The following article is by Christopher Addy, President and CEO of Castle Hall Alternatives, a hedge fund due diligence firm. We have published a number of pieces by Mr. Addy in the past (please see Hedge Fund Fees, Hedge Fund Due Diligence Issues, Issues for Hedge Fund Administrators to Consider and ERISA vs. the Hedge Fund Industry). The following post can be found here.
And the auditors work for….
Audit opinions of a hedge fund’s financial statements are unlikely to make the New York Times bestseller list. As a result, we can certainly understand if the auditor’s fine print is not exactly top of the list for investor attention. However, not all audit opinions are the same and, over time, it seems that different audit firms are quietly introducing different standards of care and attention – and, of course, liability, which is always the 800 pound gorilla.
The issue is the addressee of the audit report – or, put more simply, who the auditor works for. In a public company, the auditors report to both the shareholders and the Board of Directors. A quick web search gives us a couple of examples – GE and Goldman Sachs (don’t laugh at the Level III assets, by the way).
In a hedge fund, however, sometimes the audit report mentions the shareholders, but sometimes it does not. What seems to be a fine difference is actually very profound – exactly why would a hedge fund auditor report only to the Board of Directors and deliberately fail to address their report to the shareholders? Adding insult to injury, of course, is the reality that the average Board of Caymanian rent-a-directors hardly acts with the same vigor and intervention as the non execs on the boards of GE and Goldman.
In our experience, certain audit firms appear to have taken a deliberate decision to direct their audit opinions, wherever possible, only to the directors. This is a difference which applies across both US GAAP reports as well as audits completed under International Financial Reporting Standards. Check 10 audit reports from different firms, and see what we mean.
The underlying issue – of course – is the lack of investor control. Investors, if asked, would very likely have an opinion on this issue: but, needless to say, they are not asked. Audit engagement letters are signed under cloak and dagger secrecy (usually because they include ever more expansive terms seeking to limit auditor liability under Caymanian law). Thereafter, as investors and due diligence practitioners know to their ongoing annoyance, it proves incredibly difficult and pointlessly time consuming to get some auditors even to confirm that they are the auditor of record for the hedge fund in question.
In the short term, one answer would be for offshore jurisdictions such as the Cayman Islands to mandate that all audit reports filed for Caymanian hedge funds be addressed to the shareholders rather than just the Board. If it’s good enough for GE, it should be good enough for any hedge fund.
In the bigger picture, however, this is just one question within the broad construct of Hedge Funds 2.0 post Madoff. Unfortunately, it is only investor pressure which can enforce any change so that service providers – auditors, administrators, lawyers et al – take responsibility and recognize that their primary duty of care is to the investors that pay them. Without that pressure, hedge funds will continue to be the asset class where everyone wants to get paid, but no-one wants to take responsibility.
Hedge Fund Operational Due Diligence
Other related hedge fund law and start up articles include: