Moody's Rates Hedge Funds

Date: Tuesday, September 5, 2006
Author: HFN Daily Report

Rating company Moody's Investors Service has begun evaluating and assigning operations quality ratings to hedge funds.

According to Moody's, hedge fund portfolios often lack transparency and are difficult to value. Also, since fund managers are often focused on portfolio management rather than on the details of day to day administration, investors are rightly concerned about operational risk.

To help give investors an independent third-party assessment, Moody's has assembled a team headed by managing director Gary Witt. A statistician by training, Witt also spent a decade trading derivatives at Citibank, General Re and Sakura Global Capital before joining Moody's in 2000.

Witt says the idea for having an operations risk-focused rating came from investors wanting to have a meaningful tool when evaluating funds.

"I spent a few months talking to investors, trying to figure out what would be a good product to offer," Witt says.

The Moody's team has come up with a monitored operations quality (OQ) ratings system that looks at operations but not market risk. The ratings range from OQ1, Excellent, to OQ5, Poor.

The highest rating, OQ1, is for funds with a very strong valuation process tailored to their investment strategies. They must have policies and procedures that are extensively documented, precisely executed and strongly enforced. All key service providers must be independent and highly proficient and well-qualified. Compliance risk for these funds is minimal, and background checks must have revealed no unresolved issues of concern.

For funds with the lowest rating, OQ5, there may be an inadequate valuation process and some key service providers could be of low quality or dependent on the fund. Compliance risk might be high and risk reporting could be lacking or absent. Background checks could also have revealed issues of concern.

Where appropriate, Moody's may also add a plus or a minus modifier if a fund ranks in the higher or lower end of a designated category.

Moody's does not plan to issue unsolicited OQ ratings. If a fund manager makes a specific request for a rating, the Moody's team will request documentation and general information. This will include the investment management agreement, offering memorandum, subscription and redemption documents, internal control procedures, previous audit reports and other documents.

The ratings team will then discuss various issues with fund personnel before conducting an on-site visit. When necessary, the team will ask the manager for direct contact with third party service providers. Interviews with less known providers will naturally be more extensive than those with well known firms.

New York-based Sorin Capital Management was the first hedge fund firm to acquire a rating by Moody's. The fixed income relative value manager currently has about $335 million in assets under management. Moody's ranked Sorin OQ1-.

"In the rating that have just finished, we went to the administrator's offices, met with them, talked with them in detail about their business in general and about it specifically relative to this one fund," says Witt. "We talked to the auditor over the phone and we got a lot of background information about the auditor. The prime broker was somebody extremely well known to us."

As with other Moody's ratings, the team discusses a fund and then votes on a rating recommendation. The operations quality rating is then posted on the alternative investments area of Moody's Web site along with a report describing the firm's rationale for the rating.

People wanting to view the ratings have to demonstrate they are accredited investors. Then, with a user name and password, investors have access to ratings and rating reports at no charge.

The rating process will not end there, however. Moody's will continue to monitor the fund's processes and update ratings on at least an annual basis. Ratings will be updated more frequently if necessitated by fund-related events such as a change in auditor or administrator or the loss of a key person at the fund.

"The goal is to have annual reviews on site for each fund," says Witt. "They won't be as extensive as the initial rating." Witt says the amount of time the team spends will depend upon what has happened at the fund since the last visit and what new issues the team uncovers.

According to Witt, Moody's decided against rating market risk due to the special difficulties of measuring market risk in hedge funds. For one thing, hedge fund managers are notoriously proprietary and not excited about revealing the details of their positions to outsiders. Also, those positions change rapidly, and funds do not want firm restrictions on the risks they are allowed to take. While Witt says Moody's might consider rating market risk in the future, the firm is focused strictly on operational risk for now.

Witt says Moody's will likely tend to specialize in fixed-income funds to some extent, at least at the beginning, both because these funds are already familiar with Moody's and because there are more concerns about operations risk in fixed-income funds.