Unfortunately, those cosy days seem to be in their last stages, as institutional investment, accompanied by institutional checks and balances, have forced many managers to raise their game. It is difficult for small firms to turn their backs on institutional capital, as this brand of blue chip money has a reputation for being more 'sticky' than private cash, and brings with it additional benefits in terms of the prestige associated with an institutional client base. The downside: a vastly increased load of paperwork, and hundreds of precious man hours burned up dealing with due diligence enquiries from prospective institutional clients. And that's just the firms with a dedicated COO function: how do small start-ups cope, keeping one eye on the portfolio at the same time?
It comes as no surprise that Reiko Nahum has seen an opportunity to provide managers with a means of classifying their operational risk via a process of independent certification. Nahum was President and Director of UBP Asset Management (Bermuda) Limited and a member of the senior management team at Union Bancaire Priveé, and headed up the bank's operational risk group, leading a team of analysts in both Bermuda and New York. With a background as a chartered accountant, she was responsible for overseeing investment management, compliance, accounting, registrar and transfer agency, as well as corporate secretarial and other administrative activities for investment vehicles in UBPAM's $2bn hedge fund portfolio. It gave her unique insights into the way operational risk was being measured both by investors and by the industry as a whole. It was her realisation that there was a real appetite on the part of the investment community for a recognised independent standard that took her down the road to launching Amber.
"The industry needed a benchmark to gauge operational risk in hedge funds," she explains, "to date there has been noone in the industry who has been able to create benchmarks for the standards of acceptable practice there should be in a hedge fund environment."
This is not something anybody could do, Nahum reckoned. There are only a handful of individuals within the industry with her track record in operational due diligence. Neither is it simply a process of ticking a few boxes in a two-hour interview: it can take over 100 man hours to carry out the requisite due diligence for a long/short equity fund to receive an Amber certification! "By the time you've reviewed all the corporate documents, conducted an onsite meeting with the people within the hedge fund firm, you've spoken with the fund administrator about what they're doing in terms of the NAV calculation, the share registry, independently valuing the securities, etc, and then internally having a number of layers of review, we can easily lap up 100 hours on this kind of thing. For more complicated strategies, in the past, I have often had to spend more than 200 hours.
"After we do our review, if we have found areas of weakness, we will tell the manager how he can make improvements to address those weaknesses. It is a very labour-intensive process. Not only are we addressing the needs of the hedge fund investor community, we are also helping hedge fund managers save time and money. Many of the COOs and CFOs are also complaining that they are being bombarded by operational due diligence reviews, many of which are being carried out by people who don't really know what they're talking about, and are literally just trying to 'check the box.' They are becoming equally frustrated by the fact that, whereas this is an important function for an investor to carry out, many of the people performing it really don't know what sort of questions they should be asking, or if they are asking the right questions, are not sure what sort of responses they should be hearing."
Nahum's firm is engaged by the hedge fund, just as an auditor or administrator is retained. In Amber's case, the firm produces an operational due diligence report which can be used as a research document for current and potential investors. The manager is provided with a password which can be distributed to potential clients, who can use it to access the report on Amber's website. The benefits are obvious: the manager does not have to waste time juggling multiple due-diligence enquiries, and the investor gets a detailed report, carried out by a seasoned team working independently of the manager. One of Nahum's New York fund manager contacts recently pointed out to her that 50% of the time he spends handling due diligence requests is spent on dealing with operational enquiries. The sheer amount of time such enquiries consume for hedge fund firms cannot be underestimated.
For institutional investors, while they would like to see alpha from the funds they invest in, a disaster is a hedge fund 'blow up' – particularly one that grabs the headlines, and asks uncomfortable questions of the investment committee that allocated to the fund in the first place. Nahum points to high profile problems like Bayou, Wood River, Lipper, Lancer, Beacon Hill and Manhattan, crises that have gone down in the annals of hedge fund lore, but also remain front and centre in the minds of many investors.
The niche seems partly to have been created by the fact that no other hedge fund service providers currently carry the responsibility of providing an independent assessment of operational risk. Each focuses on their own area of operational expertise, andhistorically have been absolved of responsibility in the event of embarrassing blow-ups. It is largely left to the investor to make an independent operational risk assessment himself. If he has been used to dealing with large-scale asset management businesses historically, investigating hedge fund firms from an operational perspective will be new territory. They can look very different when you get under the bonnet, and you may not know what sort of problems you're looking for.
