Hedge fund managers refusing to provide transparency is the single greatest reason for an investor veto, according to recent research from Deutsche Bank.
Deutsche Bank’s Global Prime Finance group’s third annual Operational Due Diligence Survey, which polled investors globally representing more than US$2.72 trillion of assets, shows the five most frequently cited red flags are an unwillingness to provide transparency, inadequate compliance policies, poor segregation of duties, lack of experience in critical roles and inappropriate valuation policies.
Investors and regulators require more robust operating infrastructure across all levels of a hedge fund’s business. Emerging managers in particular are more likely to provide greater transparency.
Further highlights include:
• Expenses charged to the fund come under more scrutiny – 64% of respondents will investigate miscellaneous expenses and may place limits. Investors have little tolerance for expenses such as employee compensation, marketing and non-research related travel being charged to the fund.
• The vast majority of ODD teams are willing to provide feedback to managers to enable an investment – While 65% of responding investors have the right to block an investment entirely, 81% are willing to take a consultative approach to allow a manager to remedy a stated deficiency and re-engage with the investor.
• Outsourcing of key functions is a more accepted practice for emerging managers – 68% of respondents were willing to invest with emerging managers. Investors are slightly more likely to veto an emerging versus established manager (9% veto rate versus 6%), and will spend more time reviewing daily operations and speaking with senior management including the CIO and fund directors. However, they are more accepting of outsourcing key functions.
• Valuation is in sharp focus for 38% of responding investors in 2014 – Valuation concerns were a top five reason investors issued a veto over the past year. All the respondents (100%) indicated they will review a fund’s valuation policy during the ODD review and 78% stated they will verify the valuation procedure during the on-site review.
• Hedge fund compliance and regulatory frameworks are of critical importance – 73% of investors will increase their focus on compliance and regulatory frameworks in 2015. In the face of a challenging cross-border regulatory environment, investors must understand how managers will mitigate the risk posed by registration, reporting and the exams required by regulators.
Scott Carter, Deutsche’s co-head of Global Prime Finance & Distribution, Americas, said: “Investors increasingly access hedge funds as part of a broader set of portfolio solutions, which deliver superior risk-adjusted returns. With this comes an expectation for robust operational controls and we are seeing hedge funds successfully respond to these demands.”
The survey polled 70 investor entities globally with a hedge fund allocation in excess of US$730 billion, including consultants, endowments, public pensions, government organisations, insurance companies, funds of funds, private banks and family offices. Seventy-two percent of respondents manage more than US$1 billion in hedge fund assets under management. – July 2014