Focus on Hedge Funds:

Hedge Funds Enter 2009 With Multiple Pressures: Gaps in Credibility, Technology, Timely Reporting

Originally published January 5, 2009

NEW YORK — As is likely throughout the financial industry, hedge funds are already facing a New Year that will be filled with new regulation. Some of the new rules have not yet been determined, but new accounting standards are one area that is already codified, giving hedge funds a place to turn their attention first. FASB 157 took effect in 2008, setting the accounting standard for measuring fair value in equities transactions, and FASB 161 will take effect this year [in 2009] as a standard for measuring value in derivatives and hedging transactions.

“In the hedge fund space, funds are not currently so audited or checked out, so traditional investment managers typically do a performance audit of their funds,” says Adam Schneider, Principal at Deloitte Consulting. “If they are private accounts, the audit makes sure the money is still there. If it’s a situation where [the investor] effectively owns the records, the custodian of the assets, the statements and the performance — that’s fine. Many products actually work like that, such as insurance products. They have investment-like characteristics but less in the way of individual checks.”

While improving accounting standards cannot cure trading losses, emphasizes Schneider, valuations must be sustainable. “Investment funds have to have value so they can let people into the products,” he says. “If they’re not valued in a way that’s sustainable, then they’re letting people into the investment products and a price is too high or too low, and they’re letting people out when the price is too high or low, it’s not an acceptable situation to have valuations that are not as good as they can be. This is hard to do but those valuations are important and are critical for investors getting in and out, and investors in the middle. They’re also the basis for performance.”

Overall, the financial industry has to restore some credibility, and valuation can be one way to do so, according to Schneider. “There will be an extraordinary [examination] of quality and safety, which includes audits,” he says. “That includes asset audits, ensuring that the assets are really there, and performance audits. Both are normal and standard processes in much of the industry. It’s not like we’re inventing a new thing.”

Hedge fund administrators and the overall hedge fund industry are dealing with shortages in experienced administrative staff to contend with increasing regulation, according to Scott Powell, Senior Global Product Manager at Confluence, an investment data management automation provider. “Investors and the current environment have expanded audits to include a thorough review of process controls,” says Powell. “All the while, the complexity of investments, investment strategies and reporting on those investments continues to evolve.”

Hedge funds will continue to work with their auditors very aggressively on processes and controls, according to Powell’s colleague, Kirk Botula, Executive Vice President and Chief Operating Officer at Confluence. “The accounting firms continue to push the actual work to the hedge funds themselves and they’re going to have continued strain in the back office that will continue the trend toward data consolidation and automation,” says Botula. “The hedge funds tend to be less automated in their operations than some of the large scale retail asset management product categories such as mutual funds. There’s a ton of work still being done in spreadsheets. Even though spreadsheets are the utility knife of the industry, they are an error prone and risky way to conduct business.”

Consolidation and aggregation of information could be the new keys to meeting the new accounting standards, as well as other possible new regulation for hedge funds. “With our clients, we aggregate information from many sources into a single repository so rather than having islands of information scattered around an organization in little silos, centralizing information,” says Botula. “Imagine all the client reports, regulatory reports, statutory reports and all the accounting reports that are radiating out of a hedge fund on a 24/7 basis. Just think of this massive exhaust of data and information; 90 percent of it is really re-purposing the same information. There is a finite set of content that takes a ton of work to get to and once it’s there, 90 percent of it tends to be what’s being re-purposed in all the messaging. But what happens now is that information essentially gets handcrafted each time for each message.”

For example, a holdings report pulls information from an accounting system into the typical spreadsheet, weeds out the irrelevant information and formats it, notes Botula. “Then they will produce a top 10 holdings list and go through that exact same manual process to create some separate report for someone else that’s really re-purposing the exact same information,” he says. “The consolidation is driven around trying to gather that 90 percent of the information that gets repurposed to put it in a platform where it can be easily accessed, queried and re-presented. That will also lead to the consolidation of business functions but if you consolidate the information then you can have the information available on an as-needed basis for the different business units.”

The best means of controlling back office operations for hedge funds is automating processes, according to Powell. “Reliance on manual processes and spreadsheets is a challenge,” he says. “The key is automating data management processes and report generation — from the collection of data, creation of reports, confirmation of report data and the delivery of reports to regulators, auditors and investors. By consolidating data into one central database, fund administrators gain greater control over their data, since it is validated once and stored to be leveraged for multiple purposes.”

Automation, however, presents a significant cost challenge, according to Schneider. “Automating operations is a wonderful thing — but the reality is that it typically requires a significant capital investment and I don’t believe the capital is going to be available,” he says. “About what people are trying to do, does it improve things? Yes. Does it meet our current economic needs? No, not if you need a speedy cost savings. Does it improve quality? Yes. If your fundamental driver is cost, maybe someone can do something quickly but certain strategies like outsourcing are just easier when done quickly. It’s not that no one will do it, but it’s not their first choice.”

Overall, the hedge fund industry is contending with a credibility gap throughout the financial industry as a whole, observes Schneider, who expects more hedge fund regulation. “I expect more verification that investments are going to the purpose for which they’re ascribed,” he says. “That will take place fairly rapidly. The recent events just pushed that over the line even more. There are a couple arguments around not disclosing private, transparent strategies. But in reality these strategies seem to be everywhere at the same time. They are not quite large cap and small cap, but it’s pretty well understood what merger arbitrage means. So we’re going to see far more verification that the assets are properly deployed than ever before, but that does not necessarily require the assets to be disclosed to the general public.”

The registration of hedge funds previously attempted by regulators would not necessarily protect investors, according to Schneider. “Protecting investors is much more about actual audits of fund investments and audits of performance,” he says. “Most of the rest of the industry provides audited performance statements. Somehow the hedge fund world does not. Whether a regulator will push them on [this] is [President-elect] Obama’s decision. But it’s highly likely given some of the history and the reality. It’s one thing to lose money in a bad bet, it’s another thing for the money never to have been there.”

By comparison, traditional buy-side investment firms use sophisticated compliance programs pre- and post-trade, as well as documentation, audits, performance reviews, process reviews, pricing and valuation measures, notes Schneider. “The question is how long the hedge fund industry can pretend it doesn’t need to invest in these measures,” he says. “If investors don’t demand it, maybe hedge funds get a bye, but in light of recent events, it’s hard to believe that investors would accept that.”

Although hedge funds’ short-selling was targeted as a likely area for more regulation and restriction in the midst of the financial crisis breaking this fall, the practice cannot be held entirely responsible, according to Schneider. “From my perspective, short selling is a normal market activity,” he says. “No one guarantees that stock prices will always be rising. Every person who buys eventually sells; every person who sells eventually buys. The order and timing of that are less relevant. It is possible to consider some version of the uptick rule which gives time and market energy for people to respond to short sales. But that would be a regulatory change that to my knowledge isn’t on the table. It’s probably productive from a societal perspective to let people take bets against the crowd. It’s not like structurally they run it down to zero and get out. Structurally, [someone] must re-purchase the shares.”

   
     

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