Summary prepared by Daemon Repp, Sr. Financial Analyst, Genesee Investments
Chris Lombardy of Kinetic Partners and Jonathan Choslovsky of Albourne Partners led the discussion. Both Mr. Lombardy and Mr. Choslovsky focus on operational due diligence of hedge funds in their current roles. Given the proliferation and magnitude of frauds in the past couple years, investors are placing added significance on thorough operational due diligence when evaluating hedge fund managers. The conversation addressed three points:
- recent themes of investor due diligence and establishing an operations, compliance, and best practice infrastructure to meet the demands of operational due diligence reviews
- the changing US regulatory landscape for investment advisers
- recent themes of regulatory examinations
Gone are the days when due diligence focused solely on a hedge fund managers’ investing capabilities. Nowadays, investors are also looking for good operational infrastructure, regardless of the size of the fund. They want to see the fund operated at an “institutional” quality level. This includes a well defined segregation of duties and quality service providers such as legal counsel, administrator, and prime broker.
Mr. Choslovsky pointed out that this focus on operations is a result of recent ponzi schemes that blew up funds in 2007 and 2008. Prior to that, operational due diligence was largely an afterthought. Recent trends include the insistence upon a third party administrator who can custody assets, transfer money, and verify pricing. Another trend is the verification of AUM. In nearly every ponzi scheme, the manager lies by overstating their AUM. Mr. Choslovsky feels that verifying AUM is a full proof silver bullet for detecting a ponzi scheme.
Another trend is the focus on counterparty exposure. ISDA agreements are more closely scrutinized. How the agreements with the prime brokers structured and whether ISDA agreements are one or two-way are some examples of this focus.
Borrowing a term from banking, investors are keen to a fund’s asset/liability management (“ALM”). More specifically, are a fund’s liquidity terms consistent with the types of investments it makes? For example, a distressed debt manager with monthly liquidity on two weeks’ notice is not a favorable matchup. Nor is a large cap US equity manager with annual liquidity. A fund’s liquidity terms had not been given much through prior to 2008, and at the end of that year gates, suspensions, SPV’s, and retroactive side pockets all occurred. This caused a lot of confusion and investor backlash. In some cases, managers’ documents were written so long ago that they themselves did not know what they could do.
Currently, funds are setting themselves up with ALM in mind. Managers now carefully consider how they would handle events similar to the end of 2008 when drafting their documents. One popular method is to stagger the redemption windows. This is most effectively accomplished by creating investor level gates, where each investor is only allowed to withdraw a maximum percentage, say 20-25%, of its capital at each redemption period. This method is favored by investors over a fund level gate, as it eliminates much of the game theory in the redemption process. Completely out of favor now is the stacked gate, where investors who redeemed at prior redemption periods and were gated are given preferential treatment over new redeemers at the next redemption window.
Investors are becoming more critical of a fund’s fee structure as well, both the management fee and the incentive fee. Management fees have steadily increased over the years from 1.0% to 1.5% to 2.0% and sometimes even higher. Investors expect that the management fee be used to cover the expenses the manager incurs in operating its business. The fee should be fair and should not be so high that it incentivizes the manager to be an asset gatherer. Investors are loathe to pay a high management fee for a fund that has grown large and feel that the fees should come down when the manager reaches a certain asset level. There is a backlash against managers trying to run certain expenses that should be covered by the management fee through the fund instead. While more forgiving for smaller funds, especially those that have shrunk and thus are generating less revenue than previously, there is little leeway in investors’ minds for large managers who try to put expenses through the fund.
As to incentive fees, investors want to pay for alpha, not beta. This naturally leads to some kind of hurdle rate, whether fixed or floating based on some appropriate benchmark index. Furthermore, if a fund has a strategy with a long lockup (greater than one year), then investors would expect that the incentive fees would not crystallize until after the lockup expires.
Transparency is another hot button issue, with the general consensus being that more is better. Again, this became more of a necessity with the recent proliferation of ponzi schemes and the events in the markets during the fall of 2008.
Managed accounts were a popular issue a few years ago, but less so now. It was suggested that the decline in popularity may be due to the fact that funds are more willing to give transparency than previously. Transparency, along with no fear of being gated and no potential for a ponzi scheme are the benefits of a managed account for an investor. They are also good for FOF who are seeking to manage their own ALM issues. In general, managers do not like managed accounts due to the increased administrative burden. This is especially true of larger managers who are not as desperate for the assets. However, most all managers have an amount over which they will accept a managed account.
Mr. Lombardy gave the example of a client who conducts a “document request.” More specifically, the client wants to know if a manager’s DDQ, PPM, monthly letters, and marketing documents are all consistent with each other. This is a general test for a manager’s attention to detail and business coordination. Mr. Lombardy recommended conducting this exercise periodically after investment as well.
It is consensus among investors that they would never invest in a fund without an audit report. However, where the audit used to also be viewed as asset verification, that is no longer the case. Investors recognize that the audit only verifies a fund’s year end assets and that much happens from one year end to the next. Administrators and prime brokers are now used to verify asset levels. In most cases, the administrator or prime broker must see that the investor has received permission from the manager before answering these types of questions. Investors should view it as a red flag should service providers not freely answer these questions.
In verifying independent pricing, it is not just enough to know that it exists. Investors now want to drill down further. What level of service is the administrator providing in this regard? How easy does the manager make it for the administrator to get independent quotes from the various brokers? Is what the administrator saying about services provided consistent with what the manager says about the administrator’s services? Exactly how are the obtained quotes used in establishing a price? These are the types of questions that investors are demanding answers to.
The panelists emphasized the importance of a fund’s offering documents. Managers need to be very careful about putting limits that are too restrictive into the offering documents. Over time, managers tend to forget some of them, which could inadvertently lead to a misrepresentation. This is essentially what happened to Wood River. It is very important for managers to review their legal documents every year.
Brokerage fees are another area of increased scrutiny. How does a specific broker’s fees compare to the industry standard? Investors want to see managers check this at least annually and see that the research provided matches the commissions charged. For micro cap and small cap stocks, 5¢ per share is reasonable. For more liquid stocks, 2-3¢ is reasonable. The quality of ideas the broker suggests, how they handle large block orders, and any kind of marketing they do should also be assessed in determining a reasonable commission.
During the Q&A session, there were some questions about emergent issues that the SEC is looking at. Managers are closely monitoring whether or not they need to be registered. Legislation in Congress is moving the requirement away from a client count threshold towards an asset level threshold. Insider trading is a specific focus of the SEC, and not just of the tipper/tippee type. The focus is more on the manager’s compliance department, and if it is monitoring analysts’ networking calls or paying attention to where they got their good performing trades.
There was a question about third party marketers. The most important issue for a manager is to make sure that any third party marketer they use is a broker/dealer, because the manager’s fund is a security and the third party marketer is offering it. If the third party is not a broker/dealer, then a client who loses money may be able to come after the manager for restitution.
There was also discussion of the kinds of disclosures a manager is required to make. The consensus was anything that is material, where material means anything that would influence an investor making or keeping an investment in the manager’s fund. One area of such disclosure is personnel movement. Investors get very annoyed with managers who don’t disclose when certain employees are no longer with the manager. Even more annoying is if it is an employee the manager said was important while working there and then says was unimportant or junior after he’s departed.