In this article, originally published in HFMWeek on 15 October 2015, Daniel Harris discusses how hedge fund mangers should proceed with caution in relation to Responsible Investing.
Responsible Investing (RI), that staple of relative-return portfolios, private equity funds and traditional asset owners, is increasingly a feature in absolute-return portfolios. RI is a little unsure of its relatively new surroundings and, although it may sound heretical, hedge fund managers should feel equally apprehensive about RI.
Investors may attach RI conditions to capital allocations to hedge fund managers, but equally it might be investment managers who voluntarily adopt RI policies. We ought to keep one eye on legislative and regulatory trends as a potential third dynamic. With UK pension funds – who are often hedge fund investors – we have already seen that the UK government is keen to encourage investments to be made on the basis of both financial and social returns. The Cayman Islands - host to a multitude of hedge funds - has consulted on the idea of imposing positive obligations on directors of companies to consider human rights, employee, social, and environmental matters in the exercise of their duties.
Vague and ill-defined notions of environmental, governance and social factors at the core of the RI movement have borne a broad range of interpretations of ESG criteria ranging from the adoption of general guidelines (such as the six principles of the UN PRI) to specific exclusion lists. At the very edge of the mean-variance range, certain investors prohibit any investment in companies associated with a particular country, a broad-brush approach which dismisses the possibility of any corporate engagement or other qualitative evaluation on a stock-by-stock basis. There may be issues for hedge fund managers blindly adopting a policy with a distinctly discriminatory and political flavour.
On a practical level, the investment manager will also need to consider whether the requested RI criteria are capable of practical implementation. The investment manager’s modus operandi will be relevant here. An activist strategy or bottom-up investment process will clearly be more suited to a policy that requires active corporate engagement than, say, a systematic or algorithmic strategy, and a vice-versa when it comes to negative screening. Will it be cost-effective to implement the policy, e.g. additional research costs and additional administration costs?
Even if the policy is capable of practical implementation, the investment manager needs to consider whether adoption of the RI policy could adversely impact on its ability to execute the fund’s investment and risk management strategies, such as preventing the fund from exploiting arbitrage opportunities or hedging.
The hedge fund and its investment manager will need to negotiate a way through a labyrinth of legal issues when acceding to an investor’s RI demands in a side letter. We all know where the devil is. Is the investor insisting that the fund adopt specific RI criteria, or does the investor simply want to avoid participation in the P&L of positions of the hedge fund that do not comply with the investor’s specified RI criteria? This difference in drafting can potentially alter the legal analysis and present different implementation issues. For example, where the investor seeks to impose the RI policy on the fund generally, the fund will need to consider whether the changes are material enough to update the offering documents and/or offer investors a redemption right.
Where the deal struck with a particular investor includes, for example, portfolio transparency to enable the investor to verify compliance and adherence, the fund will need to consider whether this constitutes a variation of rights attaching to a class of shares requiring the consent of other class members, which may not be feasible. Where the investment manager is FCA-regulated, it will need to consider whether it is obliged, as a matter of industry best practice, to disclose the existence of such a side letter.
Where the net asset value of the investor’s investment is adjusted to exclude the P&L from non-compliant investments, often through a special class of shares, the fund will also need to ensure that the fund administrator can perform this adjustment by being able to identify when a position is non-compliant. Such a service is likely to come at any additional cost. An investor could of course simply have its own managed account, but this is not always a cost-effective option.
When it comes to implementing the plainly discriminatory policies of an investor, as discussed above, any FCA-regulated investment manager should weigh up whether that runs counter to any of its regulatory obligations, such as the obligation to conduct its business with integrity. Further, the fund and the investment manager need to satisfy themselves that they are not directly, or indirectly by implementing the investor’s policy, breaching applicable U.S. or other anti-boycott legislation.
Documenting the mandate should not be undertaken lightly but should be treated as an opportunity to simplify the labyrinth of potential issues, including (1) detailing the RI criteria and the associated methodologies and processes for implementation; (2) where there is ambiguity in (1), in whose favour it is resolved; (3) clarification that the investment manager is not obliged to seek advance consent from the investor for borderline trades; (4) the timing discretion afforded to the investment manager before liquidating a non-compliant position; (5) whether certain instruments are compliant or not, such as reverse repos and pre-borrows (the hedge fund acquires ownership of securities, but there is no intention to enjoy the economic benefit of ownership) or swaps (where the fund acquires the economics but not the rights attaching to the underlying shares); (6) how conflicting RI policies of two different investors are resolved; (7) the status of non-compliant positions existing in the fund’s portfolio before the investor invests; (8) whether a de minimis amount of non-compliant positions are permitted (and how this is calculated, e.g. based on the fund’s equity in the positions or the gross size including leverage); (9) absolving the investment manager where the status of a position changes from complaint to non-compliant; (10) what happens if a non-compliant positon cannot be immediately unwound , e.g. because of a disrupted market; (11) whether an index trade is treated non-compliant if a component in non-compliant; (12) whether a non-compliant position which is a hedge or part of a paired arbitrage trade is permitted; and (13) the status of profits from non-compliant positions.
The investment manager’s relationship with the fund or the investor, where it contracts with the investor direct, is also fiduciary in nature. A fiduciary must not place itself in a position where its interest conflicts with its duty; and a fiduciary must not make a personal profit out of its position without its principal’s knowledge and consent. The PRI Association has recently published a commentary to make the case that fiduciary duties and responsible investment can be reconciled. However, reckless is the investment manager who takes this is a green light without considering its duties on a case-by-case basis.
Woe betide the investment manager who does not tread carefully here.