It is just over three years since Amber Partners first began offering operational risk certification of hedge funds. Over that time the firm, founded and headed by Reiko Nahum, has put down roots and steadily expanded.
Being the first provider of operational risk certification gave Amber a crucial early advantage. It has used that to bring its operational due diligence expertise to bear on an increasing number of predominantly multi billion dollar hedge fund firms, and has steadily expanded its investor subscriber base to nearly 2,000 registered users representing pension funds, endowments, family offices, fund of funds and institutions. Amber’s staff has grown apace with the business and has now reached a critical mass of full time professionals dedicated to the delivery of Amber’s operational due diligence services. Staffing is based on a ratio of one professional for every 20 – 25 annual due diligence reviews.
“We are experiencing a significantly increased demand for our investor due diligence services,” Nahum says during a recent interview at the firm’s Savile Row offices. “What’s happened in the hedge fund industry has highlighted the need for investors to reassess and review the extent to which they are conducting operational due diligence.” She notes that it is not just investors but hedge funds, too, that increasingly realise the need for an Amber assessment of practices ranging from the valuation process to financial controls and operational risk management.
Given the Madoff imbroglio, the events surrounding Allen Stanford, and the most recent alleged fraud at Westridge Capital Management Inc, investors are sure to demand more tightly delineated operational due diligence assessments. Even hedge funds with such plain vanilla strategies as long/short large cap equity are coming under renewed scrutiny from investors who are anxious to ensure that a fund’s operating processes are up to scratch.
“We are in constant dialogue with both investors and managers and are very well informed of what is going on within the industry,” says Quentin Thom, a Director of Amber and whose role includes global business development and delivery of operational certification and due diligence services.
Amber has gained backing from several financial services heavyweights, including JP Morgan, BNP Paribas, Singapore’s Temasek Holdings and third party marketer Anchor Asset Management. “The financial stability of the firm allows us to hire the best and brightest practitioners within the industry and focus on delivering excellent services to our clients, rather than purely focusing on how we generate revenue. It is a very different model from the rest of the industry in terms of providing operational due diligence to investors,” Nahum says.
In addition to London, the firm operates from New York and Bermuda where Nahum was President and Director of UBP Asset Management (Bermuda) and was global head of the bank’s operational risk due diligence function. At Amber, the business is split into two areas. The core certification business sees the firm engaged by a hedge fund in Nahum’s words, “to go out and kick the tires on the manager and administrator.”
The detailed review process will result in an approximately 25 page report looking at a fund’s operational strengths and weaknesses along with recommendations of how to improve. Amber also offers a service to investors to conduct operational due diligence on funds that it hasn’t yet certified. This service uses the same methodology and process Amber employs for certification.
Firms that have engaged Amber range from Paulson & Co. which has had nine funds certified, to Winton Capital, the London CTA, which has had its core managed futures fund certified. Amber has found that around 15% – or about one in seven – funds are operationally weak and fail certification.
There are two areas that account for the bulk of certification failures. One is a lack of sufficient controls in place to reduce the risk of fraud. This would typically involve wire transfer controls, account opening procedures, segregation of duties as well as how funds value securities at each NAV calculation date. The second common area of certification failure is a lack of controls around the net asset value calculation process.
“Where a fund holds difficult to price securities, we do not focus on whether or not the specific values are correct or incorrect but how, from an operational point of view, the manager is applying a transparent, consistent and independent process to value the securities in the portfolio,” Nahum says. “Many reputable funds still require improvements to their valuation procedures.”
Like other industry veterans, she acknowledges that issues of how funds were marketed pose important questions forthe hedge fund industry. How, in some funds, did liquidity horizons and redemption terms get so far out of synch?
“The key is whether or not investors were aware of the nature of the securities in the portfolio and whether it was consistent with what investors thought they were investing in,” Nahum says. “There are a group of hedge funds that have likely lost investor confidence because all of a sudden they’ve had to disclose to their investors that their portfolio is illiquid and not in line with the fund’s investment strategy. But there are also those hedge funds that are very transparent and therefore it is no surprise to anyone that in these difficult markets their securities are less liquid.”
The impact of poor performance and lack of investor confidence is contracting the hedge fund sector considerably. Many observers say hedge fund numbers could be halved to 5,000-6,000. Nahum goes much further. “Forget about 10-12,000 hedge funds out there,” she says. “Today the true investible universe is 1,500 to 2,000 hedge funds. These are funds that a sophisticated investor might invest in.”
Investors focus on valuation
It is no overstatement to say that valuation is the hottest topic for hedge fund investors. New guidelines under FAS 157 requires disclosure on audited financial statements along three pricing levels: Level 1 (quoted prices in active markets), Level 2 (observable inputs other than quoted prices included in Level 1), and Level 3 (inputs that are unobservable for the asset or liability). This has spurred substantial debate, particularly about distinguishing Levels 2 and 3.
