The Pros and Cons of Managed Account Platforms

EAID 2008 Alternative Investment Conference Tuesday December 09, 4:00 pm 5:30 pm The Pros and Cons of Managed Account Platforms Jean René Giraud EDHEC Risk and Asset Management Research Center jrg@edhec-risk.com www.edhec-risk.com

Outline Overview of Hedge Fund Risk Understanding operational risks Introducing Managed Account Platforms Pros and Cons of Managed Accounts What has changed in 2008

HF operational risks Operational risks as a key risk factor Hedge fund defaults do happen at a pace than cannot be considered negligible, with 15 publicly disclosed hedge fund failures every year out of a universe comprising between 7,000 and 10,000 funds, the rate of default is far from nil. Hedge fund failures should not be mingled with hedge fund attrition as a significant number of funds cease to operate very legitimately because of inadequate performance or prospects.

HF operational risks Operational risks as a key risk factor More important is the fact that more than 60% of hedge fund failures can be directly related to operational issues that have nothing to do with the financial performances and risks of the investment. With more than two-thirds of these operational failures being directly related to different forms of fraud (misappropriation, misrepresentation, trading outside of the mandate guidelines), the risks carried by the investor affects more than the direct financial exposure only by taking a significant reputation aspect.

HF operational risks Stable levels of default risks so far The growing number of active funds is accompanied by an increasing number of defaults made publicly available. The likelihood of a hedge fund defaulting within a year is 0.30%, which means that the Number of Hedge Number of likelihood of a Funds at end of defaults year 1994 3 751 fund defaulting in 1995 2 972 a portfolio of 30 1996 3 1250 1997 4 1560 hedge funds is 1998 10 1917 1999 2 2430 once every 2000 13 2969 2001 18 3635 eleven years. 2002 2003 2004 13 12 12 4381 5068 5563 Frequency of yearly default 0.40% 0.21% 0.24% 0.26% 0.52% 0.08% 0.44% 0.50% 0.30% 0.24% 0.22% Source: Christory, Daul, Giraud, «Hedge Funds Operational Risks», 2006

HF operational risks Stable levels of default risks so far Interestingly, loss frequencies have not increased significantly over the last 10 years despite more and more funds being established. But more importantly, the Loss Given Default distribution exhibits a significant skew towards large losses. Source: Christory, Daul, Giraud, «Hedge Funds Operational Risks», 2006

HF operational risks 2007-2008 a new world 2007-2008 have seen a significant increase in hedge fund defaults. It is too early to assess the quantitative impact of those defaults but one should distinguish Pure financial performance failures Pure operational risk failures Failures related to the squeeze in financing and investor s assets availability We have no evidence so far that pure operational risk-related failures have increased over the last two years.

Outline Overview of Hedge Fund Risk Understanding operational risks Introducing Managed Account Platforms Pros and Cons of Managed Accounts What has changed in 2008

HF operational risks Understanding the nature of operational risks The dynamics of a hedge fund bankruptcy are triggered by three types of events: Deliberate initial fraud Operational failure Financial loss These events force the fund to enter into a chain of events where losses accumulate and may lead to new situations: Asset-Liability mismatch followed by secondary fraud Liquidity race leading to managed or forced liquidation

HF operational risks Understanding the nature of operational risks Dynamics of a hedge fund failure (causal model approach) Source: Christory, Daul, Giraud, Hedge Funds Operational Risks, 2006

HF operational risks Understanding the nature of operational risks Our analysis of failures documented between 1985 and 2005 confirms that: 54% of cases are fraudulent from inception, 78% of cases involve a form of fraud. 33% are failures consecutive to a financial loss 13% are purely operational failures Straight fraud Fraud disclosed by regulator Financial issue not disclosed Operational issue not disclosed Operational issue disclosed 11.0% 6.4% 6.4% 17.4% 43.1% Financial issue disclosed 15.6% Source: Christory, Daul, Giraud, «Hedge Funds Operational Risks», 2006

HF operational risks Understanding the nature of operational risks The bulk of hedge fund fraudulent cases relates to funds with less than $100mio AUM. 20% of the 70.0% cases involving 60.0% fraudulent 50.0% activities only 40.0% 64.4% are related to 30.0% funds with less 20.0% than $25mio 10.0% 16.9% 8.5% 10.2% AUM. 0.0% 0-100 Million 100-500 Million >500 Million Unknow n Source: Christory, Daul, Giraud, «Hedge Funds Operational Risks», 2006

