Cayman Islands: Post-Crisis – Investors Require Hedge Funds to Shape Up

Last Updated: 13 July 2010
Article by Appleby  

There has been significant discourse over the past eighteen months in response to the recent economic crisis on the need for increased governmental regulation for the hedge funds industry. There have been demands from numerous investor rights groups, governmental, non-governmental and supranational organisations for an increase in the regulation of hedge funds. Much of this discussion has centered around how hedge funds should be better governed, monitored and held accountable to their investors. None of this discourse, however, has taken into account the impact investors, especially institutional investors, have had in making hedge funds shape up.

In the current post-crisis economic climate, investors are becoming increasingly demanding of hedge fund managers and administrators. Lessons have been learnt from the recent collapse which has led investors to pay more attention to the operational aspects of their investments. Two specific ways in which this new investor awareness has impacted upon investment funds include the requirements investors now have for increased transparency and independent valuations.

It is more likely that changes made to the way investment managers and administrators operate hedge funds will be driven primarily by the demands of institutional investors rather than the pontification of policy makers, ministers or regulatory bodies.

Increased Transparency

Although return rates will always be an important factor in comparing investment opportunities, hedge fund managers are increasingly also seeing investors consider transparency as a comparative measure. Investors want greater information on the business dealings, arrangements and agreements between the investment fund and its service providers. There is a growing demand for more transparency on fees, especially those fees linked to performance, and to the payment of any 'soft dollar' items.

A big agenda item for investors in considering investment opportunities is whether there are any 'soft dollar' items included in the fees paid to custodians or prime brokers. Whilst usually glossed over in the relevant offering document, 'soft dollar' items can range from computer software to office facilities and are often not capped. The availability of 'soft dollars' allows administrators and investment managers to charge what would otherwise be standard operating costs to their business to the relevant custodian or prime broker providing the 'soft dollar' items. The lack of transparency on the type of items 'soft dollars' cover and the frequency and availability of them, are a serious concern for investors causing many to require that that no provision for 'soft dollar' items be included in hedge fund documentation.

Issues of transparency also address the extent of communications between investment managers and investors. The type, method and frequency of communications play a central role in alleviating investor concerns. Most importantly, investors want clear and regular communication on any changes in the methods and processes used for the valuation of investments, especially illiquid investments. There is also an increasing requirement for third party confirmations of financial positioning and regular updates on basic financial information such as net asset value, leverage and long-short risk.

Improved communication to investors on fund performance and financial information and a greater understanding of the relationship hedge funds have with their service providers such as custodians and prime brokers are becoming standard demands of astute investors.

Independent Valuations

Historically, valuations of investments that could not be easily ascertained via a third party source such as a stock exchange were delegated to the realm of the investment manager. Valuations of investments such as over-the-counter, hard to value or illiquid investments were often made by the administrator based on information provided by the hedge fund's investment manager. Who better, it was thought, would be in a position to ascertain the value of investments which had no public trade value?

These days, however, investors are cautious of the relationship between the valuation of investments and the payment of performance fees and are seeking a more independent source of valuation. Many industry bodies have responded by publishing best practice guidelines on valuation practices which call for greater transparency, disclosure and the elimination of conflicts of interest in the valuation process by way of utilising multiple valuation sources.

This new investor requirement for independent valuations backed by industry bodies has given rise to a sub-industry within the investment sector of third party independent valuers. These independent valuation agents provide an avenue for investment managers to reassure investors and the general community of the integrity of their investment managers and their pricing and valuation mechanisms.

Additional measures being required by investors include the provision of well-documented and understandable valuation and pricing policies, and in some instances investors require copies of, or input into, these pricing policies prior to considering investment into the fund.

The increasing demand by investors for improved operational standards, higher levels of communication, greater transparency and more appropriate and independent valuation methods are the guidelines which will lead hedge funds out of the current crisis and back into a more stable and sustainable investment era. This, more so than any proposed government regulation, will be the driving force behind improvements to the hedge funds industry.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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