When AIMA and the fund of funds executives began work on the guide one year ago, few could foresee the liquidity crisis that would come to dominate the latter months of 2008 and the beginning of 2009. Then, just as the worst seemed to have passed, the Madoff fraud rocked a good number of funds of hedge funds. With the benefit of hindsight, it’s clear that the decision to prepare the guide was an inspired one and showed real commitment to pushing the industry forward.
“We wanted to make sure the guide was thorough and could apply in multiple jurisdictions,” says Andrew Baker, AIMA’s CEO in an interview. “That was a big part of the challenge. Investor preferences, practices and regulators are all substantially different.”
At the same time, the Steering Group sought to avoid being overly prescriptive. Its members were well aware that a ‘one size fits all’ approach wouldn’t be appropriate for an industry that is practically defined by its resistance to easy classifications.
The guide marks a new chapter in AIMA’s publishing programme. It builds on a 2005 sound practices guide for European hedge fund mangers which has since been revised. But the approach and the principles underpinning the new guide are rather different.
“We wanted to demarcate the two,” Baker says. “We didn’t see it as our role to say what underlying hedge fund managers should be doing. The structure is the same as it covers similar ground such as the investment process, good governance, infrastructure, administration and fund structures. In every case, however, there are significant differences that can arise between funds of funds and the next level down.”
The timing of the guide’s publication is certainly appropriate. There is wide spread acceptance among both investors and managers that a number of practices must be altered and improved in order for new capital allocations to occur.
“Cast your mind back a year ago,” Baker says. “There hadn’t been the round of liquidations go through the market place. But there was a sense that gating and illiquidity could become an issue. Little did we know the tidal wave was about to break.”
Attaining best practice
The guide is meant to help fund of hedge funds managers endeavour to reach best practice. The road to this is necessarily a different one than that laid out by the Hedge Fund Standards Board for single fund managers.
“You should see them separately,” says Baker of the two guides. “We didn’t want to lecture one group of members with this guide. Our role here is to assist the process of disclosure.”
Baker commends the funds of funds who committed to the process at a time when the industry was relatively becalmed. Now, of course, the setting is very different.
“Everyone who went into this knew the implications,” says Baker. “They knew that when the guidelines were published they would have to face the scrutiny of investors. But they knew it was in their interests and would give leadership to the rest of the sector.”
Particular attention went into the investment process, including the key ingredients of due diligence. The section on administration involves detailed discussion of managing not only cash balances, but borrowings, hedging and the potential for mis-matches between the liquidity of the underlying portfolios and the investor base.
“It is crucial to be able to see the whole picture,” Baker says, discussing the importance of matching liquidity and redemption terms. “What were thought to be perfect matches became mismatched through no fault of one’s own.”
The prescription to this is straight forward. “There needs to be more modelling on the liquidity profile of the investors,” he says. “How will investors in, for example, different countries or advised by different consultants respond to different events in the redemption cycle?”
On due diligence, the guide distinguishes between the point of first allocation and ongoing monitoring. It was judged that there needs to be more transparency about this at the funds of funds level.
“There needs to be a better audit to ensure marketing claims are actually met,” Baker says. “The stronger this is the better you will get along with underlying investors.” For institutional investors, which evidence shows are continuing to allocate to the sector, the guide provides a timely reminder of many of their more pressing concerns.
“A number of funds of funds have provided good transparency to investors and have performed pretty well,” Baker says. “Those guys are keeping a low profile, but they are out there. There are plenty of lessons to be learned from recent incidents and we hope to have encapsulated them in this document.”
Members of the Steering Group that produced the guide are:
Patrick Fenal (Chair) Unigestion
Christopher Fawcett Fauchier Partners LLP
Paul Dunning Financial Risk Management Limited
Christian Bartholin HDF Finance
Sean Simon Ivy Asset Management LLC
Pierre-Yves Moix Man Investments AG
Stephen Oxley Pacific Alternative Asset Management Company
Ronnie Wu Penjing Asset Management
Steven Whittaker Simmons & Simmons
Andrew Baker AIMA
AIMA is grateful to all Steering Group members for their unstinting commitment, in particular, Gilles du Fretay, President and Christian Bartholin, Directeur Général Délégué of HDF Finance who conceived the original idea for the guide. AIMA is also grateful to Patrick Fenal and his team of colleagues who chaired the Group.
