Investor Due Diligence
A successful hedge fund launch is dependent upon providing prospective investors with comfort regarding non-investment considerations, such as the manager’s operations, compliance, and risk management. In order to do so, having a standard due diligence questionnaire (“DDQ”) is recommended.
It is also critical that managers be consistent in all of their disclosures to its investors. Consistency across documents is vital to the maintenance of a manager’s credibility in the due diligence process. The same level of care and consideration should be invested in marketing material, DDQs and requests for proposals. Each of these documents should respond to each item in the same manner. A different sentence or even a single word can change the message or meaning and result in a different understanding to the investor.
A key challenge faced by emerging hedge fund managers is weighing the need to build institutional-quality operational and accounting (“back office”) and investment (“front office”) functions versus the cost incurred in doing so. Smaller firms may consider assets under management (“AUM”) in making headcount decisions, but must also adequately address the operational risk of running too lean an operation. A firm must also take into account the complexity of its funds’ strategies in determining human capital requirements. Three key considerations in human capital management are (i) depth of the employee base, (ii) segregation of duties, and (iii) employee suitability.
Depth of Employee Base
Depth of staffing may be the most visible challenge faced by an emerging manager. Investors will have concerns if a firm’s operations appear to be overly-reliant on one individual. What happens if a key employee goes on vacation, or is hit by the proverbial bus? Employees of emerging hedge fund managers may need to possess a broader skill set than peers at larger firms. Emerging hedge fund managers should also be aware that investors may pay particular attention to the employment history and work experience of the current staff, and the scope of reference checks conducted by managers prior to hiring new employees.
At smaller firms, key professionals may not have designated back-ups. For example, some firms may not employ a senior controller or other finance team members who are able to perform the accounting responsibilities of the Chief Financial Officer (“CFO”). Additionally, other firms may be too reliant on one individual to manage the back office operations. Thus, sufficient controls should be put in place that allow for staff redundancies and mitigate key man risk.
The same concerns are shared on the investment side of the business. At the smallest firms, the portfolio manager may be the sole authorized investment decision maker. Firms must establish procedures to enable investment activity to continue seamlessly when the portfolio manager is not available. Cross-training employees can help mitigate the risk of operating with a lean staff.
Additionally, it is critical for firms to create operations manuals that detail the steps necessary to conduct the firm’s trading, operational, and accounting functions on a daily basis. An operations manual can be referenced in the circumstance that a key employee is unable to perform his or her job. Creating redundancies of key responsibilities and cross-training employees are vital practices for mitigating operational risk at smaller firms because adding additional headcount may not be possible. Firms should also establish plans that delineate a clear road map for additional hires as the firm’s assets under management increase.
Segregation of Duties
In order to mitigate conflicts of interest, segregation of duties is a key practice for hedge funds to follow. While complete segregation of duties can be difficult to achieve at hedge funds with a limited number of employees, there should be a clear distinction between front and back office functions. For example, investment professionals may collect a portion of a fund’s incentive allocation. In order to increase their compensation, they are incentivized to ensure the portfolio is marked at the highest Net Asset Value (“NAV”). To prevent upward bias, the investment professionals should not have the final authority for the valuation of investments within the portfolio. Instead, hedge fund managers should establish valuation committees to provide oversight and processes for the valuation and NAV finalization. The valuation committee is responsible for overseeing, reviewing, and finalizing the valuations prepared for each of a fund’s investments. While it may not be practical for the smallest firms (i.e. a two-person firm) to establish a valuation committee, the final approval of individual valuations and the NAV should be the responsibility of a back office professional, or a valuation committee comprised of a majority of back office professionals (this topic will be addressed further in Part 3 of this series). An additional risk mitigant against biases or conflicts of interest in the NAV finalization process is for funds to employ an independent administrator. An administrator provides accounting services, including maintaining the hedge fund’s official books and records, and is charged with independently determining the fund’s NAV.
SEC-registered managers are required to have a Chief Compliance Officer (“CCO”). As a consequence of this requirement, smaller firms may employ professionals in roles for which they have received no prior training of the role. Given their size, it is not uncommon for the CFO to also serve as CCO. Firms should consider enhancing their infrastructure by selecting third-party service providers to fill the functions which it is unable to optimally perform internally and promote the segregation of duties. For those funds that have this infrastructure in place, third parties can also be engaged to enhance a funds existing internal controls.
Hedge funds custody their securities at one or more institutions, such as prime brokers, custodian banks, clearing agents or an execution and settlement broker acting as an ISDA counterparty. Collectively, institutions providing custodial services to hedge funds are known as “counterparties.” As we have witnessed with the collapse of Lehman Brothers, Bear Stearns and MF Global, it is important for hedge funds to maintain robust procedures for mitigating and monitoring counterparty risk, in order to safeguard customer assets.
