‘Trust, but verify’
Written by Peter Carvill
Peter Carvill examines how the hedge fund industry has become more transparent to meet institutional investors’ demands
In March, professional services firm KPMG released The Evolution of an Industry, a report that outlined the extent to which institutional investment had entered the hedge fund space and the resultant changes in transparency and due diligence it had brought with it. Those changes, the report outlined, were not just wide but deep.
The Evolution of an Industry offered this summation: “As the survey data bears out, we are witnessing a significant shift in the types of investors who invest in hedge funds. Today, investors in hedge funds are much more likely to be institutions, such as charitable foundations, public and private sector pension funds, insurance companies, university endowments, and the like.”
This sea-change is a new development, say the authors, who trace it back to the economic crisis. Their message is clear: the storm that blew across the financial market did more than rattle the trees; it changed the entire landscape. Where the majority of pre-crisis capital had come from high-net worth individuals and family allocations hedge funds, now institutional investors have become the sector’s top allocators. This assertion is supported by the survey that forms the basis for the report’s findings. When the data was collated, 76 per cent of all survey respondents reported an increase in pension fund assets over the last four years. Additionally, 70 per cent said they had seen, since the credit crunch, an increase in ‘other institutional’ assets.
A demographic change such as this has its consequences. Here, institutional investors have brought with them a greater appetite for, and higher standards of, transparency and due diligence. This, The Evolution of an Industry states, has led to “the industry […] becoming more ‘institutionalised’ not only in terms of assets under management but also in terms of its own operational infrastructure.”
The report clarifies the word ‘institutionalised’ as: “Because institutional investors are extremely demanding in terms of due diligence, they require robust operational infrastructure in the managers they allocate to, so managers have responded by strengthening their own infrastructure. And because these institutional investors seek increased transparency, managers have increased their capacity to provide that too.”
“If you look at assets between 2007 and 2012,” says InfraHedge’s CEO Akshaya Bhargava, “the numbers are similar but the underlying demographics have changed dramatically. Because of that, there’s been a very significant impact on behaviour. Most of the buyers are institutional investors so their collective criteria has changed towards greater due diligence and transparency, better control over assets, and more stringent requirements on how the investment is managed.”
CQS’s head of institutional Peter Warren acknowledges the change in the industry. He says: “There is this Lenin quote that Reagan appropriated: ‘Trust, but verify.’ I think any high quality hedge fund investor has switched to this. Investors look to partner with and invest in organisations they respect and trust but they absolutely expect to verify what they’re trusting people about. And it’s that partnership which is key as the days when it was a bit of a ‘trust me’ trade have clearly gone.”
Warren further outlines his thoughts on the causes of this sea-change, arguing that the global financial crisis was one of what he refers to as ‘two inflection points’ that sent the industry down this path. Post-crisis, he says, “some investors felt they had not understood what investments they held or owned, or what those investments did. And the Madoff affair drew attention to the whole hedge fund space, and made people more inclined to be distrustful of organisations that didn’t have high degrees of disclosure, and couldn’t face, or participate in, a detailed due diligence process.”
In fact, says Cheyne Capital’s president Stuart Fiertz, the industry had already taken steps to address the issue of good governance. In 2007, the hedge fund working group was established under the remit of developing standards for the industry. This led to the formation in 2008 of the Hedge Funds Standard Board. It was, says Fiertz, in response to political pressure and a need to address the needs of investors that the board was formed to promote integrity, transparency, and good governance.
One change brought about by the industry has been the development of Open Protocol Enabling Risk Aggregation, known as OPERA. Developed by a working group of the industry’s heavy hitters, OPERA seeks to standardise information in order to allow a more meaningful collation of data about hedge funds. “The idea behind OPERA,” says Fiertz, “is to have standardised definitions of data so that the hedge fund industry can develop their systems to report and present that information in a standard way. It’s a helpful development. Furthermore, the Alternative Investment Management Association (AIMA) has developed a standardised due diligence questionnaire. Some investors like to use their own but it’s helpful that there’s a movement towards a more standardised form.”
AIMA released its first questionnaire in 1997. To date, there are six questionnaires, which have been amended and updated numerous times. They are Prime Brokers, last amended in December 2011; Hedge Fund Managers, June 2010; CTAs/Managed Futures Managers, April 2011; Fund of Funds Hedge Fund Managers, May 2009; Fund Administration for Managers, April 2007; and Fund Administration for Investors, April 2007.
According to AIMA director of external affairs Christen Thomson, there are no figures kept for its uptake across the industry. However, he posits, “it’s certainly regarded as the industry standard due diligence questionnaire. Managers and investors reference it pretty widely, and investors, I think, find it quite useful for themselves.”
On the ground, the changes in the industry since 2007 have been noticeable. Warren says: “If I look at our reports today and those from five years ago, the key stuff about risk and performance is there but we also give more information. That reflects an investor’s thirst to have a more detailed sense of what they’re really buying and how they should expect it to behave.”
The move towards more transparency and greater due diligence has not come for free. One respondent in The Evolution of an Industry is quoted as saying that they have seen their overhead increase by 35 per cent in the last three years through hiring people and bringing on new technology. That cost is more easily absorbed by the larger funds but could impose a stranglehold on a smaller firm, reducing start-up entrants to the market.
Some, including Warren, say that the move has made them a better business. “The rise in overheads hasn’t been massive,” he says, contradicting the figure put forth by the respondent in the survey. “What we found is that responding to investor needs means that we end up with better information flows in our own business, and that we become more efficient.”
Bhargava offers his view on the subject, placing the rising costs in context as the price of an industry evolving. “If you look at the automobile industry,” he says, “the fact that there are emissions standards, reliable engines, and cars that don’t break down the way that they used to has led to the adoption of driving around the world. There are so many parallels. If the industry is more transparent, with better governance, and has clear standards to which it adheres, it will create a level of comfort with hedge funds around the world that will cause the industry to grow.”
The big question is in which direction this will continue. Solvency II mandates that insurance companies need to obtain greater transparency on the positions they are invested in through funds or fund of funds. That, says Fiertz, will benefit the pension fund industry because it will require asset managers to develop more formal data management policies and to put more emphasis on master files so information can be codified. To date, he says, the pensions industry hasn’t yet mandated this through regulation. He adds that there are challenges ahead. But while the new regulation contains these principles, it is not yet present in the detail.
There is no going back, though. Fiertz says: “Managers, by and large, are supportive and will respond favourably to requests for increased transparency because they want to attain secure, reliable long-term capital. And that’s the type of capital that comes from institutional investors.”
Written by Peter Carvill, a freelance journalist