Other contributors included:
– Fortis Prime Fund Solutions (UK)
– KPMG LLP
– Managed Funds Association
Excerpts from The Guide to Sound Practices for Funds of Hedge Fund Managers
2. Investment process and portfolio risk management
Some of these practices may be very intuitive for individual portfolio managers and small teams, but it is important to recognise that investment processes evolve over time and as a Fund of Hedge Fund Management Company (FoHF ManCo) grows and staff change, clear communication about the investment process, both to staff involved in its implementation and to investors, will help in the avoidance of misunderstandings and reduce the potential legal risk and risk of errors. These processes should be tailored to individual FoHFs and the style of investment undertaken. If single investor portfolios (SIPs hereafter) are also operated, then the process and controls should be consistent with the commingled FoHFs.
2.1 Due diligence, manager selection and monitoring
One of the goals of due diligence is to try to avoid investing in underlying hedge fund frauds or failures. There is no precise definition of what is to be included in hedge fund due diligence and no international regulatory standard exists to specifically address due diligence or the selection of underlying hedge fund managers by FoHF portfolio managers.
2.1.1 Due diligence steps
The due diligence process can be split into two time frames:
a. prior to investing – during the selection process; and
b. ongoing monitoring – after initial investment, during the investment period.
And into five stages:
a. research and sourcing;
b. strategy and investment process due diligence;
c. operations due diligence;
d. legal documentation analysis; and
e. reputational checks
The FoHF ManCo may consider the delegation of any of the above stages to an external service provider. In that situation, the FoHF ManCo should be expected to have procedures and processes in place to appropriately evaluate the service provider(s) and their compliance with industry best practice.
2.1.2 Eligibility criteria
This thorough, and often time-consuming due diligence process involves checking that a potential underlying hedge fund investment meets certain basic criteria, such as the following:
a. custody of assets should be handled by an independent and financially sound entity;
b. custody of assets should be segregated from the custodian’s own assets, and/or re-hypothecated trades should be held in a segregated account in the name of the underlying hedge fund at the prime broker;
c. independent and reputable administrator;
d. minimum monthly valuation, by an independent third party;
e. mandatory annual (minimum) audit of the fund accounts by independent auditors, with hedge fund expertise;
f. independent lawyers;
g. legally enforceable ownership rights;
h. hedge funds should be based in reputable and well regulated jurisdictions, which have been the subject of favourable International Monetary Fund and Financial Action Task Force reviews;
i. liquidity profile of underlying funds should not differ significantly to the liquidity terms of the FoHF; and
j. adherence to industry standards such as the Hedge Funds Standard Board.
2.1.4 Strategy and investment process due diligence
In order to evaluate the capability of a manager to perform any investment management activities for an underlying hedge fund, the main areas requiring attention or action in the due diligence process are:
a. quality and experience of the management team, including any key-person risks;
b. investment strategy and associated investment research capability;
c. evaluation of risks associated with the portfolio (e.g. leverage, concentration, counterparty selection, type of instruments);
d. hedge funds risk management process, risk and control culture, and discipline including any risks associated with the delegation of any activity to an external service provider;
e. process and organisation of the execution and trading;
f. analysis of the track record of the hedge fund manager (if any); its feasibility (particularly with respect to back tests and pro-formas); its corroboration with the claimed strategy and stated risk levels; comparison to peers who operate using the same strategy; and capability to operate and perform successfully in varying market environments;
g. quantitative analysis which may provide a systematic and independent assessment of a hedge fund manager’s risk profile;
h. review of possible conflicts of interest; and
i. rebates (if any) provided by underlying hedge funds should accrue to the FoHF and not to the FoHF ManCo (thus ensuring the due diligence process is not influenced by financial considerations).
2.1.5 Operations due diligence
This is an essential element to the due diligence process and should be performed by separate personnel from the investment analysts within a FoHF ManCo.
Detailed reviews of the organisation of an underlying hedge fund’s management company; of any of its service providers; its technology and systems and of documents (e.g. audited statements) are undertaken in order to evaluate non-investment type risks, before an investment is made into the hedge fund investment vehicle.
