PRISM INSIGHTS 2018 PRISM INSIGHTS A semi-monthly hedge fund and private equity fund operational due diligence publication. A hedge fund and private equity fund operational due diligence publication. www.prismalternatives.com
TABLE OF CONTENTS 1. 2018 OPERATIONAL DUE DILIGENCE ( ODD ) OUTLOOK 2. EXPENSE ALLOCATIONS 3. BEST PRACTICES FOR LARGE MANAGERS
2018 OUTLOOK OPERATIONAL DUE DILIGENCE ( ODD ) OUTLOOK 2018 starts off strong with a continuing focus on honing the science of operational due diligence. Institutional investors and fiduciaries continue to outsource ODD or build out their ODD teams, to develop a tighter approach to completing diligence on hedge fund and private equity fund managers. Surprisingly, even as recently as 2017, it seems that a sizeable number of asset managers and allocators were conducting their ODD in-house using accounting, compliance, or investment staff, without the use of ODD specialists, but as businesses grow with the help of tax breaks and a booming stock market, these gaps will continue to close in 2018. Moreover, this specialist field of diligence has proven its merit over the years. The question remains, however, when or will the US move to a fund pay model? FUND PAY MODEL VERSUS INVESTOR PAY MODEL WHY HASN T THIS HAPPENED YET? Around the world, ODD is paid for and mandated by the institutional investor, and not the fund, like the case is for GAAP audits. Why would this be, when this creates a significant cost burden for the manager and for the investors? Why should each pension, endowment, wealth management platform, or FOF have different levels of ODD information, expertise, and take on different levels of fraud risk and operational costs? The answer seems to be three fold: a) FOFs continue to market their ODD as one of their edges, b) converting from an investor pay model to a manager pay model would theoretically put many internal ODD analysts out of work, c) and lastly the managers do not want to put all of their eggs in one basket betting their business on the operational risk assessment generated by one firm. So, today managers sometimes host hundreds of ODD meetings a year, and investors do varying levels of ODD work, resulting in tens of millions of dollars in duplicative costs. Some spending 100 hours on ODD using non experts, and some spending 30 hours a year using ODD specialists. Simply put, it is not an efficient frontier. Australia is one of the first countries to make the move and treat each investor equally by recently putting out regulatory guidelines recommending that managers/funds obtain a periodic ODD opinion from a reputable ODD firm. The process is in motion, but not yet fully up and running. When or will the rest of the world follow? TRENDING OPERATIONAL AREAS Current operational areas being studied by practitioners and regulators are expense allocations, HR and corporate culture, cyber security, and interaction with management and consultants as it relates to exposure to MNPI (material non public information). Specifically on expense allocations: are expenses charged to the fund actually explicitly permitted on the OM, are they accurately allocated to the proper funds (e.g. how are SMAs handled), and does the administrator review these calculations? Specifically on HR and corporate culture: how is hiring and code of ethics training handled, are background checks done annually or at all, have there been any employee HR claims? On cyber security, has there actually been a professional diagnostic performed on the firm, and what types of formal ongoing monitoring and testing is performed? For MNPI, the use of consultants and expert networks continues to be monitored, and controls around these processes are critical to a successful ODD assessment. Access to company management and long term relationships with company management also increases awareness especially with sector focused funds.
EXPENSE ALLOCATIONS Hedge fund expense allocations is a topic that has received more attention, and maybe even pressure over the past couple of years due to the SEC s attention to the matter. PRISM too has placed higher attention to the dollars spent by each fund under review, in order to better understand the financials of the fund and the financial budget and approach of the investment manager. Many investors and managers alike still focus on expense ratios, which average around 35 BPS for a long shore equity fund or a bit higher for credit funds due to deal associated legal fees, but PRISM believes it is important to go a few steps deeper into the analysis. For example, what are the fees paid to each vendor, and can we gain comfort that the manager is negotiating market rates, or further is there any operational reason why a fund is paying much higher or much lower fees to a vendor than industry average. Another important area where PRISM seems to find omissions or violations is in the disclosure in the OM on what the fund can pay for. From time to time, PRISM finds that managers may be charging through insurance or software without explicitly disclosing these charges in the offering memorandum. Industry leaders say that investors and regulators could raise issue with the lack of disclosure, or if they find other flags in the infrastructure may find issue with the lack of explicit disclosure (e.g. research travel should state business class or private airfare, if economy airfare is not being used). Investors should also list out in their minds what the OM allows the fund to pay for, and look for unusual language that may, for example, signal the use of unregulated activity. Most managers are meticulous about their costs, but the responsibility of the investor and its diligence efforts is to clearly understand the financials and operations of the fund, and to do this, granular work needs to be done to meet today s regulatory and market expectations. Last, but not least, who is calculating the expense allocations, and who is checking the allocations? Many fund costs are spread across all of the managers clients, and as such the costs for software or market data need to be allocated pro rata across funds based on current AUM, like trade allocations. Further, when a manager has managed accounts where operational charges are not shared with SMA, does the manager cover those costs, or did they exclude the SMA from the expense allocation calculation?
BEST PRACTICES FOR LARGE MANAGERS The bar for hedge fund operational best practices changes often, but here are a few best practices seen globally for large >$10 billion private fund managers. The idea with best practices is to retain and build AUM through accessing institutional capital that has set a high bar for hedge fund operational risk. Staffing and Organization Commercial hiring practices with a focus on experience, education, and merit Institutional level staffing including a full management team across verticals Use of committees (i.e. management, compliance, risk, valuation, etc.) Initial and then annual ongoing staff background checks Transparent staff biographies ie names and dates of education and employment Ongoing firm culture, technical, and ethics training Operations Written operations manuals across middle and back office Industry leading systems in-house around risk, data, trade order management, investment compliance, fund accounting, general ledger, client management Use of automation in trade flow, operations, and accounting Daily cash, trade, and position reconciliations conducted in-house Daily cash, trade, and position reconciliations conducted by the fund administrator Use of vendors for level 2 assets (instead of manually collecting broker quotes) Use of third party valuation agents for level 3 assets (at least semi-annually) Full service daily oversight from a qualified fund administrator Accounting Qualified CFO and Controller in-house with investment management experience In-house portfolio accounting system and shareholder allocation records Monthly NAV issued by BD 10-15 Monthly audits and K1s issued by March 31 Cash Treasury Existence of a separate segregated treasury team Dual signatures and authorizations required on all fund accounts Formalized processes around vendor approval Formalized multi level review process around expense allocations Fund expenses processed independently by the fund administrator Adequate portfolio risk systems to re-calculate collateral calls Regulatory Up to date registrations Current compliance manual updated at least annually Clean regulatory history (no violations for staff or firm) Qualified chief compliance officer on staff who is also independent of the front office Regulatory consultant on retainer continuously advising managers on regulatory matters Clean regulatory exams (reasonable or no findings in SEC exams) Limited or prohibited personal trading in individual securities Legal Clean legal history (no corporate or staff litigation) Existence of E&O and D&O insurance Experienced in-house and external legal counsel Corporate Governance Quarterly fund board meetings with a majority independent experienced directors Offering memorandums reviewed and updated at least annually Investor Relations Existence of qualified IR or marketing staff to be available to answer investor questions Up to date marketing material and DDQ/FAQs (updated at least quarterly) Licensed marketing personnel