Operational Due Diligence – Page 3

Getting on the right track – Managed Accounts

It seems these days that the fashion accessory to possess is the Managed Account. Transparency, Liquidity and Control are all reasons given for why this structure is the panacea to the issues that have caused woe in recent times. Managed Accounts unquestionably have a place in an investors armoury and are extremely useful but they are not by any means the answer to all situations.

Managed Accounts have been around for a long time – they were often used by Private Wealth Managers and Funds of Funds to manage the limited capacity that was held by them in hard to access managers – remember those days? But they went out of fashion for a couple of reasons and I think it is worth revisiting those reasons if for nothing else but to keep a balanced perspective.

For a start ask any Chief Operating Officer of a family of funds what their nightmares comprise and fund allocation and the associated costs whether of trading or compliance will be somewhere near the top of that list and this is before the costs of the Managed Account itself are taken into account. Pooled structures are quite simple to manage – Managed Accounts are relatively complicated because you can no longer ignore tracking error, special investment restrictions, reporting requirements and possibly multiple outsourced service providers all with their uniquely tweaked ways of dealing with things.

Manager success was another reason why Managed Accounts seemed to suffer a quiet demise – as managers developed track records – they started to consolidate their businesses into single pooled structures which were simpler to manage operationally.

And then there was cost – legal, audit, compliance, trading and supervisory control.

But a buyers market means that Managed Accounts are back in fashion at least until it converts to a sellers market again.

Liquidity through a Managed Account is often misconstrued as it is actually investment risk being managed as liquidity risk. Managed Accounts do not make investment strategies more liquid – therefore the risks when capital is recalled are in fact no different to those in an ordinary pooled investment structure – but it is in relation to contamination risk and control over realisations where a Managed Account might offer advantages when liquidity becomes an issue.

Transparency can be a double edged sword. Beware holding information that you do nothing with………… Transparency brings with it responsibility – for monitoring, for identifying early warning signs of problems and proper management. Transparency brings with it an implicit requirement to act upon the information.

Control too comes in different guises and does not eliminate the need to do proper due diligence on counterparties and service providers. In a Managed Account they become the responsibility of the investor.

If the costs are manageable then unquestionably a sophisticated investor will reap the benefits of a Managed Account but it will not eliminate fraud, nor investment style issues unless the tools of transparency and control are used properly and even these will never eliminate investment risk and associated liquidity and valuation issues. Capacity in popular managers can also make Managed Accounts extremely desirable as hedge fund investing picks up again.

Choosing the right track for an appropriate investment structure requires careful consideration and is still as difficult as it ever was.

©Jaitly LLP

Is a Rolls Royce worth paying for?

The latest addition to the AIFM proposals in the form of Annex II on Remuneration Policy simply serves to highlight how an opportunity to introduce meaningful regulation is once again being lost as a consequence of pandering to political demands.

Fashionable branding, scarcity and the premiums attached to these are a fact of life. Badges purporting to represent quality can often be just that as ownership, methodology and standards change over time whilst the badge remains the same. Should you pay for it? That depends on why you are paying the premium. Perhaps it is career risk management, or the desire for institutional grade standards, perhaps it is the perception that you cannot afford not to be in a trade that everyone else perceives as being essential to a portfolio.

Remuneration unquestionably needs to be aligned to the interests of those investing their money in an investment structure to achieve the necessary investment objectives. Should that alignment be a matter for regulation or market forces? Are regulators really the appropriate people to assess appropriate remuneration or the price of a product that is available in a market in myriad forms with many providers? The regulators don’t drive the Rolls Royce or enjoy its benefits – their opinion is relevant simply as traffic police and to ensure that the vehicle complies with safety standards to keep other road users and the drivers safe but it is the market that determines the price of the car. If the vehicle delivers what the investor wants whether it be branding, institutional standards or risk adjusted returns then the investors should be prepared to pay for what is delivered to them and the market should determine the price for it.

What the regulators need to ensure is that the story behind the badge is an honest and transparent representation of what is being purchased and that it meets safety standards and for the investor to then pay what they believe is an appropriate price for that.