The analysis includes, but is not limited to:
a. analysis of the management company structure (such as capital base composition and review; experience of operational staff; segregation of duties; IT infrastructure; valuation process and accounting; valuation policy and corporate culture) and assessment of any associated risks;
b. review of valuation process of OTC, illiquid or non-exchange tradable securities;
c. review of any tasks delegated to service providers and an assessment of their ability to perform those tasks;
d. evaluation of potential conflicts of interests at the operations level;
e. quality and structure of the governing body;
f. strength and reputation of the independent administrator, auditors, prime broker and custodian;
g. custody and/or prime brokerage of hedge fund assets handled by independent entities, appropriately regulated;
h. cash controls approval and investment;
i. process and organisation of the execution and trading;
j. evidence that a proper reconciliation process is in place including, at least, daily trades, cash and holdings, pending transactions and settlement processes;
k. analysis of the life cycle of a trade, including trade input to the IT system;
l. adequacy and appropriateness of financing arrangements;
m. counterparty risk, including: concentration of risk within counterparty; evaluation of quality and reputation of counterparty; re-hypothecation risk; conflicts of interest; and terms of contracts between the hedge fund and the counterparty.
n. disaster recovery/business continuity review.
2.1.6 On-site visits
In order for a FoHF ManCo to obtain a genuine understanding of an underlying hedge fund, it is essential that on-site visits take place. This offers the FoHF ManCo the opportunity to see the environment that the hedge fund is operating within.
Whilst other forms of communication with underlying hedge funds managers are still valuable and necessary, there is no replacement for face-to-face meetings where reactions to questions and the general substance of the business can be observed. These on-site meetings should take place at least annually.
2.1.7 Legal documentation analysis
A review of the legal documents of an underlying hedge fund (offering documents, memorandum and articles of association, and all agreements with service providers, including the management/advisory agreement, etc.) should take place in order to assess issues such as:
a. potential risks in the legal structure (e.g. lack of ring-fencing, contagion risk, inappropriate segregation of different investor classes, investors rights, side letters, fund domicile and past changes
in structure) that may potentially impact investors;
b. coherence of all the documents;
c. legal relationship between the fund and its service providers;
d. quality of the governing body;
e. any potential conflicts of interests in the structure; and
f. procedures regarding changes in liquidity terms for investors.
FoHF ManCos should establish a routine process to receive communications from hedge funds including notices to investors, as well as updated offering documents. As with proxy matters, changes to offering documents should be fully understood and, if inconsistent with the FoHF ManCo’s expectations of the offering, the portfolio manager must speak immediately to the underlying hedge fund to gain acceptable explanations of the changes.
When required, side letters also may be negotiated, for instance, in order to either clarify meaning in the legal documents, obtain better terms (i.e. tailored client reporting, fees, etc.) or to receive enhanced transparency.
2.1.8 Reputational checks
Processes should be in place to check the background of an underlying hedge fund manager and/or of any important team members. These should include:
a. reference checks of portfolio/investment managers by other managers/previous colleagues;
b. background reviews by external business intelligence professionals covering: criminal activity, general relevant information etc., of portfolio/investment managers and key employees; and
c. periodic/specific evaluation of the quality and organisation of any service providers (existing or new).
2.1.9 Procedures, policies and data management
FoHF ManCos should have documented policies and procedures covering the selection and monitoring of their hedge fund investments, including elements such asstrategy, business risk, operational and reputational matters. As well as forming a clear framework to work within, these policies and procedures can assist clients of FoHF ManCos and regulators in understanding how the portfolio manager builds and operates its FoHFs platform.
Once an underlying hedge fund has been selected for investment, a FoHF ManCo should be expected to prepare and maintain information and data in respect of:
a. the underlying hedge fund’s portfolio construction process;
b. the underlying hedge fund’s portfolio governance arrangements
c. the rationale and philosophy behind investment decisions;
d. correspondence, calls, meetings and on-site monitoring visits with the underlying hedge fund manager;
e. information on asset allocation and weighting of underlying hedge funds in different portfolios; and
f. risk management considerations.
Subsequent to this process, upon investment, it should be expected to observe:
a. clear segregation of duties between investment and execution;
b. control over the process of notification of investment decisions to underlying hedge fund managers in order to avoid possible mistakes with custodian banks (see 3.1);
c. clear lines of communication and authority with regards to subscriptions or redemptions from an underlying hedge fund; and
d. active consideration of portfolio management components such as bridge financing, leverage and foreign exchange exposure.
