At January’s 2010 International Funds Conference, hosted by Stuarts, Krys & Associates and RBC Wealth, a panel debated transparency as it applied to the hedge fund industry. The panel monitored by Ken Krys of Krys & Associates looked at transparency from four separate and distinct viewpoints: from that of a director of a hedge fund (Burke Files), a US attorney (Marc Mukasey), a Cayman attorney (Anthony Akiwumi) and a Cayman insolvency practitioner (Margot MacInnis).
The session commenced with a general review of transparency, which has been a topic of interest that is growing over the past few years, and is certainly being given considerable attention recently, especially in the wake of a number of financial institution and hedge fund failures. It is clear that regulators and investors in particular are calling for more transparency. Following the failure of Lehman Brothers and the bailout of AIG in 2008, regulators, institutional investors and private investors all over the world are demanding increased transparency of hedge funds.
Add to the mix the Bernard Madoff Ponzi scheme and that demand for transparency has surpassed poor performance as a top concern in some circles. In an effort to detect risks before they grow to systemic risks some regulators are seeking to enact legislation that would require hedge funds to provide increased levels of transparency. Regulators in onshore and offshore jurisdictions are considering what needs to be done to address this issue. There have been bills introduced in the United States that would require funds worth more than $50 million to regularly disclose the value of their investments; and another that seeks to help protect investors, identify systemic risk, prevent fraud and would also require advisers to hedge funds, private equity funds, venture capital funds and other private pools to register with the Securities and Exchange Commission (SEC).
The topic produced interesting viewpoints and lively debates at the conference. It was noted that the failure of some fund managers to provide adequate levels of transparency could negatively affect the ability of the fund to attract capital. But, the solution cannot simply be full disclosure, as this is expensive and impractical as it is simply impossible to identify and disclose every risk and material event. Even if regulators received more information, they do not have the resources to properly analyse it.
One of the challenges in providing greater transparency is balancing the costs of doing so and ensuring that a fund can maintain operational efficiency. Providing disclosure adds to the cost of business, a burden that must be passed on to investors. The challenge for a hedge fund is in striking the right balance of disclosure and transparency while not compromising the elements that give it a competitive edge. Many service providers and investment managers see an improvement in the processes as a possible solution to meet the demand for greater transparency. Fund managers are starting to automate key processes such as pricing, cash management, reconciliation and collateral management as well as escalating the use of more independent valuations and accounting to build investor confidence.
There seems to be no consensus so far. A particular challenge relates to the balance of privacy and competitive advantage over the demand for greater disclosure. Businesses must be able to protect the specific elements that separate themselves from others, particularly their investment methods, their analytical processes and any intelligence they have. In addition the personal information of their investors and service providers must be protected.
The panel queried whether additional disclosure is the answer? Discussing the Madoff case and that fuller disclosure would probably not have helped. Where a fraud is perpetrated, increased disclosure of false information does not assist. It was agreed that most importantly the focus should be on what is done with the information and how investors can use that information to assess the risks. Investors who are researching which funds to invest would be better served conducting appropriate investigations, analysis and due diligence of information that is available.
The panellists highlighted, that in cases like Madoff, there were red flags that suggested a fraud was occurring. Many investors simply ignored the signs. These include the investment manager holding custody of the client’s assets rather than them being held by third-party financial institutions. Also, the investment manager produced the reporting to investors, it did not come from a third-party provider or administrator. For a fund the size of Madoff, many found the fact that it was audited by a service provider with limited accounting service personnel to be concerning.
Thirdly, there is the old adage, if it looks too good to be true, then it probably is. The returns in the Madoff funds grossly outperformed the market and many cautioned investors that it was all a charade.
Investors cannot simply rely on word of mouth recommendations about which hedge funds are best. Investors need to focus on analysis and due diligence including reading the fund’s offering memorandum, understanding how the assets are valued, understanding the fee structure and understanding any limitations on redemption rights. Research on the background of the hedge fund managers should also be considered when evaluating funds. By considering a number of factors along with an understanding of the risks, investors can be better positioned and informed in making their investment decisions.
Panel members cautioned that there must be appropriate balance in meeting the demands of investors and regulators and that this should be done without prejudicing the confidentiality and economic interests of other stakeholders. Those funds able to find that balance are best positioned to enjoy the benefits of investment in their funds.