Otherwise European regulation may well destroy the very thing it seeks to preserve as managers look towards the Swiss borders.

©Jaitly LLP

Why fund and investor domicile matter

Interesting what people can focus on when doing due diligence on funds………. valuations, liquidity, collateral management. But fund and investor domicile? Surely thats something for the lawyers to deal with?

Ethical investing has been around for some time and there are inherent difficulties in the practical application of some of the concepts – but hedge funds have generally never really bothered too much about these aspects being wide and free ranging in their quest for “alpha”. Perhaps the time has come for investment managers to sit up and take a bit more notice. Where their funds and investors are based will have an impact that is starting to go beyond issues of taxation.

On the 10th of July this year Luxembourg – the home to many a fund vehicle – UCIT and non UCIT – ratified a law – article 3 of which when translated reads: “All persons, businesses and corporate entities are prohibited from knowingly financing cluster munitions or explosive submunitions”. Article 4 carries sanctions with 5-10 years detention and fines between €25,000 and €1 million. Luxembourg is unusual in that Ireland which has similarly ratified the convention in relation to cluster munitions with variations as to how it is interpreted/implemented do not currently appear to have defined sanctions for non compliance in relation to investment activity. Belgium and Austria have also adopted laws linked to the signing of the Ottowa convention prohibiting investment activity in businesses involved with the production of anti personnel mines and cluster munitions.

Ireland appears to have protected its fund industry by stipulating that the prohibition (which is no more than endeavouring to avoid) applies to investments where public money is directly invested in equity or debt securities issued by a munitions company. Where it does so the requirement is simply to divest itself of the investment in an orderly manner taking into account any contractual obligations it may have assumed. So apparently not too much to worry about if there is a breach as the sanctions for offences don’t appear to apply to these Part 4 breaches……!

Why is the Luxembourg law relevant – because the actions of the investment manager could have an impact on the investors and on the collective investment vehicle based out of Luxembourg particularly if someone decides to commence with enforcement of this law.

Whilst it has been common to see hedge funds excluding US taxable investors to avoid tax risks we may now begin to see investors and feeders registered in particular countries being excluded as well in order to avoid some of the issues that may arise unless investment managers are prepared to restrict their investment activities so that they fall within the permitted boundaries. It is likely to make trade compliance more onerous for managers as well.

©Jaitly LLP

Investment Management by leaps of faith

It is fascinating to read the marketing presentations of funds of hedge funds about the sophisticated due diligence procedures they employ in making investment decisions.

The reality is that few if any can really consistently perform the procedures they say they apply across all the investments in their portfolios. The simple reason for this is that different hedge fund managers take different approaches to what they will or will not discuss about their businesses. Suffice it to say that larger managers are more likely to be less transparent. Some because of concerns on consistency of disclosure and transparency to investor clients, others because there is no need to because of the clamour for capacity into their funds which means they can ignore those insisting on more information or verification of that information.

Size therefore can determine in inverse proportion the amount of due diligence that may be possible. It therefore stands to reason that if there are large names in a fund of hedge funds portfolio then the chances are that full due diligence has not been performed and “comfort” has had to be obtained from other factors involving a leap of faith based on reputation, assets under management and pedigree.

Does this mean that the investment decision is a wrong one? Not necessarily. But it does highlight the fact that the investment decision may not include all the checks and reviews that might typically be performed during due diligence in relation to an investment. If that is clearly stated in the documentation provided to clients – then that is simply stating the commercial realities of the situation and investors can make their own decisions on the risks and suitability or otherwise of such an investment. I have not seen much evidence of such transparent approaches on procedure which is what leads me to the conclusion that particularly where there are big names in a portfolio, one of the main strands of investment decision making must be leaps of faith.

©Jaitly LLP

The Emperor’s new clothes – the myth continues…..

As we come up to the anniversary of the Lehman Bank failure and the purported start of the current economic debacle it is interesting to see what lessons if any have been learnt in the field of asset management. It appears that in some quarters at least the Emperor’s new clothes remain fashionable.

