Investors want significant improvements in the way hedge funds interact with investors, and have called for greater reporting and transparency in a recently published guide to the industry.
The “Guide to Institutional Investors’ Views and Preferences Regarding Hedge Fund Operational Infrastructures”, came out of AIMA’s investor steering committee, with a number of committee members authoring chapters.
Contributors included Kurt Silberstein (CalPERS), who covered investment, looking particularly at reporting, terms and conditions, control of assets and transparency and Luke Dixon (pictured) (Universities Superannuation Scheme), who discussed governance.
Michelle McGregor Smith (BA Pension Investment Management) discussed issues surrounding a hedge fund’s ownership structure and Andrea Gentilini (Union Bancaire Privée) wrote a chapter looking at risk and reporting.
Finally, Adrian Sales (Albourne Partners) focused on operations, analysing issues surrounding valuation, business continuity planning, compliance and relationships with service providers.
Hedge funds faced a backlash in the post-financial crisis world, with critics saying their strategies were too correlated with markets.
Other investors complained that many hedge funds were too leveraged, imposed lock-ups that did not match the liquidity of underlying assets and were unresponsive to investor demands for more transparency.
Many also questioned whether the high fees investors paid were actually commensurate with performance.
Since those dark days the investor profile for hedge funds had changed. Their funding base was now recovering and was dominated by institutional investors.
But, as the guide detailed, they were much more high maintenance than previous investors.
The guide called for more reporting and greater transparency and equality in what information investors received.
Silberstein, CalPERS’ senior portfolio manager, said funds wanted both quantitative and qualitative reporting that “was no less than monthly” and was distributed equitably to all investors.
The report should be sufficiently detailed for an investor to gauge: how hedge fund capital was managed during the reporting period and how much of the performance was based on realised results relative to unrealised gains, with accompanying detail on the amount based on the valuation of illiquid assets.
Monthly reporting should also cover information on what types of risk were incurred to produce the performance and what part of the fund’s performance across its investments strategies was attributable to either its long or short portfolios.
Fees had often been a contentious issue for hedge funds, particularly if performance fees were crystallised in the short-term but the investor subsequently experienced a loss over the next performance period.
“Arrangements, which call for annual (or less) crystallisation of performance fees, do not adequately reflect the incentives associated with a long-term relationship,” Silberstein said in the guide.
Silberstein said investors wanted fund incentive fees that had a hurdle rate that was no less than the yield on a cash investment that matched the duration of the fund’s lock-up. Fees should also only be fully realised when the investor could redeem from the fund.
A performance fee should have some portion crystallised over several reporting periods.
The report does note that fees should cover a hedge fund’s operating expenses and should be consistent with the fund’s underlying strategy, investment horizon and liquidity.
Importantly, institutional investors were also looking for key signs of an alignment of interests, and wanted hedge fund managers and senior staff to have substantial investments in the funds.
If an investor did not think a hedge fund manager had enough skin in the game, they could require a portion of the performance fee was invested in the hedge fund, according to Silberstein.
In calculating fees Silberstein also advised that understanding the hedge fund’s business model and ensuring a fund could have continuity of management, even in troubled times, should be taken into consideration in minimising risk.
The thorny question of how and when an investor could take their capital out of a hedge fund had been a challenge for the industry.
Silberstein said investors should expect: “that they could receive most, if not all, of its capital within a year or less with minimal, if any, constraints”.
He noted that, if structured properly, an investor should be able to arrive at a conclusion about the viability of an investment vehicle on an ongoing basis.
But Silberstein warned that a hedge fund’s investors should not have the capacity to compromise a fund’s business or other investors’ capital by having too much power in forcing liquidity.
“Hedge fund managers should not be placed in a situation, which has occurred in the past, when they feel compelled to focus on raising cash for the next redemption period rather than maximising risk-adjusted returns,” he said.
There was often a tension between investors and hedge funds in terms of transparency.
Typically, investors wanted more information but hedge fund managers fear this could lead to their business strategy being disseminated, which could eventually disadvantage both the fund and the investors.
Silberstein said transparency levels should be adequate enough to allow for an investor to understand the hedge fund’s exposures and the risks taken, as well as what was driving performance.
Information provided should be what he describes as “security-level information” that could be used in a risk analytics tool.
The full report can be accessed at www.aima.org