Trust but verify

GAIMOps Cayman conference highlighted the latest trends in operational due diligence, writes business journalist Michael Klein.

“If I asked you to think about one word that this industry based on, what would you say that word is?” asked Joel Press, managing director at Morgan Stanley.  “I think it is the word trust.”
When it is all said and done with due diligence and when you invest in a hedge fund manager, it is about trusting each other, he said.
Eric Lazear, head of operation due diligence at Frey Quantitative Strategies, and part of a panel debating how to recover investors’ trust, said he was not sure whether he would agree that there had been a loss of trust in fund managers.
It is not so much about trust in managers, it is just that we are questioning more in the hedge fund space compared to what we were doing two years ago, he said.
“A lot of people still follow the model of trust and verify, but right now they are concentrating on the verification process,” Lazear added.
James Newman, director of operational due diligence at Ermitage Asset Management agreed, saying he does not think that anybody has the luxury of relying on trust.  He would start every single review with a score of zero and warned not to assume that there is trust.
However, Newman conceded, while we do a lot more in terms of verification of what a manager is telling us, you can never completely get away from some form of trust.

Lazear noted that the main topic of 2008, counterparty risk, has now been replaced by the new buzz word: transparency.
Everybody has different definitions of transparency and in my view transparency is the information that an investor needs to obtain to invest with a manager or to stay with a manager, he stated.
Newman added that transparency means sufficient understanding of the business operations of funds and sufficient access to evaluate internal controls.
Newman spends a lot of time speaking to individuals in the operations team, rather than the CFO or COO, for example to detect discrepancies in terms of available resources, he pointed out.
Bart Cocales, global head of operational due diligence at Blackrock, stated that the core processes of due diligence had not changed over the past two years. There is still a focus on people, processes, infrastructure and service providers.
“During the course of the reviews we expect a significant amount of transparency in each of those areas,” he said.
But, he added, there is a heightened degree of discipline and formality in the process and a massive decrease in the tolerance of substandard processes. 
“The risks are just too high.”
While he spends a significant amount of time examining funds’ retention risk around key personnel as well as service provider choices, other panellists also saw recent developments in the reporting of portfolio exposures.
James Newman stated that although it had taken time to convince managers, administrators now provide reports on asset classes, instrument classes and industry and geographic exposures.
Professor Bing Liang presented a study that was based on the premise that due to imperfect transparency and costly auditing, trust is an essential component of financial intermediation in the hedge fund industry.
The study, which analysed 444 due diligence reports, found a significant degree of misrepresentations and verification problems with regard to performance and, among others, past regulatory and legal problems.
The misrepresentation of material facts was found by the study to be a leading indicator of poor future returns and thus emphasised the importance of due diligence. However, the study also revealed that the evidence from the due diligence reports did not influence investment flows, indicating that investors in hedge funds tend to ignore red flags and merely chase past high returns.

Regulatory change
Several presentations highlighted the regulatory changes that will affect the industry in both the US and Europe in the future.
Different panels described how the debate has changed from whether the industry should be regulated to how it will be regulated.
Much of the discussion was still speculation as both the form and the timing of regulatory changes are not clear.
Walkers’ key note speaker Laurin Kleiman, a partner with Sidley Austin, outlined the current regulatory hot topics in the form of the planned private fund adviser registration, the ramifications of amendments to the SEC adviser custody rule, the SEC’s new enforcement strategy and the increasingly elusive line between unique insight and insider trading.
With regard to the heightened enforcement activity of the SEC, Joel Press remarked, that “until there is a better definition of what trust is and what this environment will turn into, we will be under tremendous scrutiny; and I don’t think that scrutiny is going to be easy to deal with.”
Press believes the industry will be regulated in some way, but rather than regulation, the real problem is the issue of perception.
How many of you convicted the Bear Stearns hedge fund managers based on what was reported in the media, he asked the audience.
Yet, they won in a jury trial, which is highly unusual with federal prosecutors, Press said. “But you don’t hear about that.”
Press also highlighted regulatory challenges such as proposed restrictions on short-selling or the suggested ban on naked shorting of credit default swaps, which may have an impact on investment strategies.