I was interested to read for example about the survey results in FTfm that investors were far more interested in performance rather than standards. It is a familiar bell with resonance in many areas. It is also interesting to see that little has really changed in due diligence methodology since the events of last year.

As a risk manager meeting clients to describe and reassure them about the risk processes used by my team I was always struck by the approach different types of investors took to the concept of risk management.

The private investor would always appear to focus on performance provided there was no immediate risk to capital. My sessions on risk with private clients were invariably short with most of the time being spent on how investment ideas were generated and where the next generators of performance were going to come from.

The institutional client was quite a different animal – here invariably the sense one often got was that the focus was ‘career risk management’. Would you get fired for having invested with a big name? The chances were that losses emanating from an investment in a big name were far safer from a career perspective provided a few boxes could be safely ticked. Talking of boxes – the miracle black box process still has formidable powers of seduction – particularly when a big name is involved. I remember the justification used to override a concern I had on a regulatory fine on a well known firm that eventually failed – that if that was the standard that was to be applied it would be impossible to employ any of the major brokerage firms as they had all at some stage been fined for regulatory infringements.

Of course in defence of the investor is it ever possible to do an effective due diligence review of a big investment house through the process of a meeting lasting a couple of hours? Is there a realistic practical alternative? There are assumptions made on teams, structures, evaluation processes and competence that are almost impossible to verify through the normal meeting process of due diligence in relation to a large organisation. Yet that is the process that continues to be employed in making an assessment and is clearly insufficient.

When I evaluate risk in an organisation my view is that some of the greatest business and operational risks that exist – lurk in large organisations and the impact of these are almost always significant – Barings, Lehman Brothers, Enron to name a few. The smaller failures that occur at the start of the journey towards disaster are easily disguised and the rot that sets in as a consequence are rarely recognised.

Very small organisations have different risks to contend with – based on keyman issues and lack of infrastructural depth – but these are assessable – because size permits it.

This is not to advocate that only medium sized structures are the safest investment vehicles to place your money with although they recommend themselves to being reviewable, having sufficient infrastructure for questions to be raised about practices that may arise or develop and yet being small enough for small failures to have catastrophic consequences for the business thereby creating incentives to implement better more permanent fixes than the papering over that can occur in much larger organisations.

What I do advocate is that there is an optimum size to an asset manager from a risk management perspective and the big names can create myths of reliability around their existence. Some of the most inconsistent service that I have ever received both as an individual and as a professional have been from large well established organisations.

Due diligence requires more verification work throughout the life of an investment and the status quo on process needs to change. It is in this blind faith in the miracle black box process and the grandeur of the large unverifiable organisation that the myth of the Emperor’s new clothes continues to thrive.

©Jaitly LLP

Auditors – watch dogs, bloodhounds or poodles?

The role of the auditor comes under examination each time a scandal emerges – my interest in the subject stems from the issue of auditor liability – what exactly are they responsible for? A source of constant worry for anyone who earns a living from expressing an opinion is that of liability when it becomes clear that the opinion expressed was incorrect or flawed in some respect. It is a worry that an auditor can never walk away from and it is understandable that they would wish to protect themselves – but the balance at present is not right and the limitations of liability that auditors are trying to impose on their clients are not always reasonable.

When I was training to be an accountant the classic debate for discussion on auditing revolved around whether the role of an auditor was that of a watch dog or a bloodhound. My contention is, that in the context of hedge funds at least, the auditor has become neither – perhaps more of a poodle. The investment manager needs to appoint one of the major firms to ensure credibility – that can make it an expensive exercise – sometimes with very little benefit to the investors and actually very little responsibility economically on the part of the auditor.

Auditor liability has been a sensitive subject and governments have found it difficult to resist the pressures to limit the burdens of liability for the auditor. It is a sound principle that where an expert needs to express an opinion – they need to do a sufficient amount of work to satisfy themselves in expressing that opinion. However, economics always comes into play – would a commercial organisation be prepared to pay an open ended bill for an auditors time in satisfying themselves over an opinion – of course not – there is always downward pressure on audit fees – or is all that matters a respectable name expressing an opinion at a commercially acceptable rate?

