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S&P to Launch Operational Risk Ratings

Date: Wednesday, November 22, 2006
Author: Emma Trincal, Senior Financial Correspondent, Hedgeworld.com

NEW YORK (HedgeWorld.com)—As investors are giving increased attention to the issue of transparency, rating agencies are listening and slowly adopting new criteria for rating hedge fund managers.

The latest breakthrough finds Standard & Poor's rolling out a new stand-alone rating product destined to evaluate the sole operational risk of hedge funds. The product will be launched in the early part of next year, said Tanya Azarchs, managing director of S&P's financial institutions ratings, who will spearhead the project. A spokesman at the agency said that a month from now, S&P will have a better sense of the exact timing of its launch, set for the first quarter, and the number of managers it has already enrolled.

In September, S&P had already made a move in this area, announcing the enhancement of its credit ratings of hedge funds, with the inclusion of operational risk factors.

"Operational risk is a component of the credit rating. But we are now planning on putting that on a separate product in order to address the issues that are important to a broader set of investors than merely the credit counterparties," Ms. Azarchs said. S&P has been rating the creditworthiness of hedge funds since 2000.

So far, rating agencies have been offering credit rating of hedge funds based on the likelihood of defaults in order to satisfy the demand of prime brokers, lenders and the smallest of their creditors—even their landlords.

S&P's plans come on the heel of similar developments in the recent past months. In September for instance, Moody's completed its first publicly issued report on the operational risk of a hedge fund managed by Sorin Capital Management Previous HedgeWorld Story. Moody's does not rate the creditworthiness of hedge funds yet, but is in the process to do so, said Gary Witt, managing director at Moody's.

The criteria S&P will use to rate operational risk for hedge funds, Ms. Azarchs said, include asset verification, leverage, liquidity, fund administration—whether the NAV is calculated by an independent third party or not—and valuation. Back-office procedures, relationships with prime brokers and background checks on the managers will be also part of the methodology.

The demand for ratings focused on the operational risk of hedge funds come from both managers and investors, Ms. Azarchs said. "Investors want a second opinion or a more in-depth due diligence analysis than what they may have been able to do," she said. "And fund managers want it because they spend an awful lot of time with a wide variety of investors going over due diligence issues over and over again. It's very convenient and time-efficient to have it done by an independent party."

The investors seeking operational risk ratings will include the smaller ones that do not have the staff to conduct an adequate due diligence, Ms. Azarchs said. "But even the larger investors would prefer not to have that large staff if they could be more efficient. At the very best, they want to have a second opinion to their own."

As is the case with credit ratings released for corporate debt issuers, the development of hedge fund ratings may pose an eventual conflict of interest. Hedge funds, just like debt issuers, will be the ones paying the agencies for a report issued on their own business. But Ms. Azarchs said that such potential conflict will subside once performing hedge fund ratings will become a more common market practice, which is what happened in the credit market.

"Investors may say: ‘I am not going to invest in this hedge fund unless I have a rating,'" Ms. Azarchs said. And as a result, hedge funds will have no other choice than to participate in these ratings. Such evolution would be lucrative for rating agencies and is sure to make the hedge fund market a bit more transparent. At least, that is what S&P and its competitors are betting on.