The ongoing stress being experienced by global financial markets and the well publicised collapse of investment giant Lehman Brothers should provide the right impetus for Asian hedge fund managers to acquaint themselves with a report titled "Best Practices for the Hedge Fund Industry" (the "Report").1 The Report released in April this year by the Asset Managers' Committee of the President's Working Group on Financial Markets is an attempt to provide guidance and promote robust business practices and accountability to the largely unregulated hedge fund industry which has become an increasingly important participant in global markets with an estimated $2 trillion in assets under management. Such is the size and impact of hedge funds on global markets that many financial regulators worldwide late last week temporarily banned all 'short selling' - a tool in trade for most hedge fund managers.
The Report advocates that managers implement a comprehensive 'best practices' framework in the five critical areas of (i) disclosure, (ii) valuation of assets, (iii) risk management, (iv) trading and business operations, and (v) compliance, conflicts, and business practices. Managers are expected to assess their specific practices against the frameworks suggested in the Report and adopt the best practices applicable to their operations. Anecdotally it is expected that larger institutional investors such as pension funds will require the funds they invest in to comply with the recommendations in the Report, and accordingly, as the recommendations in the Report are adopted as the industry benchmark, it will be crucial that managers are able to explain to investors how they have implemented and adopted the best practices.
Some of the salient points of each of the above five areas addressed in the Report are outlined below.
Managers should disclose sufficient material information on a timely basis, so that investors are able to (i) make informed investments decisions, and (ii) appropriately monitor and manage the risks associated with their investment. Disclosure to credit and lending counterparties should also be considered, so that both parties can adequately assess the risks associated with the relationship.
As a starting point, investors should be provided with a current copy of the fund's offering memorandum, which should be kept updated and outline the fund's operations, and include descriptions of its investment philosophy, strategies and products, as well as any risks associated with an investment in the fund. It is also best practice that managers provide investors on a quarterly basis:
- Investor Letters - these should update investors on significant shifts in investment strategy; key risk exposures; changes in key personnel; fund performance information and any significant business or market developments.
- Risk Reports - should disclose the manager's investment approach and discuss assets under management, including asset types; geography; leverage use; concentration of positions; material changes in asset allocation; and the disclosure of any material events that may affect the fund's performance.
- Performance and Investment Related Financial Information - should be provided on a frequency that is appropriate to the nature of the fund and include annual GAAP audited financial statements; estimates of the fund's performance; the NAV to each investor reflecting each investor's specific capital account balance or share value; and any qualitative information that will help investors better understand the fund's financial performance. It is also suggested that a statement be provided to investors on a quarterly basis detailing the percentage of assets within the fund that may be evaluated for levels 1 - 3 assets: i.e. "1" being a readily valuable asset (exchange traded); "2" being an OTC or other broker priced asset and "3" being a private equity type investment that cannot be readily valued.
A valuation framework should be adopted that includes:
- a valuation committee responsible for (i) establishing and reviewing compliance with the manager's valuation policies, and (ii) providing consistent and objective oversight and implementation of the manager's valuation policies and procedures. Such committee should be structured to provide an appropriate measure of independence from the portfolio management function;
- well-documented valuation policies developed by the manager, as well as guidelines to evaluate exceptions and to test and review compliance with policies and procedures; and
- skilled and independent valuation personnel that are segregated from the manager's trading or portfolio management personnel, and who are responsible for the valuation of the fund's investment positions, and for implementing the manager's policies and procedures. To maintain such segregation, the Report suggests that the manager may wish to develop a process for portfolio management personnel to "challenge" the determinations of valuation personnel. The ultimate decision as to the appropriate price for a "challenged asset" would be made by the valuation committee.
Reviews of the valuation framework should be conducted by the valuation committee at least annually and address issues such as:
- the fairness of valuation policies and their consistent application by all parties including third-party service providers;
- the selection and oversight of third-party service providers with significant involvement in the valuation process;
- valuation methodologies used by the manager; and
- any material exceptions that were made to the fund's valuation policies and procedures, and include back-testing of a sample of valuations against similar positions.
In the case of hard-to-value investments which have no readily ascertainable independent market value (such as private equity investments), managers should arrange for an independent review or generation of its final valuations. Where it is necessary for a manager to provide an internal valuation, notwithstanding a potential conflict of interest, valuation policies and procedures that address the circumstances in which a manager may rely upon pricing models should be adopted. A manager should also not hesitate to consult with the fund's third party service providers and legal advisors where it is unclear how the valuation policy should be applied.
