from black box to open book: hedge fund trust and - pwc

Our view, validated by conversations with UShedge fund investors, managers and otherindustry participants

From black box to open bookUS hedge fund trust and transparency

www.pwc.com/alternatives

Foreword

Adapted from Ben Stein’sspeech at PwC’s From BlackBox to Open Book AlternativeInvestment Seminar, held inNew York in December 2011.

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From black box to open book

Without trust, there is no capitalism. Until a time in the 18th century when woolmerchants, sea captains, land owners and nobility realized that they could placetheir money with others, and others would treat capital with respect, there was nocapitalism. There could be wealthy families and there were. But until investorscame to believe they could place their money with banks, there could be noaggregation of capital from many different investors to build and invest.

Capitalism was off and running when capital could be entrusted with thirdparties, fiduciaries, who would not steal the money, but would invest it and passon the profits to investors.

But for capitalism to get started, there had to be trust. The human wish to stealhad to be overridden by the belief that in the long run it would be more profitable,as well as honorable, to treat the trustors fairly and invest the trustors’ moneyinstead of just riding away with it.

Trust is still the fundamental building block of capitalism. When there is trust thatinvestors’ money will be honestly accounted for, handled with care andtransparency, and the proceeds from its use returned to the investors whenwanted, there will be growth. But when trust is betrayed and investors arecheated and mistreated, money stops flowing, or flows less, and the whole basis ofcommerce teeters in the balance.

This failure of trust has happened over and over since the 18th century. On manyoccasions there have been bubbles in real estate, railroads, canals, technology andgovernment debt—and when they burst, the results have been calamitous.

So trust lies at the heart of the modern economy. Without it there can be nogrowth because there is no confidence. And without trust, asset managers—today’s investment fiduciaries—can’t gain the confidence of investors and raisecapital to invest.

Ben Stein

Ben Stein is a writer, actor,economist and lawyer

Contents

Executive summary 2

Introduction 6

Managers 10

Investors 18

Administrators 22

Prime brokers and custodians 26

Directors 30

Auditors 34

Outlook 36

Conclusion 38

Contacts 40

From black box to open book 1

US hedge funds have significantlyenhanced their transparency, controlsand infrastructure, helping to win thetrust of institutional investors that iscritical for their future growth. Across the hedge fund value chain, a new framework is emerging that isimproving investor protection. But thisevolution remains a work in progress,with inefficiencies and areas forimprovement yet to be addressed.

Executive summary

Transparency plays animportant role in buildinginvestor trust in every part ofthe value chain. A “trust andtransparency” framework isgradually emerging that willenable the sector to earn thetrust needed to fulfill itsgrowth potential.

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Transparency plays an important role inbuilding investor trust in every part ofthe value chain. A “trust andtransparency” framework is graduallyemerging that will enable the sector toearn the trust needed to fulfill its growth potential.

The US hedge fund sector is an integralpart of capital markets, yet it hasdeveloped in a different way to thebroader asset management industry.While its investment processes are highlydeveloped, its governance andoperations are less so. In the past fewyears, hedge funds have reacted to theinstitutionalization of their investor base,and increasing regulation, by enhancinginfrastructure and further aligninginterests with investors, in an evolutionwe describe as ‘from black box to openbook’. A ‘trust and transparency’framework is gradually emerging, but itneeds to be completed before the sectorearns the trust needed to fulfill itsgrowth potential.

In order to understand the measures thathedge fund managers need to take tomeet institutional investors’ expectationsfor transparency, governance andoperations, we have interviewed seniorexecutives from approximately 40leading US hedge fund managers,

investors, service providers and otherparticipants in the value chain. We founda sector that has made significantimprovements in the four years since thefinancial crisis. Even so, specific areasremain where stronger practices wouldbenefit the sector.

In particular, we believe that focusing onthe following five key factors would helpto enhance trust:

• Pro-active partnership and alignmentof interests across the value chain.

• Standardization of investor reportingand operational due diligence,balanced with the necessary level of customization.

• Institutional-quality infrastructure and controls.

• Robust processes underlying thevaluation and safekeeping of assets.

• High standards of fund and corporate governance.

In today’s challenging investmentenvironment, hedge funds are attractinginstitutional investors with the prospectof relatively high returns and minimalcorrelation to other asset classes. Butthese investors also expect a first-ratequality of reporting and infrastructureand a high-touch level of service.

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This shift in the investor base is changingthe nature of the sector. Hedge fundmanagers are evolving into moremainstream client service organizations.Each member of the hedge fund valuechain—manager, administrator, primebroker and custodian, auditor anddirector—is subtly adapting to this newparadigm. Investors themselves are alsotaking part in this evolution, formingcloser relationships with managers thatfoster trust.

In the future, being a “trusted advisor”will differentiate a hedge fund manager;ranking below investment performancebut being critically importantnonetheless. In this paper, we explorehow each member of the hedge fundvalue chain can strengthen trust in thesector. We examine the currentshortcomings, potential improvementsand the future outlook. By continuing toenhance the current value chainframework, hedge funds can claim“trusted advisor” status and be rewardedby significant long-term inflows ofinstitutional investor capital.

In the world of hedge funds, we judge that the following elements breed trust:transparency, credibility, reliability and alignment of interest, all combined withlow self-orientation.

These relationships are depicted in the equation below:

• Transparency is the single biggest contributor to a trusting relationship; it playsan important part in building investor trust in every part of the value chain.

• Credibility fosters trust based on the manager’s words, skills, expertise andexperience—and also based on the quality of the manager’s key personnel andthat of its service providers.

• Reliability relates to the predictability of the manager’s actions in terms of itsstrategy, performance, communications and controls.

• Alignment of interest conveys the manager’s commitment to investors’ needs,including an appropriate level of transparency, and in some cases a degree ofcollaboration that verges on partnership.

• Self-orientation affects trust profoundly. A low level of self-orientation (or selfinterest)—defined as having the right behaviors, proper structure and effectivegovernance—builds trust significantly. By contrast, a manager that puts its owninterests before its investors’ will erode trust.

TA = T+C+R+AI SO

TA = Trusted Hedge Fund Advisor T = Transparency C = Credibility R = Reliability AI = Alignment of Interest SO = Self-Orientation

The “trusted hedge fund advisor” equation1

1 The above equation is based on the well known “trusted advisor” equation(Source: http://trustedadvisor.com) but modified to suit the hedge fund industry.

Five key factors to enhance trust

• Pro-active partnership and alignmentof interests across the value chain.

• Standardization of investor reportingand operational due diligence,balanced with the necessary level of customization.

• Institutional-quality infrastructureand controls.

• Robust processes underlying thevaluation and safekeeping of assets.

• High standards of fund andcorporate governance.

Introduction

Hedge funds are at acrossroads. Four years afterthe credit crisis, they haveregained their 2007 peak inassets. But, along the way,their investor base has becomemore institutional andregulatory oversight of thesector has increased inintensity and scope.

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Hedge funds are at a crossroads. Fouryears after the credit crisis, they haveregained their 2007 peak in assets. But,along the way, their investor base hasbecome more institutional andregulatory oversight of the sector hasincreased in intensity and scope.Institutional investors such as pensionfunds, endowments and sovereignwealth funds have become critical to thesector’s future and are requiringenhanced standards of operational riskmanagement and transparency.

“Members of the hedge fund sector arewelcoming regulatory reforms, broaderoperational controls and compliancepractices that encourage the flow ofinstitutional assets to our industry,” saysRichard H. Baker, President and ChiefExecutive Officer of the Managed FundsAssociation (MFA). “Institutionalinvestor assets now represent themajority of the sector’s global assets,

and the sector has made a strong effort to respond to their requests for greater transparency and moredetailed reporting.”

