The Asset Managers’ Committee (AMC) and the Investors’ Committee (IC), two private-sector organizations formed by the President’s Working Group on Financial Markets (PWG), recently released final reports on best practices for hedge fund managers and investors.1 The goal of the reports is to “reduce systemic risk and foster investor protection through enhanced market discipline.” Additionally, the reports focus on transparency in the industry and accountability for fund managers.
The current economic crisis and stress of the financial services sector underscores the need for alternative investment managers and investors to implement strong practices to manage their businesses and investment decisions. This need is amplified by the significant growth of the hedge fund industry and the systemic concerns funds pose on the financial systems in general. By implementing these best practices reports, the industry is attempting to implement a self-regulatory structure in the face of increased scrutiny by legislators.
Notably, this is the first time managers and investors have worked together to formulate best practices, and both committees stress that the reports should be read together to create better managed funds and better educated investors. Managers are encouraged to use the IC report as a guideline for interacting with investors, and investors are urged to use the AMC report to help conduct their due diligence.
Overall, the reports are designed to be flexible and emphasize that practices should vary depending on the nature of the fund and the interests of the investor. This advisory outlines some of the key recommendations in both reports and discusses implementation concerns.
What Are the Key Recommendations of the AMC’s Report?
The AMC’s recommendations are divided into five topics: (i) disclosure, (ii) valuation, (iii) risk management, (iv) trading and business operations and (v) compliance, conflicts and business practices. The report establishes a framework under each topic and then specifies best practices to help implement the framework.
The disclosure framework is designed to disclose the material information necessary for investors to make, monitor and redeem their investments. The report calls for comprehensive disclosure of all material information in the fund’s Private Placement Memorandum (PPM), including the fund’s legal structure, investment philosophy, investment strategies, products, significant risks, valuation framework, use of side pockets, redemption rights, fees and compensation structure, potential conflicts of interest and biographies of managers and key employees. The PPM should be updated at least annually, or more frequently in the event of a material change. The report also recommends providing investors with monthly performance updates that include quantitative information such as audited financial statements and investor-level net asset values (NAVs). These performance updates should also include a qualitative discussion to supplement the raw numbers. Similarly, managers should provide monthly risk reports covering the asset types held, the leverage employed, the concentration of large positions and any material changes in asset allocation. Furthermore, it is recommended that managers inform investors on a regular and ongoing basis of any material developments such as significant shifts in investment strategy, change in key personnel and changes in the market. This may require immediate “specific event reporting,” particularly when there are changes to the fund’s valuation policies, key investment personnel or the discovery of fraud or wrongdoing by any employee of the manager. Notably, the report recommends that much of this information also be disclosed to counterparties such as banks and broker-dealers, which would allow both sides to better understand their credit exposures.
Managers are urged to establish clear, consistent valuations of all investment positions in the fund’s portfolio, while minimizing potential conflicts. Funds should create a Valuation Committee (VC) that includes key members of the fund’s senior management to oversee the valuation policies and to ensure that appropriate valuation methodologies are followed. The fund manager may participate on the VC; however, the committee should be independent because of the conflict of interest that arises from the correlation between a fund’s valuations and the manager’s compensation. The fund’s written valuation policy should include the participants in the valuation process, the valuation methods employed for different investments, the selected pricing sources, the valuation of assets in side pockets, the procedures for valuing hard-to-value assets and the procedures for mitigating potential conflicts in the valuation process. The report also recommends that the valuation policy for each asset be established contemporaneously with the acquisition of the asset, and that the selected valuation methods be reviewed on at least a semi-annual basis to address the fairness of the valuation policies and the need for any changes in selected methods. This periodic review should also include back-testing a sample of valuations against recent sale prices of investment positions to ensure the policy is working properly, and include stress testing.
Managers should adopt comprehensive, integrated policies and procedures to measure, monitor and manage risk. The report recommends that a Chief Risk Officer determine the fund’s risk profile, implement procedures to manage the identified risk categories, provide investors with ongoing disclosure regarding the fund’s risk profile and frequently distribute risk reports to senior management. Risk monitoring and management should not be outsourced, and the fund must maintain knowledgeable personnel capable of supervising the analysis, measurement and monitoring of risk.
The report makes specific recommendations for monitoring risk in each of the designated risk categories:
- Liquidity: Funds should monitor changes in market liquidity conditions (including trading volume, bid-ask size and spread), monitor the terms of their credit and lending agreements (particularly in relation to variations in margin calls or any adverse developments with respect to counterparties), review the amount of investor capital that is subject to redemption right agreements and review agreements involving shortterm cash-like instruments for any potential illiquidity and unexpected delays in satisfying redemptions. Additionally, managers should consider conducting regular liquidity stress scenario analyses to better understand the ability to meet obligations.
- Leverage: The report recommends taking into account factors such as the asset types, the overall liquidity profile of the fund, the volatility and crowdedness/concentration of trading strategies and the terms (including concentration, diversification and liquidity limits) on which prime brokers, lenders and other trading counterparties provide leverage.
