This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008. The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds. The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here.
The excepts below provide a good picture of what institutional investors look at when deciding to invest in a hedge fund. Hedge fund managers have moved towards greater disclosure because of the instutitutional investors have been vetting their investments more thoroughly. If a hedge fund manager is recieveing attention from institutional investors, it is likely that the investors will conduct due diligence which a manager should be prepared for.
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Investors, Creditors, and Counterparties Have Increased Efforts to Impose Discipline on Hedge Fund Advisers, but Some Limitations Remain:
Investors, creditors, and counterparties impose market discipline–by rewarding well-managed hedge funds and reducing their exposure to risky, poorly managed hedge funds–during due diligence exercises and through ongoing monitoring. During due diligence, hedge funds should be asked to provide credible information about risks and prospective returns. Market participants told us that growing investments by institutional investors with fiduciary responsibilities and guidance from regulators and industry groups led hedge fund advisers to improve disclosure and transparency in recent years. Creditors and counterparties also can impose market discipline through ongoing management of credit terms (such as collateral requirements). However, some market participants and regulators identified limitations to market discipline or failures to exercise it properly. For instance, large hedge funds use multiple prime brokers, making it unlikely that any single broker would have all the data needed to assess a client’s total leverage. Others were concerned that some creditors and counterparties may lack the capacity to assess risk exposures because of the complex financial instruments and investment strategies that some hedge funds use, which could illustrate a failure to exercise market discipline properly if the creditor or counterparty continued to do business with the fund. Further, regulators have raised concerns that creditors may have relaxed credit standards to attract and retain hedge fund clients, another potential failure of market discipline.
Better Due Diligence and Greater Demand for Transparency from Investors Have Resulted in Increased Hedge Fund Disclosure, but Some Investors May Lack the Capacity to Assess Risk Exposures:
By evaluating hedge fund management, the fund’s business activities, and its internal controls, investors are imposing discipline on hedge fund advisers. Market participants who generally transact with large hedge funds and institutional investors told us that before investing in a hedge fund, potential investors usually conduct a due diligence exercise of the business, management, legal, and operational aspects of the hedge fund under consideration for investment. Market participants further noted that the exercise moves from an initial screening to quickly identify the funds that do meet the potential investor’s investment criteria to a detailed evaluation that involves addressing a series of questions about the business, management, legal, and operational aspects of the hedge fund. Among other things, investors may take into account investment strategies hedge funds use to produce their returns, the types of investments traded, and the fund’s risk management practices and risk profiles. Investors analyze this information to determine whether the investment’s risks and reward warrant further consideration.
Typically, prospective investors receive written information from the hedge fund manager in the form of a private offering memorandum or private placement memorandum (PPM).[1] We could not obtain hedge fund offering documents, but market participants who have reviewed PPMs told us that there are no standard disclosure requirements for PPMs and the information disclosed is often general in scope. Consequently, investors may seek information beyond that provided in PPMs and sometimes beyond what hedge funds are willing to provide. For instance, they may request from hedge fund managers a list of hedge fund securities positions and holdings (position transparency) or information about the risks associated with the hedge fund’s market positions (risk transparency). However, according to market participants we interviewed, although most hedge funds may be willing to provide information on aggregate position and holdings, many hedge funds decline to share specific position transparency, citing the need to keep such information confidential for fear that disclosure might permit other market participants to take advantage of their trading positions to the detriment of the fund and its investors. Additionally, some prospective investors also may obtain from hedge fund managers access to the hedge funds’ prime brokers and other service providers such as auditors, lawyers, fund administrators, and accountants for background checks. A representative of a group that represents institutional investors we met with told us that after making an investment, investors typically will monitor their investment on an ongoing basis to evaluate portfolio performance and track how well investments are moving toward investment goals and benchmarks.
