Tag Archives: institutional investor

Audit Issues from Due Diligence Provider

The following article is written by Chris Addy, president and CEO of Castle Hall Alternatives which is a hedge fund due diligence firm.

For funds raising assets from institutional investors, the due diligence process will be quite familiar and Chris describes some of the frustrations from the investor/due diligence standpoint.  I would imagine that these issues will continue to arise as more service providers strive to find ways to limit their potential future liability.  Please feel free to comment below.

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A recap on some audit issues

Looking back over our posts over the past year or so, we’ve commented on a number of issues which impact investors’ due diligence procedures when thinking about the audit process, the financial statements, and the auditor themselves.

We thought it would be useful to recap on a group of issues which continue to be troubling:

1) And why can’t the auditor identify themselves?

Back in November, we commented on the challenge of getting the Big 4 audit firms to admit that they are, actually, the auditor of the fund in question.  In the six months since then, practices appear to have standardized: typically, the Big 4 will now provide a form response, but only after the investor has signed an extensive disclaimer letter.  The slight snag?  The disclaimer is usually so wide ranging that it appears to materially impact the investors’ ability to sue the auditor in the event of audit failure (which, of course, is the idea).  We advise our clients not to sign it.

As a counterpoint, it is worth noting – and forcefully reminding the Big 4 – that every other auditor on the planet makes the confirmation process smooth and effective.  Castle Hall is particularly appreciative of the responsiveness and professionalism of Rothstein Kass each time we make an audit confirmation request.  In fact, that reminds me…do I actually need a Big 4 auditor?

2) And it’s pretty much the same for SAS 70s..

Unfortunately, the SAS 70 process is pretty much the same – it is becoming increasingly difficult for the end investor to obtain a copy of the SAS 70 document for many administrators.  This is, of course, despite the fact that the SAS 70 is now a key marketing point in the admin industry.

It’s particularly annoying when the SAS 70 is stated only to available (i) to the auditors of (ii) the administrator’s clients, the funds.  The first point makes the SAS 70 process seem more than a little self serving, as the auditors give each other work for the sake of it.  The second raises the broader issue (and one of our favorite topics) of who exactly is the administrator’s client – the fund or the investor?

A particular black mark goes to those administrators who will not provide investors with a copy of the SAS 70 under any circumstances, and insist on providing a summary of the SAS 70…prepared by themselves.  And exactly how is the investor supposed to place any reliance on that?

An honorable mention in the hall of shame must go, however, to those administrators who try to charge the costs of their SAS 70 review through to their fund clients as an out of pocket expense.  In other words, the admin expects the funds’ shareholders’ to pay for their own SAS 70.

And no, we still can’t see it.

3) Who distributes the financial statements?

While the confirmation issue above is tediously annoying, thinking practically, the risk that a hedge fund simply fabricates a relationship with PwC or KPMG is pretty remote.  What is more likely is that a reputable audit firm has been appointed and completes their work…but a manager then elects to change some or all of the financial statements and gives investors a set of fake accounts.  As we have said before, a copy of Adobe photoshop only costs $500.

The double irony is that, even with the audit confirmation we discussed above, the auditor does not send the investor the accounts directly.  There is, therefore, no way of getting a direct confirmation from the auditor that the accounts in your possession are, in fact, genuine.

One suggestion we have heard would be, in the offshore world at least, for investors to access financial statements direct from the Cayman Monetary Authority (perhaps via a secure website with appropriate authorizations).  This would draw on the requirement that the fund auditors must give the Cayman authority a copy of the (genuine) accounts themselves.  An excellent idea….Cayman?

As a more immediate solution, we are always anxious to confirm that the fund administrator receives the audited financials direct from the auditor and thereafter sends them to investors.  This is a great control – it ensures that the financial statements are authentic, and it also unequivocally confirms the identity of the auditor at the same time.

The snag?  While this is crucially important, administrators seem pretty casual about the whole process.  Admins are generally happy to do this, but only if a fund asks for this “service”, and many admins are certainly far from proactive on this topic.  There are some admins, mind you, that don’t want to get involved (we came across one admin that had decided, on a related point, that they would not send offering memos to investors.)

In our mind, this is a vital control and should be mandatory for every administrator.  Getting the financials from the admin is just as important as ensuring that the investor monthly NAV statements come from the admin and not from the manager.