The relationship between the redemption terms of a FoHF’s liquidity and the liquidity of the underlying hedge funds holdings should be monitored and appropriately managed.
The force majeure clause embedded in almost all FoHFs’ offering documents allows it to suspend redemptions or, sometimes, to redeem in kind. Less liquid redemption terms permit a hedge fund to invest in less liquid instruments or with a longer investment horizon. Less liquid investment, however, does not permit active management and active liquidity management is consequently essential to successfully manage investment risk in a FoHF.
2.6.1 Liquidity terms
FoHF ManCos should have documented internal policies governing liquidity management of their portfolios. They should incorporate the liquidity terms of the underlying hedge funds into their overall investment portfolio construction and portfolio management processes. These policies and processes should be consistent with the FoHF’s constitutive documents.
2.6.2 Liquidity management process
The best practice at a FoHF ManCo is to ensure that the portfolio construction process reflects a reasonable balancing of the following factors:
a. liquidity actually available from the portfolio of hedge funds (including possible gates, lock-ups, restructurings or side pockets) as well as any preferential liquidity terms;
b. implications of cash flow from any FX hedging activities, taking into account available banking facilities;
c. consideration of known liquidity restrictions (gates, lock-ups, restructurings, side pockets and liquidations) of underlying hedge funds;
d. actual liquidity of the assets in an underlying hedge fund; and
e. consideration of any other factors such as availability of “emergency” clauses, including, but not limited to, the potential for the suspension of the investors’ redemption rights, in kind distribution and extended lock-up periods.
2.6.3 Transparency on liquidity profiles
In managing a FoHF, the FoHF ManCo should ensure that its shareholders and investors have a clear understanding of the liquidity profile of their investments. In order to accomplish this, FoHF ManCos should be able to provide clear and understandable/standardised liquidity measurements of their portfolios taking into account gates, lock-ups, restructurings and side pockets. This should assist both investors and the FoHFs to achieve the most efficient match of assets and liabilities whilst taking into account both the risk profile of the portfolio and an analysis of the investor base of the FoHFs. Some measure of liquidity profile reporting by FoHFs permits a clearer assessment by investors of comparable performance between FoHFs when adjusting for liquidity and should permit investors to make informed redemption decisions.
3. Administration and operations
FoHF ManCos will benefit from proper segregation of duties, by dovetailing major responsibilities across a number of distinct groups, effectively establishing a system of checks and balances within the FoHF ManCo. Internally, there should be an appropriate segregation of duties between investment teams and the risk management/operational staff; and procedures should be established to ensure that third party service providers are acting in the best interests of the FoHFs.
The appointment and governance of service providers by the governing body establishes a high level internal control framework for FoHF ManCos and their investment offerings. The use of an independent administrator offers both investors and the FoHF ManCos many benefits and these are outlined in this chapter which will also cover trade processing and settlement, cash management and control, pricing of portfolios, net asset valuations, maintenance of appropriate information systems and service provider oversight.
3.1 Trade processing
The FoHF ManCo should ensure that the administrator has adequate internal controls to properly identify and record detailed information on all transactions between investors and the FoHF. Although a FoHF ManCo does not control the FoHF’s official books and records, it should develop a process to ensure that any data it receives from investors is sent to the administrator promptly.
In addition, the FoHF ManCo should encourage investors to communicate directly with the administrator/custodian bank with respect to their respective transactions in a FoHF. It should be noted that this is not a replacement for good investor relations and client service practices within a FoHF ManCo. Staff involved in those functions should have a full and in-depth understanding of transaction processes so that they can assist investors in this.
Procedures for dealing with the notification and receipt of subscriptions should be established. The timing of subscription notices and receipt of cash is a key part of managing a FoHF in order to ensure the portfolio manager has enough time to determine the allocation to new funds and that monies are cleared with ample time to invest in underlying hedge funds. FX hedging may also be impacted. A FoHF ManCo should ensure that the planned and actual cash movements are available on a timely basis to the portfolio manager.
Measures to reconcile and resolve differences between planned and actual cash movements should also be in place. New investments in a FoHF require the investor to complete and submit an account opening document (subscription agreement). The administrator should perform a proper document review that includes appropriate know your investor procedures to ensure that the documents are complete and to verify the legitimacy and suitability of each investor.
