Ten key operational risks for hedge funds

How hedge funds are rewriting some of the ground rules of capitalism.
With billions of dollars at their command, big hedge funds aren't only moving markets with bets on everything from corn to biotech.

They are also rewriting some of the ground rules of capitalism. The Financial Times newspaper recently quoted a banking source as saying the enormous clout that comes from hedge funds having $1.4 trillion under management at the end of 2006 makes them the "new JP Morgans."

For instance, although hedge funds own just 1.5% percent of global assets, they account for more than half of US bond trading, 40% of US equity trading, and 80% of distressed debt trading, according to the FT. Hedge funds' influence extends far beyond mere numbers, of course, because many have assumed the role of shareholder activist, influencing the corporate governance of companies ranging from Blockbuster to Wendy's International to H.J. Heinz. Much as the actions of JP Morgan and his fellow financial titans did a century ago, the investment decisions of hedge fund managers reverberate throughout the U.S. financial system.

Tales of hedge fund blowups tied to aggressive investment strategies that are concentrated and highly leveraged are well known. But, in fact, the data indicate that mundane, nonmarket risksùbetter known as operational risksùcould pose just as large a threat to hedge fund investors as exotic investing strategies. There isn't always a bright line distinction between investment and operational risks because they are often interrelated. But one indisputable difference is that operational risk is uncompensated risk. In the hedge fund industry, it's even known as silent risk because most institutional investors have little or no awareness of the operational differences among hedge funds. As such, they typically don't factor operational risk into their risk/reward considerations.

Standard & Poor's Ratings Services thinks more should be done to raise awareness of operational risk. A good first step is an introduction to 10 common operational risks that hedge funds face. But first, a little background on why operational risk in hedge funds is more important than one might think.

Operational risks can be found throughout the enterprise
Operational risks can be found anywhere from back-office IT systems to controls intended to mitigate the probability of rogue trader losses. Some of a hedge fund's greatest exposures typically reside in aspects of the business such as staffing, technology infrastructure, regulatory compliance, legal issues, trade processing, accounting, fund administration, and valuation.

A March 2003 study by Capital Markets Co. (Capco) found that operational issues account for a relatively high proportion of hedge fund closures and that better due diligence and monitoring practices are key to detecting risk factors. Moreover, Capco says in the two decades prior to 2002, 54% of all funds that failed because of fraud suffered from operational problems, some of the most common being:
- Failure to prevent the misrepresentation of fund investments.
- Misappropriation of investor funds.
- Unauthorized trading.
- Inadequate resources to run the fund efficiently.

Most recently, operational risk has come to the forefront with the alleged frauds at Bayou Management and Wood River Capital Management as well as at Amaranth Advisors. Obviously, Amaranth assumed market risk with the natural gas positions it held, but it also took a risk that it might not be able to unwind these holdings if it had to sell quickly, which is exactly what happened. In our view, this is a classic example of instrument liquidity risk, which we characterize as an operational risk.
A new breed of investor demands a greater focus on risk management

Today, more mainstream institutional investorsùsuch as pension funds and university endowmentsùare pouring money into hedge funds. According to the TABB Group, a financial market research firm, pension plans will account for 19% of hedge fund assets by 2008, up from 12% in 2005. Because these investors must fulfill a fiduciary duty, they're even more interested than traditional hedge fund investors in how a fund manages risk.

As hedge funds grow rapidly, it's not clear that their management teams properly gauge the increased operational risk that accompanies such growth. According to an April 19, 2007, article in the "Wall Street Journal," the 100 largest hedge funds now control about 70% of the money in the hedge fund world, up from less than 50% at the end of 2003. In addition, the 300 hedge funds with $1 billion or more control about 85% of all the money in the business. As capital pours in, investors are increasingly asking hedge funds if their infrastructure can meet the challenge.