4) And who is the audit report addressed to?

Another particular bugbear is the obsession of one of the Big 4 audit firms in Cayman to change the addressee of the audit report from “to the board of directors and shareholders” to just “to the board of directors”.  The objective, of course, is transparent and predictable – the auditor is looking to enhance the concept of privity and assert that the firm only has a relationship with the Board and no relationship – none, never, nada – with the investor.

The irony here – the directors who are now the sole recipient of the audit are usually our rent a director friends who sit on a few hundred other hedge fund boards.  And does anyone really think – including the partner at the Big 4 firm signing the opinion – that these guys really have time to read every set of audited financial statements from cover to cover?

One solution here – could the Cayman regulator mandate that the audit opinion must be addressed to the shareholders in order to be meet Cayman requirements?  Again, this would be a small change that would send a very helpful, investor friendly signal from this jurisdiction.

5) In fact, do you even have to leave the office?

A final observation reflects what seems to be an emerging trend over the past audit cycle – certain auditors (and certain offices of certain auditors in particular) seem to be adopting a desk fieldwork process.  We have recently completed due diligence on a number of funds – albeit usually long short equity – when both the administrator and the manager stated that the audit team had never came on site to do any audit work.  All work was done remotely from the auditor’s own offices.

Now, aside from the fact that fieldwork is called fieldwork for a reason (er…you’re in the field) we see this as a worrying trend.  It stands to question that the quality of the audit is not the same if you never look the individual responsible for preparing the accounts in the eye.

As a counterpoint to our observations, we do continue to recognize that the audit process is ever more challenging and that many skilled professionals work incredibly hard, especially during busy season. As just one example, we were recently speaking with the audit partner of a Big 4 firm discussing FIN 48 – a tortuous challenge for the profession.

At the same time, the audit process is critical for investors and we’re certainly entitled to ask tough questions – we are “sophisticated”, after all.

It’s also worth noting that the auditors’ ever increasing fees are, of course, borne by the end allocator.  We’re happy to pay….provided we get good value.  Net net, the hedge fund audit profession would certainly be well served to make things a little easier for the person cutting the pay cheque.

www.castlehallalternatives.com
Hedge Fund Operational Due Diligence
“Risk Without Reward” is a trademark of Entreprise Castle Hall Alternatives Inc.  All rights reserved.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP is one of the top hedge fund law firms and provides comprehensive formation and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

For more articles by Chris Addy, please see the Castle Hall Alternatives post where we have listed our reprinted articles.

Hedge Funds and Insider Trading after Galleon

By Bart Mallon, Esq. (www.colefrieman.com)

High Profile Case Highlights Issues for Hedge Fund Managers to Consider

Insider trading is now an operational issue for hedge fund managers.  The high profile insider trading case involving RR and the Galleon hedge fund has put the spotlight directly on hedge funds again and has also sparked a debate of sorts on the subject.  Given the potential severity of penalties for insider trading, it is surprising that we still periodically hear about such cases, but nevertheless it is something that is always going to be there – human nature is not going to change.

As such hedge fund managers need to be prepared to deal with this issue internally (through their compliance procedures) and also will need to be able to communicate how they have addressed this issue to both the regulators and institutional investors.  While managers always need to be vigilant in their enforcement of compliance policies and procedures, during this time of heightened insider trading awareness, managers need to be even more vigilant about protecting themselves.  As the Galleon liquidation too vividly shows, a lapse in operational oversight can and will take down an entire organization.

Insider Trading Overview and Penalties

We have discussed insider trading before, but as a general matter insider trading refers to the practice of trading securities based on material, non-public information.  Whether information is material depends on case law.  In general information will be material if “there is a substantial likelihood that a reasonable shareholder would consider it important” in making an investment decision (see TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)).  Information is non-public if it has not been disseminated in a manner making it available to investors generally. An insider is generally defined as officers, directors and employees of a company but it can also refer to a company’s business associates in certain circumstances (i.e. attorneys, accountants, consultants, and banks, and the employees of such organizations).  Additionally, persons not considered to be insiders may nevertheless be charged with insider trading if they received tips from insiders – such persons generally are referred to as tippees and the insider is generally referred to as the tipper.  [HFLB note: more information on insider trading generally can be found in the discussion of Regulation FD on the SEC website.]

