Castle Hall Alternatives, a hedge fund due diligence firm, has just released a new white paper entitled “Hedge Fund Investing in a New World: Five Questions for Investors.”  We greatly respect the thoughts and opinions of Christopher Addy, President and CEO of Castle Hall, who has allowed us to repost some of his earlier blog posts (please see Issues for Hedge Fund Administrators to Consider and ERISA vs. the Hedge Fund Industry).

In this article, I have summarized the thoughts presented in the white paper and added my own thoughts as well.  The thesis of the white paper is that the hedge fund industry will change because of the recent market events.  The paper is broken up into five different questions and each answer discusses how the current industry trends and what the trends will likely (or should) look like in the future.  The issues the white paper raised are:

1.  Is 2 and 20 fundamentally flawed?

In this section Castle Hall believes that there may be more hurdle rates in the future, that performance fees periods will need to mirror lock-up periods and that performance fees on hard to value assets need to be reconsidered.

HFLB: We agree with some of the points made in this section.  While the fee structure will ultimately be decided by the market, whatever the manager decides upon can be implemented by the attorneys in the hedge fund offering documents.  A good hedge fund attorney should discuss the above issues with hedge fund managers who have hard to value assets or long lock-up periods.

2. Do Hedge Funds Need Better Corporate Governance?

In this section Castle Hall argues that hedge funds, especially offshore funds, have very low corporate governance standards and that there may need to be greater oversight in the future.  The paper states, “As an immediate priority, investors need a Board which can provide genuine, active oversight in two key areas: portfolio valuation and situations in which funds elect to impose gates or suspend redemptions.”

HFLB: We agree generally and in principle.  However, investors will ultimately pay for the expense of greater corporate governance.  If investors show themselves willing to pay for the added expenses then it seems there should not be a lot of push back from the hedge fund managers.

3.  Is there an ‘Expections Gap’ in the administration industry?

Castle Hall notes that “vigilant oversight from an independent administrator remains by far the most effective protection investors have against manager errors, be they honest or dishonest.”  CH then goes on to discuss how hedge fund administrators do not all provide the same services to hedge fund managers and many administrators provide “NAV Lite” services.  CH believes that administrators need to have clearly defined and delineated roles which should include real asset valuation (not just rubber stamping a manager’s good faith valutation).  CH notes that third party valuation specialists may be a solution but that this could be an expensive option for hedge fund managers and investors.

HFLB: We agree.  The term “hedge fund administrator” is one of the loosest terms in the industry right now.  Administrators may be full service, provide “NAV lite” or provide mid and back office support as stated in the paper.  Sometimes hedge fund offering documents do not thoroughly discuss the actual duties of the hedge fund administrator and we believe that disclosure in the offering documents will increase in the future.  In the future hedge fund managers may want to include the actual administration contract in the offering documents as an exhibit.

With regard to third party valuation specialists, we agree that these types of firms will provide valuable services to both hedge funds and administrators in the future.  Hedge fund managers should discuss this option with their hedge fund attorney.

4.  Is the Prospectus written for the Manager or the Investor?

Castle Hall discusses the interesting phenomenon of “Prospectus Creep” or basically the lengthening of hedge fund offering documents as hedge fund lawyers add more clauses to the documents which are designed to protect the managers.  Castle Hall notes that “today’s offering documents are typically drafted to give maximum freedom of action for the manager and often permit unrestricted investment activities. Investors are also faced with offering documents which list every possible risk factor in an attempt to absolve the manager from responsibility under virtually all loss scenarios.”

HFLB: We agree that offering documents can be long and that often they contain a long list of risk factors associated with the investment program.  The purpose of the offering documents is to explain the manager’s investment program and if the manager truly has a “kitchen sink” investment program, then all of the disclosures and risk factors are a necessary part of the offering documents.  However we also feel that hedge fund offering documents should accurately describe the manager’s proposed investment program and that if the manager has a very specific strategy, he should provide as much detail to the investors as possible.

5.  Is it possible to hold illiquid assets in an open ended vehicle?

Castle Hall questions whether funds which hold illiquid assets should have open contribution and withdrawal periods.  If there are open contribution or withdrawal periods then illiquid assets must be valued so that there can be a NAV calculation.

HFLB: We agree that hedge funds need to have valuation methodologies if a fund will hold illiquid or hard to value assets.  We do not necessarily agree that funds which hold illiquid assets need to be closed ended (i.e. have a private equity fund structure).  Hedge fund attorneys will usually address this issue in a couple of ways: (1) through specifically delineated valuation practices to be utilized on valuation dates or (2) side pocket or similar structures.   We do note that in certain instances the manager, as well as the investor, would be better served through a closed end or private equity fund structure.  These are issues which the manager will need to discuss with their hedge fund attorney.

Conclusion

Castle Hall concludes with the following statement: “Ultimately, challenge brings opportunity: we remain convinced that a better, stronger hedge fund industry can emerge from the difficulties of today’s markets.”

HFLB: We agree.  I have stated before that we think the hedge fund industry will come back strong.  As regulations are added and due diligence increases, hedge funds should continue to grow as investors grow more comfortable with hedge funds as an asset class.

The full white paper can be found here.  The press release reprinted below, can be found here.

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November 03, 2008

Castle Hall Releases White Paper on Hedge Fund Investing in a New World

Castle Hall Alternatives, a leading provider of hedge fund operational due diligence, today published “Hedge Fund Investing in a New World: Five Questions for Investors and Managers.”

Chris Addy, Castle Hall’s President and CEO, said “the credit crisis and market events over the past year have challenged the hedge fund industry as never before. Alternative investments will remain integral to diversified, institutional portfolios, but there will unavoidably be a re-evaluation of the hedge fund model.”

Castle Hall’s focus on hedge fund operational risk has helped the firm identify five questions relevant to both investors and managers in this “New World”. The firm’s White Paper asks whether the typical “2 and 20” fee structure is fundamentally flawed; whether hedge funds need better corporate governance; and whether there is an “expectations gap” in the fund administration industry. The White Paper also questions whether the fund prospectus should be written to protect the manager or the investor and asks if it is possible to hold illiquid assets in an open ended vehicle.

“The structures and conventions accepted in the past may not be the best for the hedge fund industry going forward” said Addy. “We have highlighted a number of areas where current practices are weak and, in the New World, we expect investors to be more vocal and require greater protection and control when allocating to hedge funds. Investors will also focus more intently on operational, structural and business issues in addition to performance and strategy.”

Hedge Fund Investing in a New World, the first in a series of thought leadership papers to be published by Castle Hall, can be accessed on our Website, under the Publications section.

Please feel free to contact us if you have any comments or questions.  Other relevant HFLB articles include:

• Hedge Fund Due Diligence
• Hedge Fund Due Diligence 2.0 (discusses some of the same issues as Castle Hall)
• Side Pockets and Side Pocket Investments
  
• Side Letters
• Private Equity Hedge Funds
• Hedge Fund Offering Documents
• Hedge Fund Attorney
• Offshore Hedge Funds Structures and Considerations
• Hedge Fund Auditor
• Hedge Fund Administrator