HF operational risks Understanding the nature of operational risks Fraud does affect mostly funds with fairly basic strategies (equity market neutral, equity longshort) Opaque 24% Unknown 14% Complicated 2% Simple 60% Source: Christory, Daul, Giraud, «Hedge Funds Operational Risks», 2006

Outline Overview of Hedge Fund Risk Understanding operational risks Introducing Managed Account Platforms Pros and Cons of Managed Accounts What has changed in 2008

HF Managed Accounts The case for managed account platforms The costs of a thorough due diligence is unlikely to be recovered through management fees and remain considerable compared to the possible loss of a correctly diversified portfolio. Conducting efficient operational due diligence remains extremely difficult for several reasons: Lack of adequate personnel Significant bias during the interview/investigation process Ex-ante analysis does not take into consideration actions the manager may take at difficult times when independent review is not permanent Due diligence costs are likely to be the first ones cut during cost restriction periods as it is unlikely to immediately influence investor s confidence Information asymmetry and moral hazard.

HF Managed Accounts The case for managed account platforms Fund Size Cost of due diligence in bpts $50mn 120 bpts $100mn 60bps $250mn 24 bpts $600mn 10 bpts $1bn 6 bpts Source: Managing Operational Risks, Jean-René Giraud 2004

HF Managed Accounts The case for managed account platforms Most investors (direct or FoHF) lack the size to be in a position to properly protect investors against operational risks. Controls, procedures, systems and legal structures are well suited for bundling into a set of services allowing investors to access HF vehicles in a controlled manner. This case has supported the development of a number of service offerings described as managed account platforms

HF Managed Accounts The case for managed account platforms All managed account platforms are however not equal: Some were born from the back end of the value chain (administrator / prime broker) with the aim of leveraging a risk control and operations infrastructure. Some were born from the front end with negotiated capacity with a number of successful hedge fund managers. A temptation exists for some Fund of Hedge Funds to pretend proving platform services and market themselves as such, a boundary however exists.

HF Managed Accounts A few principles Managed accounts should offer: A full segregation of manager s risk with the manager being appointed as sub-advisor only; Cash management and counterparty risk should be in the hands of the platform operator, delivery versus payment being the rule otherwise; Possible conflict of interests may exist between the functions of platform provider, fund of fund manager and/or Prime Broker; The responsibility of pricing & valuation of assets & liabilities should remain in the hands of the platform provider.

HF operational risks How do managed account offer protection? Hedge Fund operational risks: mitigation through managed accounts Source: Operational Risk and Managed Accounts, Jean-René Giraud 2005

HF operational risks How do managed account offer protection? It is essential for the investor to properly understand the real level of protection and independence he will gain from the managed account provider as these come in very different flavors. Managed accounts, when accompanied by appropriate risk monitoring and adequate structuring of the relationship with the hedge fund manager today represent a very efficient approach to mitigating operational risks, especially when the size of the investments does not allow for a dedicated operational due diligence and risk monitoring team to be set up.

Outline Overview of Hedge Fund Risk Understanding operational risks Introducing Managed Account Platforms Pros and Cons of Managed Accounts What has changed in 2008

Pros & Cons of platforms Range of protections offered Range of advantages provided by managed accounts Traditional private partnership Standard custodial account Primebrokerage custody Basic managed account Advanced managed account Segregation of assets Privileged redemption conditions Elimination of misrepresentation risk [1] Elimination of misappropriation risk [2] [3] Elimination of mispricing risk Mitigation of other operational risks [4] [1] Only when independent reporting of assets is performed by the custodian bank directly to the investor [2] Only when cash instructions are countersigned by the prime broker [3] Only when the manager mandate can be withdrawn at any time [4] Only when back office services are provided as part of the platform Source: Christory, Daul, Giraud, «Hedge Funds Operational Risks», 2006

Pros & Cons of platforms Myths and realities: platform costs Platforms usually charge fees directly to the managed accounts Directly as direct administrative cost Indirectly through the sharing of management fees Those costs pay for the operational services provided to performing the platform. They are usually in the 50-100bps range. Share-classes allow to manage those costs when managed accounts are bundled together in funds of hedge funds.

Pros & Cons of platforms Myths and realities: platform costs Indirect costs may be charged in addition or included in those fees: - Administration costs (independent valuation) - Legal costs Those costs represent a significant element of tracking error but should be analyzed in light of the service and the protection rendered by the structure of the managed account. A fraud case can represent a 2,5% to 5% loss for a Fund of Hedge Fund, notwithstanding the reputation risk.

