You’re the general counsel at a small to midsize institution that doesn’t have its own endowment manager, much less a team of them. Board members and top administrators bring up the possibility of investing in hedge funds for possible higher returns and as a buffer against market volatility. But they’re worried about increased risk. What do you tell them?
First you might re-evaluate that perceived risk with them. Most hedge funds, in fact, are no riskier than traditional investment options; they are just risky on a different axis. Many have lower investment risk than traditional “long only” portfolios, like mutual funds, because they have more flexibility to pursue return regardless of short-term market trends. Managers of hedge funds can, for instance, sell short — that is, borrow a security, then sell it in anticipation of being able to buy it back at a lower price before repaying the lender. And they can more easily leverage their portfolios, which means they can borrow funds and carry more debt than some other, more-traditional investment vehicles can. While some newer mutual funds are beginning to use “hedged” strategies, they are limited by various regulatory constraints that prevent them from aggressively pursuing those approaches.
In other words, while hedge funds generally do have more mismanagement and fraud risk than a traditional investment portfolio because they are not as heavily regulated, a nimbly managed, reputable hedge fund can see its way through tough market conditions with more success than many more-traditional competitors. An investment in a particular hedge fund is, at its most basic, an investment in the trustworthiness of the fund’s manager. If general counsel, their staff members, and investment professionals don’t trust the fund manager, no amount of due diligence or independent checks and balances should persuade them to invest.
If an institution decides to move into the alternative-investment world and has identified several potential candidates for its portfolio, the next step is to carry out that due diligence, making sure the hedge fund is what its documents say it is, and that the fund fits well into the institution’s portfolio. Doing so can be difficult for small institutional investors because most don’t have specialized staff members who know the peculiarities of the hedge-fund industry. But niche consultants can be hired to assist. With industry-specific experience, they can better assess a hedge fund’s operational and investment risks, and can review investment strategies and techniques, risk-management systems, and other related facets of the fund.
Once the due diligence is done and the money invested, you should ensure that an independent third party be retained to maintain checks and balances on the fund’s activities. The most common of those measures is an annual audit conducted by an independent firm. General counsel should take care to verify the auditor’s independence, and should contact the auditor to confirm that it tracks the fund’s operations or is in a position to do so. (There have been instances in which funds have said they were being audited by a firm, but the firm had never heard of them.) You also should contact the state board that licenses the auditor to make sure that the firm is in good standing and to verify that none of the principals of the hedge fund is affiliated with the auditor. In one recent case, a fund’s auditing company had been formed by one of the principals of the firm acting as the hedge fund’s manager. One of the auditor’s key responsibilities is to verify the existence and consistent use of valuation procedures for the fund’s assets, usually by spot-checking. An auditor who isn’t independent has an incentive to collaborate with the manager rather than to act in behalf of the fund’s investors.
Because an annual audit is usually conducted late in the first quarter of the fiscal year subsequent to the one under scrutiny, a hedge-fund manager has the opportunity to engage in improper conduct before the auditors begin their work. That is, the yearly audit can be too little, too late. That’s why institutional investors often insist that the fund hire a third-party administrator to keep an independent eye on the fund’s activities. That administrator can monitor the fund’s investment portfolio, the value of its assets, and the cash flows among the fund’s accounts, making sure the money is going where the fund says it’s going.
Monitor the monitor, though. Carefully review what services the administrator actually provides. Many offer what is referred to as “admin light,” where they basically act as a conduit between the fund’s investors and the investment manager. Get the fund’s permission to talk directly to the administrator firm and ask exactly what services it is providing. An administrator that provides full services will determine the fund’s net asset value on a periodic basis, usually monthly; prepare and distribute investor statements; and act as a client-relations manager for the fund.
Your institution’s investment and legal staff should carefully review hedge-fund documents to determine what it will be doing with investors’ money, and how much leeway the fund has in deviating from its stated investment terms. The offering documents of most hedge funds describe the investment strategy to be used. (If not, then the funds are probably not being actively sold in the institutional marketplace.) But often those documents give the investment manager latitude in investing assets, creating a risk commonly known as “strategy creep.” For example, recently a manager ran a hedge fund that traded U.S. Treasury debt securities. When profit opportunities in that area declined because so many other funds were trading in the same markets, the manager began trading European sovereign debt instruments. Unfortunately, the investors realized too late that the manager’s knowledge of the American market did not carry over to the European market, and they lost significant capital.
As a fund’s assets grow, its investment strategies might become capacity-constrained, andbecause hedge funds tend to live or die based on performancea manager may decide to branch out into other strategies in an attempt to maintain the fund’s returns. In the late 1990s and early 2000s, a popular investment strategy was convertible arbitrage, which involves carefully timing the purchase of convertible securities, changing them into common stock, and then selling them short. But as more and more managers began pursuing opportunities in that arena, the number of potential deals plateaued, and profit margins began to shrink. A manager who might have been making a 5-percent margin on a trade found the margins reduced to 1 percent or 2 percent. Some convertible-arbitrage managers tried to transfer their skills into other types of arbitrage trades, but most had trouble. The problem is that managers may end up “creeping” into strategies that they don’t know as well as those on which they sold themselves to investors to begin with, or they may not have the staff or systems in place to manage an expanded or new kind of portfolio.
Pay particular attention to fees and expenses. Hedge funds have more leeway than their more-traditional competitors in charging certain types of expenses to the fund, as opposed to bearing those costs themselves. Such fees are usually performance-based — the management firm receives a percentage of the gains it generates for the fund. The danger is that the manager has an incentive to be more aggressive in its investing, since it generally participates in the upside but is not directly penalized for poor performance.
Take note of liquidity provisions specifying the amount of cash on hand that a fund is required to have. Hedge funds are rarely as liquid as more-traditional investment alternatives, and some can even suspend their liquidity altogether. The risk, of course, is that when you want to withdraw your investment from the fund, you simply might not be able to. Finally, beware of provisions allowing for amendment of the fund’s governing documents — language alterations that would let the fund change its material terms, without consent of the investors.
Many such concerns can be worked out in separately negotiated side letters, in which an investor can get certain rights and representations from the fund and its investment manager that other investors may not have. For instance, you might ask for a “most-favored nations” clause, in which a fund agrees that if it gives better terms to any other investor in the fund, it will offer those same terms to you. While many funds are resistant to offering that provision, the size of your investment, whether in raw dollars or in proportion to the fund’s size, can be sufficient leverage. If your investment is $10-million or more, or will represent at least 10 percent of a fund’s assets, you will have a better chance of negotiating a side letter.
Hedge funds clearly require significant investment in both assets and resources. But if their historical return and volatility continue, they can improve long-term endowment performance while reducing the overall volatility of an institution’s portfolio. Investing in them carries risk, but dismissing the possibility does, too.
David M. Matteson and Jeffrey Blumberg are partners in the law firm Gardner Carton & Douglas LLP.
http://chronicle.com Section: Endowments Volume 52, Issue 39, Page B20