The penalties for insider trading are potentially harsh – censures, cease and desist orders, fines, suspension and/or revocation of securities licenses are all potential penalties.  Depending on the severity of the insider trading there may be criminal sanctions in addition to the listed civil penalties.  Securities professionals (or other business professionals like an attorney or accountant) may jeopardize their ability to work in their industry if they are caught engaging in insider trading which, for most people, would be a large enough deterrent to engage in such activity.

Addressing Compliance Inside the Firm

Insider trading is usually addressed in the firm’s compliance policies and procedures.  Indeed, Section 204A of the Investment Adviser Act of 1940 requires SEC registered investment advisers to maintainpolicies and procedures to detect against insider trading.

Usually such policies and procedures forbid employees from trading on material non-public information (as well as “tipping” others about material non-public information).  Additionally, employees typically are required to disclose any non-public material information they receive to the chief compliance officer (“CCO”) of the firm.  The employee is generally prohibited from discussing the matter with anyone inside or outside of the firm.  The policies and procedures may require the CCO to take some sort of action on the matter.  There are a number of different ways that the CCO can handle the situation including ordering a prohibition on trading in the security (including in options, rights and warrants on the security).  The CCO may also initiate a review of the personal trading accounts of firm employees.  Usually when the CCO is informed of such information the CCO would contact outside counsel to discuss the next course of action.

Dealing with Regulators

While many large hedge fund managers are registered as investment advisors with the SEC, many still remain unregistered in reliance on the exemption provided by Section 203(b)(3).  With the Private Fund Investment Advisers Registration Act likely to be passed within the next year, managers with a certain amount of AUM (either $100 million or $150 million as it now stands) will be forced to register with the SEC.  Of course, this means that such managers will be subject to examination by the SEC and insider trading will be one of the first issues that a manager will likely deal with in an examination.

As we discussed in an earlier insider trading article, the SEC has unabashedly proclaimed war against insider trading and they will be aggressively pursuing any leads which may implicate managers.

Some compliance professionals believe that the SEC comes in with a view that the manager is guilty until proven innocent.  While I do not necessarily subscribe to this blanket viewpoint, I do believe that managers, as a best practice, should be able to show the SEC the steps they have taken to ensure that compliance with insider trading prohibitions is a top priority of the firm.  The firm and CCO should be prepared to describe their policies and structures that are in place to deal with this issue.

Institutional Standpoint

Potentially more important than how a firm deals with the SEC, is how a firm describes their internal compliance procedures to institutional investors.  The question then becomes, how are institutional investors going to address this risk with regard to the managers they allocate to – what will change?

Right now it appears a bit unclear.  Over the past week I have talked with a number of different groups who are involved hedge fund compliance, hedge fund consulting, and hedge fund due diligence and I seem to get different answers.  Some groups think that institutional investors will be focusing on this issue (as many managers know, one of the important issues for institutional investors is the avoidance of “headline risk”); other groups seem to think that this is an issue that institutional groups are not going to focus on because there are other aspects of a manager’s investment program and operations which deserve more attention.

We tend to agree more with the second opinion, but we still believe that robust insider trading compliance policies and procedures are vital to the long term success of any asset management company.  We also encourage groups to discuss their current procedures with their compliance consultant or hedge fund attorney.

Outsourcing and Technology solutions

Many large managers have implemented compliance programs which have technology solutions designed to track employee trading.  Presumably there will be technology programs developed to address this concern for manager.  Although I do not currently know of any specific outsourced or technology solutions which address this issue, I anticipate discussing this in greater depth in the future – perhaps there is some data warehousing solution.  [HFLB note: please contact us if you would like to discuss such a solution with us.]

Final Thoughts

The Galleon insider trading case could not have happened at a worse time for the hedge fund industry which is trying to put its best face forward as Congress determines its future regulatory fate.  However, increased awareness of this issue will force managers to address it from an operational standpoint which will only help these managers down the road.  While the full effect of this case will not be understood for a while, in the short term it is likely to cost managers in terms of time and cost to review and implement increased operational awareness and procedures.

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Other related hedge fund law articles:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog and the Series 79 exam website.  He can be reached directly at 415-868-5345.

Hedge Fund Investors – What are investors looking for?