As has always been the case, strong risk-adjusted investment performance is whatreally differentiates a hedge fundmanager. But now many investors aregiving strong operations similarimportance. So, they will not invest witha manager unless they can be sure of acertain standard of operationalinfrastructure, controls andtransparency. Showing the increasingimportance accorded to operations,investors ranked operational robustnessas equally important to performancetrack record in allocation decisions forthe first time in the Goldman SachsGlobal Hedge Fund Investor Survey 2012.

Both managers and investors are inagreement on this point. “Our

investment approach differentiates ourfirm. That is what opens doors and gets meetings.

The fact that we have great operationalinfrastructure by itself will not be the driver for investors to invest, butoften is the tipping point,” explains Jim Rowen, Chief Operating Officer,Renaissance Technologies.

In our US ‘Trust & Transparency’ point ofview—which follows similar exercises inEurope (released in November 2010)2

and Asia (released in April 2012)3—weset out to understand the most effectiveways for the US hedge fund sector toenhance investor confidence and theeffect of these measures on its outlook.Our study revealed a US hedge fundsector that’s more mature than those inother regions but nonetheless isencountering similar challenges.

2 http://www.pwc.com/gx/en/asset-management/assets/pwc-hf-trust-and-transparency.pdf.3 http://www.pwchk.com/home/eng/am_hedge_fund_trust_apr2012.html.

“Members of the hedge fund sector are welcoming regulatoryreforms, broader operational controls and compliance practicesthat encourage the flow of institutional assets to our industry.”

Richard H. Baker, President and Chief Executive Officer of the Managed FundsAssociation (MFA)

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“The US hedge fund sector is the mostmature regionally, but also one that stillholds significant growth opportunities formanagers,” asserts Mike Greenstein, GlobalAlternative Investments Leader at PwC.“Seizing those opportunities meansunderstanding and accommodating therequirements of regulators and leadinginstitutional investors—both of which canbe exceptionally demanding in theoperational standards they require.”

As hedge fund managers have improvedtheir operations and enhancedtransparency, institutional investors haverewarded them by increasing allocations.Institutions account for two thirds of hedgefund assets today compared to less than afifth in 2003, according to Deutsche Bank’sTenth Annual Alternative InvestmentSurvey.4 Eighty percent of the institutionsin the survey either grew or maintainedtheir hedge fund assets under managementin 2011.

Helped by rising institutional investment,the sector regained its previous high of US$ 2 trillion in assets at the end of 2011,previously reached at the end of 2007,according to Chicago-based Hedge FundResearch, Inc (HFRI). This was in spite ofvolatile performance that saw the HFRIFund Weighted Composite Index declineby -4.8%, only the third calendar yeardecline since 1990.5

Estimated asset growth/net asset flow hedge fund industry 2000—Q4 2011

-500

500

0

1000

1500

2000

2500

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Q1

2011

Q2

2011

Q3

2011

Q4

2011

Ass

et ($

bn)

Estimated Assets Net Flow Assets

Source: HFR Global Hedge Fund Industry Report, Year End 2011

4 Deutsche Bank Tenth Annual Investment Survey, published March 2012.5 Hedge Funds Conclude Challenging 2011, Position For 2012; published January 9th 2012; www.hedgefundresearch.com.

“The US hedge fund sector is the most mature regionally,but also one that still holds significant growthopportunities for managers.”

Mike Greenstein, PwC’s Global Alternative Investments Leader


In order to establish how far hedge fundshad progressed on their journey ‘fromblack box to open book’, we interviewedsenior executives from approximately 40firms in the sector. Our intervieweesincluded investors, consultants,managers, administrators, prime brokers, lawyers and directors. Theyranged from the largest and mostestablished managers, investors andservice providers, to fast-emergingsmaller organizations.

The interviews revealed a state oftransformational evolution. Over thepast four years, the sector’sinfrastructure, governance andtransparency have significantlyimproved. For example, investorreporting has been enhanced,independent administrators are nowstandard and investor operational duediligence (ODD) is a fundamental part ofinvestors’ research.6

“2008 changed the sector significantly,”says Todd Groome, Chairman of theAlternative Investment ManagementAssociation (AIMA) and a principal inBreton Hill Capital. “These changes haveincluded both new regulatoryrequirements and increased demandsfrom institutional investors. Since theearly 2000s, we’ve seen increasedinstitutional investor capital flows intohedge funds, and with this capital hascome the increasing institutionalizationof hedge fund operations andinfrastructure. Following 2008, a muchgreater investor focus on liquidity,portfolio transparency, control and fundgovernance was clearly evident. Maybemore than most regulatory changes, theinstitutionalization of the sector is likelyto bring profound changes, and will nodoubt continue to evolve from here.”

As this evolution progresses, the changestaking place need to be refined, acceptedand standardized. “The US hedge fundsector’s broad framework has emerged,yet it is still work in progress,” explainsMark Casella, PwC’s US AlternativeInvestments Leader. “US hedge funds and their service providers still havechanges to make before their pace ofevolution slows.”

6 Having a third-party administrator is the most important aspect of due diligence, according to The 2012 Credit SuisseGlobal Survey of Hedge Fund Investor Appetite and Activity.

“The US hedge fund sector’s broad framework has emerged,yet it is still work in progress. US hedge funds and their serviceproviders still have changes to make before their pace ofevolution slows.”

Mark Casella, PwC’s US Alternative Investments Leader

“Maybe more than most regulatory changes, theinstitutionalization of the sector is likely to bring profoundchanges, and will no doubt continue to evolve from here.”

Todd Groome, Chairman of the Alternative Investment ManagementAssociation (AIMA) and Principal, Breton Hill Capital

Managers

Hedge fund managers havebecome far more open,communicating moreinformation and providinggreater access. They routinelyprovide investors with detailsof their control infrastructuresduring due diligence reviewsand most have enhancedportfolio transparency. Yettransparency for its own sakeis not always a good thing—there’s a balance to be struckin the interests of bothmanagers and investors.

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Finding the right transparency balance

Hedge fund managers have become farmore open, communicating moreinformation and providing greater access.They routinely provide investors withdetails of their control infrastructuresduring due diligence reviews and mosthave enhanced portfolio transparency.Yet transparency for its own sake is notalways a good thing – there’s a balance tobe struck in the interests of bothmanagers and investors.

While the increase in openness has gonea long way towards restoring trust,managers and investors have to strike theright balance between what’s useful andwhat’s excessive. Failure to do so couldpotentially damage portfolio returns,burden the manager with excessive costsand oblige the investor tocomprehensively understand the datareceived. Managers understandably wishto safeguard certain position levelinformation and to manage the cost ofmeeting requests for information.Investors wish to gain the best possibleinsight into portfolios and controlinfrastructures. By working together,managers and investors can agree what’spracticable and useful.

Finding the most efficient ways toorganize data and due diligenceinformation helps managers andinvestors alike. Constantly meetinginvestors and sending them informationtakes up managers’ time and resources.Managers can tackle this dilemma bystandardizing as much information as

possible. Managers and investors should both remember the 80/20 rule—that 80% of the benefit will come from20% of the effort. By standardizing asmuch information as possible, managersand investors can spend more timefocusing on the unique risks associatedwith an investment strategy and themanager’s distinctive investment andoperational capabilities.

Managers have responded to investors’requests for greater transparency in avariety of ways. The managers weinterviewed all told us that they haddevoted significant extra resources tomeeting investor requests. RFPs and duediligence questionnaires (DDQs) havebecome longer and more detailed, andinvestors are requesting moreinformation and access in both initial andongoing due diligence reviews. At thesame time, the Securities and ExchangeCommission is requesting moredisclosure in its Form PF and other formsof reporting.