Based on our experience tracking the hedge fund market, we've identified the following 10 operational risks that institutional investors should look for when considering hedge funds:

- Concentration of strategy in just one or two hedge fund managers.
- Inexperienced or untested staff.
- Unclear overall business viability.
- An inconsistent approach to choosing and working with crucial service providers.
- A culture with haphazard risk-management and internal-control structures.
- No written valuation procedures.
- Liquidity and leverage inappropriate for the fund's investment structure and style.
- Governance practices that are not best-in-class.
- An outdated or incomplete technology infrastructure.
- A nonexistent or noncomprehensive business-continuity plan.

1. Concentration of strategy in just one or two hedge fund

Investing in a hedge fund really means investing in the general partner or partners who run that hedge fund. Because hedge strategies can be both opaque and complex, the investor is betting on management to a much greater degree than in traditional fund investing.

This dynamic can lead to key-man risk, in which some hedge funds hand big strategic decisions over to one person or to a small group of executives. Hedge fund investing is particularly vulnerable to this risk because of its star system, in which highly successful traders who have mastered one niche area of investing start a new fund. For two reasons, this concentration of strategy and knowledge in one or two executives is among the more common and serious personnel/governance risks. First, the person could leave or get ill. Second, and more likely, the star will inevitably suffer a bad streak or come up with an investing strategy that doesn't pan out, at least for a short time.

The best run hedge funds use proven risk-management practices designed to reduce the influence of one or two top managers, like sign-off procedures for taking large investment positions, segregation of duties, and the creation of broad guidelines and limits that must be followed when making investments. Much like well-run corporations, well-run hedge funds will create a succession plan for its top executives.
2. Inexperienced or untested staff

Another major question concerns hiring key staff members.

Assembling an industry all-star team isn't necessary, but institutional investors now expect corporate officers like a CFO, CIO, and general counsel to be around at the beginningùand to bring a few years of relevant hedge fund knowledge to the table. Acquiring that kind of firepower is both time-consuming and costly.

Successful, stable, high-yielding hedge funds, once they hit a critical mass, can grow very quickly as investors pour in. The challenge is to hire new staffers with the experience and knowledge to take on critical roles as the founders' responsibilities expand concurrent with growth.

Any solution to staffing challenges at hedge funds must include ongoing training that increases employees' current value and helps them improve their overall skill sets. Most major financial services firms have extensive training programs, whereas many young hedge firms have little or no formal training to introduce employees to organizational policies and procedures.

3. Unclear overall business viability

Hundreds of hedge funds close every year. In 2006, more shuttered their operations than opened.

Many successful Wall Street traders and investment bankers open a hedge fund, failing to understand that they are, essentially, opening a small business.

Founders of new hedge funds might possess a talent for investing but could find that they're not that adept at the operational aspects of running the fund, such as transaction processing, accounting, building an IT infrastructure, fulfilling regulatory requirements, and managing employees.

When hedge funds were in their infancy and playing to a much smaller audience of investors with whom they probably had a personal relationship, they could afford lean back-office operations, but that's not the case anymore. More institutional scrutiny and the potential of increased regulatory review of hedge funds demand beefed-up and more transparent back-office systems. In response, some hedge funds have become models of superior back-office operations, even providing back-office outsourcing services to other funds.

One clear advantage for those investing in a hedge fund with excellent back-office operations is the scale that can achieve lower trading fees while still offering a full menu of investing strategies.

4. Crucial service providers without a strong track record serving hedge funds with a similar investment strategy

Relative to most other investment vehicles, hedge funds can invest in a broad swath of instruments across a wide variety of investment strategies. That means they need to establish relationships with a wide variety of crucial service providers.

For example, hedge funds typically rely on a prime broker to serve as the nexus of trading activity, and the quality of this particular working relationship must be strong when thousands of trades are executed every day. It's also important to choose external auditors, attorneys, and bankers who really understand the fund's mandate and the risks it faces. Particularly in the areas of legal/compliance issues, valuation, and leverage, hedge funds need experienced vendors that can point to a solid track record serving that specific type of investment strategy.

Hedge funds must be careful in selecting service providers with deep experience in the business because in a potential hedge fund blow-up, unresponsive counterparties can exacerbate liquidity difficulties to the point where losses wind up being greater than they should be. Hedge funds with a good working relationship with their partners will have a much easier time dealing with situations such as liquidity or margin crises.
5. A culture with haphazard risk-management and internal-control structures
Once upon a time, hedge fund mangers revelled in their on-the-fringe reputations and cultivated a
reputation for secrecy. No longer.

