Investing in hedge funds just got harder: Corgentum

Corgentum Managing Partner, Jason Scharfman recently authoried a guest article for Pensions and Investments where he discusses the many challenges facing pensions seeking to perform operational due diligence on hedge funds.

The article, which is featured in the publication's Regulation & Legislation section, is entitled, "Investing in hedge funds just got harder" . In the piece, Mr. Scharfman writes, "In the post-Madoff environment, sponsors of pension and other funds face a number of complex challenges with respect to performing due diligence on hedge funds..with all of these potential pitfalls, what are pension funds to do? There are a number of basic steps that can be taken to ensure a pension fund is adequately insulated from bearing unnecessary operational risks when investing in hedge funds through separately managed accounts structures."

Mr. Scharfman goes onto highlight the benefits and pitfalls of separately managed accounts including, the fact that such structures do not completely remove operational risk. The full article can be read on the Pension & Investments website .

Click here to discuss this post.

Permalink

Impact of European hedge fund regulation in the US

In the article entitled, "Europe's Hedge Fund Regulation Efforts Have US Implications", Jason Scharfman, Corgentum Managing Partner, discusses the potential consequences of European hedge fund regulation in the US with the Wall Street Journal. Mr. Scharfman outlines that new regulations are actually "going to hurt a lot of pension funds and other large hedge fund investors because it will be giving them a false sense of security."


He further goes on to clarify that "hedge funds aren't trying to avoid tough regulation so they can commit fraud. Rather, they are trying to avoid the bureaucratic red tape that can cost managers lots of time and money, and ultimately dent investors' returns." The full article can be read on the Wall Street Journal website (subscription required).

Click here to discuss this post.

Permalink.

Obama and Geithner's New Hedge Fund Regulation Fosters Environment for Next Madoff

It has been reported that on June 17 the Obama administration is reported to release its new plans for broad financial regulation. This will reportedly be followed by the June 18th testimony of Timothy Geithner before the House Financial Services Committee.

Reuters reports that it is likely that the administration plan will effectively carve up the existing regulatory framework into four agencies. These will be:
1)the FED
2)the FDIC
3) a new entity which will be the merger of: Office of Thrift Supervision and the Office of the Comptroller of the Currency
4) another new entity which will be the merger of the: SEC and CFTC

Here's an outline of how it is supposedly all supposed to break down:

THE FED
The new plan will support putting the Federal Reserve in charge of broadly overseeing systemic market risk.

While the Fed may lose some of its oversight powers over consumer protection (such as credit cards and insurance issues) it will likely gain several new regulatory powers including supervisory powers over: broker dealers, private equity, derivatives and hedge funds.

The FED's Advisory Committee
The FED would be backed up by a so-called, "advisory committee" (similar to the President Working Group on Financial markets) to assist in monitoring system risk.

THE FDIC
The proposal will give new power to the Federal Deposit Insurance Corp. (FDIC) to oversee the unwinding of troubled financial institutions.

OFFICE OF THRIFT SUPERVISION AND THE OFFICE OF THE COMPTROLLER OF THE CURRENCY
It has also been speculated that the Obama administration will propose merging the Office of Thrift Supervision and the Office of the Comptroller of the Currency. So effectively instead of the current four bank regulatory agencies, we would be left with three larger ones.

THE SEC + CFTC
It has also been reported that a likely merger of the SEC and CFTC is likely - this new entity would oversee: investor protection and market integrity. Although other reports have come out, including this one by Bloomberg, suggesting that Geithner may not support such a merger. Such public dissent by Geithner is nothing new as continued turmoil seems to persist between Geithner and President Obama's chief economic advisor, Larry Summers.

Where is the Unsystemic Risk (Aka: Operational Risk) Regulatory Oversight?

While it has also been reported by CNBC that republicans are preparing their own version of financial system regulatory overhaul, on the surface it seems that these plans have essentially completely ignored, or severely minimized, the risks association with the operational risks in hedge funds.

Operational risks (i.e. - legal and compliance risks, valuation and accounting risks, reputational risks, asset verification, third part independence etc.) are exactly the types of risks that led to the Madoff scandal and the recent deluge of hedge fund frauds and Ponzi schemes. Ignoring such risk fosters a lax regulatory environment that could foster the next Madoff.

It seems as if the voices of the hedge fund industry lobby groups such as AIMA and the MFA, at least in the US, were loud enough to steer the discussion away from operational risk.

Where are the investor advocate groups touting the importance of enhanced operational risk disclosures for hedge funds and private equity?

With regards to alternative investments these proposed plans are essentially the polar opposite of the gist of the European Union's directive which - while still not focusing on operational risk - places a great deal more emphasis on overall transparency, risk reporting and monitoring.