Are Hedge Fund Managers Lowering Fees?

There are a few common topics which have been coming up lately in my conversations with managers.  Of these probably the question of greatest interest deals with what sort of fee structure investors are looking for right now and what kinds of fee concessions are manages granting to investors.  In the article below Bryan Goh (First Avenue Partners) addresses these issues and shares his thoughts on the hedge fund industry after a recent conference.  This article was reprinted from Byan’s blog called Ten Seconds Into the Future by Bryan – I highly recommend this blog for all hedge fund managers.  [Another blog I highly recommend is Compliance Building by Doug Cornelius.  This blog will be a great resource for anyone interested in issues involving compliance issues.]

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The month of June is replete with hedge fund conferences. Conferences earlier this year were either poorly attended, or else investors attended them for the free breakfast or lunch, a chance to commiserate with fellow sufferers of the global financial crisis/hedge fund witch hunt. What a differences a couple of months of rising markets make.

I recently attended the Goldman Sachs European Hedge Fund conferences held in London a couple of days ago. Over 50 hedge fund managers attended to present their funds and a rough count of what must have been over 300 investor groups showed up if not to allocate soon then at the very least to window shop.

The quality of managers was in general very high. Perhaps the weaker managers had been washed out or were facing legacy issues and thus not investable, there was clearly a Darwinian dynamic at work. The organizers would have been very selective as well so as not to waste investors time. Or maybe it was just that Goldman Sachs simply had a bigger client base and could move further into the right tail of quality. Or, dare I say it, Goldman’s clients were of a better quality. I don’t know, all I know is what I saw. 5o over managers, all to a greater degree, investable if one was so inclined to their strategies.

Many established managers previously closed to new investment, or usually reluctant to be presenting at capital introduction events were presenting. Only recently, Israel Englander’s much vaunted Millennium was out looking for new capital at a number of conferences around the globe. These managers have experienced outflows of capital, redemptions which may be uncorrelated to the quality of their performance in 2008, and find that they have capacity to replace this exiting capital, as well as are faced with rich opportunity sets upon which to capitalize and thus have improved capacity.

Panel upon panel of strategy specific discussions were held and all well attended. Investors were clearly looking for new ideas, a sign of recovering risk appetite and the need to put capital to work. In every discussion, the macro landscape was an issue of great importance. At each panel, regardless of the uncorrelated or non-directional nature of the strategy from event driven to market neutral strategies, moderators and panel members were clearly focusing on the macro landscape, on regulation, on government intervention, and how these would impact the functioning of markets in which they invested. One thing was clear, there was no consensus as to the health of the global economy. Goldman Sach’s Head of Global Economic Research Jim O’Neill was of the opinion that the worst was over and that a V shaped recovery was underway. His team forecasts better than expected growth from economies like the BRICs driving global growth. Hedge fund manager’s, however, were almost evenly split 50:50 between bulls and bears, with the bears with the slight edge in extra time. Student’s of Murphy’s Law and other dynamic system theories will tell you that this is a healthy balance and likely to prolong current trends whether rising or falling and that reversals occur when the balance is jeopardized one way or the other.

What was really interesting for this observer, was that despite the lack of consensus over economic growth and market direction, each manager saw immense investment opportunities in their own particular strategies and markets. This would appear to be an inconsistency at best and more cynically, disingenuity at worst. Not so, in my view.

Of all the strategies represented at the conference, there was consensus among the respective manager groups, that the opportunities for profit generation were great. Equity long short, Distressed Debt, Merger Arbitrage, Volatility, Multi Strats. They all saw ways that they could make money, yet none of them could agree on whether the economy had stabilized, whether growth would resume or falter, whether inflation would rise or sink into deflation, whether markets would rise and fall. There is a larger lesson for students of economics, but that is not our aim here.

One can argue that macro leads micro, I’m not quite sure how yet, but in the narrower context of this discussion, micro leads macro. What these managers are individually telling us is that there are micro strategies that can be profitable. A macro analysis of the strategies that these managers employ will simply not be granular enough to capture the opportunities they talk about. And yet, when sufficient numbers of them make money, when sufficient capital is put to work in these opportunities, the macro structure of the trades becomes evident. This is the natural evolution of strategy.