In order to meet these requests, managershave no choice but to hire more people,invest in technology and automateprocesses. Much of the extra work falls toinvestor relations and fund accounting,but marketing departments are also beingupgraded, with senior managementspending more time focusing on thisarea. Furthermore, in order to satisfy theneed for more and richer information,larger managers are building datawarehouses. All of this is adding toexpense at a time when bothmanagement and performance fees areunder pressure.

Key points:

• Managers and investors arestriving to strike the rightbalance between useful andexcessive transparency.

• Greater standardization ofinformation is reducing theburden of transparency, but more standardization is needed.

• Managers have becomemore transparent, and arebeginning to developinnovative ways ofdelivering transparencyefficiently.

• Managers and investors arebuilding mutual trustthrough closer partnerships.

• Entrepreneurialism andinstitutionalization haveshown that they can co-exist.

• Managers are investingsignificantly in people,processes and technology.

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“We have doubled the size of ouroperations and accounting group in thelast three years,” notes JosephWekselblatt, Chief Financial Officer atAngelo, Gordon & Co., the New York-based alternative investments manager,best known for its capabilities in credit,real estate and private equity. “Some ofthat was because we needed to expandour staff as we grew, some of it wasgetting involved in new asset classes—but a lot of it was to meet the increaseddemands for information.”

While each fund manager is different andso some level of specific information willalways be needed, the current volume ofrequests is proving very challenging forsome managers. In line with the 80/20rule, managers and investors can betterstandardize the basic informationprovided so that they can both focus on customizing the unique and valuable information that has real value for investors.

“A huge part of what investors do inoperational due diligence is informationgathering. Seventy percent of thequestions investors ask are the same,”says Adrian Sales, Head of OperationalDue Diligence at Albourne Partners.“There’s a huge overlap because there’salready a significant body of informationavailable setting out what operationalrisk is and what you should focus on -from the Hedge Fund Standards Board(HFSB), Alternative InvestmentManagement Association (AIMA), MFA,President’s Working Group etc. Anyonecan build a DDQ. What the sector needsto focus on is how operational duediligence (ODD) can be more efficient, bydeveloping a generally accepted list ofquestions/concerns, tools and reports toanswer those in a scalable way. Ifinvestors can do ODD more efficientlythen that frees up time to focus on theunique aspects of the manager’s businessand how risk is managed, instead of justinformation gathering.”

Forms of standardization are alreadyemerging. Hedge fund managers areasking their administrators to disclosedetails of the information investors valuemost—existence and price verification ofassets—through online reporting portals.And the ‘operational due diligence day’,where managers invite a number ofinstitutional investors to hearpresentations, is an emerging practice.These ODD days are an efficient use ofmanagers’ time and give investors thechance to hear their peers’ questions.

A number of sector initiatives areoffering opportunities forstandardization. In September 2011, anindustry working group published theproposed Open Protocol Enabling RiskAggregation (Open Protocol) standards,which offer consistent practices forcollection, collation and conveying riskinformation. And AIMA’s due diligencequestionnaires, which have been inexistence for many years, give aframework for a basic level ofinformation that investors cansupplement with more focusedquestions. Finally, the HFSB is currentlyseeking greater support for its standardsin Asia and the US, extending theirinfluence beyond Europe, where they’remore firmly established. Whileinterviewees expressed different degreesof familiarity with these efforts, mostagreed that they’re too fragmented andthe sector needs a common frameworkfor due diligence information andoperational standards.

“We have doubled the size of our operations and accountinggroup in the last three years. Some of that was because weneeded to expand our staff as we grew, some of it was gettinginvolved in new asset classes – but a lot of it was to meet theincreased demands for information.”

Joseph Wekselblatt, Chief Financial Officer at Angelo, Gordon & Co.


Additionally, Service OrganizationControls (SOC) reports (formerlyreferred to as SAS 70s)7 are becominganother widely accepted and recognizedaid to ODD. “These independentassurance reports give stakeholdersinsight into and confidence in themanager’s control environment, leavingthem the option of supplementing thestandard information with their ownprobing,” says Chris Thompson, a PwCRisk Assurance Partner. As such, they’rea classical illustration of investors’ ‘trustbut verify’ approach to hedge funds.

Independent assurance or SOC reportsare also a valuable benchmarkingexercise. “The decision-making processaround additional reporting such asinternal control reports or agreed-uponprocedures often focuses purely on theinvestor needs and requirements, but thebeneficial impact that preparing for thesestandards can have on an organization’sinternal control environment is oftenoverlooked,” says Mike Gismondi, ChiefOperating Officer at TPG-Axon Capital.These reports allow managers to take a disciplined review of their systems and processes, at least on an annualbasis, and make evolutionary changes as needed.

“All of these practices go a long way toeasing the manager’s transparencyburden,” says Paula Smith, PwC’s USAlternative Investments AssuranceLeader. “But ultimately investors andmanagers alike need to approachtransparency in a spirit of partnership.”Investors need to be frank with managersabout the level of transparency theyrequire before investing; managers fortheir part need to explain what level ofdisclosure they believe is appropriate forboth their investment strategy and their business.

Enhancing manager/investor relationships

As managers seek to build trust withinvestors, they’re giving far greatertransparency into their businesses andoften forging collaborative partnerships.By doing so, they’re aligning their owninterests and their investors’ interestsmore closely.

Going beyond standard reporting andcommunication, managers are givinggreater insights into investment decision-making processes and their dailyoperations. Some managers are formingsuch strong partnerships with their mostsignificant investors that they’re

becoming virtual extensions of theinvestors’ organizations, offeringcustomized investment solutions andgiving more open access to a range ofindividuals within their own firms.

We believe this redefinition of themanager/investor relationshipdemonstrates a growing mutualunderstanding between managers andinvestors. It’s also an example of how thesector is changing as managers embracewhat it means to be a fiduciary. Hedgefund managers are aiming to combine aprincipal’s alignment of interests with anagent’s behaviors and structures.

“As institutional investors seek betterlegal and operational structures for theiralternative investments, issues relating toagency versus principal relationshipsenter the discussions,” states KennethPhillips, Chief Executive Officer ofHedgeMark International.

How far individual managers choose toprogress with this new spirit ofpartnership depends on factors such astheir size and culture, and howimportant particular investors are tothem. At the most basic level, investorswant total insight into how a managerthinks about markets, what risks arebeing taken and what’s driving returns.

“The decision-making process around additional reportingsuch as internal control reports or agreed-upon proceduresoften focuses purely on the investor needs and requirements,but the beneficial impact that preparing for these standardscan have on an organization’s internal control environment isoften overlooked.”

Mike Gismondi, Chief Operating Officer, TPG-Axon Capital

7 As of June 15, 2001, the American Institute of Certified Public Accountants (AICPA) replaced the internal controls reporting standard “SAS 70” with Statementof Standards for Attestation Engagements No. 16 (SSAE16), Reporting on Controls at a Service Organization (SOC). Some people still refer to all internal controlreports as SAS 70, while others may use the newer reference SSAE16. For consistency, we will use the term “SOC” in this paper.

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Paul Roth, Founding Partner of the lawfirm Schulte Roth & Zabel, believes thenew spirit of partnership is invaluable.“Managers and investors need tounderstand each other’s needs,” he says.“This reciprocal pathway builds trust and confidence.”

To have such a “reciprocal pathway,”hedge fund managers have to let downtheir guard and forge relationships withinvestors that go beyond the standardanswers and presentations. Thisincreases credibility and reliability and,in doing so, enhances trust.

“I would say that one of the things thathelps me gain trust in a manager is whenthey can help me understand what theimpact of specific types of events will beon their strategy, before they actuallyhappen,” explains TJ Carlson, ChiefInvestment Officer, at the KentuckyRetirement Systems. “That helps give mea lot of confidence. From the back officeperspective, one of the things I like to

have is direct access to the personnel thatare actually doing the work. Then mystaff members have more usefulcommunication channels open. What Ido not want is broad corporate answers.”

