- Firstly, the standards are simply not specific enough. There are far too many "weasel words" and concentration on more generic concept than specific controls and procedures.
Albourne, for example, commented that "while it is understandable that the HFWG wants to limit prescription, there needs to be more explicit recognition within the consultation paper that investors require sufficient detailed, timely and accurate information to exercise their ownership function and discharge fiduciary obligations."
Against this background, we were consequently surprised by Mr. Borges' statement today (reported by Reuters) that "even if people don't sign up, they should know these are the standards by which the industry operates." At first glance, this sounds marvelous - but, in reality, the standards are simply too broad and need to be more specific if they are to be a true "roadmap" to best practice.
- Fundamentally, we disagree with the "comply or explain" approach. It seems nonsensical to us that hedge fund managers can sign up to the "code" but then explain why they don't follow certain sections of it. This is exactly like saying that I follow the speed limit, except for those times when I am in a hurry and drive faster.
Specifically on this point, the HFSB documentation states that managers who who sign up to the standards must provide a "disclosure statement", "in relation to those standards, if any, with which we do not comply either because we are unable to comply or choose not to do so."
In other words, it is entirely plausible that a hedge fund manager could sign up to the standards, claim compliance, and display the HFSB's logo on its website and marketing materials....but continue to use front office prices for a material portion of the investment portfolio. The explanation would be that such instruments are "hard to value" and that only the front office portfolio managers have the expertise and market contacts to determine fair value.
- There is no enforcement mechanism, and managers themselves can decide whether they are in "compliance".
Anyone who has completed operational due diligence on hedge funds knows that the devil is in the detail. Every manager - particularly large firms - has a great operational "story" for the first few questions as they are very used to responding to "standard" points. It is only through ongoing discussion and more detailed questioning that investors can flush out what often turns out to be a surprising number of exceptions.
This turns to one of our biggest concerns in today's hedge fund industry - the ongoing view by too many investors that the largest hedge funds are "institutional" and have the best quality controls. We have discussed this topic before, and continue to believe that many large, well known hedge funds do not necessarily match best practices, particularly related to valuation.
- We continue to believe that best practice standards for hedge funds need to drafted with the inclusion of - and ideally leadership from - investors. To be true best practices, standards need to reflect what investors would like managers to achieve, not settle for what managers are prepared to deliver. To follow our auto analogy, putting the managers in charge of hedge fund standards is like putting the auto manufacturers in charge of car crash testing: the manufacturers may set the crash speed at 20mph, while consumers would prefer 30mph.
- Going forward, we view the US President's Working Group proposals to be significantly superior to the HFSB "standards". Firstly, the PWG includes specific investor representation, thereby answering the key criticism against the HFSB. Secondly, the PWG document is typically more specific, and some of their proposals, notably that funds disclose quarterly portfolio composition by FAS 157 Level, is very helpful. Finally, the substantial majority of the hedge fund industry (likely two thirds) remains in the US, so a US based initiative must lead the way.
Certainly, we recognize the clear and considerable effort from those managers who have participated in the HFSB effort. Any movement towards better standards is also welcome and valuable. However, we still feel investors should make their views clear on this initiative: allocators putting hundreds of millions of dollars into hedge funds deserve something better than a process which sounds great on paper but, in reality, does not make a material step forward from the current status quo."
Four months later, we don't see anything which leads us to change our opinion. Against the backdrop of the most calamitous markets of a lifetime, the argument of "trust us, we know what we are doing" just won't cut it. Investors both deserve and need more than this.
Hedge Fund Operational Due Diligence