How many more Madoff's will it take before the US, and the rest of the world, begins to dedicate the appropriate focus towards truly monitoring operational risk?

Many compliance and legal professionals in the US feel that a good first step would be with the SEC enhancing form ADV disclosures, but it seems as if this is a low priority on Mary Schapiro's to do list.

A Mini Regulator Not A Super Regulator
The planned merging of the SEC and CFTC, with the combined oversight of the Fed, effectively creates a super regulatory agency for the hedge fund industry.

With respect to operational risk in the alternatives space, this is the wrong approach.

Operational risk data collection and on-going monitoring from hedge funds and private equity will best be served by an experienced regulator focused on the nuances and specifics of the hedge fund industry. Lumping hedge funds together with all other financial institutions (such as banks, mutual funds, thrifts, insurance companies etc.) is simply the wrong approach. Too many small operational issues will slip through this broad regulatory net. These smaller issues may not be deadly in isolation but in aggregation they can snowball into a Madoff like blizzard for the financial markets.

A better approach would be a smaller regulatory agency (or dedicated division of a larger regulator) with the nimbleness and detailed knowledge and experience necessary to properly oversee and monitor operational risk in

[caption id="" align="alignleft" width="192" caption="Harry Markopolos"][/caption]

hedge funds. To quote Harry Markopolos (the man who knew Madoff was a fraud) - they should have enough experience to "have gray hair or no hair."

Unfortunately for US investors, and perhaps fortunately for the hedge fund industry lobbies, who generally it seems oppose such increased transparency and disclosure requirements are not in the plan for the short term regulatory framework.

A Continued Hedge Fund Exodus from Europe?
This proposed lax operational risk disclosure environment, the failing of increased hedge fund regulation on the state level (i.e. - recent news of Connecticut's recent decision to let proposed hedge fund legislation, which would in part

[caption id="" align="alignright" width="92" caption="Crispin Odey"][/caption]

enhance disclosure requirements, die for the time being) combined with the hedge fund industry's disdain over the EU directive, may add more fuel to the talks of a European hedge fund exodus, from hedge fund manager's such as Crispin Odey, from UK to the US. Hopefully, the US is appropriately planning for the impending deluge.

Click here to discuss this post.

Permalink.

AIMA to EU Commission: Thanks, but no thanks on proposed directive

AIMA today announced its intention to fight the European Commission’s draft directive for Alternative Investment Fund Managers tooth and nail.

AIMA’s CEO (Andrew Baker) stated, “There are provisions in this directive with potentially serious consequences for managers, investors, service providers and advisers internationally. As the global trade body for the industry it is right therefore that AIMA takes the lead in mobilising resources in order to secure the best possible outcome for the industry on the directive.”
There has been much furor over this directive – but what exactly is all the fuss about?
On April 30, 2009 the European Commission issued this directive with the goal of creating a comprehensive framework for hedge funds and private equity managers in the European Union. The directive also has implication for certain alternative investment service providers including administrators. This directive is essence seeks to fill a regulatory gap in the European Union by applying to hedge fund and private equity manager and administrators who are established in the EU yet are not regulated under directive 85/611/EEC undertakings for collective investment in transferable securities (UCITS) or so called AIF Managers.

Part of the criticism of this directive is its vagueness, and rightly so. As an example many critics have pointed to the “established in” language questioning what this truly means. For example, would a hedge fund manager originally founded in the US but with a satellite office in the EU be established?

The directive further establishes a number of hoops managers must go through including:
· obtaining authorization from the competent authority of their home Member Sate
· Suitability requirements
· Disclosures with regards to internal arrangements with respect to risk management, valuation, asset safekeeping and regulatory reporting

Hedge funds clearly do not like this proposed piece of legislation one bit. It is very interesting to see different reactions to hedge fund regulation in the US and abroad. In the US, hedge fund groups such as AIMA openly stated they embraced notions of additional regulation and increased transparency. Yet it seems that when regulators take them seriously and make an effort to make disclosure requirements meaningful, the hedge fund industry quickly changes its tune. To me this demonstrates the hedge fund industry’s implicit acceptance of the notion that information disclosure requirements being proposed in the US are far below meaningful levels to place a meaningful disclosure burden on hedge funds.

As an example, Florence Lombard, Executive Director of AIMA stated, “We are very concerned about the manner in which the European Commission’s directive on the industry has been drafted. It does not appear that the drafting of the Alternative Investment Fund Managers Directive has been coordinated with the relevant international institutions. The G20 mandated the Financial Stability Board and IOSCO (International Organization of Securities Commissions) to look at these issues, and it is not clear how this directive will fit in with the new international architecture established by the G20.”