But some hedge fund managers aretaking collaboration to a new level,offering their significant investors ‘whiteglove’ services by customizing managedaccounts to fit their specific investmentobjectives and helping them to managetheir cash flows. One manager we spokewith was giving an investor advice abouthow to structure its asset allocation, notjust for hedge funds but stretching acrossthe entire portfolio. Another was sharingsome of the research underlyinginvestment decisions.

Of course, enhanced relationships don’treplace formal checks and balances indue diligence and transparencyreporting. As a minimum, institutionalinvestors want verification of the qualityof management controls and processes,

robustness of compliance controls,existence of assets and price verificationprocedures. What’s more, investors nolonger regard being told how controls orprocesses work as sufficient. Extendingthe ‘trust but verify’ mantra further, theywant to get out of the conference room towitness processes and controls in action.They want to see them and review them,all within the constraints of the time they have available and the access theyare provided.

For the manager, meeting theseexpectations absorbs time and resources.Standardizing as much of their responseas possible, and automating thecollection of information throughefficient infrastructure, creates moretime for improving the quality ofrelationships. Managers also enhance thecredibility of their responses by beingprepared to demonstrate and verify whatthey say they do.

“Managers and investors need to understand each other’s needs.This reciprocal pathway builds trust and confidence.”

Paul Roth, Founding Partner of the law firm Schulte Roth & Zabel

“From the back office perspective, one of the things I like to haveis direct contact with personnel that are actually doing the work.And then I can have staff members who have channels open.What I do not want is broad corporate answers.”

TJ Carlson, Chief Investment Officer, Kentucky Retirement Systems


Reconciling entrepreneurialismand institutionalization

While entrepreneurialism must remainthe essence of hedge fund management,winning investors’ trust increasinglyrequires ‘institutional-quality’infrastructure. Entrepreneurialism andinstitutionalization might seemincompatible, but managers are provingthat they’re not. To date, there’s noevidence to suggest that increasinglyeffective control environments constrainhedge fund traders’ dynamism.

Managers have grown their businesses inan environment with a high degree ofmulti-tasking and informal managementpractices—the flip side of which is lessdeveloped support functions, with fewerthan normal bureaucratic processes. Butinvestors and regulators are drivinginstitutionalization of hedge fundfunctions such as tax, finance, HR,technology and marketing.

Like many of his peers, Jim Rowen, ChiefOperating Officer of RenaissanceTechnologies, recognizes the need forboth entrepreneurialism andinstitutionalization. “Whileinstitutionalization of the back office iscritical for sustainability of aninvestment firm, the front office must beentrepreneurial enough to achieve thereturns investors seek. The relationship islike a slinky—the entrepreneurial frontend should set the momentum anddirection for the operational back end. A primary goal is to ensure that the

two ends never get too far apart fromeach other.”

For most investors, high-qualityinfrastructure is a prerequisite.Regulators, too, are driving specificinfrastructure enhancements in areassuch as compliance, risk management,valuation and investor reporting. Thehedge fund managers we spoke to wereresponding by strengthening theirinfrastructures—upgrading their people,processes and technology. Yet others stillneed to adapt their infrastructures toemerging business requirements.Although infrastructure alone will neverbe a selling point, without it managerswill not get the opportunity todifferentiate themselves.

During our interview process, bothmanagers and investors stressed theimportance of high-qualityinfrastructure. “Institutional investorsare rigorously checking that appropriatecontrols are in place across the hedgefund value chain,” observes GaryMeltzer, PwC’s US Asset ManagementAdvisory Leader. “They want to seeprocesses, controls, IT systems andpeople working together in a way that is robust, repeatable and verifiable.”

More probing ODD has encouragedchange. It has obliged the sector toincrease automation, improve processesand to communicate better. “Five yearsago you asked some managers abouttheir disaster recovery policy and they

were just taking their tape home at theend of the day,” says Charles Cassidy,Head of Operational Due Diligence atCambridge Associates, an investmentconsultancy firm. In the time since then,the ODD questions of consultants andinvestors have spurred substantialimprovement, not only in the area of disaster recovery but across operations generally.

One aspect of this improvement is theincreasing quality of middle and backoffice employees. Using the term‘athletes’ to signify high-qualityemployees, one hedge fund manager toldus how he previously used to only seekpeople of this caliber for the tradingdesk—but now he needed themthroughout the firm. Generalist roles and‘double-hatting’ are being replaced byspecialist positions. Managers have agreater need for legal and tax expertiseto interpret and comply with newregulations and tax requirements, as wellas more client services specialists.

What’s more, the capabilities of the HRfunction often need to be upgraded.“Today’s hedge fund HR leaders arechallenged with leading the transition toa new operating culture in parallel tofundamentally redesigning today’shiring, development and managementprocesses. This can catalyze theevolution of HR from order taker to astrategic business partner,” statesBhushan Sethi, PwC Financial ServicesPeople & Change Leader.

“While institutionalization of the back office is critical forsustainability of an investment firm, the front office must beentrepreneurial enough to achieve the returns investors seek.The relationship is like a slinky – the entrepreneurial front endshould set the momentum and direction for the operationalback end. A primary goal is to ensure that the two ends neverget too far apart from each other.”

Jim Rowen, Chief Operating Officer, Renaissance Technologies

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Better systems, processes and controlsare reducing reliance on individuals. Inparticular, managers are upgradingcontrols around traditional high-riskareas such as valuation and safeguardingof fund assets, as well as emerging riskareas such as regulatory compliance andtax compliance. The SEC’s new Form PFis creating a huge need for data to meetits filing requirements, and the ForeignAccount Tax Compliance Act (FATCA)will require managers to capture farmore information about their investors.

Practices are evolving even in traditionalrisk areas like valuation. Regulators areincreasingly signaling their expectationfor managers (and auditors) tounderstand more about the models,inputs and assumptions used by thirdparty pricing vendors. This need to“know your price” is particularlyimportant for those securities that aremore complex or less actively traded.

Tax, too, is becoming an important partof the manager’s infrastructure. “Underpressure from investors, regulators andlegislators, hedge fund managersglobally are integrating their taxdepartments into the firm’s operationalrisk management functions,” says WillTaggart, PwC’s Global Asset

Management Tax Leader. “This requiresthe tax department to think and actdifferently. In an environment whereinvestors are doing more thorough duediligence, tax does not escape.” Inparticular, managers need to make surethat the information they input into datasystems is high quality and designed tofacilitate tax reporting.

Managers are investing in upgradingtechnology platforms in order to meetinvestors’ and regulators’ mountingdemands for reporting. As firms havegrown, they have often built informationtechnology on a piecemeal basis. But inorder to satisfy huge demands for data,some larger managers are building datawarehouses that allow them to slice anddice information across strategies, fundsand investors, as well as to drill down tomore detailed data. As part of theirtechnology upgrades, some managersare enhancing cyber security,acknowledging this as a key operationalrisk as data breaches and internetsecurity continue to make the headlines.

Enhancements across these three areas—people, processes and technology—arereinforcing infrastructures, and haveconsiderably reduced operational riskalready. But the expense of institutional

infrastructures is raising barriers to entryand in this sense might dampen thesector’s entrepreneurial vigor anddevelopment of new talent. Investorsview institutional quality in operationsand the control environment as animportant issue when discriminatingbetween new launches. “Our researchshows that investors have a markedpreference for what we describe as ‘TheNew Launch Core Four’ attributes,namely pedigree, continuity,differentiation and institutional quality,”says Robert Leonard, Global Head,Credit Suisse Capital Services.