It is also common for managers to place hard-to-value investments in a 'side pocket' isolated from the main asset pool. Side-pocketed assets generally cannot be redeemed for a fixed period, thus avoiding the need for a manager to provide regular valuations for NAV purposes. In deciding to use side-pockets, managers should consider:
- how easily the side-pocketed assets can be valued by the use of external sources;
- the anticipated ability to exit the investment subject to a consideration of the restrictions; and
- any applicable contingencies or special events upon which the investment's realisation will depend.
A risk management framework should allow the manager to (i) identify risks to the portfolio, (ii) measure the principal categories of risk (liquidity risk, leverage, market risk, counterparty credit risk and operational risk), (iii) include policies and procedures that establish monitoring and measurement criteria, (iv) maintain a regular and
rigorous process of risk monitoring, and (v) retain knowledgeable personnel to measure and monitor risk.
Specific recommendations to consider include:
- preparing risk reports describing the portfolio's exposures to the key risks identified by the manager which should be distributed to senior management responsible for the portfolio; and
- appointing a designated person (i.e. a chief risk officer and other person with similar responsibilities) or establishing a risk committee to supervise risk analysis, measure and monitor risk, and to take responsibility for the creation of policies and procedures covering all areas of risk management.
The Report also strongly asserts that risk monitoring and management functions should not be outsourced and that a manager must maintain responsibility for the overall risk framework. Risk measurement functions however can be provided by external providers, but senior management should retain responsibility for the outsourced part of the process.
Trading and Business Operations
As managers increasingly engage in sophisticated and high volume cross-border trades, managers are advised to adopt a trading and business operations framework that reflects the size and complexity of its activities. In developing such framework, managers should have in place policies and procedures which provide for appropriate checks and balances in respect of operational and accounting controls such as:
- the selection and management of counterparty relationships;
- adequate management of cash, margin and collateral requirements;
- selection of key service providers;
- ensuring adequate operational and accounting processes, including the appropriate segregation of business operations and portfolio management personnel; and
- disaster recovery processes.
Managers should also consider whether their existing systems, infrastructure and automation are proportionate with the scale of their trading and business operations. Regular reviews of such infrastructure should be initiated to assess operational risks in light of both internal and external changes. To this end, managers should appoint a chief operating officer with responsibility for the manager's business operations, supported by internal personnel or, where applicable, external resources, with skills appropriate to the complexity of the manager's business operations.
Where counterparties and service providers are to be appointed, the Report emphasizes that managers should be prudent by:
- reviewing the details of the terms of agreements (i.e. account opening, prime brokerage, stock lending, ISDA and give-up agreements) entered with counterparties in order to understand the risks that can affect the counterparty's obligation to extend credit or provide other services (such as terms that can increase collateral requirements); and
- selecting reputable service providers that have expertise and experience suitable to appropriately support its business. These service providers may include, where appropriate - providers of administration, accounting, consulting, proxy services, IT product vendors, and legal counsel. Agreements should only be entered with service providers which clearly delineate the service levels being provided.
Compliance, Conflicts and Business Practices
To promote a strong culture of compliance that also addresses conflict of interest situations, a framework that is supported from the top down that includes aspects of the following should be adopted:
- a written code of ethics that establishes principles governing the conduct of the manager's personnel;
- a written compliance manual that addresses (i) the various rules and regulations governing the manager's operations, (ii) potential conflicts of interest that may arise in the course of those operations, and (iii) the maintenance and preservation of adequate records;
- the establishment of a conflicts committee to review conflicts;
- regular training of personnel on the material elements of the compliance program; and
- a compliance function that includes (i) a chief compliance officer to monitor and maintain the manager's compliance program, (ii) appropriate discipline and sanctions to address departures from the manager's compliance program, and (iii) an annual review of the manager's compliance program.
While the Report's recommendations appear to restate what is already practised by most regulated hedge funds, its recommendations are in fact more extensive and prescriptive. In fact, one observer has said, that if all the recommendations are implemented, a hedge fund begins to look a lot like a regulated financial institution. Thus going forward, the Report should become a 'bible' for hedge fund managers as its recommendations are practical and add value and rigour to the operations of managers wishing to review their existing structures, or for those managers in the stages of planning a new fund setup.
1. A full copy of the Report can be downloaded at: http://www.treasury.gov/press/releases/reports/amcreportapril152008.pdf
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