Hedge funds should not necessarily bear this burden and are right to fight it, but taking such a hostile stance as the [Photo]industry has taken against the EU directive does little to foster a collaborative environment where hedge fund investors, regulators and hedge funds themselves share the burden for industry regulation and setting appropriate and meaningful minimum disclosure requirements. Furthermore, global coordination (among groups like the G20, IOSCO, the SEC, the FSA and hedge fund industry groups) should be fostered as opposed to individual jurisdictions and industry lobbies each proposing their own versions of a regulatory framework.
This carving up of the regulatory globe will certainly foster an environment where different practices and disclosure requirements exist in different jurisdictions. This is not necessarily bad in and of itself, but in major hedge funds jurisdictions (UK, Hong Kong, US) a certain level of regulatory uniformity and uniform minimum disclosure requirements will likely only help the hedge fund industry and further protect its investors.

Hedge Fund Red Flag Warning System

The UK’s Serious Fraud Office announced that it is working on creating a hedge fund red –flag warning system. This is a follow up to the two arrests that were made in earlier this week in relation to the Weavering Capital fraud.

The Weaving arrests made via raids at houses in Kent and Surrey marks the first arrest in a hedge fund case in the UK.

It will be interesting to see if regulators in other jurisdictions create similar red-flag systems warning systems. Furthermore, I would like to see how such systems integrate any operational risk concerns instead of focusing purely on investment related concerns and the use of leverage as most of such previous proposal have in the past.

Click here to discuss this post

Permalink

Increased Hazards of Financial Regulation - May Lead to Lower Diligence Standards

APRIL 7, 2009

The Washington Post published an article today, "Expanding financial oversight may add risks - White House regulation plan could increase hazards it's mean to prevent."

It reads in part: "The government is going to be more hands-on,and that's going to imply to people the government is vetting the risks relevant to a hedge fund," said Jason Scharfman, managing director of Corgentum, a firm that evaluates whether hedge funds have proper safe internal procedures. "It exposes investors to a false sense of security that they don't need to perform adequate due diligence on the hedge funds they're investing with."

The full article is available on WashingtonPost.com or on MSNBC.

Click here to discuss this post.

Permalink

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.

Click here to discuss this post.

Permalink

Hedge fund regulation, operational due diligence, Transparency act, Geitner, SEC

MARCH 30, 2009

Hedge fund's seem very nervous about the upcoming G20 summit in London.

So nervous in fact that in a rare sign of unity in this often fragmented space three of the most prominent
industry groups have committed to work towards a global hedge fund standard via a letter to the Financial Stability Forum. The three groups are:

1) Alternative Investment Management Association (AIMA)
2) President's Working Group (aka Plunge Protection Team)
3) Managed Funds Association

The AIMA plan seems to mirror the Financial Services Authority model - so once again it appeared as if the U.S. SEC would be left trailing the rest of the world, but then U.S. President Obama stepped in to state that the U.S. would not lag behind European efforts. Even in times of unity there appears to be discord and the Hedge Fund Standards Board (a European group trying to make its methodology the standard) is still absent as yet.

Within the G20 itself there is a lack of agreement on exactly how to regulate hedge funds. The French government reportedly has referred to the issue as a, "philosophical debate." Like the original incarnations of Tim Geitner's plan, specifics are still lacking from industry organization plans and will likely be filled in by the G20 itself.

The broader hedge fund community voicing its opinion to embrace regulation is commendable if even slightly disingenuous.

Hedge funds will be reregulated and it appears now that the hedge fund community has come to terms with this
and is jumping on the bandwagon lest it appear to be uncooperative and fall prey to an unsympathetic, heavy handed regulatory regime.

If hedge funds are so in favor of regulation why is the industry so quick to react to news of G20 regulation both with the US and abroad? Is it simply fear of the unknown or perhaps a desire to prevent regulating the industry out of existence?

My guess is the answer falls somewhere in-between.

Click here to discuss this post.

Permalink

Hedge Fund Regulation Doesn't Matter: An Artificial Operational Due Diligence Floor

MARCH 27, 2009

The new proposed hedge fund regulations suffer from a number of missed opportunities to raise operational due diligence standards for both "professional" hedge fund allocators such as fund of hedge funds and consultants as well as for individual investors.

Corgentum Consulting has released a new paper entitled, "Hedge Fund Regulation Doesn't Matter: An Artificial Operational Due Diligence Floor." This paper provides an overview of some of the primary shortcomings and pitfalls of the proposed legislation.

It is available here and was recently referenced at Conde Nast Portfolio.

Click here to discuss this post.

Permalink