Operational Due Diligence: New Challenges For Hedge Funds

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The Third Annual Operational Due Diligence Survey Summer 2014 by Deutsche Bank Global Prime Finance drew responses from more than 70 investor entities across the globe managing investable funds of over US$ 2.72 trillion. Of this nearly US$ 730 billion was allocated to hedge funds.

“The environment in which investors answered the survey is one of continued regulatory pressure as the alternatives industry adapts to the impact of global regulation. Additionally, the business model of hedge funds is becoming ever more institutional, converging with their peers in the broader asset management industry. These changes mean hedge funds face greater challenges in handling regulatory, reputational, business and operational risk, in addition to delivering returns for their clients,” observes the survey.

Clients obsess with compliance and regulatory obligations

Compliance with increasingly arduous regulatory reporting obligations, often cross-border in scope, such as FATCA, AIFMD and EMIR, is uppermost in the minds of investor entities. 73% of responses were in favour of a sharper focus on regulatory compliance by the prospective fund manager in 2015. A due diligence survey by an investor would seek to establish preparedness of the manager to deal with responsibilities for registration, timely and accurate reporting and regulatory scrutiny.

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How hedge funds can guard against the dreaded veto

According to the survey, 43% to 81% of investor ODD teams have the explicit right veto the proposed investment. However, only 2% of the managers reviewed received a qualified veto while 5% were served an explicit veto.

Inadequate transparency was cited as the top reason for exercising the explicit veto option by 22% of respondents. Unsatisfactory compliance with policies and procedures was another reason given by 19%, while personnel factors such as inadequate segregation of duties or unsuitable experience (12% each) also headed the list of reasons for explicit vetos.

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Investors willing to give the fund manager another chance

Encouragingly, the survey found that a large majority of investors (81%) ODD teams were willing to reconsider their veto provided the manager could rectify shortcomings. Such qualified vetoes indicate that in general investors bring a consultative or constructive approach to the table.

“We will always try to find a solution first – veto is the last resort,” said one European fund of funds respondent in the survey.

The top three reasons for a qualified veto were inadequate personnel or lack of relevant experience in critical roles (19%), lack of appropriate cash controls (14%) and inadequate or inappropriate compliance policies and procedures (9%).

Investors not afraid to work with emerging managers

68% of respondents said they would invest with an emerging manager (defined in the survey as a manager with a track record of less than three years). However, these investors are likely to entrust smaller sums as compared to investments placed with established managers.

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Investors were also more supportive of outsourcing of key functions by emerging managers.

Expenses a sensitive issue

The survey found that the 64% of respondents would question miscellaneous line-item expenses and could also demand that certain expenses be subject to agreed limits. Employee compensation, marketing and non-research-related travel are sensitive heads of expense.

Valuation is a key concern

“Valuation was a topic echoed throughout the entirety of the survey by investors with particular emphasis on independent pricing,” observes the survey. “100% of respondents indicated that they will review a fund’s valuation policy and 78% stated that they will observe the valuation procedure during the on-site review.”

Out of cycle review

The occurrence of a material event could drive an investor to conduct an out of cycle review outside of routine monitoring of the manager’s operations. “The two most cited individual factors leading to an out-of-cycle review included regulatory investigations (94%) and the departure of a key person or principal (75%),” says the survey. “These two factors have consistently remained top ranked by investors over the past two years.” Other material events include, for example, NAV restatement, style drift, a change in leverage, abnormal redemptions and key service provider issues.

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