Decagon Client Briefing Hedge Fund Investors Monitoring Firm Durability Dynamic Assessments within the Operational Due Diligence Framework Summary Durability of a hedge fund firm s operating structure can be threatened by the fragile nature of the manager s revenue model, which can lead to periods of escalating conflict Costly infrastructure, coupled with liquidity concerns among large management firms, leads us to conclude that bigger is not always better Operational measures assessing categories of risk such as financial leverage, control persons, financial reporting and instrument complexity are best monitored dynamically with an eye to the valuable lessons learned over the last decade Risk reporting has evolved to provide investors and fiduciaries consistent and comparable measures of operational risk. Decagon s 10 operational risk categories provide benchmark standards to monitor durability in changing times
Overview Hedge fund failures over the past decade have exposed an established set of risk categories, fund weaknesses and conflicts inherent to the industry. While evaluation methods have improved the quality of operating policies and procedures, we note this has also occurred during a period of firm revenue acceleration. Although hedge fund investing may appear somewhat less risky now than it was 10 years ago, the true test will occur during the next business cycle downturn. Fragility is in the very nature of a hedge fund firm s business model. Fluctuations in firm durability occur rapidly due to changes in (1) firm revenue and (2) strategy liquidity. In the next wave of the business cycle, these two factors are likely to fuel periodic increases in operational risk across the 10 categories of assessment (Figure 1). We will examine firm durability from the viewpoint of management company economics and incorporate the current debate over firm size and strategy liquidity. These dynamics impact the operational risk categories that we detail above and help us derive lessons from past failures. Figure 1: Categories of Operational Risk Measurement Investor Transparency Financial Leverage Investor Terms Instrument Complexity Control Persons Audited Disclosures Treasury Function Firm Maturity Operating Policies Process Formality Through the lens of a stressful decade of failures, in the final section we provide examples of operational breakdowns and document the changes that resulted from a firm in duress. Before looking at specific risk categories, let s review the revenue and liquidity dynamics that, under challenging circumstances, present the greatest likelihood of increased conflicts, a breakdown in risk management, a reduction of transparency, deviations from GAAP accounting, increased liquidity risks or weakened processes. Decagon Advisors LLC Monitoring Firm Durability 2
Firm Durability Durability is the measure of a firm s ability to endure, to survive. In an investment management context, this often focuses on a firm s continued ability to meet investor needs while maintaining risk management and compliance standards in the face of shifting capital market and business currents. Operational due diligence seeks to not only evaluate the durability of an investment strategy, but also to determine the management firm s ability to maintain consistently high operating standards. Fluctuations Evaluations of a management firm often begin with ownership structure, employment arrangements and revenue stream diversity. Early assessments that also monitor fluctuating revenues and team dynamics have evolved to consider the potential impact on the operational risk framework. When critical issues such as cashflow shortages arise at the management firm level, conflicts are more likely to escalate, resulting in management decisions that may short circuit best practices. The sufficiency of capital available to support the operating needs of the management firm is not often transparent. Funds are often perceived as doing well if fund managers take home large payouts. However, these large payouts can leave a hedge fund management company critically undercapitalized. In March of each year, privately owned fund managers pass taxable earnings through to owners and portfolio managers. Owners can often be a team of managers who co-own a limited liability corporation. The taxable earnings pass-through may be matched with a large percentage of the company s capital being paid out in tandem. The result can lead to the undercapitalization of the hedge fund management firm, potentially putting it at greater risk of operational breakdowns stemming from stress due to revenue fluctuations. The scenario in Figure 2 illustrates a typical alternative manager that derives revenue from management fees of 1.5% and performance fees of 15%. This scenario demonstrates that even modest performance and asset fluctuations can immediately cut yearly revenues by as much as 50%. Decagon Advisors LLC Monitoring Firm Durability 3
Figure 2: Change Scenarios Year 1 Scenarios Year 2 A B C Firm Size AUM $500 MM $500 MM $400 MM $300 MM Investor Retention % Drop in AUM Year 1 (Gross Performance 15%) Year 2 (Gross Performance -5%) % Change in Firm Source: Decagon $17.6 MM 0% -20% -40% $7.5 MM $6.0 MM $4.5 MM -57% -66% -75% Our scenario assumptions include: Assets under Management (AUM) of $500 million and gross return on these assets of 15% in the first year within one vehicle, followed by a gross loss of just -5% in the second year, along with various investor retention scenarios. fluctuations can dramatically impact durability. During performancerelated downswings in revenue, the required budget reductions, at a minimum, can cause stress within the management team. The scenario begins to illuminate how future risks can increase when the cost structure expands during a period of affluence, as we are in now. In our example, the challenges and management firm stress arising from a loss of revenue increase exponentially in year 3. s are unlikely to recover until performance exceeds the high watermark. The duration and timing of the recovery adds uncertainty that further compounds the operational stress. Firm Size Strategy Liquidity Discussions about durability are incomplete without a brief mention of firm size. Does the size of the firm mitigate or increase durability? Sometimes size is seen from the perspective of bigger is better. This is often the view of investors seeking best practices for firm durability and operational integrity. However, larger firms often exhibit more complex and costly fixed in-house infrastructures that can compound size concerns. Large operating budgets can make it difficult to adapt to revenue declines while seeking to retain top talent. Risks to firm durability are also generated from strategy liquidity Decagon Advisors LLC Monitoring Firm Durability 4