While all firms need to meet a minimumstandard, it’s important to guard againsta “one-size-fits-all” expectation given thediverse nature of the sector. The controlenvironments of emerging managersmight be less mature and proven thantheir established counterparts, butthey’re not necessarily less effective.They supplement their own credibilityand reliability with that of their service providers.

Once again, transparency and opennesshold the key, as they allow investors tojudge whether the attractions of amanager’s investment propositionoutweigh heightened operational risk.

“ Under pressure from investors, regulators andlegislators, hedge fund managers globally areintegrating their tax departments into the firm’soperational risk management functions.”

Will Taggart, PwC’s Global Asset Management Tax Leader

“Our research shows that investors have a marked preference forwhat we describe as ‘The New Launch Core Four’ attributes, namelypedigree, continuity, differentiation and institutional quality.”

Robert Leonard, Global Head, Credit Suisse Capital Services

How do you build trust?

• Standardize as much investor information aspossible for efficiency; but concentrate oncustomizing the remainder to meet investors’specific needs.

• Build a spirit of proactive partnership with your investors.

• Think of yourself as providing a service ratherthan a product, and develop a highly responsiveclient service culture.

• Make sure your infrastructure is, and appears tobe, fit for purpose.

• Enhance the credibility and reliability of yourinfrastructure—review whether it’s as good asyou think it is.

• Develop a strategy to push trusted,standardized information to your investors,reducing what they need to request themselves.

Investors

During the 2008 credit crisis,unexpected liquiditymismatches, redemptionsuspensions and othersurprises eroded investortrust. Since then investorshave demanded far greatertransparency. They’re willingto place a degree of trust inmanagers—but only if theycan also verify controlprocesses, existence of assets,independent pricing ofinvestments and thecompliance environment.

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Standardizing and customizingoperational due diligence

During the 2008 credit crisis, unexpectedliquidity mismatches, redemptionsuspensions and other surprises erodedinvestor trust. Since then investors havedemanded far greater transparency.They’re willing to place a degree of trustin managers – but only if they can alsoverify control processes, existence ofassets, independent pricing ofinvestments and the complianceenvironment.

ODD already existed but it has blossomedto bolster trust, shining a light into thesector’s combination of portfoliocomplexity, opacity and partialregulation. As institutional investors suchas pension funds grow their hedge fundteams and their use of consultants, sothey are performing more rigorous ODD.Additionally, many funds-of-funds havemade ODD a significant part of theirvalue proposition.

As ODD has become more commonplace,so its nature has changed. What wasoriginally a forensic accounting task hasevolved into a more commercial, riskassessment exercise. Investors, eitherdirectly or through the use of ODDconsultants, now conduct extensivereviews of all aspects of the manager’sbusiness practices, policies andprocedures, and operational workflows.They review the entire value chain, frommanager and fund through to primebroker, auditor, administrator and,increasingly, directors—not onlyreviewing paperwork, but also visiting orverifying the different parties.

While the more extensive exercisemitigates risk, it also takes far more timeplacing a considerable resource strain onmanagers. The ODD process is leading tomanagers standardizing fundamentalinformation so that investors can spendmore time monitoring and understandingrisk. ‘Due diligence days’, internal controlreporting and agreed-upon proceduresare forms of standardization that some

Key points

• Investors have demandedand received far moretransparency, which theyregard as the prerequisite for trust.

• Operational due diligencereviews have becomecommonplace, althoughtheir quality still varies.

• Investors acknowledge thatmanagers have tostandardize someinformation to reduce thecost of transparency.

• Investors want to be surethat managers aren’t tooguarded and strike the rightbalance of transparency.

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managers practice. The Rohatyn Group,a specialist emerging markets manager,has developed a standardized datalibrary that addresses due diligencequestions. Some of the investors wespoke to agreed that these standardizedforms of information were a useful wayof gathering the basic facts aboutmanagers’ operations, allowing them toconcentrate their own research onparticular areas of risk.

Managers have become far better atdelivering information that consistentlyexplains operations, whether in thepresentations they make to potentialinvestors or in objectively verified forms

such as SOC reports. Making standardinformation available to investors in thisway means they don’t have to request itand enhances trust.

But investors caution that the welcomemove towards standardization andhigher quality reporting should notdetract from the spirit of partnership.Some ODD professionals noted that overthe years it has become harder to get tothe heart of the information they want.One ODD professional commented:“Managers are more used to ODDreviews, so they are more polished intheir presentations and workflow charts.But some are also more guarded.”

Investors need to explain whatinformation they need and assuremanagers that they will use theinformation they receive wisely. “Asinvestors, we have a responsibility toclearly articulate the standards oftransparency we expect prior to investingwith a manager,” explains CharlesCassidy of Cambridge Associates. “Weunderstand the reasons managers havefor limiting disclosure and these need tobe balanced with our needs tounderstand the strategy and ongoingperformance attribution. We make it apoint to discuss these issues as a part ofour first meeting with a manager and ifwe can’t agree on the level oftransparency we will walk away. Anupfront communication approach shouldbe where it all starts.”

Making ODD a two-way dialogue notonly helps managers to focus onproviding valuable information but alsohelps to strengthen the mutualunderstanding that underlies allproductive partnerships.

“As investors, we have a responsibility to clearly articulate thestandards of transparency we expect prior to investing with amanager . . . An upfront communication approach should bewhere it all starts.”

Charles Cassidy of Cambridge Associates


• Develop smart, user-friendly ways ofstandardizing information.

• Be prepared but don’t stick to a script.

• Build confidence in the information that youprovide through demonstration and verification.

• Make ODD a two-way dialogue.

• Manager and investor should agree uponcommunications expectations from the outset.

Administrators

Administrators are both thehedge fund manager’s partnerand the investor’s lookout.They play an important rolein a ‘trust but verify’ world.

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Providing independent insight

Administrators occupy an importantplace in today’s hedge fund value chain.As independent organizations, withresponsibility for calculating the fund’snet asset value (NAV), they are both thehedge fund manager’s partner and theinvestor’s lookout. Furthermore, withhighly scalable information-processingtechnology platforms, they ‘own the data’and are well-positioned to help managersfurnish regulators and investors with theextra information they require.

To some extent, the administrator’s valueproposition has historically suffered froma lack of transparency andstandardization—yet in a ‘trust but verify’and transparency-dependent world,administrators have an important role toplay. In the immediate aftermath of thecredit crisis, investors insisted that hedgefund managers employ third-partyadministrators to oversee NAVcalculations and perform otherverification services. Since then, moreand more transparency has beendemanded, leading administrators toseize this business opportunity byoffering a growing range of services,including advanced risk, regulatory andreporting services.

Investors told us they value services suchas ‘transparency reporting’, which buildtrust in the sector. Yet the evolution toindependent administration has beenswift and there is room for refinement.Most interviewees questioned theadministrators’ ability to independentlysource the right inputs and makeappropriate assumptions about hard-to-value investments when striking fund NAVs.

Many respondents, includingadministrators themselves, called formore standardization about how priceand asset verification are determined andreported in transparency reports. Thiswould give investors a betterunderstanding of their verificationpractices and enhance comparability.Managers and investors alike viewed thisas an important area with room forimprovement. They called for solutionsincluding potentially self-imposed andtransparent standards, as well asstandard tolerance levels when verifying prices.

While investors generally are calling forthe administrators to play a greater roleas third-party verifier of the fund’s NAV,some of the managers we spoke toquestioned to what extent investors are prepared to pay for this increased transparency.