Today, institutional investors expect hedge funds to embrace risk management in much the same way a blue-chip financial institution does, with policies governing risk, an infrastructure of risk monitoring and measurement, articulated risk-measurement methodologies, and an enterprise-wide approach that brings risks out of individual business unit silos and to the attention of management.

For example, a rigorous risk culture can help minimise fraud, which at hedge funds often involves misstating of assets. Investors are finding that fraud can be better detected with the most rudimentary due diligence. Another sign that a hedge fund has a good risk-management culture is if it works with a thirdparty administrator. It's more difficult to perpetrate traditional hedge fund frauds, like purposely mispricing the book, when a third-party administrator is independently pricing a fund portfolio.

The general internal control environment is one of the best barometers of how seriously a hedge fund takes operational risk. Funds on the leading edge of operational excellence can point to specific controls that track how trades are executed, how financial information is communicated, how orders and reconciliations are processed, and how a system of checks and balances exists among key personnel.

Another indication of transparency in the control environment is clear independence among important business functions such as the finance team and the risk-management team. Yet another is the existence of an empowered advisory board that includes professionals not involved in the fund's day-to-day operations. An advisory board in and of itself doesn't always imply good governance; some are typically ceremonial in nature. Three good indications of an advisory board with teeth are the presence of independent directors, meetings held several times annually, and, of course, how often their recommendations are followed.

6. No written valuation procedures

One of the most intriguing aspects of a hedge fund for investors is its unique ability to invest opportunistically in many kinds of financial instruments that lie outside the mandate of many other types of more conventional investment vehicles. The flip side of this flexibility is that some hedge funds hold illiquid securities that are difficult to value.

These might include a company that the hedge fund has acquired, a pool of loans purchased from a bank, or securities backed by that pool of loans. Unlike securities such as stocks and bonds, assets without a ready market are much harder to price, and a hedge fund that fails to value its assets properly could face a scenario in which it is severely overexposed. According to Capco, 58% of funds face operational risks related to calculating net asset value.

The best sign of a consistent, methodical approach to valuation is a written policy and procedures manual devoted to pricing. It's also important to look for a set of valuation checks and balances, which might include a valuation committee to double-check management's valuation calculations as well as a thirdparty administrator to provide another opinion on both the value of the fund's investments and its consistency of documentation.

Another valuation technique hedge funds use is to establish side pockets, akin to separate private equity funds within the hedge fund itself to hold illiquid instruments that are hard to price. Because they're held separately from the rest of the fund, these assets are usually not subject to the same redemption clauses as the fund's other assets.

For valuing more standard instruments, such as an over-the-counter derivative instrument, hedge fund managers should either seek out price information from established, well-known pricing services or use one of the many recognised valuation models to come up with its own price.
7. Liquidity and leverage inappropriate for the fund's investment structure and style

Hedge funds are exposed to liquidity risks (runs on the bank) in two ways: fund liquidity and instrument liquidity. Fund liquidity risk occurs when hedge funds use leverage to take positions that are far larger financial commitments than the cash in the fund at any one time. A hedge fund might make a bet on a small movement in commodities prices but use leverage to amplify the potential of returns. Because of this dynamic, even the most well-capitalised hedge funds can lack sufficient cash flow to fulfill their obligations if a number of leveraged positions turn bad at once.

Instrument liquidity pertains to a company holding an inordinately large position in one kind of instrument. An example would be a hedge fund holding an unusual derivative contract that other players would be unlikely to, or unable to, purchase if the fund holding the contract had to sell quickly. Another example of instrument liquidity is the enormous natural gas positions that Amaranth held in the spring of 2006 and then couldn't unwind quickly enough because any potential buyer knew that Amaranth had no choice but to sell.

