e Managed Funds Associations Practice's Sound?

APRIL 1, 2009

Ahead of the now ongoing G20 London summit and eventual US regulation, the traditionally clandestine hedge fund industry has seemingly raised its own public profile via the actions of leading industry associations in the past few weeks. It seems the goal of this public profile raising is two-fold:
1) To show the world that the hedge fund industry is serious about self-regulating itself and it doesn't really need strict regulatory oversight

2) The hedge fund industry welcomes regulation BUT, (to plead in the alternative) if the hedge fund industry should be regulated then:

a) it wants a hand in designing that regulation

b) it wants just enough regulation to quell the current ire of the masses who have lost millions in Ponzi schemes and irresponsible risk taking, but not too much to actually make a difference

One of the most vocal voices in this campaign has been the Managed Funds Association which has released:
1) Sound Practices for Hedge Fund Managers 2009
2) A due diligence questionnaire

Each of these items should be addressed individually:

1) Sound Practices for Hedge Fund Managers 2009-
In what is essentially a regurgitation of the Presidents Working Group's Report of the Asset Managers' Committee, this 277 page document provides a series of platitude like generalist statements which are supposed to guilt hedge fund managers into building stronger operations. The most interesting thing to me about this document is that it contains approximately 1 page of "guidance" to hedge fund managers regarding what it terms to be operational risk. This as much an oxymoron as is a jumbo shrimp.

Operational risk is the very same series of risks that caused Ponzi schemes such as Madoff. Yet, apparently it's not sound practice to focus on such risks, rather things like Anti-Money Laundering (which received an entire chapter in the report) are apparently more important. To be fair the report does cover other operational areas such as valuation, trading and compliance in more detail without using the term "operational risk."

Specifically the report states, "A Hedge Fund Manager should have a strong operational infrastructure that is commensurate with the complexity of its business..." If anyone can explain to me what exactly this means I'd love to know. For example, is an infrastructure with no in-house accounting staff commensurate with a $50 million long/short manager? What about a $50 million distressed fund? Would one on-staff accountant be commensurate with the needs of a $500 million distressed fund? What if a hedge fund outsources the entire accounting process to a top-tier administrator? Is that commensurate enough? Of course the answer is it depends - to which the sound practices offer both hedge fund managers and investors no real guidance in developing an answer to these question.

2) A due diligence questionnaire-
This questionnaire, which in light of the massive Sound Practices document, is a ridiculously short 15 pages begins with an introduction from the MFA stating, " We believe that Hedge Funds are valuable to our capital markets and provide investors with valuable portfolio diversification and risk management." Translation, just give this questionnaire to your manager (or make any small changes you want), have them complete it, check the box and move on.

There is a general movement in the operational due diligence industry away from utilizing due diligence questionnaires. In certain instances, due diligence questionnaires are useful tools but the key is that they be detailed and probing. Operational due diligence is a detailed oriented and resource intensive process - the responsibility for which hedge fund investors cannot outsource to a questionnaire.

A Modest Proposal:
Far be it from me to offer criticism without offering my own solution.

Sound practice documents and due diligence questionnaires (along with the regulation of the hedge fund industry) are a good thing. However, such guidelines and questionnaires become very dangerous to hedge fund investors when they come with a wink and a nod that "the hedge fund industry accepts regulation, is self-regulating and if you don't believe it here's a guide to perform your own cursory due diligence." To me this is equivalent to giving investors a loaded gun with a hairpin trigger. The same types of investors that lost money with recent frauds, are exactly the same types that will look towards the MFA's due diligence questionnaire for guidance. Unfortunately, it is unbelievably short on real world specifics. Yes, the due diligence and the Sound Practices are meant to be only a starting point but my questions is - why set the bar so low?

A better approach would be to require hedge fund managers to provide an increased global uniform level of transparency and disclosure in relation to both financial and operational data. This would be the first step
towards leveling the playing field for hedge fund investors and stamping out fraud. But unfortunately in the hedge fund industry disclosure is dirty word, so for now we are left with the 2009 model of the old status quo.

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