Alternative Investment Management Association
Brian X. Hurley
Horizon Cash Management, LLC
When it comes to the business of running a hedge fund, sound practices do matter and are being broadly implemented by fund managers across a wide variety of investment and operational realms. These findings emerge from a recent survey of alternative investment professionals, conducted by Horizon Cash Management.
This survey, conducted online via an independent market research firm, The Guild Group (an Austin, TX-based company that specialises in online surveys), was fielded in April/May, 2006. Invitations to participate in this survey were sent to more than 2000 industry professionals – screened to ensure that only the senior-most executives charged with the management of their respective hedge funds took part. With a response rate of 10%, the survey reflects the viewpoints of more than 800 hedge funds worldwide.
To ensure that the research touched upon all aspects of best practices, Horizon invited a host of firms that serve the alternative investment industry – among them: AIMA, the Managed Funds Association, Custom House, DPM Mellon, FIMAT, IMS Consulting and Walek & Associates – to submit questions that focused on areas particular to each. Responses were then gathered and organised under such topics as:
• management structure and fees
• investment process, transactional practices and operations
• valuation policies and procedures
• risk management
• regulation, compliance and due diligence
• marketing and sales
Respondent universe: broad and balanced
While 57% of the respondents have funds based in the US, the survey sample includes strong representation from the UK (16%), Asia (13%) and Europe (11%). The sample also reflects an extraordinary balance in fund size, with funds under $50 million, $51 to 200 million, $201 million to $1 billion and $1 billion or more evenly represented.
Survey respondents also demonstrate excellent longevity, with nearly three-quarters (71%) in business three to 10 years, and half of these (35%) having existed six or more years. Given the extraordinary growth of the industry in this period (since 2000, the number of hedge funds has doubled and the assets under management have trebled), this affirms the managerial and leadership virtues of the respondent group.
With a comprehensive analysis of the data to be performed later this summer, here are some early findings from this research.
While the alternative investment business is hardly a ‘cottage industry’, hedge funds still tend to be small enterprises (57% of respondents indicated they had 10 or fewer employees) with a single individual – most often, the firm’s founder – in control. It was somewhat surprising, then, to learn that 36% of respondents report not having a succession management plan in place. While not terrific, this figure is exactly the same as found in Fortune 1000 companies, as reported by SHRM (Society for Human Resource Management) in an analysis performed a few years ago.
Drawing upon third-party resources
No longer intent upon ‘going it alone’, nearly 85% of respondents indicate that they employ an independent third-party administrator for a host of ‘mission-critical’ tasks. The reliance that fund managers place upon these third-party administrators is manifested in a variety of ways. Not only do 79% of respondents state that the fund administrator is responsible for portfolio valuation, but a virtually identical number (78%) report that they have no internal valuation committee. This task is entrusted totally to the fund administrator. Additionally, nearly three-quarters of respondents (72%) report that their fund’s pricing and valuation policy is reviewed by an external/independent auditor (with 85% of these reviews performed annually and the remainder every six months).
Interestingly, nearly 35% of managers never review the quality of their external price sources, placing confidence instead upon the audit. As Martin Kelly of IMS Consulting observes: “Investors may be surprised to learn that a significant number of managers do not evaluate the quality of the price sources going into the valuation.”
Compliance remains chiefly an internal function, with only a third of the survey’s sample indicating that it outsources the compliance process.
Business management studies over the years have shown that between 65% and 75% of all managers will face major ethical dilemmas (e.g. situations in which knowing what the ‘right thing’ to do may not be clear or certain) in the course of their careers. An important indicator of the alternative investment industry’s maturation and development is its embrace of formalised expressions of ethical behavior. Our survey reveals that 84% of respondent firms have a written Code of Ethics and/or Code of Conduct. A like-minded number (85%) maintain a Policies and Procedures Manual. Importantly, rather than existing merely as an internal document, each is highly likely to be shared with investors.
While it’s a truism that ‘good ethics is good business’, the survey provided significant evidence that investors have enormous influence in helping hedge fund firms shape their ‘best practices’. Eighty percent of respondents stated that their investors believe it to be ‘important or very important’ that the firm’s operational controls be sound and effective; 75% reported that investors placed the same high values (‘important or very important’) on regulatory controls being sound and effective.
Respondents to this survey were twice as likely to be Registered Investment Advisers (69%) as not (31%). Notably, of those who are not yet registered, 75% plan on doing so. (It should be pointed out that fieldwork for this survey was completed on May 20 2006, one month prior to the US Circuit Court of Appeals’ decision to vacate the Securities and Exchange Commission petition requiring hedge funds to register.)
At this writing, it’s uncertain what the SEC’s next steps will be in its re-evaluation of the proposed hedge fund registration petition. What is revealed in our research, however, is that for those whose funds fell under the SEC registration requirements prior to the Circuit Court’s decision, the process of registering was not particularly onerous. Thirty five percent reported that the burden associated with registration was non-existent or slight; another 35% indicated that the burden was moderate. Only a quarter (24%) of our respondent base suggested that the registration process was truly burdensome. When probed, respondents stated that the two areas most profoundly affected by the challenges of the registration process were personnel and time. Financial considerations (i.e. legal fees, etc.) were a distant third.
Side letters, which are used by some hedge fund managers to provide certain investors with terms that differ from the fund’s standard offering documents, have engendered quite a bit of discussion and controversy. Our survey respondents are fairly evenly divided on their use of side letters: 40% do, 43% don’t. Remarkably, 13% of our respondent universe claimed not to know whether their firm employs side letters. Of those who use side letters, more than half (53%) cite ‘fee concessions’ as the number-one reason. The next most-stated reasons for side letter use: transparency (44%) and relaxation of liquidity constraints (35%).
Among surveyed respondents who offer side letters, communication of this fact is narrowly targeted. Nearly two-thirds (63%) don’t disclose to all investors, choosing instead to communicate this fact only to those who benefit from the terms of the side letter. Among those who disclose the use of side letters to their entire investor universe, this is more than twice as likely to be done via a dedicated letter or special report (54%) than through the offering document (23%).
The Financial Services Authority of the United Kingdom (FSA) recently declared side letters to be the subject of regulatory focus, stating that it expects managers to ensure that “all investors understand that a side letter has been granted and that conflicts may arise”.
From our early examination of these topline findings, we conclude that:
• Best practices do matter within the hedge fund universe. The reported levels of activity and compliance, coupled with the thoughtfulness and care respondents devoted to answering this 100-question survey, suggests keen and active interest in the subject.
• Fund managers’ efforts to implement ‘sound practices’ are not limited to a particular discipline. Rather, we observe initiatives to do ‘right things right’ across a broad array of operational and investment areas.
• While significant progress has been made to develop and implement ‘sound practices’ throughout the alternative investment industry, opportunities abound for continued progress. Practitioners need be reminded that this effort is a journey rather than a destination.
As previously noted, this article discusses several preliminary findings from our survey. A comprehensive analysis of the raw data is yet to be performed, with results to be available in the 4th Quarter in an Executive Summary. If interested in this, we invite you to send an email to email@example.com.