Recently, hedge fund advisers have increased their level of disclosure in response to demands from institutional investors. Institutional investments in hedge funds have grown substantially in recent years. Over the last 3 years, institutional investors in search of higher returns and risk diversification, such as pension funds, endowments, and funds of hedge funds, have accounted for a significant portion of the inflows to hedge funds assets under management. (See app. II for information on pension plan investments in hedge funds). According to market participants and industry literature, the increasing popularity of hedge funds among these institutional investors has led to changes in the industry. That is, hedge fund advisers have responded to the requirements of these clients by providing disclosure that allows them to meet fiduciary responsibilities. For example, one market participant we met with stated that a trustee to a pension plan that is subject to the “prudent person” standard of the Employee Retirement Income Security Act of 1974 (ERISA) is required to make investment decisions for the plan in accordance with a “prudent person” standard of care that may require plan trustees to demand greater quality oversight of their capital; in consequence, they may demand greater transparency, risk information, and valuation techniques than individual investors.[2] Market participants with whom we met also told us that the trend toward permanent capital also has been driving hedge fund transparency. Markets participants further noted that as hedge funds reach a certain size, they tend to seek more permanent capital through the public markets to avoid the liquidity risks inherent with sudden investor redemptions.
The ability of market discipline to control hedge funds’ risk taking is limited by some investors’ inability to fully understand and evaluate the information they receive on hedge fund activities or these investors’ willingness to hire others to evaluate that information for them. An example can be found in the Amaranth case. According to market participants we interviewed and industry coverage that documented the event, Amaranth noted in its periodic letters to investors that it had a large concentration in the natural gas sector. The market participants and the documents noted that some investors became concerned about the potential risks associated with concentrated positions and withdrew their money from Amaranth several months before Amaranth failed. They also said that other investors did not heed potential warning signs included in the investor letter and kept their money in Amaranth either in pursuit of higher investment returns or because they did not fully comprehend the changing risk profile of the hedge fund.
Regulators, market participants, and academics generally agree that hedge funds have improved disclosure and risk management practices since the LTCM crisis and have largely adopted the guidance from various industry groups and the PWG. Regulators told us that from their examinations of regulated entities that transact business with hedge funds as creditors and counterparties, they have observed that hedge fund disclosure and risk management practices have improved since LTCM. For example, in response to the 1999 PWG report recommendation that hedge funds establish a set of sound practices for risk management and internal controls, private sector entities such as the Managed Funds Association (MFA), and the Counterparty Risk Management Policy Group (CRMPG), as well as the public sector International Organization of Securities Commissions (IOSCO) published guidance for hedge funds and their advisers.[3] Market participants told us that many hedge fund advisers with which they conduct business have adopted these best practices, including risk management models that go beyond measuring “value at risk,” and now regularly stress-test portfolios under a wide range of adverse conditions.[4] Representatives from a risk management firm told us that in the past, hedge fund advisers viewed risk management practices as proprietary. However, as the trading environment evolved, advisers realized they needed to provide results of risk assessments to investors to attract investments.
[1] According to an SEC report and some market participants we interviewed, PPMs discuss in broad terms the fund’s investment strategies and practices; risk factors; information on the general partner or investment manager; management fees and incentive compensation; key personnel of the fund manager; synopsis of the limited partnership agreement or other organizational documents; conflicts of interest; side letters (preferential redemption terms that may be granted to one class of investors) and side pockets (illiquid investments held separately from the primary fund); investment, withdrawal, and transfer procedures; and valuation.
[2] ERISA § 404(a)(1)(B) [ 29 U.S.C. 1104(a)(1)(B)] requires a fiduciary to act with the care, skill, prudence, and diligence under the prevailing circumstances that a prudent person acting in a like capacity and familiar with such matters would use.
[3] MFA is a hedge fund trade group.
CRMPG is an industry policy group that formed in 1999 after the near collapse of LTCM and comprises the 12 largest internationally active commercial and investment banks.
IOSCO is an international organization that brings together the regulators of the world’s securities and futures markets. IOSCO and its sister organizations, the Basel Committee on Banking Supervision and the International Association of Insurance Supervisors, make up the Joint Forum of international financial regulators.
[4] Value at risk is a calculation used to determine the amount that could be expected to be lost from an investment or a portfolio of investments over a specified time under certain circumstances.
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