concerns as strategies near capacity, in addition to organizational inertia when reacting to capital shortfalls. Conflicts and risk management challenges can escalate more quickly when attempting to maintain a liquidity profile during volatile markets while facing team leadership and budgeting concerns. Optimal size is a moving target depending on ever-changing market liquidity and counterparties. At the other end of the spectrum, small firms, often considered those with less than $200 million in AUM, can operate more nimbly when deploying their portfolio construction, but face significant constraints in expenses. Smaller firms may face challenges with team member retention and the ability to enact sufficient operational risk controls to meet investors risk thresholds. There are various benchmarks for optimal size. Risks due to size dynamics are strategy specific and most likely to increase risk at both ends of the spectrum. Liquidity and cost structure are just two of the many challenges to firm durability. Dynamic Assessments While extreme financial pressure may be most acute for the smallest or largest hedge fund firms, at any size it can impede the effectiveness of operational risk controls, impair services and lead to a vicious redemption cycle. Each consequently impacts investor confidence, as well as talent retention. Recently, a well-known Tiger alum stated, At the end of the day, we really only have two assets: The confidence and loyalty of our investors, Secondly, the talent of the team we are putting together. It s a challenging business... With insight into revenue volatility and size considerations, the stage is set to review the dynamic categories of risk that have led to firm and fund failures over the last decade, as well as identify operational risk categories that indicate when a firm is near or in duress. Below we present a sample of risk categories triggered during large firm failures over the last decade; without mentioning names, we detail a sample operational breakdown within each category of risk. We utilize as a framework, Decagon s 10 Operational Risk Categories (Figure 3, left column) to highlight the measurable areas that contribute to a firm s and fund s durability assessment. These have been matched with notable industry failures over the last decade leading to dramatic events. Operational breakdowns (right column) were often a result of short-term operational dysfunction, rather than a long-standing policy. An assessment of measures within the 10 categories of operational risk can help shape the direction of due diligence testing, verification and onsite visits. Decagon Advisors LLC Monitoring Firm Durability 5
Figure 3: Categories Category of Operational Risk 1 Control Persons 2 Treasury Function Operational Breakdown Leading to Firm & Fund Liquidation Poor oversight of self-dealing / affiliated transactions Deviation from GAAP accounting and fraudulent transfer of assets 3 Operating Policies Failure to supervise receipt of inside information 4 Process Formality 5 Firm Maturity 6 Audited Disclosures 7 Instrument Complexity 8 Financial Leverage 9 Investor Transparency 10 Investor Terms Failure of the operational controls to meet the needs of a more complex firm Failure to retain key team members and institute plan for broad leadership structure Poor disclosure of liquidity risks and non-explicit leverage Failure to assess loss of liquidity and scenarios for a negotiated exit or margin call Inadequate risk management to anticipate scenarios of heightened basis risk and market illiquidity Inadequate disclosure of a rapid change in assets under management Mismatched fund assets and liabilities, as well as poor governance with respect to lock-up provisions Source: Decagon Advisors research initially identified failures among firms listed in Alpha Magazine s list of largest 100 Hedge Fund Firms (June 2006) and includes both public and private documents made available. Compiling the categories and underlying risk measures harnesses technology that has evolved to assist investors in monitoring operational risk with benchmarked reporting on hundreds of inter-related operational details. Decagon Advisors LLC Monitoring Firm Durability 6
Conclusion Maintaining timely operational risk assessments between deeper due diligence reviews can provide investment committees with more frequent updates regarding the state of a manager s durability in the dynamic market environment. Timely assessments deploying benchmarked standards, tailored to each investor s risk profile, can help monitor against historical culprits leading up to a negative event. Recent years of strong AUM growth and ample market liquidity appear to be at a peak. Market gyrations earlier this year, along with fund closures over the last decade, provide evidence of the fragility of the asset management business model and the value of active monitoring of firm and fund operational quality and durability. In the best case, assessment practices can identify early-warning signs of stress so that fiduciaries can focus on areas of greatest concern among the key categories of operational risk. About Decagon Advisors LLC Monitoring Firm Durability www.decagon-advisors.com 1350 Avenue of the Americas, 3rd Floor New York, New York 10019 646.755.3825 Based in New York, the Decagon team provides Alternative Asset Investment Consulting and Manager Consulting by providing comprehensive COO, CIO, Due Diligence and IR support to institutional investors and fund managers. The Decagon team accelerates the success of investment processes and programs by providing a competitive advantage and strategic partnership. We offer our advisory services and work with investors and managers that exhibit skill, experience, drive and a strong sense of fiduciary duty. Our goal is to support innovation, durable investment programs, firm creation and job growth within the alternative investment management industry based on a foundation of best practices. Disclaimer The author makes no representations or warranties with respect to the accuracy or completeness of the contents of this document. The advice and strategies contained herein may not be suitable for your situation. The contents shall not constitute an offer to sell securities, or the provision of sound legal or tax advice. You should consult with a professional where appropriate. Neither Decagon Advisors nor the author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. Copyright Material Decagon Advisors LLC Monitoring Firm Durability 7