Hedge funds-of-funds need to pay more attention to the business
models, policies, and valuation practices of the underlying hedge
fund managers in their portfolios. In many cases this means hiring
additional staffers with auditing or business analyst backgrounds to
delve deeper into the health of managers in which they invest
assets.
The
topic grabbed the focus of several speakers at the
Financial Research Associates
(FRA) “Hedge Fund Regulation and Compliance” conference held earlier
this week in New York. They focused on how it could underpin a new
Securities and Exchange
Commission rule applying to funds-of-funds. It also
has surfaced in personnel moves, such as the fund-of-funds
Lighthouse Partners
hiring an analyst dedicated to operational due diligence, and other
firms recruiting for individuals who combine that role with other
duties.
The
SEC weighed in on the issue in the
staff report on hedge funds
issued last fall. In tandem with its centerpiece recommendation to
require hedge fund managers to register as investment advisers, the
staff also issued a call for the commission to require the boards of
funds-of-funds to adopt procedures that ensure the underlying
managers value their assets in accordance with federal securities
law.
The
SEC staff’s recommendation sounds a wakeup call for funds-of-funds,
warns Michael Caccese, a partner at the New York law firm of
Kirkpatrick & Lockhart,
who spoke at the conference and in an interview. “The SEC is very
much emphasizing, even if you’re in a fund-of-funds, that you as the
manager can’t necessarily rely on the net asset value that the
underlying fund gives you,” he says.
That
should trigger not just a review of pricing procedures, but also an
operational review, he adds. “The SEC focuses on this,” Caccese
says. “They’re totally paranoid about this.”
While the SEC recommendation for funds-of-funds has not gotten much
publicity, it could have a significant impact on how they operate,
says Anthony Artabane, partner at
PricewaterhouseCoopers.
He also spoke at the FRA conference and in a later interview.
Artabane says current practice is “uneven in terms of application”
in the funds-of-funds marketplace, especially among firms not
registered with the SEC. “There is a wide dispersion in terms of how
rigorous the operational due diligence function is at these shops,”
he says.
One
reason for the varying practices, Artabane says, is that there are
currently no requirements for funds-of-funds to analyze the business
practices of the funds in which they invest. It remains unclear, he
adds, whether the SEC’s much-awaited proposal on hedge fund
regulation will include the funds-of-funds recommendation – and how
far it would go. “The question becomes one of how fair it is to hold
the fund-of-funds sponsor accountable for the very detailed pricing
of the underlying funds,” Artabane says. “What’s a sufficient level
of awareness of the policies?”
No
matter what the level of review is, most funds-of-funds planning to
buttress this function will need to hire staff. “This will require
more infrastructure,” says Caccese.
Several searches for such positions have popped up within the last
year, says Tom Kellerhals, senior partner at the
Westminster Group,
a recruiting firm in Chester, S.C. He attributes the moves to
broader focus on business best practices by funds-of-funds, rather
than SEC scrutiny per se. While he says such due diligence was
always done to some degree, "it's starting to show up on everybody’s
checklist."
“We’re in an environment where we look for everything that could go
wrong,” he says. “People now understand there are all sorts of ways
to provide a negative surprise. It makes sense in any due diligence
process to look at the nature of the principals, to look at how the
principals manage or don’t manage their business, to business
continuity issues, who’s watching the store, how the store is being
watched."
Kellerhals cites three models he has come across to date, and a
fourth that he expects will also take hold. The first three all
combine the operational due diligence duties with other positions in
a fund-of-funds. One is a high-level role, with the CFO of a firm
taking on the responsibility of conducting operational due diligence
on the underlying managers. The second is having someone in the role
of risk manager take on this business analysis role. The third is
having an analyst charged with performance-based manager selection –
focused on qualitative and quantitative analyses – also conduct the
business analysis.
Kellerhals says he has filled the first two kinds, and is working on
the third. In all cases, people with auditing or CPA backgrounds
offer a good fit for the roles, but Kellerhals says the searches are
typically trickier, since the firms are seeking specialized
backgrounds that can be in short supply. “There is not a lot of
supply when you say, ‘Find me a chief financial officer whose
additional duty will be to do business accounting operational due
diligence on managers that we have screened and have passed our
quantitative and qualitative requirements,’” he says.
The
fourth model, Kellerhals says, would be a staffer dedicated solely
to operational due diligence. He has not come across this assignment
yet, he adds. But that is precisely the role that Lighthouse
Partners filled recently, as reported in FundFire. The hedge
fund-of-funds based in Palm Beach Gardens, Fla., has brought on a
new analyst in its New York office to concentrate on digging into
manager business models, including their front and back office
relationships, third party providers, and accounting processes. The
firm has pegged its effort to support its manager selection with
operational due diligence as unique in the marketplace.
Among the issues that funds-of-funds can scout for, says Artabane,
are whether the underlying firm has processes and procedures in
place for proper valuation, appropriate documentation of those
policies, and adequate disclosure of that information to investors.
Other checkpoints are having strong models, third-party
verification, board-level review, and the ability to flag and
analyze changes to the models and procedures.