Fees and Terms:

The industry has been debating if there has been any fee compression in the wake of the financial crisis of 2008, and hedge funds’ apparently failure to perform as advertised. I have defended the performance of hedge funds through the initial stages of the crisis, but that is the subject of another discussion. At the Goldman conference, there was definitely a growing number of managers charging less than the usual 2 and 20. 1.5 and 15, and even 1 and 10, fees were seen. Encouragingly, I met a handful of managers who were either considering or in the process of establishing a holdback provision with a vesting period, on performance fees, whereby a portion (say 50%) of a year’s performance fees are held in escrow and a negative performance fee is applicable to the amound held back.

Liquidity terms were also a lot more logical. Illiquid strategies did not shy away from lock ups, while well performing or big name hedge funds with liquid portfolios and strategies, passed on that liquidity to investors. Some managers went as far as to formally exclude so-called gates, restrict suspension of NAV rights to specific circumstances, and specify side pocket provisions more explicitly. It appears that the events of 2008 have precipitated a much welcome self regulatory campaign.

Strategies:

Equity long short managers were in abundance, naturally, given their market share of the hedge fund industry. The diversity of styles within what many consider a relatively simple strategy makes it a very interesting area to analyse and invest. There are managers who are driven by the philosophy that fundamentals, that is earnings, cash flow generation, financial strength, matter most in determining valuations. There are those who are traders, for which fundamentals are secondary, and what matters most is how a stock’s price has behaved and is behaving. Still others, have a macro or thematic approach, and apply these to equity investing. The trading style managers were bullish, arguing that increased volatility and dispersion in equity returns represented opportunity for profit. It also represents opportunity for loss as well of course. Alpha can be negative. Some of them were bullish on the market, some were bearish on the market, but there was general enthusiasm for the opportunity to trade. Fundamentally driven stock pickers were similarly upbeat about their strategy, arguing that the last 6 months have seen a wholesale disposal of risk followed by in the last 6 weeks, a reversal of this risk aversion, and that such large systemic moves create mispricings in individual companies which they seek to exploit. As always there were some very clever approaches to equity long short. There was a manager who had a very strong macro view, and invested a lot of time in macro research, then researched company fundamentals in an attempt to understand the impact of macro developments on company fundamentals. There was another manager which analysed only audited financials and ignored all street and interim data, and then built sophisticated models to obtain their own interim numbers. All these various managers had credible reasons why their approaches would work. In 2005, I would not have believed them; today I am a lot less skeptical.

Convertible Arbitrage managers were conspicuously absent from the conferences. The best performing strategy in 2009, albeit the worst performing strategy in 2008, convertible arbitrageurs were too busy making money from the market to attend a capital introductions event. Moreover, who would listen, they would argue, most investors having being burnt in 2005 and then again in 2008. There are good reasons why the strategy is working and is likely to work further, but the managers were too busy working it than selling it. Good for them.

Distressed Debt has been a preferred strategy since late 2007. That, however, was an expensive false start. By the end of 2008, with insufficient defaults and a catastrophic dislocation in credit markets from LIBOR to swaps, from ABS to corporate, from cash to synthetics, distressed debt managers had suffered considerable losses. Rational, no memory investing would have suggested getting back into distressed investing in 2009 and to their credit, investors have been bullish on distressed investing once again. A number of surveys taken in 1Q 2009 ranked distressed investing as one of the top 3 hedge fund strategies among investors for 2009.

One of the least favored strategies, if investor survey’s are to be believed, is merger arbitrage. It may surprise one to learn that on a rolling 12 month basis, merger arbitrage has been one of the best performing hedge fund strategies, behind global macro and CTAs. Merger arbitrage, or risk arb, was well represented at the Goldman conference and it was clear that risk arbitrageurs were very much excited about the opportunities before them.

Since July 2008, M&A transactions numbered over 5000 representing over 1 trillion USD in value, and deal flow continues on the back of cashed up corporate buyers seeking strategic assets, distressed sales from corporate restructurings, distressed sellers and government interventions. Company’s are happier to do deals in rising stock markets and easing financing conditions. Also, BRICs and other EM markets outbound transactions have been strong and remain an area of considerable potential growth.

Deal spreads have been volatile. The dislocation of markets in 2008 represent a stepwise repricing of an over arbitraged space. Deal spreads of circa 10-11% blew out to 50 – 60% before settling at current levels of 15 – 20% IRR.