In order to mitigate counterparty risk, firms should consider maintaining codified procedures for counterparty selection and monitoring. Firms may assess the financial strength of their counterparties by evaluating metrics such as credit ratings, CDS spreads, and leverage. In their due diligence process for selecting prime brokers, firms may focus on the ability of a prime broker to provide services specific to their hedge fund’s strategy and the financial instruments in which the fund transacts. The ability of counterparties to provide execution, custodial, and capital introduction services may be secondary considerations. Firms should carefully consider the entity with which their funds enter into agreements. Many of Lehman Brothers’ customers’ assets were custodied at its United Kingdom subsidiary, LBIE. The U.K. maintains no limits on rehypothecation and some customer assets have yet to be fully recovered. Assets custodied at U.S.-based entities are subject to legal limits on re-hypothecation and clear, delineated bankruptcy and liquidation procedures. International subsidiaries may be subject to less transparent liquidation procedures and may not be subject to rehypothecation limits.
In order to avoid disruptions in a fund’s borrowing ability, firms should attempt to negotiate favorable financing terms. Favorable terms in prime brokerage agreements may include margin lock-ups, which prohibit the prime broker from changing the financing term within a certain period (usually between 30 days and 90 days). Favorable terms in ISDA agreements may include bilateral agreements, parental guarantees, higher NAV triggers, and NAV triggers which exclude the impact of redemptions.
In order to determine an appropriate allocation of assets amongst their funds’ counterparties, firms may discuss the metrics noted above in regularly-scheduled committee meetings. Management and Risk Committees (“M&R Committees”) should meet on a regular basis and under certain circumstances may require ad-hoc meetings, in order to formally review their funds’ counterparty exposure. M&R Committees should be comprised of senior-level staff from the front and back offices. Establishing thresholds at which a fund will move assets away from its counterparty can provide a roadmap for action in the event of counterparty distress and serve to reduce counterparty risk.
Engaging a second prime broker (or custodian) may be a top priority for emerging hedge fund managers, in order to obtain flexibility in the custody of assets in the event of counterparty distress. Hedge funds engage custodian banks to hold unencumbered cash and fully-paid securities that are not actively traded. Maintaining cash-related instruments and securities at a custodian bank helps to mitigate counterparty risk, as a fund’s securities held at a custodian are segregated from the entities’ assets and may not be re-hypothecated. Hedge fund managers must understand the risks pertaining to the instruments in which unencumbered cash is invested. For example, during the 2008 credit crisis, some money market funds invested in commercial paper and debt securities issued by companies that later defaulted and / or deteriorated in credit quality.
A firm’s systems, and the ability of its employees to effectively utilize those systems, are critical to maintaining efficient day-to-day operations and minimizing disruptions. Emerging managers face the dilemma that while robust systems are available, implementing them may not be cost-effective, or may be subordinate to other firm needs (such as adding headcount or engaging a second prime broker and/or custodian bank).
Accounting systems are critical to a manager’s operations. A hedge fund manager should engage a third-party administrator whose duties include maintaining the official books and records of the fund. Ideally, a manager will use a dedicated accounting system that maintains parallel fund-level and investor-level accounting records to the administrator. However, because of cost or personnel constraints, emerging managers may employ less robust internal controls, such as maintaining only fund-level accounting records, or using Microsoft Excel, rather than an accounting system. In these cases, the manager will ultimately need to rely on the administrator’s records. Given this reliance, managers should thoroughly review the administrator’s records on at least a monthly basis, and investors should understand the manager’s review process. Managers must understand the administrator’s internal accounting and operating processes. Are the administrator’s systems automated or is there manual intervention? Relying on an administrator’s accounting records rather than maintaining complete parallel accounting records in-house can be risky for an emerging manager and is not recommended. Managers with lower AUM typically generate lower fees for an administrator. As a result, emerging managers may receive less responsive service and/or a less experienced support team at the administrator. These factors may pose problems in the event that the manager has questions regarding its accounting records. Overreliance on any service provider, including the administrator, creates operational risk.
Trading systems, including those pertaining to execution, order management, and reconciliation, can be the backbone of a firm’s operations. Utilizing these systems, particularly, systems that are integrated with a manager’s accounting system, can eliminate the need to enter the same information more than once, thereby reducing the potential for human error. In some cases, however, systems may not be cost-effective for emerging managers. Prior to launch, managers should create documents that address each stage of the trade flow process, including the systems employed. If the manager expects to employ additional systems as assets grow, managers may supplement their current documentation with additional diagrams and flow charts that clearly delineate the change in the operating environment.
Managers may also consider implementing systems to assist in risk reporting, investor reporting, and regulatory reporting as well as systems to help manage and automate margin and collateral processes.