"Anyone within the industry that has any serious length of experience of doing this type of work, has realised that the needs of investors have changed, and that therefore there has to be a way to meet the demands of the investor and manager community. I believe we're able to add a tremendous amount of value and create some efficiencies within the industry," Nahum says.
Amber's principals are industry veterans, and are supported by a team of hedge fund specialists, including chartered accountants and operational risk professionals. Nahum is emphatic that accountancy qualifications are necessary for her team to be able to do a good job. Her approach is very much a scientific one. Alongside her is the firm's other principal, Jamie Jared Donnelly, who acts as the Amber's Chief Compliance Officer and Managing Director. She was previously a vice president for fund administration with BISYS, where she managed a team of 45 people, and oversaw 60 alternative investment vehicles with assets under management exceeding $10 billion. In her pre-BISYS days, Jared Donnelly was at Ernst & Young in Bermuda, where she worked as a manager in the investment focus group, including being responsible for a portfolio of hedge fund audit engagements.
What is Amber Certification?
So what do you get for your money when you retain the Amber team to scrutinise your operations?
Amber focuses on five risk factors within a hedge fund: the manager organisation, the fund structure, the back office, the valuation process, and the degree and quality of independent oversight. For a fund to receive Amber certification, its overall operational infrastructure must, in the opinion of Amber Partners, be sufficient to reduce operational risk to acceptable levels. Given the diversity of the hedge fund industry, Amber does not use a rigid formula or checklist to determine eligibility: its Certification Committee considers each fund's individual strengths and weaknesses rather than trying to match it up with the standard of the 'ideal' operational set-up.
Take, as an example, the issue of portfolio valuation, an increasingly sensitive topic, particularly with US funds at the moment. Amber points to it as "one of the most significant risks faced by hedge fund investors" yet also acknowledges that practices vary widely, and that even large and established hedge funds can have fairly opaque valuation practices. Valuation, however, is clearly of less concern in a fund trading only liquid, exchange-traded securities. Amber places increasing emphasis on valuation issues as the degree of valuation subjectivity in the portfolio rises. Its process recognises that with increasing valuation subjectivity, the degree of imprecision and estimation necessarily involved in determining the fair value of complex or less liquid securities must also increase. Accordingly, Amber recommends that managers should (1) have a clear valuation policy, (2) ensure it is consistently applied for similar securities at a point in time and over time and (3) have independent oversight over the pricing process by empowering the back office to take ownership and control of the pricing and by ensuring that the fund administrator ultimately prices the securities for each NAV calculation.
"The operational due diligence function does not exist in the mutual fund industry," Nahum says. "Hedge funds differ in three ways: managers are incentivised on performance, there can be a large degree of valuation subjectivity, and many hedge fund managers are not regulated. Those factors have created an environment where managers can literally set up their own organisation and manage millions of dollars, not be under regulatory supervision and really develop their own way of building their business. In the course of my career, I've never seen any two hedge fund firms that are similar- everyone has their own unique way of setting up their infrastructure, engaging service providers, and hiring people into their firm. It is a fairly secretive world.Even hedge fund managers that are large organisations do not really know what their peers and competitors are doing on the operational front. It is creating an environment where there is no ability for hedge fund investors to benchmark one firm against another, because there are so many permutations and combinations, depending on the complexity of the strategy and the demands that are placed on the back office of the operation.
"What we have done is create a process and a methodology which, regardless of the strategy being traded, regardless of the size of the organisation or the geographic location of that organisation, allows us to look at various operational and structural areas that we feel are relevant to an investor's investment decision making process. It also assists investors in looking at these operational controls and procedures on an entirely consistent and comparable basis."
The idea is to provide investors with a means of making effective comparisons at an operational level of very diverse businesses. It also protects Amber against conflicts of interests: managers cannot, for example, exclude negative information from the report, because there would be obvious gaps.
"If it's something fundamental to the operational control environment, and there is not sufficient information disclosed to us, which means we cannot then opine on whether a fund passes or fails, then we will not issue an Amber certification," Nahum says. "This is outlined in the contract. If however, it is something like side letters, for example, where the manager does not want to disclose details of the side letter, that is not necessarily an operational control issue. In this case we would say that management had opted not to disclose that information, and leave it to investors to have a one-on-one discussion with their managers individually."