The financial crisis of 2008 has also reduced the number of participants leading to a much less crowded space. Bank prop desks have exited or significantly reduced their books and hedge fund capital dedicated to risk arb has shrunk more than proportionately to the industry. Many risk arb funds drifted into a much too early play in distressed credit as quite often the resources if not the skill sets are the same. M&A very often wanders into litigation and distressed investing is very much about litigation. While a pure risk arb strategy would have done relatively well in the last 12 months, the contamination from a catastrophic credit strategy has hurt many multi strategy funds with large risk arb books resulting in poor performance and redemptions. The reduced capital employed in risk arb not only results in wider deal spreads but allows more time for analysis and deal selection leading to more selective participation.

A renaissance for hedge funds:

Since hedge fund indices have been compiled, that is 1990, until the present, with the exception of 1998 and 2008, hedge funds have steadily generated positive absolute returns. These returns have seen varying correlations to the returns of other traditional asset classes such as equities and bonds, as well as varying information ratios over time. From 2005 to 2007 hedge funds’ returns exhibited increasing correlation to traditional asset classes, decreasing returns to invested capital, increasing inter strategy correlations and increasing leverage. These features are interrelated and are directly related to the amount of capital dedicated to hedge fund strategies.

With more capital deployed in arbitrage and relative value strategies, continuous risk was more evenly distributed, volatility was dampened, volatility of volatility and correlations was also dampened, credit spreads converged, other arbitrage and relative value spreads also converged. The only way to maintain return on equity was to increase the level of leverage, a practice eminently feasible in an environment of cheap credit. Return on capital at risk, however, compressed to unsustainably low levels.

Such periods of calm accumulate imbalances for discontinuities. It would seem that a protracted reduction in continuous risk results in an accumulation of gap risk. In 2008, that gap risk was crystallized resulting in a discontinuous reduction in systemic leverage and thus capital employed  in arbitrage and a concomitant system wide widening of arbitrage and relative value spreads.

This is one of the more plausible explanations for why, in an economy clearly in decline, with recovery highly uncertain and non-robust, with differing opinions and outlook for financial markets, arbitrageurs are optimistic about their profit generation potential across almost all, if not all, hedge fund strategies.

Arbitrageurs will be required once again to police arbitrage and relative value spreads to bring convergence to no-arbitrage pricing, to bring relative value valuations in line and to aid in the efficient allocation of capital. In a sense, and to a certain extent, the real economy is reliant on the arbitrageur in the healing process, and therefore, one factor for the rate of recovery, or repair, of the real economy, will be the rate at which capital is redeployed to take advantage of mispricings and other arbitrage opportunities.

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Please feel free to comment below or contact me if you have any questions or would like more information on starting a hedge fund.

Hedge Fund Due Diligence Firm Releases Whitepaper on Hedge Fund Industry

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 Capital – How to Raise Assets for a Hedge Fund

The biggest issue for start up hedge funds (and also established hedge fund managers) is how to grow assets under management.  Growing a hedge fund’s capital base is very important because increased AUM mean both increased management fees and performance fees (assuming the fund has positive performance returns).   This article focuses on traditional avenues of raising capital for a hedge fund.

Raising Hedge Fund Capital – Friends and Family

Most hedge funds raise capital to start up through their friends and families.  Often this can be a significant sum, other times it can be relatively small.  I have seen some hedge funds start with as little as $500,000 and sometimes less.  Often, after a hedge fund has a few months of performance (assuming again positive performance) these friends and family members will invest more money.  Other friends and family members, who did not originally invest, may also decided to invest.  Family members of investors may also be persuaded to invest in the hedge fund.

Generally investments from friends and family are completed fairly quickly and through less formal conversations than from other types of investors.  However, the hedge fund manager must always make sure that the friends and family have the fund’s offering documents and have made the appropriate representations in the subscription documents.

After an initial investment from friends and family, it is important for a start up manager to focus on the trading as it is most important to have a good 6-12 month track record that you will be able to market to other potential investors.

