Having been stuck in Europe last week, even the joke "UK to Iceland - no! We said send cash not ash!" wore a little thin as the days passed by. Now that the flights are moving once more, we wanted to regroup with a couple of comments on the Goldman vs SEC case in this and a subsequent post. Both points can be interpreted to be of relevance to hedge fund investors.
The first is the frequent refrain that sophisticated financial products - such as synthetic CDOs - are only sold to sophisticated investors. Such investors, the argument goes, should have the knowledge, time and money to be fully informed as to the nature of every financial product they purchase. By extension, such investors can be sold very sophisticated things and certainly only have themselves to blame if they lose money.
We would agree that institutional investors employ investment professionals who have both relevant training and a full time focus on investment decision making. At one level, therefore, an institutional investor is undeniably a sophisticated client for an investment bank.
However, this position seems superficial - and for Wall Street, very self serving. The real definition of an institutional investor - i.e. the investor's true nature, characteristics and risk - is entirely unrelated to the quality of the investment professionals who happen to be employed by that institution. Rather, the definition of an institutional investor relates, quite simply, to who's money it is. An institutional investor's money does not belong to the employee receiving a CDO investment pitch in a Wall Street boardroom from Fabulous Fab. Rather, the money belongs, for example, to pension recipients who may be corporate retirees, municipal workers, government pensioners, teachers or fireman. In the case of a sovereign wealth fund, the money belongs, self evidently, to an entire society, at every level of income and social class.
There is, therefore, an evident disconnect between the "sophistication" of the investor's employees and the real word impact of financial loss when we consider who, ultimately, bears the risk of an unsuccessful investment. It is disingenious at best for Wall Street to claim that they only sell to sophisticated clients and, by extension, have a duty of care to disclose and describe their products only at this highly "sophisticated" level. Wall Street obviously understands who are the end, beneficial holders of many of the investment products sold to institutions.
To take a simple example, let's think about a car manufacturer. Now, let's say that this manufacturer sells minivans to car dealerships, but takes the position that the dealerships are "sophisticated", given that they employ full time professionals in the vehicle business. As such, it is each dealership's responsibility to read through lengthy offering documents and be clever enough to ask the right questions to understand the quality of the product.
The example doesn't work, does it? It's pretty obvious that if you're building a minivan, then someone's kids will end up inside. You'd better make sure your product is suitable for that purpose.
What does this have to do with hedge funds? We have commented in prior posts that the hedge fund industry has evolved from being the "secret club of the super rich". At present, and especially in the future, capital flows will be increasingly dominated by institutional - yep, you've guessed it, "sophisticated" - investors.
We should always be conscious that the increasing percentage of hedge fund industry capital held by institutions unavoidably means that the footprint of the hedge fund industry is felt on Main Street as never before. Taking the view that only "sophisticated" investors buy hedge funds and, therefore, that everything from disclosure to regulation only needs cater to this "elite" may help legal liability - but, we hate to say it, ignores reality.www.castlehallalternatives.com
Hedge Fund Operational Due Diligence
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