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S&P may form hedge fund operational risk service

Date: Wednesday, December 20, 2006
Author: Dane Hamilton, Reuters.com

NEW YORK, Dec 20 (Reuters) - Ratings firm Standard & Poor's expects to establish a service that would rate hedge funds on their operational risk early next year, moving to serve growing demand from investors in the ballooning asset class, senior executives said.

Tanya Azarchs, managing director in S&P's financial institutions unit, said the agency would provide analysis for investors that is "expected to cover all the risks of investing in a hedge fund other than investment risk."

"It is something we are seriously looking at," added Charles Davidson, an S&P director. "It's a huge opportunity and a lot of people are approaching us about it."

The possible move comes amid rising investor concern about whether hedge funds are adequately protected against failure due to business shortcomings, as opposed to investment risk. Many hedge fund managers are considered adept traders, but can fall short when running a business, experts said.

"Most hedge funds fail for operational reasons rather than for poor investment decisions," said attorney Paul Roth, partner in Schulte Roth & Zabel, a leading law firm advising hedge funds.

"Operations risk is a very real factor," Roth told an industry conference in New York last week.

The move comes amid rising concern about risk controls that apparently failed at recent hedge funds blowups including Amaranth Advisors LLC, MotherRock LP and others, which cost investors billions of dollars in total.

While both blowups could be ascribed to wrong-way trades, experts say it is plausible that better risk controls could have prevented the debacles.

"There is tremendous demand for this kind of service because you have embarrassing blow ups," said Sol Waksman, president of Barclay Trading Group, which tracks performance for some 4,500 hedge funds. "The industry doesn't need any more black eyes."

However, Waksman warned that high marks by an established rating agency is only one indicator investors should weigh when evaluating a hedge fund, as with any investment. Major rating agencies, he noted, "were completely blindsided by the failure of Enron and others."

An S&P move into the space would follow other services, such as rival Moody's Corp. (MCO.N: Quote,Profile , Research), in expanding beyond traditional credit rating services. And London-based Amber Partners specializes in evaluating hedge fund operational risk, while Morningstar Inc. (MORN.OQ: Quote,Profile , Research), best known for tracking mutual funds, is expanding its hedge fund research operations.

S&P currently rates counterparty default risk for hedge funds, as it does with public and private companies, but not for operational risk. And the firm recently rated Citadel Investment Corp.'s recent $2 billion debt offering.

Azarcks said S&P would evaluate hedge funds' due diligence procedures, back office operations, risk management procedures, liquidity and leverage and give ratings for each fund.

"It's a fairly broad range of types of considerations," said Azarcks. "Investors are expected to make up their own mind about investments a firm may hold."