Raising Hedge Fund Capital – High Net Worth Individual Investors

High net worth investors (generally qualified purchasers as well as some qualified clients and accredited investors) often invest in hedge funds.  High net worth investors will usually have legal and investing teams which will vet the managers and the strategy.  Usually there will at least be a minimum amount of due diligence requests on the manager and the fund.  Managers can be introduced to high net worth investors through their own networks or through other channels such as hedge fund conferences, hedge fund databases or through other means.

Raising Hedge Fund Capital – Institutional Investors

Institutional investors will occasionally invest in hedge funds with a track record shorter than one year.  Generally in these cases the hedge fund sticks out to them for various reasons.  Such reasons might be that the hedge fund performance was just spectacular, or the institutional investor likes the way the particular investment strategy fits within the institution’s allocation design, or the hedge fund manager may have a strong pedigree which appeals to the institutional investor.

Whatever the reason, getting an investment from an institutional investors is usually a longer and more in depth process than receiving money from friends and family or from a high net worth investor.  The hedge fund manager will need to first establish a meeting with the institutional investor.  Generally the meeting will be at the office of the institution and the manager will have a certain amount of time to give his pitch, usually through a pitchbook presentation.  Some managers of the institution will look carefully at these presentations; others will not even open the cover.  However, the hedge fund manager should be ready to answer any number of different questions from the institution regarding the program.  Such questions will likely cover the following topics: risk management procedures, expected performance in down markets, performance analytics, etc.  The hedge fund manager should act composed and answer each question directly and completely – this is the time for the manager to show his knowledge of the investment strategy and sell the strategy to others.

Either before or after the meeting with the institution, the hedge fund manager will likely be asked to complete some basic due diligence.  I’ve outlined a sample request in this article: Institutional Hedge Fund Due Diligence.  After the institution has interviewed and vetted a manager it may take some time before the institution actually invests in the fund.  This happens for a variety of reasons and the hedge fund manager is urged to stay patient during the process.

Non-tradtional forms of raising hedge fund capital

I will be discussing other ways to raise capital in subsequent articles.  Such non-traditional ways include: utilizing the services of a third party marketer, capital introduction services, hedge fund conferences, and hedge fund databases.

Legal Implications of Raising Capital for a Hedge Fund

As most hedge fund managers know, under the Regulation D offering rules managers cannot raise capital through any type of general advertising or solicitation.  This means that they cannot: buy advertising in any financial publications, advertise generally on the internet (but please see article on Hedge Fund Websites), cold call potential investors and or engage in other similar activities.  Additionally, hedge fund managers, and others raising money for hedge funds, must be aware of and abide by all broker-dealer regulations.  This is a very important issue, so please discuss it with your hedge fund attorney (please see Guide to Broker-Dealer Registration).

Please contact us if you have a story on raising capital for you hedge fund – we would like to hear your story and potentially profile your fund on our blog.  Other articles which are related to items in this article include:

Hedge Fund of Funds

One hedge fund strategy is a hedge fund of funds or fund of funds for short. Fund of funds managers invest in other hedge funds rather than trade directly in the financial markets, and thus offer investors broader exposure to different hedge fund managers and strategies. Like hedge funds, funds of funds may be exempt from various aspects of federal securities and investment law and regulation.

Structure and Offering documents

As noted above the FOF structure is generally the same as a regular hedge fund. The FOF manager will need to consider whether he will need to be registered as an investment advisr with the SEC or state securities commission. The FOF also may be a 3(c)(1) fund or a 3(c)(7) fund and of course, the FOF may also be an offshore fund. The fund of funds offering documents are going to look exactly the same as the hedge fund.

Fund of Funds Fees

FOFs regularly face a lot of criticism for the fee structure. FOFs will generally charge annual management fees of 0.5% to 1.5% and annual performance fees of 5% to 15%. These fees are on top of the management and performance fees which are paid out at the fund level. Because of the two layers of fees FOFs can be very expensive.

Reason for FOFs – Diversification

Although FOFs face criticism because of their high fees, they do offer investors a greater degree of diversification than individual hedge funds. Because FOFs invest in many hedge funds the performance of any single hedge fund will not, in theory, affect the whole portfolio. In extremely volatile times like we are currently experiencing, the FOF is trying to dampen volatility by being diversified. Many FOFs can weather these volatile times, but many FOFs are suffering along with their underlying funds.

