The changing fund manager-investor relationship

A Campbells Cayman Fund Focus panel highlighted the changes in the relationship between hedge fund managers and investors, business journalist Michael Klein reports.

We are seeing a tremendous amount of change over the last year,” said Boris Onefater, President and CEO of Constellation Investment Consulting, referring to the hedge fund industry’s developments. 

The market downturn in 2008 had in particular a profound impact on the manager-investor relationship as investors are looking for additional transparency, involvement and information about their investment.

They want to know that their money is safe and that their manager has proper infrastructure in place not just to manage the money but to account for it correctly, Onefater said.

One indicator of the changed relationship is that two years ago no investor would have asked about the fund’s counterparties, he stated.
But the world from the investor perspective has changed immensely.

Due diligence
The panellists agreed that as a result investor due diligence had increased already.

Typical due diligence questionnaires of fifteen to twenty page still included gaps in terms of operational or counterparty risks and the industry is now seeing cases of due diligence documents requesting 50 to 60 pages of data, that investors not necessarily knew how to interpret, Onefater argued.
In what he termed “death by due diligence”, funds are beginning to be overwhelmed by due diligence requests that require additional infrastructure and staff to manage.

Both the level of volume and detail required by investors is increasing.

Kelli Holm, a partner in the investment management group at Schulte Roth & Zabel LLP and fellow panellist concurred, stating that managers on the other hand are forced to implement what investors want, in terms of due diligence and transparency, in order to retain the investors and capital.

The big change in terms of transparency is the manager’s willingness to give so much more information than they have in the past, said Moll.
“Sending someone a capital account statement… once a month or once a quarter and the occasional investor letter is no longer working.”

Investors are now getting weekly estimates, in some cases full portfolio transparency and quarterly conference calls with managers to talk about the strategies, risk metrics, position and holdings, she said.

While the level of transparency granted has increased significantly, technology is catching up to offer new and more efficient ways of delivering this information.

Moll quoted in this context the underlying regulatory issue of selective disclosure, by supplying one investor with more information than another investor. 
Managers are now trying to give the lowest common denominator so no investor can gain an advantage over another, for example by putting in a redemption request before anybody else on the basis of additional information.

Increased transparency may, however, cause confidentiality problems. Depending on the investment strategy, for example long/short strategies, some portfolios could be recreated with the information provided.

“If someone did a dissection and reengineered it, they could be able to figure out the secret sauce,” said Onefater.

Other strategies such as private equity could be more transparent, because investors would not have access to the same type of deals.
In general however managers have to be more transparent than in the past simply to retain the capital, argued Moll.

Risk management
Many investors focus specifically on the fund’s risk management.

This concerns the risks involved in managing the portfolio as well as operational and infrastructure risk management, said Onefater.

Investors are interested in the types of key risk metrics that the manager uses and how often this information is shared with investors.

This by far exceeds the typical management of market credit or counterparty risks but encompasses operational, political and reputational risks, argued Onefater.

Media has played an incredibly important role in the industry, said Moll.  Many funds now retain public relations firms who have to deal with managing the information flow and media and investor reactions.

All these risks need to be managed in formalised programmes, which is a new concept for funds and money managers in general.

Large funds are even contemplating or forced by investors to install Chief Risk Officers sometimes in conjunction with Chief Compliance Officers, Onefater said.

Role of the directors
Another area that is becoming more critical is the role of the director and the interplay between manager, director and investor to ensure that the fund’s assets are safe and the manager’s follow the agreed investment strategy.

Moll believed that there has been a change in the way managers view their relationship with the board of directors
The board of directors is no longer rubber stamping decisions and ceding complete control over operations to managers.

Instead the relationship between manager and director is much more formalised and consultative.

This expresses itself in regular meetings and conference calls to inform the board of new developments and also to get input and sign-off on potential conflict situations. Boards are also better informed and prepared by managers to pass a resolution, said Moll.

This change in attitude of the managers is a positive development that results in a more robust corporate governance system and better protection for investors, she said.

There was agreement that there had been a significant amount of pressure on fees and that straight two per cent management fees and 20 per cent performance compensation would not be seen for some time.

Some large institutional investors are pressing for incentive-based compensation to be charged over a multi-year period. This makes new demands in terms of accounting systems and infrastructure.

For funds that have sustained large losses incentive-based compensation and thus the retention of talent is an issue as they struggle with high water marks. Modified high water marks with lower compensation levels during the time the fund recovers any losses were now seen in the industry, Moll said.

Finally investors had learned the painful but valuable lesson to negotiate terms that they can live with, Onefater said, such as lock-up and suspension provisions that prevent investors from withdrawing their funds.

Moll said she would expect to see more negotiation on those terms in the future in particular for plain vanilla funds.
The use of side pockets, accounts in which typically illiquid investments are placed, has been widespread recently and is another issue when negotiating terms.

Side pockets give managers the flexibility to time the sale of illiquid assets and manage liquidity, as investors requesting redemptions do not have access to the part of their investment that is held in a side pocket.

On the whole, investors are now more careful when negotiating terms, verifying the integrity of managers and conducting their due diligence, concluded Onefater.

With regard to the burden these investor demands now impose on fund managers, he commented tongue in cheek: “Now the management fees are actually spent on managing the fund.”