Both of the above conditions can be compounded by investor liquidity that does not match the fund's investment style and structure. Hedge funds must establish the appropriate gatesùlimitations on when investors are allowed to exit the fund. Gates ensure that if a big position turns out to be wrong, only a set number of investors can redeem their investments at the same time, preserving the fund's long-term health.

8. Governance practices that are not best-in-class

The key to managing governance issues is to go beyond what's minimally required. In June 2006, the Court of Appeals for the District of Columbia Circuit invalidated an SEC requirement that hedge funds register with the agency as investment advisers and submit to nominal audits. Even without a mandate from the SEC backing them, institutional investors will most likely demand from hedge funds far more detail about investment strategies and guidelines in the offering documents. They'll also likely support tighter terms and conditions around implementation.

9. An outdated or incomplete technology infrastructure

One of the most important aspects of infrastructure is the adequacy of a fund's IT infrastructure. For example, the goal of any hedge fund is to maintain what's known in the industry as a straight-through processing. On any given day, a hedge fund might be making thousands of trades, reporting information on those trades to the SEC, and running models testing its performance that day against other days.

That fund's systems have to be as integrated as possible to allow timely and accurate information to flow straight through from the back-office to the administrator to the prime broker. A big trading position can head south at any time in this era of global, 24-hour trading, so having the right information at the right time is critical for hedge fund managers.

An efficient IT infrastructure is also important for funds with a global presence, given their dealings with multiple currencies, time zones, and asset classes. The faster and more accurately that information flows among managers, the more informed decision-making can become.

In addition, IT security is always a concern. A hedge fund committed to operational excellence will employ securely encrypted and password-protected data, redundant systems, chain-of-handling procedures for sensitive data, specific data retention and disposal time frames, and a number of other best-in-class IT security practices.
10. A non-existent or non-comprehensive business-continuity plan

For most companies, business continuity means staying operational in the event of a blackout or catastrophic event like a hurricane or flood. That goes for hedge funds, too, because they can't afford to have their IT systems down or electronic trading ability hampered for even a few minutes because it could mean millions of dollars in losses. Given the opportunistic nature of hedge funds, a robust businesscontinuity plan can put them in position to take advantage of any price dislocations that might be happening in the market while others are affected by an unforeseen event.

Systemic risk reduction ù all the more reason for operational safeguards

Back in 1998, the turmoil caused by the demise of Long-Term Capital Managementùwhich was rife with counterparty exposure to lenders, brokers, and administratorsùthreatened the stability of global financial markets. But if a relatively big hedge fund failed today, the capital markets appear much better equipped to absorb the shock. Amaranth's $6 billion one-week loss in September 2006 barely caused a ripple outside of the hedge fund industry.

Through more sophisticated risk-management techniques and better technology, a good amount of systemic risk seems to have been wrung out of the equation. This reduction in systemic risk isn't because of greater regulation or a hedge fund czar handing down edicts. It's because many players in the global financial systemùfrom the big Wall Street firms that give credit to hedge funds, to the companies that hedge funds buy, to the banks whose loans hedge funds purchaseùare much more aware of the risks and have amended their dealings with hedge funds accordingly.

But risk will never be completely removed from investing, particularly in the case of hedge fund managers who are pushed by competition to look further and further afield to find new sources of high returns. Ironically, the reduction of systemic risk could result in individual hedge fund managers making even bigger bets if they perceive a safety net below them, hence the need for a greater focus on operational risk.

One way for investors to find a hedge fund committed to managing operational risk is to consider those who have opted for a third-party, detailed evaluation of their operational systems and control infrastructures. This can be a powerful tool for hedge funds to improve operations and for investors to understand how a particular fund stacks up operationally against other hedge funds with similar strategies.

As a natural evolution of Standard & Poor's product portfolio, we are further developing our methodology for evaluating funds' operational capabilities. We will also use this methodology for the analysis supporting the counterparty, debt, and bank loan ratings we have performed on hedge funds since 2000.

In the end, of course, institutional investors are responsible for their own investment decisions, and they should use any tools at their disposal to choose hedge funds with documented, tangible operational safeguards.

Written by Mike Brewster
¬ Haymarket Media Limited. All rights reserved.
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