Reason for FOFs – Access to managers

One of the main selling points to accredited and high net worth investors is access to hedge funds and managers which the individual investor may not have access to. Many of the very large premier hedge funds are no longer open to any investors. These premier hedge funds may, every so often, open their funds for new investments by existing investors. FOFs which have an investment with these managers will be able to get investor money into these funds.

Many individual hedge funds have very high minimum investment requirements which certain individual investors would not be able to meet. An accredited investor with $250,000 to invest will not be able to invest in a fund with a $1 million minimum, but that same investor will be able to get exposure to that fund through a FOFs. By pooling money from many investors the FOF is able to meet the minimums to these hedge funds with high minimum investments.

Reasons for FOFs – Due Diligence

Fund of fund managers are expected to perform in depth due diligence on the underlying hedge fund investments. This includes both operational due diligence as well hedge fund manager background checks. Many times a FOF manager will actually make in-person visits to the hedge fund’s offices to make sure that the hedge fund is not acting fraudulently.

Entry point for Institutional Investors

Fund of funds serve as a common entry point for institutional investors who want to get into the alternative investment arena. While there is a very large amount of assets in hedge funds through institutional investors, investments by these groups is growing at a great rate. Because these investors are typically conservative by nature, the more diverse FOFs serve as a great way for the investor to test the alternatives market. It is expected that institutional investors will become even bigger players in the alternatives area and therefore it is expected that FOFs will continue to serve as a good entry point to the industry.

For more information on this topic, please see our earlier post (GAO hedge fund report) which details what institutional investors look for when they invest in hedge fund of funds.

Non-active management – Sponsor

The FOF managers main job is to monitor investments in underlying hedge funds. While most fund of hedge funds managers were once active stock pickers, brokers or other industry professional, we are seeing the advent of the FOF manager who is really a sponsor of the fund of funds. A great example of this is Ron Insana, the CNBC analyst who became a FOF manager.

These types of FOF managers have great connections and are able to raise assets for investments in hedge funds but will not spend as much time determining the investments which will be made in the fund. In fact these managers may hire a sub advisor (paid out of the management fee) who will determine the investments the FOF will make. Other parts of the FOF back office can be outsourced – for instance there are firms which will do much of the initial hedge fund manager screening (through databases and other sources) and hedge fund due diligence. If you would like more information on these groups, please contact us.

Should a start-up hedge fund have an audit?

Question: Should a start-up hedge fund have an audit?

Answer: This is a question which we will get very often for funds that aim to launch on July 1 or later.  While there is generally no legal requirement for a hedge fund to have their performance results audited, a vast majority of hedge funds have their returns audited because it will aid in the marketing efforts by lending credibility to performance results.

With regard to this question, and as with most business-issue oriented hedge fund questions, the answer is going to depend on the manager’s program and what the manager plans to accomplish during the first 6, 12 and 18 months of operations.

Generally, first year hedge fund manager’s are going to need to focus on costs. Not only from a cash flow perspective, but also from a return perspective. Any costs (which the fund bears) affect performance. Accordingly, many start-up hedge fund managers may forgo an audit of the fund’s track record during the first year. The manager then may have the fund audited after the end of the fund’s second year. A manager might consider doing this in a couple of situations. The first situation is when the fund starts trading during mid-year or later. In this instance it will probably not make a lot of sense to have an audit for fund operations of less than one year. An exception to this generality is if you have a decent amount of AUM and you are looking to begin courting institutional investors. If this is the case, then it will generally be a good idea to have an audit.

The second situation when a start-up hedge fund manager might not choose to have an audit after the first year is if the manager has a longer term hedge fund incubation program. This might be the case if the hedge fund manager has a longer term trading strategy (buy and hold) or when the manager does not plan to seek institutional money during the second year. Many managers will go with this slow and steady approach to asset raising in order to understand the back end operations of their fund. As noted in numerous places, one of the main reasons why hedge funds fail is inadequate back office operations.

If a start-up hedge fund manager plans to start with a larger asset base, say $10 million or more, and plans to aggressively court the institutional market during the first half of the coming year, then it might be wise to think about an audit. While the decision to forgo a first year audit is strictly a business decision, it is recommended that you discuss this decision with both your legal team and your potential auditor.  Additionally, if you will be using the services of a third party marketer, you will want to discuss this decision with the third party marketer.