Getting under the hood
The process of operational evaluation kicks off with a questionnaire for the manager to complete, following which there is a desk review of the fund's corporate information, including prospectus, key agreements, compliance manual, disaster recovery plan, financial statements, and marketing materials. This is followed by the onsite due diligence visit, including interviews with key staff. Amber also contacts the fund's administrator to confirm its engagement, the scope of servicing, and the specific procedures used to value securities and compute each NAV.
Amber prepares its due diligence reports based on its Operational Certification Methodology (i.e. reporting the same issues in a consistent format – see above). A draft copy is given to the manager to identify any errors of fact, after which Amber's Certification Committee reviews the report and considers the relative strengths and weaknesses identified during the due diligence process. Funds which are considered to have controls in place to reduce operational risk to acceptable levels are eligible to be Amber certified.
"If there are any areas of weakness, we will tell them how they can make improvements," Nahum explains. "If they agree to make those improvements, we can delay publication of the report until we can go in again to make sure our recommendations have been implemented. Once a fund has been Amber certified, we will provide the manager with a password to the report which he can distribute to his investors. They can then access the report on our website, free of charge. Our role is to promote the concept of operational transparency and best practices within the industry by promoting managers who have signed up for our services as leaders within the industry in this field. It is a way for managers to signal to their investors that they have met a benchmark of operational quality.
"On the other hand, once we created this company, we started speaking with hedge fund investors, including pension funds, endowments, family offices, funds of funds groups, and private banks, to get their support as users of our reports. I knew that when I eventually approached hedge fund managers, I would need to point to a wide audience for these reports. We call these people members of our User Network. They are all hedge fund investors, and very large hedge fund investors at that, who have said they will use Amber Partners' certification reports as an important operational due diligence tool where managers make them available. Managers therefore know there will be time and cost savings, as they will see that investors are going to use these reports. Secondly, these investors have said that they will approach their hedge fund manager relationships where possible, and push them towards certification."
Amber's engagement also requires the manager to notify Amber of material operational changes during the course of the certification period (a one year period after the date of each due diligence report). This covers circumstances like a change in the fund's prospectus, key service providers, turnover in key personnel, regulatory issues or a change in the ownership of the management company involving third party investors. Managers also provide regular monthly or quarterly investor letters to Amber, along with the monthly NAV per share and total assets figures.
Each certification and supporting due diligence is valid and available to shareholders for a period of one year. The full due diligence cycle is performed in its entirely on an annual basis, with a new certification (along with an updated due diligence report) being issued every year.
The collective hedge fund industry does seem to be indicating that it supports the concept of transparency and operational best practice. Amber currently has hundreds of hedge fund investors registered on its website and approximately 50 hedge fund investors in its User Network, ranging from very large fund of funds groups, to pension funds, endowments, private banks, financial institutions, and family offices, all actively supporting its efforts. All the investors participating were invited to be a member of the User Network, and together they manage in excess of $50 billion in hedge fund assets. The Hedge Fund Journal has viewed some of the names on the list, and although we cannot publish them here, we can attest to the scale and importance of the institutions involved.
For certification assignments, managers retain control over who sees their reports online: they retain full control of the password that allows investors to download reports. The only exception are those groups in the User Network: they have posted their names on a portion of the Amber site which is only accessible by fund managers, and can access the reports of all funds that are certified, unless the manager opts out. Thus, Amber-certified funds have the opportunity to get exposure to a group of major investors simply by gaining certification.
"It provides members in our User Network with the ability to access the reports they need without having to keep track of the individual passwords," Nahum explains.
The concept of independent operational certification looks set to gather speed. Talk to large-scale investors in hedge funds, and there is obviously a serious appetite for this kindof service in the industry, with major players already queuing up for independent and trustworthy operational intelligence. With first mover advantage, Amber is well-positioned to become the generally accepted stamp of approval for operational risk in the investor community. It is conceivable that there will come a time when the majority of funds which wish to be taken seriously by investors will need to have some form of operational certification. Nahum is preparing for what she expects to be rapid growth in Amber's user base, with plans already afoot to open an office in New York to complement existing operation in Bermuda and London. If take-up spirals, as could well be the case, she and her team will be kept very busy.