Shadowing administration

While hedge fund managers acknowledgethe growing role of independentadministrators, they’re not ready todismantle the fund accounting systemsthey’ve built, and so duplication ofactivities is adding expense to the hedgefund value chain. For many hedge fundmanagers, turning over the business offund accounting to externaladministrators has been hard to accept.Some of the managers we spoke to feltthat the administrators have done a goodjob but don’t get credit for it. Otherslacked confidence in administrators’systems and ability to independentlyaccount for complex transactions andprice hard-to-value securities, amongother things. As a result, a lot of largermanagers ‘shadow’ the administrator bykeeping their in-house personnel and

Key points

• Independent administratorsplay an important role in a‘trust but verify’ world.

• Administrators are offeringa widening array oftransparency reporting andother services.

• Transparency reporting, such as price and assetverification, is well receivedbut there is opportunity formore standardization.

• Full shadowing ofadministrators isincreasingly uneconomic at a time when somemanagers’ profitability isunder pressure.

• Administrators are workingmore closely with managersas business partners.

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systems to check the administrators’results. In effect, they don’t yet haveenough confidence in the administratorto dismantle what they’ve built and rely entirely on the third-party fund administrator.

“We shadow the administrationinternally and the level of detail of ourbooks and records is better,” explainedone manager. “But we recognize thatinvestors want some independence intothe process so we have reacted to marketneeds and appointed an administrator.”

“The administrators don’t really knowhow to value some complex derivatives.Anything that is listed and traded in asomewhat liquid fashion they are finewith. But once you get to the world ofesoteric derivatives, illiquid/distresseddebt positions etc., we have to directthem to the sources of pricing.”

Managers have mixed views on thesubject. Some feel very strongly that theywill never rely solely on theadministrator. Others expect to scaleback what they’ve built over time ascredibility is enhanced and confidencegrows with positive experience.Administrators are seeking to win hedgefund managers’ confidence by givingthem greater transparency into theirprocesses through ‘workflow dashboards’that allow them to track the process ofstriking the NAV. They’re also providingmore visibility and access to theunderlying data.

Some managers are moving fromshadowing to vendor management asthey approach their relationship with theadministrators much more strategicallyand collaboratively. While someshadowing might always be necessary,not all of it is. There are other ways tocontrol the administrator and thisduplication of effort gives rise to extraexpense at a time when managers areunder more pressure economically.

Depending on the manager’s size,strategy and complexity, many mightalways need to maintain some of theirown books and records. In fact, in certainareas, it’s the administrator who may beshadowing the manager. Over timemanagers are likely to move from fullshadowing to ‘shadowing lite’—a morestrategic, risk-based approach. Thisapproach should produce an effectivecontrol environment, with fullaccountability for the end result, aseconomically as possible.

Moving beyond fund administration

Like other members of the sector’s valuechain, administrators are working hardto adapt to the current environment.They’ve expanded their service offeringsand invested in the specialist skills andtechnology to adapt their businessmodels to deal with increasedexpectations and needs in areas such as valuation.

Administrators are moving from beingjust a “fund administrator” or“outsourced back-office” to morecomprehensive “servicing” businesses,offering a range of other services as thecalls for information grow. They’reproviding more middle-office servicesand risk reporting, and are beginning tofacilitate regulatory filings.

“As the sector has evolved over thecourse of the last few years, theadministrator’s role has also evolved,”remarks Jay Peller, Citco’s Global Headof Marketing and Product Development.“Given the administrator’s core functioncomprises independently processing andreconciling a fund’s activities and data,the scope for managers andadministrators to work cooperatively tomeet these new requirements hasexpanded into areas that includefacilitating transparency and riskreporting, and complying withregulatory rules.”

As managers learn to rely more onadministrators, they are increasinglytreating them as partners. They areworking together more openly, placing greater trust in one another. The role of the administrator is becomingmore critical, but with this comes greater scrutiny.

“As the sector has evolved over the course of the last few years,the administrator’s role has also evolved.”

Jay Peller, Citco’s Global Head of Marketing and Product Development


• Make administrators the independent lookoutsoverseeing the fund’s NAV.

• Provide more transparency into the role of the fund administrator and the proceduresthey perform.

• Encourage clarity and consistency in price andasset verification reporting.

• Evaluate the current shadowing approach andmove towards a risk-based approach.

• Work collaboratively with the administrator indesigning key performance indicators and otherways to assess and measure their performance.

• Demonstrate effective control over theinformation provided to administrators and thereporting that comes from them.

Prime brokersand custodians

Anxiety over the health offinancial institutions in late2011 once again raisedconcerns about the safety ofassets held by prime brokers.As a result, hedge fundmanagers are seeking greatercomfort over the security oftheir investors’ assets.

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Seeking greater asset security

Anxiety over the health of financialinstitutions in late 2011 once again raisedconcerns about the safety of assets heldby prime brokers. As a result, hedge fundmanagers are seeking greater comfortover the security of their investors’ assets.They are doing so in a variety of ways—by increasing their use of multiple primebrokers, by seeking more transparencyinto the segregation of assets in theirprime brokerage accounts and by sendingsome assets into the safekeeping of third-party custodians.

Still greater transparency into levels ofasset segregation and controls wouldhelp to build confidence over thesafekeeping of assets. While primebrokers’ reporting of asset segregationhas improved in recent years, financialmarket volatility in the second half of2011 led some commentators to questionwhether even current controlarchitectures would protect assets.

Recent volatility serves as a reminder ofcounterparty risk. Managers need to lookmore deeply into the legal, regulatoryand operational issues behind theirbrokerage and counterpartyrelationships. Just as investors aredemanding more transparency frommanagers, so managers need to request more information from their counterparties.

Concern among hedge fund managersand their investors led to an upsurge inassets held by independent custodians in2011. In particular, they want to holdcash with custodians, but they areincreasingly also placing assets withthem, in spite of the administrativecomplications of doing so. In the last fewyears, hedge funds have become a majorpart of the custodian’s business.Relationships and technology have beenbuilt to bridge the administrative gapbetween prime brokers and custodians. Inaddition to multi-prime relationships,managers may also have one or twocustody relationships.

Key points

• Hedge funds are seekinggreater security over assetsthrough segregation of assets and tri-party custody.

• Prime brokers have achallenge to respond withinnovative but safe ways to use collateral.

• There’s an opportunity for more integrated reporting across primebrokers and custodians.

• Prime brokers have enhanced their controlstransparency through their own SOC reports.

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“Hedge funds’ approach to counterpartyexposure has evolved dramatically inrecent years,” states John Levene,Goldman Sachs’ Head of US primebrokerage. “As a consequence, the role ofthe prime broker has evolved to ensuremanagers have a wide array of innovativecollateral management solutions at theirdisposal. This allows managers toeffectively express their investmentthesis, while still protecting investorassets. The ability to balance assetprotection with efficient financing willcontinue to serve as a key differentiatorfor prime brokers.”

But there are also challenges associatedwith hedge fund managers moving assetsto independent custodians. Tri-partyarrangements add operationalcomplexity and make the servicing ofsome assets more difficult. What’s more,the economic model for prime brokers isalso impacted as the cost of leverage may increase due to these and otherfactors such as the level of regulatorycapital that has to be assigned to prime brokerage.

Several of our interviewees called formore integrated reporting across serviceproviders. “It would be ideal and efficientif administrators could transfer datathrough systems to custodians,” saidBrian Gavin, Chief Operating Officer ofBlackstone Alternative AssetManagement. “Progress has been madebut finding a way to provide moreconsistent integrated reporting acrosssuch service providers would beextremely helpful.”

The need for greater controltransparency has led many of the leadingprime brokers to obtain their own SOCreports as they are increasingly thesubject of ODD scrutiny. In the four yearssince Lehman Brothers, the independentassurance provided by these reports hashelped inspire greater transparency and confidence.

