Checklists and smell tests

Two years on from the financial
crisis due diligence and trust remained important topics of debate at the
Campbells Cayman Fund Focus Conference, closely followed by investor concerns
over liquidity.

Since the financial crisis, the
significance of due diligence and the demand for transparency from investors
has increased considerably and become a practical issue the fund industry has
to tackle as part of everyday business.

Constellation Investment Consulting’s Boris
Onefater says investors are looking for more information on a consistent basis.
He believes that while many practitioners in the industry use the AIMA due
diligence questionnaire, it can only serve as a basis. Specifically,
operational due diligence, which has become much more of a focus recently, is
not something covered by the AIMA questionnaire at the level of depth that is
demanded today, he said. As a result, most questionnaires have evolved to fill
these gaps.

Scott Elphinstone, an investment manager
and partner with Five Continents Financial, also sees increased demand for
information and transparency but believes that up to this point it is
reasonably manageable.

“The fool in the room”

However, he does not think that checklists
are the appropriate due diligence instrument when selecting an investment
manager because the things that are most important, such as the personality of
a manager or culture of an organisation, are very difficult to capture.

“You really have to get an idea of how they
are going to behave when the chips are down and that is really hard to get from
a checklist,” he said.

Stating that a checklist is more of a
“covering your rear-end kind of exercise”, Elphinstone shared with delegates
the example of a fund manager who looked into investing with Bernie Madoff. 

The manager did all the due diligence and
ran all the checklists. And although he had Madoff over for dinner at his house
and visited Madoff’s office, where he received “royal treatment” and went
through all the numbers in great detail, “in the end his gut just was not right
and he did not invest,” said Elphinstone. “He saved me a pile of money.”

On the institutional side, the difficulty
is to read the culture of an organisation rather than the personality of a
single manager or team.

“Any American investment banks, I will not give
discretionary authority over anything, because their culture is very clear,” he
said, referring to mortgage backed securities and the subprime crisis.

“It is
to find the fool in the room and stuff him full of crap. That’s the culture of
the organisation and if you don’t know who the fool is, it is probably you.”

Elphinstone acknowledged that he trades
with US investment banks and benefits from excellent liquidity and choice, but
for the cultural reasons mentioned he would not buy any of their funds.

Elphinstone concluded that “if you give
someone money to manage on a discretionary basis and you don’t have a feel for
who it is and you don’t have a relationship of trust with the manager, you are
taking a real risk.”

David Bree, managing director of dms,
argued that trust also plays a part in the relationship between investors and
independent directors.

“We open up our internal documentation system to them to
create a degree of transparency that explains to them exactly the nature of
work that we are doing on the particular funds in which they are invested.”
Bree added that his firm helps investors understand how the business is managed
in such a way that it provides a resource to investors.

“And what you find is
when you create that type of trust and comfort, it is not unlike the trust and
comfort that Scott [Elphinstone] was speaking about with regard to the
investment manager.”

Such an exercise will also create goodwill
with investors and establish the director as a “known quantity” to them. 

What are investors asking about?

Bree noted that most investors typically
ask questions that relate to their experience during the financial crisis,
including: Under what conditions would you suspend redemptions? What is your
perspective on investors holding voting shares versus the investment manager
holding voting shares? And the favourite question, to whom is your duty owed? 

“You have to be able to put your answers
into a proper context that does reinforce the fact that you recognise your
responsibility to the company as defined by the investors,” Bree said.

The main challenge for independent directors
based in the Cayman Islands is to build relationships with investors and
investment managers that will enable them to work through issues that might
arise, he added. “A lot of times it comes down to who does a manager or
investor feel comfortable with to work through a problem, either over the phone
or meeting in person.”

This is achieved initially through web
demonstrations of how the business is run and how the directors have worked
with other funds on a no-name basis to get investors comfortable about how
directors would work with them through issues. 

For the same reason, managers are now
engaging their own investors a little bit more when it comes to the selection
process of directors to ensure that independent board members are acceptable to
their investor base.

Elphinstone agreed that investors are
looking for independent directors. However, while independent directors are
very useful when something goes bad, “by the time the directors are actually
taking action, they are probably trying to save the last half of your money,”
he said. 

“I prefer to try to invest in a way that I
can keep the first half as well as the last half.” He would therefore
concentrate on finding the right manager and the right strategy to protect the
first half of the investment, he said.

Speaking about Cayman’s service providers
in general, Bree concluded that “we have to view due diligence as an
opportunity and not as a burden. Cayman is the number one jurisdiction, and due
diligence is a way that we can show that.”

No new fund structures

Ethan Johnson, a partner in Morgan Lewis’
investment management and securities industry practice, noted that there may be
more due diligence, but not many changes to the fund structures in response to
liquidity and transparency demands. “We don’t see as many changes in the
template as we all thought we might.”

In a product that is largely the same it
was five years ago, investors are looking for “performance and pedigree”
instead, he said.

Liquidity now priced correctly

In terms of liquidity, “people are trying
to describe a lot more how they are going to deal with illiquidity issues”,
said Campbells Partner Ian Dillon. The use of side pockets is still prevalent,
although they might be called differently at times.

Elphinstone said that investors will have
to be realistic and sacrifice liquidity if they want performance.

“That is the
nature of the beast.” To a certain extent liquidity also explains the
popularity of UCITS funds, he said.

“Investors see it as a more liquid instrument
and accept lower performance.” By the same token, managed accounts are more in
demand, albeit not for every type of investment class.

“The issue with managed accounts versus a
fund is two-fold: it is liquidity and it is transparency,” Elphinstone said.

Liquidity is important because clients have
now realised what it feels like not to have liquidity, and 2008 was a good
reminder of that. As a result, liquidity is now more valued than it has been in
the past, when instruments that were illiquid were not offered at much of a
discount, Elphinstone said.

“[Investors] bought them at premium price.
When liquidity failed, people realised liquidity was valuable. So in part the
demand for managed accounts is demand for greater liquidity.”

The second aspect reinforcing demand for
managed accounts is transparency. Transparency is important to investors when
constructing portfolios in which all individual elements must have certain
characteristics. “All the pieces have to work in a certain way to make money and
to protect the downside,” Elphinstone said.

“The biggest threat to client
portfolios is when pieces don’t behave in the way we expect them to

Both liquidity and transparency are dealt with by managed accounts
because it allows an investment approach on a security by security basis.

Ultimately, however, investors will have to
be realistic and know that for performance they will have to sacrifice
liquidity, he said. 

“What you are seeing is that investors are
carving up their portfolio into parts that are very liquid and others that are
less liquid.”

With regard to hedge funds he concluded that if investors want to
have liquidity, they will have less invested in this asset class.