Investing in hedge funds just got harder

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 fund’s operational risks. These operational risks cover a wide spectrum of areas ranging from the quality of a hedge fund manager’s 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 fund’s 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 client’s 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.

In addition to the steps outlined above, there are additional measures pension funds should consider taking to vet fully the operational risks associated with separately managed accounts investing. These include:

• having an independent party perform a periodic audit of the account;

• performing a periodic asset verification search, including verifying asset custody and bank balances; and

• conducting continuing operational due diligence reviews of a hedge fund organization.

Before embarking on separately managed accounts investing, one point of consideration for pension funds should be that the use of such independent third parties would likely increase the costs associated with investing in hedge funds. In the current environment, many pension boards are beginning to accept that such costs should be chalked up to the cost of doing business and that they effectively represent a necessary hedge to the fat-tailed operational risk events that can completely decimate a pension’s investment in a hedge fund.

When allocating to a hedge fund manager through either a separately managed account or a pooled vehicle structure, it is also prudent for a pension fund to take a step back and analyze the entire hedge fund organization. One area of consideration related to separate accounts would be for a pension fund to consider the total number of separately managed accounts that a hedge fund has in place. As the popularity of separately managed accounts has increased, a key red flag would be if a manager had recently added several SMAs without making major operational improvements. Separately managed accounts create a great deal of addition additional back-office and reporting work, which a hedge fund might not be equipped to handle without properly scaling their internal operational capabilities.

As part of the due diligence process, a pension fund should also evaluate the total assets under management represented by separate accounts as a percentage of both similarly managed strategies and total firmwide assets under management. Separate accounts can present a risk for pension funds that might be invested directly in a particular fund’s pooled capital vehicles that may be managed alongside other separate accounts. Under certain circumstances a pension fund’s investment in a pooled vehicle could be forced into situations where the prolonged burden of any illiquid assets is shifted to them, if those in the separate accounts choose to liquidate first once market liquidity has dried up.

The likely impending rule change that will require hedge funds to register with the Securities and Exchange Commission can be viewed as a mixed blessing for pension funds that invest in hedge funds through separate accounts. SEC registration will promote transparency by increasing oversight and disclosure requirements of hedge funds. Unfortunately, the SEC information disclosure bar is set very low and only requires a de minimis level of operational information to be disclosed. For example, in the vast majority of newly proposed hedge fund regulatory regimes, a hedge fund manager will not be required to disclose if, for pooled vehicles, they maintain a separate custodian, which was one of the factors that led to the Madoff scandal. As such, pension funds run the very real risk of embracing a false sense of security with regard to the amount of resources they will be required to devote to initial and continuing operational due diligence.

In order to ensure they are adequately vetting operational risks, pension funds likely will have to go above and beyond whatever information disclosures are required by the SEC. Collecting and monitoring this operational data across a portfolio of hedge funds is a costly proposition and in most cases, it is prohibitively expensive for a pension fund to fully develop its own internal operational due diligence department. As such, pension funds may look to outsource this work by investing via a hedge fund of funds with a robust operational due diligence function.

Regardless of the approach taken, pension funds must embrace sound due diligence practices. Otherwise, pension funds risk ending up in the headlines as victims of not only the next hedge fund Ponzi scheme but the more likely risk of loss due to poor operations management at a hedge fund.

Jason A. Scharfman is managing partner of Corgentum Consulting LLC, a Jersey City, N.J.-based operational risk consultant to the alternative investment industry.