- Market: Managers should, depending on their portfolio positions, monitor their exposure to equity indices, interest rates, credit spreads, foreign exchange rates and commodities prices, and managers should conduct stress tests, scenario analyses and forward-looking measures to assess the vulnerability of a portfolio to these changing rates and spreads.
- Counterparty: Funds must assess their credit exposure to counterparties, including the impact of counterparty insolvency, and examine how the prime broker finances fund positions.
- Operational: A Chief Operating Officer should implement strong internal controls such as the use of a centralized position data set, the adoption of trade capture devices and the prompt reconciliation of trading information with the fund’s prime broker or settlement agent.
Trading and Business Operations
The report recommends that managers develop a comprehensive and integrated framework to manage trading and business operations and to implement this framework through a Chief Operating Officer. The framework should include policies to manage the following:
- Counterparties: In selecting counterparties, managers should consider a counterparty’s creditworthiness, reputation, experience, efficiency, financing capabilities, staffing capabilities, terms and conditions for movements of margin and cash required for transactions, and the regulatory environment in which the counterparty operates.
- Cash Management: In managing cash, margin and collateral, managers should understand and monitor credit agreements, verify marks used by the fund’s counterparties to value the fund’s positions and verify and meet margin calls in a timely manner.
- Clearing, Settling, and Wiring: These procedures may include the reconciliation of positions and cash accounts across counterparties, the segregation of duties between investment and operation personnel, the use of industry utilities and software tools to automate a manager’s OTC derivatives processes and a process for monitoring and taking timely action on options, warrants, rights, conversions and all other positions that have expiration dates. If relevant to the portfolio, managers should maintain infrastructure, personnel and processes that are broad enough and specialized enough to handle complex products such as OTC derivatives, mortgage backed securities and structured credit trading.
- Disaster Recovery: Managers should prepare for disasters and other unforeseen business disruptions by developing a comprehensive business continuity/disaster recovery plan. The plan should prioritize critical processes, and include business impact analysis, business recovery and resumption objectives, written procedures and documentation, and test plans and scenarios.
- Accounting Processes: Managers should maintain a general ledger that includes important trading related data (such as quantity, cost-basis, market value, interest and dividends, trading fees, realized and unrealized trading gains/losses) and ensures that all activities are appropriately recorded, including non-trading activities. Furthermore, in addition to annually-audited financial statements, managers should implement a month-end close process to verify material valuation adjustments and to allow for preparation of monthly investor statements that detail the investors’ current NAVs.
Compliance, Conflicts and Business Practices
Overall, the report urges that funds strive to create a “culture of compliance.” The report recommends that funds have a comprehensive compliance and business practices framework that provides guidance to managers and personnel with respect to ethical, regulatory compliance and conflict of interest situations. The framework should include the following:
- Code of Ethics: The code of ethics should address standards of integrity and professionalism, the fiduciary capacity of the manager, the protection of confidential information, personal trading by the manager’s personnel, the receipt and provision of gifts and entertainment, and an internal reporting mechanism for conduct inconsistent with the code of ethics.
- Compliance Manual: The manual should address marketing and communications, anti-money laundering, trading and business practices, and surveillance for compliance with the fund’s policies and procedures. Funds should develop procedures for sound recordkeeping including records of contracts, constituent documents, trade data, accounting records, documents relating to valuation, communications with investors and records of any meetings of the principal committees. The compliance manual should address conflicts of interest that may arise from proprietary trading, the valuation process, the allocation of costs and expenses between the manager and the fund, arrangements with affiliates and any conflicts that may arise between employees and the fund, such as personal trading and private investment activities.
- Chief Compliance Officer: A Chief Compliance Officer with sufficient knowledge and experience should be appointed to direct the compliance program. Among his or her duties, the Chief Compliance Officer should identify compliance risk, monitor compliance and review the compliance framework annually. Managers should provide the Chief Compliance Officer with adequate resources to seek outside expertise where needed, and they should direct their employees to report all compliance matters to the Chief Compliance Officer.
- Conflicts Committee: Managers should establish a conflicts committee to assess new or potential conflicts as they arise. The committee may include the Chief Compliance Officer and other members of senior management, and should meet at least annually to review the effectiveness of the manager’s conflict management process and recommend new policies, as necessary, in light of its review.
What Are the Key Recommendations of the IC’s Report?
The IC Report is divided into the Fiduciary’s Guide and the Investor’s Guide. The Fiduciary’s Guide provides best practice recommendations for assessing the suitability of hedge fund investments for fiduciaries, while the Investor’s Guide goes into more detail about due diligence, risk management, valuation and other topics that should be considered by any investor in hedge funds.
The Fiduciary’s Guide is directed at assisting fiduciaries, including plan trustees, banks, consultants and investment professionals, in determining the suitability of hedge fund investments for their institution. In assessing suitability, fiduciaries are encouraged to consider the temperament of their organization, the resources and qualifications of their staff, any assumptions concerning risks and returns, the liquidity of their investment, any potential conflicts of interest, and the fees charged by managers. Additionally, fiduciaries are urged to assess proper allocation to, and diversification among, hedge fund investments.