The sector might decide to strike abalance. With greater use of custodianscomes the risk of increased costs ofleverage—indeed at a time whenregulatory capital costs are increasing,some smaller hedge fund managers mightfind their access to leverage limited.

“Hedge funds’ approach tocounterparty exposure has evolveddramatically in recent years. As aconsequence, the role of the primebroker has evolved to ensuremanagers have a wide array ofinnovative collateral managementsolutions at their disposal. Theability to balance asset protectionwith efficient financing willcontinue to serve as a keydifferentiator for prime brokers.”

John Levene, Goldman Sachs’ Head of USPrime Brokerage


• Work with your prime broker tooptimize the security of your portfolio.

• Be prepared to clearly articulate anddemonstrate your strategy forsafeguarding fund assets.

• Support more consistent data transferacross service providers.

Directors

Governance is becoming oneof the hottest hedge fundtopics, not only in the US but globally.

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Protecting investors’ interests

Governance is becoming one of thehottest hedge fund topics, not only in theUS but globally. We’re at the early stagesof an important discussion about the role,capacity and accountability of directors.This is not just a debate for the managers.It’s also an issue for fund domiciles suchas the Cayman Islands, Dublin,Luxembourg and other jurisdictions.

Like administrators, the role of directorshas been poorly defined and understood.As a result, you hear very mixed views ontheir role and effectiveness today. But weexpect that to change. How fast it willchange depends on the attitude ofinvestors and managers, and on theperformance of directors. “Institutionalinvestors and other stakeholders wantdirectors to be independent guardians oftheir assets - with the motivation, timeand qualifications to perform this role,”says Don Seymour, Managing Director ofdms Offshore Investment Services Ltd.

In the wake of the recent WeaveringCapital case and the Cayman GrandCourt’s verdict that its directors aidedfraud8, there is a debate about the bestway to establish and operate independentbodies to protect investors’ interests. Yetthere is widespread agreement that thereshould be accepted norms for goodgovernance across jurisdictions and structures.

Governance standards are beginning toslowly emerge. The Hedge FundStandards Board (HFSB) has releasedguidance calling for a fund governingbody comprising a majority ofindependent directors, who possess

suitable experience and qualifications tohold the manager to account for itsperformance and conduct.9 Additionally,the Irish Central Bank has recently issuedguidance and the Cayman IslandsMonetary Authority and otherjurisdictions are reviewing whether tofollow suit.

We believe that moves such as these willcontribute to protecting investors. Goodgovernance can enhance trust bydecreasing the self-orientation of themanager. Furthermore, we think thatoffshore jurisdictions should establishcodes of practice, against which directorscould be held to account.

“Anyone can follow a template boardagenda, sign what lawyers and auditorsplace before them and do the otherdirector tasks that they believe to be theirresponsibility without adding value to theprocess,” states Gary Linford, ManagingDirector of Highwater Ltd, whichprovides independent directors. “A quality independent director will usethe good times to understand the fund,its service providers, investors, theconflicts inherent in the structure and toensure that he or she has the tools andknowledge to deal with any difficultissues that may arise long after thelaunch documents are first approved.

“Sophisticated investors will appreciatethat a quality independent director issomewhat like insurance; you onlyappreciate its value in times of stress.Fiduciary investors that promotecorporate governance must takeresponsibility for the credibility of the directors of funds with which they invest.”

Key points

• There’s a growing debateabout hedge fundgovernance and the role of directors.

• Governance standards are beginning to emerge as calls for independentoversight increase.

• Supply and demanddynamics may impactdirectorship service and cost models.

• Proposals for governanceare beginning to extend toUS limited partnershipstructures.

8 Less is more for Cayman jumbo directors, Financial Times, November 20, 2011.9 Hedge Fund Standards Board strengthens standards with international dimension. www.hfsb.org. February 17, 2011.

“Sophisticated investors willappreciate that a qualityindependent director issomewhat like insurance; youonly appreciate its value intimes of stress.”

Gary Linford, Managing Director ofHighwater Ltd.

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The opacity of the governance processcauses too few funds to appear toconform to best practice. In the past year,interest in fund governance hasincreased and the need for qualifiedhedge fund directors of offshore funds has grown. Yet the investors we interviewed echoed others’ doubts,asking whether directors really devote sufficient time and attention to their roles to be able to protectinvestors’ interests.

“I think the key issue today is theindependence of the fund board ofdirectors,” asserts Florence Lombard,Chief Executive of the CharteredAlternative Investment Analyst (CAIA)program. “I think investors and regulatorswant to see more independent oversight.”

Establishing a workable form ofgovernance is not straightforward. Thequestion of capacity, competence andcredentials is valid, but there are no easyanswers. Even so, the debate is a stepforward. The question of whetherinvestors should participate on boardsraises a number of issues related topreference, power and protection in thelonger term.

In the offshore fund world, one of thereasons that hedge fund directors haveso many directorships is that theirremuneration is relatively low.Increasing remuneration on the

condition that directors increase theircommitment would mean charging morecosts to the fund. Doing so might makeindependent directors an unaffordableluxury for smaller funds. In a worldwhere many are being asked to do ‘morefor less’, directors might ask to do ‘morefor more’. “Managers and investorsshould demand more from funddirectors, but they should also expect topay more,” says William Jones, Founderand Managing Partner ofManagementPlus Group.

Standard practices need to be introducedcovering what powers these directorshave, the composition of the board, therole or involvement of investors, and thetransparency and accountability given to investors.

Some sector participants believe thatfund governance can never be fullyeffective until it covers the domesticfunds managed by US managers. To thisend, in February, the HFSB proposed aform of governance applicable to USlimited partnerships, which generally donot have boards.10 It proposed that wherea fund doesn’t have an independentgoverning body in place to protectinvestors’ interests, there should be anobligation to ask for investor approvalbefore taking certain actions that mightinvolve a conflict of interest betweenmanager and investor.

Among the hedge fund managersthemselves, corporate governance ismore mature as regulatory expectationsand growing organizations establishcommittee structures and othermechanisms to help professionallymanage the firm in a controlled way. Forexample, valuation committees are nowcommonplace, and we are seeing thebeginning of internal audit functions andquasi-audit committees.

“Good governance is good business,” saysTom Kirkpatrick, Global Head of ClientRelationship Management at GlobeOpFinancial Services, referring to the valueof sound corporate and fund governancein today’s hedge fund industry.

Will we ever get to the point whereinvestors’ interests are routinelyprotected by standard sets of codes andpractices? In the case of offshore funds,will investors ever elect directors? Howcan investors effectively hold directorsaccountable? And should there be morepromulgated standards for directors?

We believe that fund boards along withstandard codes and practices willbecome the norm, significantlybolstering hedge fund governance.

10 http://www.hfsb.org/sites/10188/files/hedge_fund_standards_-_february_2012.pdf.

“Good governance is good business.”

Tom Kirkpatrick, Global Head of Client Relationship Management, GlobeOp Financial Services


• Revisit the composition of your Board ofDirectors in light of the current debate.

• Establish a Board Charter that codifiesDirectors’ roles and responsibilities.

• Look into making directors moreaccountable to investors through more transparency reporting.

• Monitor the progress of the newdiscussion about governance of USdomestic partnerships.

Auditors

As an independent partytasked with the role ofauditing funds, the auditorplays an important role in thevalue chain.

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As an independent party tasked with therole of auditing funds, the auditor playsan important role in the value chain.

The role of the auditor attractedcomments during our interviews and, atthe risk of sounding self serving, we willaddress the auditor’s role and some of theissues raised. As an independent partytasked with the role of auditing funds,the auditor plays an important role in thevalue chain: enhancing the credibilityand reliability of the fund’s financialstatements through the issuance of auditreports. Additionally, auditors provideconfidence on other matters by givingopinions about issues such as internalcontrols and performance reporting.