Pros & Cons of platforms Myths and realities: tracking error Managed accounts replicate the strategy implemented in it s master hedge fund. The strategy is however replicated within a set of risk management constraints imposed on the platform. Numerous studies attempt to analyze this tracking error but are not conclusive.

Pros & Cons of platforms Myths and realities: tracking error It is difficult if not impossible to conclude on this question without analyzing portfolio holdings and the source of the discrepancy: Limitation due to risk constraint Limitation due to manager decision not to fully replicate Three elements ought to be considered It is the responsibility of the platform provider to monitor the TE and react accordingly; Tighter risk controls are there to protect the investor s assets, over performance in the master fund may be at the expense of higher/un-wanted risks; Significant TE are an indication the strategy might not be suitable for porting on a platform.

Pros & Cons of platforms Myths and realities: selection bias A number of managers/strategies can not be found on managed account platforms for a number of reasons No interest from the manager (capacity constraints, transparency issues) Inadequate management process with regards to the constraints imposed by the platform Liquidity issues Counterparties used Nature of instruments (private equity ) Those can be considered as signals that increased attention should be given to the master fund.

Pros & Cons of platforms Myths and realities: liquidity Most platforms offer weekly or monthly liquidity. The attention of the investors should be on the exceptions the platform is allowed to raise under particular market conditions (gates, side pockets) which are consistent with industry practice. More importantly, its is crucial to assess whether the liquidity offered is in line with the liquidity of the underlying strategy to avoid any liquidity squeeze (e.g. distressed). Platforms do indeed enhance liquidity through systematic and consistent rules applied to investments, they do not generate liquidity.

Pros & Cons of platforms Myths and realities: transparency Managed account platforms have access to the detailed positions (holdings) of the portfolio. As such they are in a position to perform a number of risk controls only available to themselves (VaR, B-exposures ) This full transparency does however not mean in any way that the final investor is provided full access to the holdings or those risk indicators, nor is the investor systematically informed of breaches managed by the platform risk monitoring team.

Outline Overview of Hedge Fund Risk Understanding operational risks Introducing Managed Account Platforms Pros and Cons of Managed Accounts What has changed in 2008

What has changed in 2008 Impact of the 2007/2008 Financial Crisis The crisis: Large-scale writedowns on debt Total writedowns on US-originated loans: $425bn to date (IMF). Market participants try to deleverage. The pressure to deleverage also affects nonbank financial institutions like hedge funds and mutual funds. Writedowns on US-originated loans of such institutions is estimated at $60-$100bn to date (IMF).

What has changed in 2008 Impact of the 2007/2008 Financial Crisis The crises has caused tighter financing conditions for hedge funds reducing their ability to lever returns. Margin financing from prime brokers has been cut, and fees on repo financing have increased, so that leverage has decreased from 1.7 to 1.4 times capital since last year (IMF). In addition, cash margins have increased from 14% to 22% to satisfy redemption requests from investors (IMF).

What has changed in 2008 Impact of the 2007/2008 Financial Crisis Hedge funds redemptions are small compared to those of traditional investment funds (in particular money market funds) Investors redeemed USD 40 bn from hedge funds worldwide in October 2008 (Hedge Fund Research) US mutual funds suffered redemptions of USD 68b in the same month (TrimTabs Investment Research) German mutual funds suffered redemptions of 46,3 bn (BVI) Deleveraging of hedge funds is heading towards completion In mid-november, 63% of hedge fund managers say more than 50% of their deleveraging has occurred. 23% say more than 75% of deleveraging has occurred (Sanford C. Bernstein & Co. LLC )

What has changed in 2008 The liquidity squeeze

What has changed in 2008 The liquidity squeeze Over the last 18 months, higher levels of redemptions and limited available financing has resulted in an unprecedented asset-liability mismatch within hedge funds. In addition to the difficulties to operate the strategies with the usual level of leverage, funds have been forced to liquidate illiquid positions and/or unwind long-term strategies with resulting losses. The analysis of how a liquidity squeeze can be managed by the fund can be considered as the new frontier in HF due diligence.

What has changed in 2008 The liquidity squeeze Managed accounts offer a wide range of protections that allow to significantly reduce the level of operational risk and effectively outsource the operational due diligence process. The cost of those platforms are comparable to the costs of the required due diligence and allow to offset the cost of fraud risk on a defined universe of funds. All platforms are however not equal and significant attention should be made to the details of the service provided and the reality of the risk mitigation.