The fifth annual Ernst & Young global hedge fund survey “Coming of Age” compiled by Greenwich Associates sees, amid the trends of consolidation of the industry, greater institutionalisation and greater transparency, diverging investor and fund manager views not least with regard to independent oversight.
The survey, which contrasts the responses by managers and investors, indicates that the two groups have a somewhat different perception on issues of governance, fund expenses, administration, succession planning and capital raising.
The report described independent oversight of funds by boards as a “thorny issue”, stating “everyone believes it is a good thing, but everyone doubts its practical effectiveness.”
Generally boards are widely used globally except in North America where less than 15 per cent of domestic funds have boards. In line with this geographic distribution, European and Asian hedge funds overwhelmingly believe that it is important to have independent boards and that they are ultimately responsible and accountable, compared to a majority of North American hedge fund managers who do not agree.
Unsurprisingly, investors are much more likely than managers to believe boards should have greater responsibility and accountability for valuations, risk management, the imposition of gates, suspensions and risk management policies.
Managers meanwhile consider boards to be more effective than investors do. This gap is the widest in Europe where 90 per cent of managers say boards are effective and only about 30 per cent of investors agree.
Investors would like to see more board responsibility for investment guideline compliance, approving NAVs, resolving disputes on valuation and setting risk policies. However, one of the issues identified by survey respondents is the limited technical knowledge of many board members, which, according to this view, limits their ability to have ultimate responsibility.
Therefore, in each of these areas most managers feel that they have more responsibility and accountability than the board. Some even argued that in practice boards only exist for “cosmetic reasons”.
Correspondingly 80 per cent of investors think that boards only have limited ability to challenge the decisions of the investment manager.
“The challenge for the industry is not only to empower the board to have more effective responsibility but also to make sure it has the independence and knowledge and is fully engaged to carry out its responsibilities on behalf of investors,” the report noted.
“As the industry comes of age, investors are getting increasingly interested in governance and supervision where there remains considerable gaps in perception and in reality,” commented Ratan Engineer, global leader of Ernst & Young’s Asset Management practice. “To continue satisfying investor demands and foster compliance, we need to ensure that hedge fund investors and managers are on the same page.”
As far as service providers are concerned both managers and investors named independent valuation as the main benefit of using administrators, stating it is the role of the administrator to calculate and issue the NAV.
Given that the majority of funds use administrators in some form, hedge funds are clearly reacting to investor sentiment, but the survey reflected doubts over the effectiveness of administrators in the key area of hard-to-value Level 3 assets.
The report noted investors are obviously favouring independent valuation but questioned its feasibility for anything other than the most transparent and liquid assets, resulting in a mismatch between expectation and practice. “Most administrators currently do not take responsibility for valuation and, in many cases, do not have the resources to value independently complex securities and Level 3 assets,” the report said.
Only one in four hedge funds or investors is confident that administrators can accurately value these types of assets. As a result, funds with hard to value illiquid assets practice shadow accounting out of necessity as a key part of their risk management to mitigate the risk of error, which often means a duplication of efforts and significantly higher costs.
It is a situation that is unique to hedge funds – mutual funds carry out their valuations in-house – which sees the replication at the fund level of the work performed by the administrator and subsequent reconciliation between the fund’s and the administrator’s systems.
The expectation of the report authors is that “hedge funds are likely to re-examine their extensive shadowing activities and begin to create a control environment that would take advantage of the administrators’ strengths while building compensating controls to address the administrators’ shortcomings.”
While shadow accounting is clearly important to investors, it is also one of the areas of contention in terms of who is going to pay for it. Seventy-six percent of investors agree that it is important to perform shadow accounting, yet only one in three believes it is appropriate to pass these related costs through to the funds.
How expenses should be shared between the investment manager and the fund and which expenses should be covered by the management fee will be increasingly controversial in an environment of tightening margins, the report predicts.
The pressure on fees and margins has caused more managers to offer graduated fees in return for larger mandates than in previous years, while other funds offer fee concessions for more stringent liquidity terms. The report interpreted this as a sign of unabated investor pressure on fees and the belief among investors that the erosion of margins and lower fees are inevitable.
Meanwhile investor due diligence has become more intense and due diligence processes have lengthened as investors focus more strongly on operational due diligence, internal controls and risk management.
The more extensive due diligence process is widely regarded as growing investor sophistication, the report said, with investors taking into account more factors than in the past and opting for a more informed process before committing funds to hedge funds.
This means also that at times that capital is flowing to funds with “mediocre performance but robust infrastructure, strong management teams and reputable outside administrators”.
Hedge funds relied historically on the track record of their founding principals to attract and retain capital. Given the relative immaturity of the industry topics like succession planning were so far not high on the agenda. However, investors, who typically have a focus on repeatable investment performance, are considering it as increasingly important to ensure an effective transition to the next generation of leadership.
Nearly two thirds of investors expressed that a well-articulated succession plan forms an important part of their investment decision.
However, what is meant by succession planning is often cause for confusing, the report noted. “Does one mean succession of the founders, the solidity of the firm or individual portfolio managers?”
According to the survey, the majority of the investors are concerned with the investment professionals rather than the founding principals, whereas hedge funds believe investor loyalty lies with the founding principals.
Despite this discrepancy, investors are more likely than hedge funds to consider it important that founding principals retain significant personal assets with the fund, as a sign of confidence in the transition.