The FoHF ManCo should ensure that the FoHF’s lawyer reviews a subscription document template for the FoHF ManCo that contains the appropriate representations from the investor including those relating to accreditation and suitability.
Similar to subscriptions, procedures for dealing with the notification and receipt of redemptions are critical in order to submit redemption notices to underlying hedge funds and reallocate investments across each of the strategies in a FoHF. The FoHF ManCo needs to ensure that the planned and actual cash movements are available on a timely basis to the portfolio manager. Measures to reconcile and resolve differences between planned and actual cash movements should also be in place.
Eachredemption request from the FoHF’s investor should be reviewed against the FoHF’s offering document; exceptions need to be identified by the administrator, agreed upon by the portfolio manager and approved by the FoHF’s governing body. Procedures should be in place to ensure that money is returned to the original account that it was subscribed from.
Liquidation of underlying hedge fund positions can take time and those hedge fund managers may return investors’ money in tranches, may gate or hold back some investors. A FoHF must ensure that each of its investors is allocated cash from liquidating investments in proportion to their underlying exposure, at the same time as other investors in the FoHF.
3.1.3 Underlying hedge fund investments
Managers should have adequate systems in place to store and maintain information pertaining to its underlying hedge fund investments. Such information should include liquidity terms; key subscription and redemption dates; dealing and execution procedures; and contact and document management.
Much of this can be gleaned from the respective hedge funds offering documents. Submission of subscription forms, monies and redemption notices to underlying hedge funds should be actively managed to ensure that their delivery meets the timing requirements of the hedge fund.
Particular attention must be given to the following points in order to control risk:
a. all trade tickets must be sent to the custodian or administrator for execution within their specified deadlines;
b. workflow for sending trades must be prepared in advance with the custodian or administrator. They are usually delivered in a standard agreed template;
c. trade tickets that are incomplete or incorrectly filled out are usually returned to portfolio managers for the missing data to be completed leading to delays in execution;
d. portfolio managers must ensure that trade tickets are signed in accordance with their most up-to-date signatory procedures. In the case of electronic transmission, they must ensure internal approvals likewise;
e. implementing sequential numbered trade tickets is a matter of best practice followed by many FoHF ManCos and custodians/administrators. This enables both parties to control trade ticket flows;
f. FoHF ManCos must ensure that the custodian/administrator not only possesses the correct document for execution, but also all the requisite information to complete the document; and
g. procedures must include clear confirmation rules that all trades have been executed.
3.2.1 NAV calculation process
The calculation procedures will typically be undertaken by the administrator who will calculate and report on a FoHF’s NAV. The policy and methodology for the calculation of performance, management and administration fees should be described in the offering document.
The FoHF ManCo should ensure that the administrator has the capability to fulfil calculation requirements comprehensively, including complex fee structures, and that their systems are capable of recording all transactions and calculations.
The NAV of the FoHF should reflect the current fair value of a portfolio of underlying funds or investments. Investments should be valued as of each FoHF’s NAV date and/or when investors subscribe or redeem, otherwise referred to as a dealing day. At each valuation date, investments in which the FoHF invests should be valued in accordance with the underlying fund’s offering document and/or other fund constitutive documents.
NAVs for FoHFs are reliant on the values received from the underlying hedge funds. A FoHF’s offering document should include appropriate disclosures stating that the fund relies on such values in computing its NAV. The NAV of the underlying hedge funds is the starting point for the calculation of the FoHF’s own NAV.
The FoHF ManCo should have procedures and systems (independent of the administrator) in place to check all fee calculations and to enable it to include realistic fee accruals into anyintra-month NAV reporting to investors. As these will impact the FoHF’s NAV, the governing body will be responsible for ensuring that there are sufficient controls in place to independently verify these calculations. Additionally, double checks of the administrator’s NAV calculations should be conducted by the FoHF ManCo.
A FoHF’s administrator, and/or FoHF ManCo, should ensure that the audited semi-annual (where applicable) and annual reports of the underlying hedge fund investments are received on time and that the NAV per the audited report agrees to the valuation used in the applicable NAV. Any discrepancies should be investigated and resolved immediately.