It is economics that drives some of the problems we face in receiving audit reports in the hedge fund world.

Let us take a hypothetical situation. Lets assume a hedge fund with assets of say $500m needs an audit and that the going rate for a straightforward audit by a major auditing firm is say $50,000. Let us also assume that this fund is domiciled in the Cayman Islands but administered in another jurisdiction e.g. Ireland, so that the audit work and audit opinion sign off are in different jurisdictions and where the operation of contractual limits of liability may differ. Let us also assume that the audit engagement terms limit liability for the audit to the fee paid for it. The balance of probabilities on a wrong opinion in this scenario lend itself to the audit being staffed with as junior as possible staff (i.e. the cheapest) that would be able to carry out the programme of work as the downside risk even taking into account reputational issues is still extremely low on getting the opinion wrong. What is likely to matter far more to the audit firm, other things being equal, are the economics of retaining the hedge fund as a client to capture the annuity income through reappointment as auditor. In such circumstances the real incentives are neither to be bloodhound nor watch dog but a poodle albeit well trained.

Does this mean that investors in hedge funds get what they pay for? What it means is that investors need to consider very carefully the terms under which their auditors are appointed and they need to pay particular attention to what liability terms have been agreed upon and to whom they report and even where the work will be done and how related firms will apportion work between them. Yes, even major firms have restricted reliance on audit reports and I am aware of a firm that has tried to address the report to the fund’s directors rather than its shareholders which throws open what the purpose of the audit report might be in the first place! The relationship that exists between the auditor and the hedge fund is a contractual one and the parties negotiating the contracts do not necessarily always have at the forefront of their minds in their decision making the likely impact on the investors if things go wrong. The auditor is a necessary appointment but the choice is generally limited to a major name, often with little time being spent on the terms under which they are appointed.

Why is this important? Let us assume that a major fraud with devastating consequences occurs in our hedge fund example, that an auditor conducting their work under acceptable standards should have spotted. In most jurisdictions the contractual terms are likely to prevail – and even if the auditor had been grossly negligent in the conduct of their work there is a real possibility that their liability in this example would be restricted to the $50,000 fee paid. Is that what the investors would have expected when investing in the fund? Almost certainly not – but that may be the reality of the prospect they face. It is what makes it so important for investors to look very carefully at the basis on which auditors are appointed on their funds. Sometimes having a major name as an auditor is not necessarily the panacea that an investor would need.

There needs to be a continuing debate on the role of the auditor – as often the auditor is the only independent entity that has access to the books and records of the vehicles in which investors place their money and there need to be real economic incentives to ensure that the work they perform is to the right standard with people having the requisite experience to reach appropriate conclusions so that they can be watch dogs with bloodhound abilities.

A $50,000 liability in the scenario described is likely to still keep the poodle’s tail wagging.

©Jaitly LLP

Liquidity Management – new fad or back to basics….?

Ever wondered how a fund or a fund of funds manages liquidity?

Offering documents can include an arsenal of provisions for the moment when things go wrong – redemption gates, side pockets, suspension of NAV calculations, suspension of redemptions, revaluation of assets, creation of provisions and reserves, payment of redemptions in specie and the creation of separate classes with differing liquidity.

But these are all cures for the malady once management has to face up to a liquidity problem – what is far more interesting is the approach to prevention.

The spectre of the liquidity axe always hangs in the air – however well managed a fund – because if, for example, you take the case of a fund of funds with quarterly liquidity which only invests in funds with monthly liquidity you still have to manage for the prospect of the fund you wish to redeem from, suspending its normal redemption processes thereby impeding the liquidity flow on your investment. All funds will retain some form of rights and discretion to delay redeeming and paying out to an investor.

The obvious starting point will always be to try to ensure that the liquidity of your vehicle at least matches the liquidity of the underlying investments.