The Investor’s Guide
The Investor’s Guide is divided into seven topics: (i) due diligence, (ii) risk management, (iii) legal and regulatory, (iv) valuation, (v) fees and expenses, (vi) reporting and (vii) taxation. The key best practice recommendations relate to the due diligence process, risk management and valuation.
The Investor’s Guide encourages investors to utilize a due diligence questionnaire which should contain questions addressing (i) the manager’s investment process, including questions about the markets in which the manager invests, as well as questions about the instruments that the manager uses to carry out any investment themes; (ii) the historical performance of the fund and any trends or changes in performance over time; (iii) issues concerning the fund’s personnel, including those who perform both key management functions and back office functions such as accounting and cash and trade reconciliation; (iv) the risk management strategies employed by the manager, including those addressing market, liquidity, counterparty and operational risks; (v) the structure and domicile of the fund, including questions regarding limits on investor and manager liability and the tax consequences of the chosen structure and domicile, and (vi) compliance policies, including policies regarding response to compliance breaches. The guide also recommends that investors conduct due diligence in the marketplace on the reputation and experience of hedge fund managers and other key principals. Lastly, the guide encourages investors to assess the manager’s reliance on models to predict investment performance, make investment decisions or manage risks.
Both investors and managers should develop risk management programs that are appropriate to their size, complexity and structure. An investor’s risk management program should be independent of both the manager selection process and the process for monitoring performance. If investors do not believe that they have adequate knowledge or resources to administer a risk management program, they should engage outside consultants.
Specifically, investors should expect funds to employ a comprehensive risk management framework that includes an independent risk compliance function, and investors should review and understand the manager’s formal and informal risk management policies. Furthermore, investors should closely monitor leverage and should understand the manager’s plan for reducing leverage if necessary.
Lastly, investors should confirm that the manager has procedures in place to protect against fraudulent conduct. These procedures may include segregating accounting, valuation and the wiring of funds, sending net asset value statements directly to the investor from an independent administrator and having a relatively independent compliance function.
The guide strongly emphasizes the importance of valuation, noting that valuation is the key to deciding whether an investment should be made, and also what the returns on that investment should be over time. The guide recommends that investors confirm that there is a written statement of valuation policies and procedures in place. The valuation policy should be separate from the PPM or other fund documents, and should describe in detail the valuation policy for each type of security in which the fund invests. This policy should be available for all investors to review, and should be updated at least annually.
The guide also recommends that investors evaluate whether the manager is providing sufficient oversight of the valuation process, and should look for governance mechanisms, such as a Valuation Committee. Investors should check for adequate segregation of valuation duties, and confirm that the valuation duties are being performed by individuals with sufficient skill, training and independence. Investors should also make sure that fund managers use multiple sources for dealer quotes when they are available, as well as secondary sources when possible, to ensure more reasonable pricing estimates. Finally, the guide recommends that investors seek a semi-annual, independent valuation of funds that hold significant illiquid or difficult to value assets.
Other recommendations in the Investor’s Guide relate to legal and regulatory concerns, taxation, fees and expenses, and reporting. It is recommended that investors negotiate fees, ensure that fees are based on audited valuations and demand that all fee sharing arrangements be described in the fund’s offering documents. On the reporting front, it is recommended that investors confirm that the fund’s financial statements comply with accepted accounting standards and are audited by a reputable auditing firm. Lastly, investors should pay close attention to the structure of the fund, the inclusion of any lock-up periods, gates or other restrictions on redemptions, and the extent of the fund’s use of side pockets.
How Will These Reports Be Implemented?
Although created pursuant to a mandate of the PWG, these reports do not have the binding force of law, and how these best practices will be implemented or “enforced” remains to be seen.
The tone and language of the reports concede as much. Throughout the reports, the Committees “recommend,” “encourage” and “call on” market participants to adopt their proposed best practices—there are no demands or mandatory standards. Indeed, in their January 15, 2009, response letter, the AMC expressly rejected the request of one commentator to require “full adoption of a ‘comprehensive set of ethical and professional industry standards’ rather than permitting managers to ‘pick and choose among recommendations[.]’” Thus, because they are not legally binding, investors, fiduciaries and asset managers should interpret the reports as exactly what they claim to be: recommendations for best practices.
That being said, the recommendations set forth in the reports may lead to self-enforced implementation. Better educated investors will demand more in their due diligence process, and it follows that fund managers will have to provide more. Furthermore, the reports indicate that “a manager that does adopt a different practice [should] be prepared to explain its rationale to investors[.]” As such, managers may do well to consider the reports’ best practice recommendations as the possible new industry standard of care.
Ultimately, the reports offer value beyond their substantive recommendations. The new presidential administration and recently-elected Congress are widely expected to advocate new regulation of the hedge fund industry, and the reports could conceivably influence such regulation because of the stature of the PWG and their timely release.