, it was not uncommon for the manager to "self-administer" accounting and administrative aspects of a fund; charging back all or some of the manager’s overhead to the fund to cover such costs. In this scenario, the internal accounting function does not adhere to the best segregation of duties because the authorization, execution, recording, reconciliation and approval of NAV are performed by the same personnel or are under the direction of the same management team. Back in the day when I was an independent auditor on various hedge fund engagements, I even witnessed employee bonuses being allocated as hedge fund expenses. For some of the mega hedge funds, this would equate to only a few basis points of a burgeoning NAV--but it still never felt "right". This feeling was due to the weakened segregation of duties and independence that was apparent in self-administration. Since self-administration is effectively a service provider payment--lacking independence and a solid "arms-length" nature--I was always perplexed why this was not outsourced to a third party provider. Today, this is much less apparent and with the growing expertise of administrators, managers are hard-pressed to claim they can "do it better". As far as doing it for less than an independent administrator--any perceived savings is greatly overshadowed by the lack of independence. For managers who charge employee costs (e.g., bonuses) back to hedge funds, you can simply ask if they also pay their service providers (e.g., auditors, legal, etc.) bonuses, and that tends to drive the point home.
Less Focus on R² and More on Fair
Aside from looking at how expenses can reduce performance, we also need to look at what they add to the overall investment experience. Certain expenses can be true indicators of adding value to investors. For example D&O and E&O insurance can be apportioned to hedge funds and still be a fair and valuable asset to investors. Many managers employ policies where trade errors, if a loss, are borne by the manager, not the fund, and gains are retained by the fund. This sounds great, but an investor does not necessarily want the manager to be susceptible to a large loss, possibly emptying firm coffers and subjecting the control environment to deterioration if employee compensation is reduced due to a lack of available profits and cash. Furthermore, in the event of litigation, most funds have indemnification provisions where investor’s capital is used by the fund, directors and management to defend themselves. As an investor, it does not seem fair that my assets can be used against me in the event of shareholder activism against a fund. A reasonable insurance policy, whereby the fund pays a portion of the premium, can mitigate this concern; both at the management company level for trade errors, as well as the indemnification provisions of the fund.
The New Age of Operational Due Diligence
For allocators and fund of funds, operational due diligence has gained prominence. Whether it is from an astute investor in a fund of funds or an unknowing beneficiary in a sovereign wealth or a state pension plan that allocates to hedge funds, operational due diligence is extremely valuable. These investors and beneficiaries are arguably willing to pay a price for such value in a post-Madoff era.
Having a separate layer of expenses for external due diligence is a valuable asset. Hedge funds that bear this cost can mitigate future instances of management reduction in these efforts from a cost perspective--and once the Madoff tides begin to ebb we should all be wary of lessened operational due diligence. Furthermore, it also creates an additional level of segregation of duties and independence.
Even when an internal Operational Due Diligence team has veto power over the Investment team, one must consider the practicality of the Operational Due Diligence team actually wielding such power. While I truly believe in this age that most Investment and Operational Due Diligence team’s interests are mutually aligned, if a true disagreement exists, vetoing against the team that includes personnel who determine your compensation and general career track does not bode well. The use of an external team alongside the internal team mitigates this perceived conflict of veto power and also reduces the instances of group think since the external team is not paid a bonus and does not enjoy the upside potential of approving a manager who later has great performance. They also do not have to listen to the investment team saying how great a particular manager is day in and day out. As an investor, I completely welcome this slight additional expense since it enhances operational due diligence, adds an external independent element and ensures the continuity of such a process in the future.
We should all continue to analyze expense ratios, review expenses in absolute dollar terms and compare to industry practices as well as specific cases. However, as investors, we should also understand what we get out of these charges and make sure they enhance the overall control environment and protect our capital.
Dan Federmann, CPA, CFA
Board Member-Hedge Fund Business Operations Association
Managing Director & Chief Financial Officer
Protégé Partners, LLC