Is this always practical given lock up periods of 6 months to 6 years upon subscription? Some funds will try and cater for this issue by creating lock up periods for their own investment vehicles and by imposing charges for any financing they might need so as not to affect the portfolio as a consequence of a redemption – but that is not so easily done – sometimes because of the push back from the sales personnel linked to selling these funds to investors.

So what are some of the practical things that can be done?

Ensure you have a liquidity profile for your portfolio which shows the time taken and the cash flows for the portfolio to go wholly in to cash by taking into account lock ups in force, notice periods, compulsory gates and any penalty charges that may be imposed
Always maintain a cash buffer to meet ongoing expenses and to meet margin calls – a number of funds faced extreme liquidity constraints in 2008 in the absence of credit facilities because they were not prepared for the Euro/Dollar exchange rate movements for their currency hedges
Ensure that your credit facilities will enable you to meet redemption calls equivalent to the proportion of your longest locked up investment outside the liquidity range of your own investment vehicle.
Avoid investing in investment vehicles or investments that have liquidity mismatches with your investment vehicle.
Ensure that you have given no covenants to your own providers of finance that could place your investments in jeopardy because “they would never happen” – do you know for example what cross default provisions there are in your financing agreements and what percentage reduction in assets triggers a default?

The best liquidity management is done from the perspective of decisions made on the assumption that the fund will need to go wholly into cash and ensuring that any borrowings and requirements for return of capital are properly catered for in the offering documents of your own investment vehicle for such an eventuality.

In order to do it well – assume that the worst will happen – that is the best form of liquidity management.

©Jaitly LLP

The “Expenses” Debate – worth examining?

The current media interest on UK parliamentary expenses is a good moment to take stock of what constitutes a reasonable expense for an investment manager to charge a fund as opposed to a cost that it should bear itself.

I have always found it very interesting to see what an investment manager will charge as an expense to a fund it manages. Practice varies enormously. Some managers will charge bonuses payable to their traders as a fund expense, others research related travel or the costs of information technology and risk management systems.

Received wisdom in the alternatives industry justifies a two tiered fee structure on the basis that the management fee charged – typically on a monthly basis – covers the running costs of the investment manager including staff, systems and premises. The performance fee is the reward that the investment manager receives for generating the risk adjusted returns for which he is appointed.

The fund itself bears its own direct costs such as the costs of trading, audit, service provider fees (including those of the investment manager), direct legal costs and director’s fees.

Soft commissions or bundled commissions are another way for an investment manager and the fund it manages to receive additional benefits that the fund indirectly pays for through the commissions it is charged for trading. These are considered acceptable expenses where the investment manager receives benefits which may for example be research related such as the provision of Bloomberg terminals for the investment manager. The benefits become more nebulous when they relate to travel and accommodation or entertainment. Different regulatory systems may also specify what is permissible or not for investment managers regulated by them.

Where an investment manager starts to charge expenses to the fund that would typically be investment manager costs such as trader bonuses and information technology – it raises a basic philosophic question as to what the management fee is supposed to represent? Is it no longer representative of the investment manager’s running costs or is it to be viewed as a monthly premium for the privilege of having the investment manager manage the fund? Is it reasonable for the investment manager to charge a pure fixed profit element in the form of these fees if running costs are also to be charged to the fund as additional expenses?

Who for example should bear the costs of the investment manager and its staff having to travel to research investment opportunities used for trading the fund’s portfolio? Are these exclusively for the benefit of the fund or are there other clients of the investment manager who receive a free benefit as a consequence? Is it not this very expertise for which the investment manager is appointed and if so are you as an investor paying twice for it?

Investors will often accept the status quo based on the investment manager ‘s success but it is essential that investors understand what they will eventually be picking up the costs for – and whether this was something acceptable or that they were prepared to accept. Success generally keeps these issues at the bottom of the pile.

A careful fund investor should understand the expense profile of the fund. A good investment manager should be able to justify the management fee it charges based on properly budgeted staffing, research costs, premises and systems so that the management fee is what it is described to be – a fee for managing the fund’s portfolio. Where the costs of an investment manager and the management fee it receives begin to diverge – then this should be the catalyst for a review and a discussion between the investment manager and the investors in the fund.