Investors we spoke to expressedfrustration over their lack of access tocertain information about the auditrelationship and the audit process.

But as the boards of offshore fundsbecome more active, which we expectwill become the case, communicationsbetween directors and auditors willstrengthen to the benefit of investors. The independence of audits lies at theheart of trust in the capital markets, and enhanced quality communicationsbetween fund directors and auditors will benefit investors and bolster truststill further.

As a provider of audit, tax and advisoryservices, audit firms enhance value in anumber of ways. Notably, auditors delivervalue through the independentassessments and judgments made whenperforming audits, which means thatinvestors can confidently rely on thefinancial statements that accompany theaudit report. A high-quality audit requireswell-executed procedures, combinedwith technical expertise and anindependence of mind, which togetherenable the auditor to act with integrityand exercise objectivity and professionalskepticism.

But audit firms contribute in waysbeyond financial statement assurance.Like other participants in the value chain,audit firms have invested in people,processes and technology to keep pacewith the dynamic hedge fundenvironment. With broad talent poolsand global networks, audit firms are wellpositioned to give management valuableinsights – while adhering to applicableindependence requirements – about howto enhance value and build trust in areassuch as controls, valuation, regulatorycompliance, tax planning andcompliance, operations and technology.

More and more, the relationship betweenhedge fund managers and audit firms hasmoved beyond an annual exerciserequired to meet reporting requirements.

Key points

• Auditors play an importantrole in supporting the ‘trustbut verify’ framework.

• The auditor enhances thecredibility of a fund’sfinancial statements andinternal controls throughopinion-based reporting.

• Investors we spoke toexpressed frustration overtheir lack of access tocertain information aboutthe audit relationship andaudit process.

• Enhanced qualitycommunications betweenfund boards and auditorsbenefit investors.

Outlook

As investors push to minimizeoperational risk in the hedgefund sector, they’re drivinginstitutionalization of thesector that is preparing it forsustainable future growth.

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As investors push to minimizeoperational risk in the hedge fund sector,they’re driving institutionalization of thesector that is preparing it for sustainablefuture growth. The demands of investorsand regulators for more transparencyand better controls are adding significantcost to hedge fund managers’ operations— making scalable operationsimportant. But they’re also creating asafer and more sustainable sector thatcan access a broader range of investors.

“Four years on from the credit crisis, thesector’s future blueprint is already set interms of greater transparency, improvinggovernance, better controls and strongerunderlying infrastructures,” explainsPwC’s Casella. “Opportunities forimprovement remain in some areas, but they are likely to be addressed in the future.”

Yet while the changes discussed in thispaper will enable the sector to grow, theywill have significant consequences.Among hedge fund managers, barriers toentry will rise and there could be furthersegmentation among managers. Amongservice providers we are seeingconsolidation of administrators andchanges to the prime broker model couldincrease the cost of leverage.

While the 2008 credit crisis accelerated the sector’s evolution,institutionalization had already beenhappening. The quality of people,controls and processes was alreadyincreasing, but investment in these areas has accelerated in the past fouryears, in part following the earlierevolution of other sectors of the assetmanagement industry.

In the future, hedge fund managers andadministrators will continue the processof standardizing their responses to ODDquestions as they seek to reduce the costsof transparency and controls. For thisreason, we anticipate a shift from a “pull”system to a “push” system wherebyproactive and innovative practices suchas due diligence days, different deliverymechanisms and standardization ofreporting will increase.

The sector will also resolve remainingareas of weakness. Under pressure frominvestors, the sector’s fund managers andoffshore domiciles will improve fundgovernance. New practices may alsoemerge regarding how administratorsverify funds’ underlying assets and prices.

As institutional investors make strongoperational controls and transparency acondition of investment, so they will onlyinvest with the hedge fund managerswith infrastructures that make the grade.Emergence of more institutional-typemanagers will also prepare the way forconvergence with regulated products. Tosome extent, convergence is alreadyhappening—both through institutionalinvestors such as pension plans andthrough retail investment products—butit will accelerate, driven by the managersthat have strong brands, infrastructureand distribution.

But as the sector gets larger andoperational risk diminishes, investmentperformance remains paramount.Should today’s managers not deliver, anew set of entrepreneurial managersmight well emerge—offering an‘alternative’ to the alternatives.Institutional quality infrastructureshould remain a focus in order to meetthe increasing investor and regulatordemands; but not at the cost of amanager’s entrepreneurial spirit.

“Four years on from the credit crisis, the sector’s futureblueprint is already set in terms of greater transparency,improving governance, better controls and stronger underlyinginfrastructures. Opportunities for improvement remain insome areas, but they are likely to be addressed in the future.”

Mark Casella, PwC’s US Alternative Investments Leader

Conclusion

The US hedge fund sector is in aperiod of rapid evolution as itcompletes the transition from“black box to open book.”Yet this evolution is unfinished.

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The US hedge fund sector is in a periodof rapid evolution as it completes thetransition from “black box to openbook.” Yet this evolution is unfinished.In some areas further refinements areneeded to improve investor protectionand generally the process of givinginvestors and their proxies transparencyhas to be made more efficient in order toavoid excessive costs.

For a sector that thrives on exploitinginefficiencies in financial markets, thehedge fund sector is sometimesinefficient itself. Duplication in areassuch as ‘shadow accounting’ can beminimized and due diligence reportingcan benefit from further standardization.

The sector’s transition will bringchallenges as managers adapt toinvestors’ and regulators’ growingdemands and the costs that accompanythem. Yet managers also haveopportunities for growth from ‘big-ticket’ institutional capital investmentthat are far greater than ever before.

What’s more, the growing culture ofcompliance and institutionalization isnot completely incompatible with thedynamism and entrepreneurialism thatgives hedge funds their edge. While riskis being squeezed out of the middle andback office operations, investors acceptthat the front office will need tocontinue to take risk in order to maximize returns.

In order to complete its evolution, winthe trust of institutional investors andregulators, and in turn fulfill its growthpotential, we believe the sector needs torefine and improve the transition it hasstarted. In order to do so it needs tofocus on the five key factors wehighlighted at the beginning of this report.

Concludes Mike Greenstein, GlobalAlternative Investments Leader at PwC:“By concentrating on the areashighlighted in this paper, hedge fundmanagers will be able to demonstratethe high credibility, reliability andalignment of interest, all combined withlow self-orientation, that lie at the coreof being a trusted hedge fund manager.”

“By concentrating on the areas highlighted in this paper, hedgefund managers will be able to demonstrate the high credibility,reliability and alignment of interest, all combined with lowself-orientation, that lie at the core of being a trusted hedgefund manager.”

Mike Greenstein, PwC’s Global Alternative Investments Leader

Five key factors

•Pro-active partnership andalignment of interests acrossthe value chain.

•Standardization of investorreporting and ODD, balancedwith the necessary level of customization.

•Institutional-qualityinfrastructure and controls.

•Robust processes underlyingthe valuation and safekeepingof assets.

•High standards of fund and corporate governance.


This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the

accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers Limited, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

ContactsBarry BenjaminUS & Global Asset Management Leader +1 410 659 [email protected]

Gary Meltzer US Asset Management Advisory Leader +1 646 471 [email protected]

Will TaggartUS & Global Asset Management Tax Leader+1 646 471 2780 [email protected]

Mark CasellaUS Alternative Investments Leader+1 646 471 [email protected]

Mike GreensteinGlobal Alternative Investments Leader1+ 646 471 [email protected]

Paula Smith US Alternative Investments Assurance Leader +1 617 530 [email protected]

www.pwc.com

© 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved.

PwC refers to the US member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please seewww.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute forconsultation with professional advisors.

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