With pension fund allocations to hedge funds increasing over the past two years, institutional investors are refining asset allocation investment philosophies into risk-based approaches. A risk-based approach, however, is only as good as its methodology. For an investor considering private equity and hedge funds, this raises two questions: What is an appropriate risk-based approach; and what risks does it consider?
Until recently, issues other than investment performance of alternatives played a secondary role for institutional investors and their consultants. With the 2008 financial crisis and resulting scandals, investors shifted to back-office risks in areas such as custody, valuation and audit. Today, operational due diligence teams are just as important in vetting managers as investment teams.
Despite these changes, due diligence efforts still minimize legal and regulatory risks. In many cases, regulatory risks are weighed only after a scandal erupts. This backward-looking mindset leaves significant risks unrecognized — until the next scandal breaks — and creates risks for pension fund investors.
Alternatives investment managers have gone from being relatively unregulated to heavily regulated. Additionally, the glare of regulatory scrutiny has only intensified. Indeed, activity by one regulator will typically draw the focus of others both in the U.S. and international markets. At the same time, penalties are inflicting more damage; with larger fines, compensation clawbacks, industry bars and, perhaps most importantly, loss of adviser focus and investor confidence.
What does this mean for investors?
As an active and intense enforcement environment continues into 2013, investors, especially those with fiduciary duties of their own, will need to re-examine their approach (and that of their consultants) to risk in order to ensure that both current and emerging regulatory risks are embraced.
Managers can no longer be measured merely by looking at past firm failures. Investor due diligence teams must be sophisticated enough to assess whether a manager can thrive in today's complex environment.
Astute managers will embed forward-looking regulatory requirements into business processes. For example, the question of whether investor relations or marketing personnel should be registered as broker-dealers has been a significant concern for years. The Securities and Exchange Commission, however, remained quiet on the topic. In April, frenzy erupted when a senior SEC staff member raised the topic in a speech and an enforcement action was brought against a finder and the firm for which he worked. The media then reported, correctly, that failure to address the issue might give disgruntled limited partners legitimate grounds to exit a fund.
So how does an investor identify astute alternatives investment managers that warrant a long-term investment? For starters, each due diligence review must be tailored to an adviser's specific strategies, investor base and operational jurisdiction. This examination should test three factors: base-lining; sustainability; and accountability.
A manager must create a base line of all contractual, legal and regulatory requirements applicable to its current operations, and investors need to confirm this has been done. Many advisers make the mistake of narrowly focusing on only one or two regulators, typically the SEC and Commodity Futures Trading Commission. This is insufficient. In the U.S. alone, more than 10 federal regulators oversee the typical investment adviser. Some have active enforcement programs. Laws actively enforced include anti-bribery, antitrust and sanctions regimes. Their foreign equivalents can be more stringent than in the U.S. market.
Once requirements are base-lined, a sustainable process for remaining current must be employed. Changes in business practices — such as new products, office locations and regulatory developments — need to be integrated into the firm's governance program.
Finally, it is increasingly important for investors and managers to be transparent about core business functions in order to be able to determine that roles are clearly defined. Clarity with respect to legal and regulatory risk can only be achieved by embedding requirements into daily workflows and documenting that they are followed on a consistent basis.
Where does this leave the investor?
As the universe of risks evolves, so too must investors' due diligence. Only by examining a manager's enterprise risk management infrastructure and testing it against current and emerging risks can investors truly be confident of the safety of their investments.
Deborah Prutzman is founder and CEO of New York-based Regulatory Fundamentals Group, a cloud-based risk management platform for institutional investors.