Nahum says the guidelines are beneficial. “That information will give investors a very good snapshot at year end,” she says. “It shows the nature of the securities in a hedge fund portfolio that are easily priced and those that are not so easily priced.” Indeed, Amber’s certification process from the outset incorporated a similar analysis of valuation. It ran along a continuum from low valuation subjectivity for exchange-determined prices to high valuation subjectivity on low liquidity securities that might require manger estimates of fair value.
The certification process
But the firm’s analysis goes much further in a certification mandate. Taking what’s in a portfolio, Amber drills into how managers are calculating daily profit and loss data. The certification process also scrutinises how the month end NAV is calculated and assesses what the administrator is doing to independently price securities. “We literally go line by line in terms of the types of securities that are traded in the portfolio to understand the level of operational complexity as well as the types of valuation issues that may exist within the fund,” Nahum says.
Most hedge funds other than long/short equity in the big liquid stocks require robust back office infrastructure that can handle over-the-counter confirmations. “A lot of it,” she says “is still done manually by many firms in terms of the confirmation-reconciliation process. We expect to see the relevant level of staffing and knowledge to handle these types of issues. A manager should also have an order management system appropriate for the volume of trading and the nature of instruments traded.”
Amber’s operational due diligence considers a number of factors to assess a fund’s operational risks, including the complexity of the strategy and size of the organisation. A distressed debt fund, for example, will have potentially many valuation issues.
The back office reconciliation/confirmation process is also more complex. To certify the fund, Amber would require that a top tier fund administration firm is on board. It will also demand that a chief financial officer or chief operating officer have relevant industry experience, professional qualifications, and authority within the firm to handle the strategy’s complexity.
Risk dominates investor concern
In 2008, counterparty and credit risk exploded onto investor consciousness. Nahum says few foresaw the failure of several major financial institutions. As a result, managing counterparty risk has leapt up investors’ agendas.
“In the past, managing it was a function of only dealing with well rated firms,” she says. “Now, for instance, firms have created formal credit committees, monitor CDS spreads, look at market capitalisations and review legal documentation to ensure, amongst other things, that they are limiting the amount of securities that can be re-hypothecated.”
The average Amber certification features about 200-250 man hours of operational due diligence. The process is repeated annually for funds to remain certified.
“We are not out to certify hundreds and hundreds of hedge funds every year,” says Nahum. “With each client we spend six to eight weeks in the certification review process. Post-certification Amber acts as a sounding board on a variety of issues they may be facing, including operational changes, investor queries or possible fund structuring issues.
“We pride ourselves on giving a high level of service,” Thom says. “We are looking for those managers of hedge funds that have the mind set of wanting to demonstrate best practice. Our service complements those who aspire to having a sustainable long-term asset management business.”
Once a report is prepared, it is presented to a manager to ensure factual accuracy. At this stage, Amber will have identified strengths and weaknesses, and what a fund needs to do to improve. If changes are needed and the manager makes them, Amber will verify that the changes have been made and then issue a final report reflecting the changes made as a result of the review so that the process is fully transparent.
“The focus is not on a rating, it is on the fact that a fund that has gone through a thorough due diligence process, achieved a benchmark of operational quality, and responded to the recommendations we’ve made,” says Nahum.
“Our work supports both investors and managers and significantly increases the efficiency of the operational due diligence process. No other group within the industry can dedicate the same amount of time to this activity. We are the only firm dedicated solely to operational due diligence.”
Amber also prides itself on being a thought leader in the hedge fund industry. Its principals have been active with the Managed Funds Association sub-committee responsible for looking at recommendations from the President’s Working Group, and making suggestions for the next version of MFA Sound Practices for hedge fund managers. They also provide a reference guide to the UK HFSB Hedge Fund Standards.
“Whether or not you become a signatory (to the HFSB regime), a hedge fund manager can show that each one of the standards has been addressed by referencing the operationally related standards from the guide back to the certification report,” Nahum says. “Clearly the Amber report provides a very effective vehicle to actually demonstrate your compliance.”
Nahum is careful to point out that Amber is engaged by a hedge fund on a similar basis to an auditor or administrator. “We are very clear it is not a pay to play type service. Our contract stipulates that our fee is due regardless of whether or not we award certification. The fact is that we do maintain our independence and will fail some of the hedge funds we review.”
“What makes us unique,” says Thom, “is that we are able to periodically challenge how funds operate. We are at the forefront of operational bestpractice and play a key role in helping managers raise the bar in order to improve their processes and controls.”