Industry still in the growth cycle
Deloitte’s key note speaker Ellen Schubert, a chief advisor to the asset management services of the firm, made the case that the hedge fund industry is right in the middle of its growth cycle.
Comparing the industry development to that of the industrial life cycle of infancy and innovation stage, growth phase, mature phase and then death or decline, the hedge fund industry was still in the growth phase for at least another decade, she noted.
As regulatory changes and the financial crisis will demand changes to the hedge fund business model and require significant investment, it was important to determine where the industry is, before it is possible to say where it is going and what the next steps should be, Schubert argued.
Likening hedge fund managers to producers, fund administrators, primer brokers and auditors to suppliers, leverage and balance sheets to raw materials and investors to customers, Schubert described the infancy phase of the industry and its product of generating alpha.
The industry started with a one shape and size product offering and just over 100 hedge funds in the mid-1980s, although the name hedge funds was not used at the time.
Demand for the product was relatively small and the investment strategies of long/short and global macro were the only flavours around.
As the performance of the product picked up, so did demand. New bells and whistles were added to the product and more competitors entered the market.
By 1990 the industry was in a sharp upward slope with 500 hedge funds managing about $38 billion in assets.
In the 1990s the industry moved from its infancy stage to the growth stage. The product evolved as new investment strategies were developed. Demand began to outstrip supply as acceptance of the product increased. New competitors and suppliers, eg prime brokers, entered the scene resulting in more competition and the need for hedge funds to find market niches and a competitive edge.
The geographic spread widened amidst a huge increase of assets under management from $38 billion to $2.2 trillion and in the number of hedge funds from 500 to 10,000, Schubert outlined.
In 2008 the credit crisis and the financial meltdown as well as the largest financial fraud in history by Bernard Madoff reduced demand from exponential to zero, said Schubert.
As a result the industry has experienced the most radical transformation to date.
Shattered trust has to be restored by addressing the concerns of investors, in terms of additional quality assurance such as COOs, internal audit and trading and risk technology enhancements, she stated.
As a result it is more difficult to start a hedge fund and it has become more difficult to stay in business.
New funds will find that the barriers of entry have been raised. They will have to invest their own capital to build state of the art manufacturing facilities, she said.
There are fewer suppliers and their services are more expensive. In the current buyers market, higher investments into marketing are required, as investors opt for the brand names they know and previously might not have had access to, she argued.
Existing businesses face the difficulty of having to rebuild their customer base and educate the public.
In order to return to double digit growth the industry will have to “pull back the veil of mystery and mistrust that has shrouded industry since inception and replace it with transparency and an aggressive campaign of integrity,” said Schubert.
“We have to do all that we can to build our public image” she said, “and not let it be painted for us by misinformed reporters or misguided politicians looking for re-election”.
Quoting the late Sy Syms of Syms Department Store, Schubert believes “an educated consumer is our best customer” will become the mantra of the hedge funds business.
The prospect of potentially attracting retail clients and new investors such as sovereign wealth managers will allow the industry to put off the mature phase, for some time she concluded.  UBS key note speaker, Kai R. Sotorp, head of UBS Asset Management, Americas and member of the UBS AG management board agreed with Schubert’s assessment that the industry is still in a growth cycle, saying “there is definitely a great future for the hedge fund industry”.

He believes hedge funds will be subject to the overall larger market forces of the asset management industry and the alternatives that exist for investors.
He also suggested that there are many lessons that the industry can take from the core asset manager in terms of where the industry is going. He described three structural drivers that will make asset pools of global retirement and mutual fund pools grow significantly faster than long-term GDP.
Existing drivers in the form of an ageing population as the main motivation for savings and the importance of emerging markets in asset pools are joined by the effects of the recession on assets and the need for increased savings.
He predicted that the accelerating consolidation of the asset management industry will favour larger asset managers.
The three day event held at the Ritz-Carlton successfully mixed the discussion of hedge fund industry meta-trends in panel discussions and presentations with more detailed practice oriented afternoon sessions, covering issues such as operational due diligence, valuation, fund governance, investor relations, leverage or liquidity management.


GAIMops sponsors, from left, Deloitte’s Norm McGregor and Odette Samson, Walkers’ Mark Lewis and Ingrid Pierce, UBS Fund Services’ Darren Stainrod and Jennifer Collins.