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Institutional investors outline operational wish list for hedge funds in AIMA guide

Date: Wednesday, June 1, 2011
Author: Martin Leonard, COO Connect

Corporate governance featured highly in an institutional investor guide laying out terms for the allocation of capital to hedge funds.

The guide, which was published by the hedge fund industry body, the Alternative Investment Management Association (AIMA), is designed to outline investor views, expectations and preferences on a variety of operational and organisational issues that are increasingly the focus of due diligence reviews.

Luke Dixon, portfolio manager for absolute return strategies at the Universities Superannuation Scheme (USS) wrote: “Presently, the standard of governance among hedge funds varies and this can expose investors to significant risks.”

Dixon highlighted that investors should be given the option to subscribe for voting shares in a fund, whereby they would be entitled to vote on material events or changes in the fund. “These might include the appointment and removal of the investment manager, the election of directors; approval of directors’ fees; variation of shareholder rights; or a winding up of the fund at annual or extraordinary general meetings,” he wrote.

A number of hedge fund directors did not fare particularly well during 2008. Industry experts complained that numerous directors, particularly in offshore jurisdictions, sat on far too many funds’ boards. This has prompted investors to call for limits to the number of boards directors can sit on – even if this means paying them more money. Directors’ links to service providers and fund managers has also frustrated investors with many calling for greater independence between the parties. Dixon wrote the financial crisis uncovered “poor governance practices among many hedge funds, which for example, used force majeure considerations to impose unjustified limits on investor redemptions. In some cases, those redemption requests have yet to be honoured and filled, more than two years after the crisis abated.”

“Other examples include failures by directors to review and appropriately approve non-arm’s length dealing between a fund and its investment manager or sponsoring bank. This sometimes permitted the investment manager to engage in activity that served its interests above those of the fund’s investors. This has led to the conclusion that the standard of governance of hedge funds should be improved,” he added.

The use of expert networks was also touched upon in the report. Expert networks are firms that match industry specialists including those working in public companies with fund managers in exchange for a fee. This enables managers to gain getting cutting edge information about particular sectors. However, the US Securities and Exchange Commission (SEC) suspect some of these firms may have been providing material, non public information to hedge funds. San Francisco-based Primary Global Research is one such firm facing the SEC’s wrath. Several of its consultants, who were also employed by technology companies, are accused of supplying material, non-public information regarding those companies to hedge funds and other investment professionals.

“Where a manager uses expert networks, every relationship should be pre-cleared with the compliance department, who should perform due diligence on either the individuals or the firm,” wrote Adrian Sales, head of operational due diligence at consultancy firm Albourne. “Staff that work with such consultants should receive special training and compliance should undertake extensive surveillance - for example – looking for trading spikes, reviewing trade volume around news releases, email searches and recording of telephone calls,” he wrote.

However, others feel that despite AIMA’s good intentions, the impetus for change will mainly be driven by managers and investors. “"The AIMA guide to institutional investors’ views and preferences is another useful preliminary step on the hedge fund industry's journey to better business models that align with investors' interests for improved corporate governance, but they are only that - views and preferences,” said Rajiv Jaitly, an independent consultant and a former fund of hedge funds chief operating officer.

“The impact of good governance, risk management, operations and structures for commonality of interests - however - will only be felt if managers are prepared to act on these views and preferences. Institutional investors have a pivotal role to play in creating change around these broad areas as they have the investment size to make a real difference to a hedge fund manager's assets under management and their ability to generate fees from it. However, investors are often reluctant to question a successful hedge fund manager's operations for fear of losing capacity with them when it becomes available because they may be viewed as difficult investors and passed over, but it is essential that investors do ask the difficult questions because it protects the entire industry's reputation during times of stress and difficulty and is actually beneficial to a manager prepared to listen because it will serve to strengthen their business model by balancing the different interests,” added Jaitly.

The guide also touches upon reporting, transparency, marketing activities and risk management. The report’s authors include Kurt Silberstein of CalPERS, Michelle McGregor Smith of British Airways Pension Investment Management and Andrea Gentilini of UBP.