Information Leaks Cause Headline Risk

Funds can suffer immediate and future damage

Originally published in the November 2010 issue

The saying, “There is no such thing as bad publicity” has never come from the lips of a hedge fund manager. In fact, the growing number of hedge funds which have had their investor letter or risk report leaked to Dealbreaker, The Wall Street Journal or Marketfolly would say that certain types of publicity can damage your reputation and ability to win new allocations. It could even trigger a wave of redemptions.

Hedge funds and investors refer to bad publicity as headline risk – the possibility that negative news, even unfounded news, could spread throughout the media and impact an investment. The risk of a fund’s investor letters, risk reports or other confidential information being made public is headline risk.

Who actually turns a fund’s confidential information into public information? Paradoxically, its people authorised to receive the fund’s confidential information – investors, advisors, accountants – that are usually the source of the leak. Some pass the information on to the media accidentally and others do it intentionally. Rarely does a hacker or unauthorised user obtain a fund’s investor letter and circulate it to the media.

Leaks put allocations at risk

Investors have shifted into high gear as they make the turn for the fourth quarter. This is shown by the $30 billion in net assets that have flowed into hedge funds during August and September 2010 alone, according to the Eurekahedge Index. Having your investor letter turn up on a website accompanied by some colourful comments would be inopportune to say the least. Especially when you consider that most investors receive 180 proposals or more a year but make 10 or fewer investments.

So does having your investor letter or risk report leaked to the media hurt your ability to compete with other firms for allocations or is it just embarrassing? The numbers say it hurts. Investors cited headline risk as the third most damaging action to a fund’s reputation and a deterrent to making an allocation. Headline risk turns off investors, particularly institutional investors, more than invoking a gate, side pockets or changing liquidity terms.

It is also worth remembering that headline risk – like all risk – is a matter of perception. Prospects can perceive a fund as risky and pass on investing if they don’t see tangible controls that diminish their being exposed to headline risk.

Plugging the leak
Funds have varying approaches to reducing information leaks that create headline risk and can threaten to damage their ability to win allocations.

The Water-down Approach
Some funds are so fearful of having confidential information published that they remove anything unique, insightful or controversial from their investor letters. They effectively convert their investor letters into press releases by stripping out the distinct point of view that drew investors to them in the first place.

This approach is something of a Pyrrhic victory – funds reduce headline risk by watering down the content in investor letters, making them less useful to investors. Remember, it’s called an investor letter for a reason.

The Watermark Approach
Many funds use watermarking – the display of an individual’s name on confidential information – to deter authorised users from passing their investor letters or risk reports externally. Funds relying on watermarking should understand that there are different types of watermarks, some of which can be easily removed.

An annotated watermark is a separate object from the content of the document and can be simply deleted within Adobe Acrobat. Applying “SetLocK” to a pdf document and the annotated watermark sounds effective but isn’t. An individual can easily remove the “locked” flag and delete the watermark from the investor letter. Encrypting the document prevents the locked flag from being deleted.

However, once an authorised individual opens the document it’s no longer encrypted. At that point the individual can use a variety of widely available tools to delete the annotation, resave the investor letter without encryption and send it to whomever they want.

A stamped watermark is the most effective type of watermark. It is actually part of the content of the document, making it very difficult to cleanly remove, particularly if it appears in multiple spots on the document.

A watermark is an effective but passive approach to modifying an investor’s behavior. The challenge with deterrents is what to do when they don’t work. In the case of watermarks, the damage has been done when a fund’s confidential information has been published and a fund’s recourse becomes unattractive.

The Watertight Approach
The only sure way to eliminate information leaks, reduce headline risk and preserve your opportunity to win allocations is to control what authorised individuals do with the confidential reports. Funds do this by applying Information Rights Management (IRM) technology to their investor letters and risk reports.

IRM enables funds to prevent confidential documents from being forwarded, saved locally, printed or screen printed. Additionally, since IRM encrypts documents, a fund can remotely “shred” an investor letter left on a USB or local drive by revoking the key required to decrypt the document.

Funds can selectively use IRM. For instance IRM could be applied to documents such as investor letters, but not spreadsheets that a fund of funds relies on for data points they incorporate into their own reports. Funds can also apply IRM to documents shared with some recipients but not others.

There’s also the argument that IRM helps preserve a fund’s relationship with its investors. It does this by preventing an investor from inadvertently sharing a fund’s investor letter with the media, avoiding a strain on an otherwise good relationship. It also prevents the intentional sharing of confidential documents which can lead to legal action and irreparable damage to the fund/investor relationship.

Money is flowing into hedge funds again and strong performing managers with pristine reputations will be the beneficiaries. Conversely, funds susceptible to headline risk will struggle to capitalize on a strong market. Risk reports and investor letters leaked to the media increase a fund’s headline risk and individuals authorised to view the reports are surprisingly the source of most leaks.

Funds should utilise watermarking and IRM technology to reduce their headline risk, protect their reputation and preserve their relationship with investors. Watermarks are an effective deterrent to sharing confidential information. However, not all watermarks are the same. Funds should only use stamped watermarks and avoid annotated watermarks which can easily be removed.

IRM technology enables funds to control what authorized users do with their confidential information. It is the only sure way of reducing headline risk and preserving your opportunity to winallocations and build relationships with investors.

Paul DiBlasi is Vice President, Product Marketing at IntraLinks which provides solutions to the secure exchange of critical information. DiBlasi has global responsibility for business strategy, message development and revenue growth of the firm’s business with private equity firms and hedge funds.