In the post-Madoff environment, sponsors of pension and other funds face a number of complex challenges with respect to performing due diligence on hedge funds. In addition to vetting the investment merits of a manager, now more than ever pension funds have been tasked with evaluating a hedge funds operational risks. These operational risks cover a wide spectrum of areas ranging from the quality of a hedge fund managers service providers to the appropriateness of valuation methodologies in place. In an attempt to mitigate these operational risks, there has been a resurgence of interest among pension funds in investing or considering investing in hedge funds through separately managed accounts or platforms of such accounts.
Proponents of separately managed accounts tend incorrectly to suggest that they completely remove operational risk. They do not. While such accounts go further than pooled investment vehicles to reduce outright fraud and mitigate certain operational risks, approximately 65% of all current separately managed accounts structures are still capable of being susceptible to different types of fraud. This figure includes pre-Madoff structures that might not have appropriate safeguards in place, as well as separately managed accounts without real-time monitoring and liquidation capabilities. Additionally, separately managed accounts do not necessarily reduce a pension funds exposure to any potential organization-wide operational issues such as regulatory actions, reputational risk, personnel turnover and business continuity, or disaster recovery events, all of which could negatively affect a clients performance. Further complicating the issue is a lack of uniformity in the separately managed account structures offered among different hedge fund managers.
With all of these potential pitfalls, what are pension funds to do? There are a number of basic steps that can be taken to ensure a pension fund is adequately insulated from bearing unnecessary operational risks when investing in hedge funds through separately managed accounts structures including:
• mandating that the pension fund, not the hedge fund manager, should be the actual owner of separate accounts;
• requiring independent third-party service providers across major functions that service a separate account, including administration, audit, prime brokerage and custody. Additionally, pension funds should take care to verify the credentials and extent of services performed by these third parties. This is particularly important with regard to separately managed accounts auditors; and
• ensuring that proper cash management controls are in place, including multiple signatories to move cash and limits on the amount of cash that can be transferred at any one time.