Becoming a “trusted hedge fund advisor”

At a time when trust is a topic of debate in the financial sector, hedge fund managers have been taking great strides towards improving investor confidence. In doing so, they’ve been moving towards gaining the status of ‘trusted hedge fund advisor’. But to meet institutional investors’ demanding requirements, and so to fulfil their growth potential, managers need to complete the transition.

In the four years since the credit crisis, hedge fund managers have travelled a long way on a journey we describe as “from black box to open book”. Working with their service providers, they’ve significantly improved transparency, operational infrastructures and governance. Pension funds, insurance companies, sovereign wealth funds and others have rewarded them by steadily increasing their investment allocations.

Yet this journey is not finished. While the magnitude of the improvements made must not be under-estimated, we’ve identified a number of measures which will be critical for raising investor confidence, and will do so as efficiently as possible. Addressing these areas will, we believe, bring opportunities for growth from ‘big-ticket’ institutional investors that are greater than before.

“Black box to open book”

We base these conclusions on our global ‘Black Box to Open Book’ research project conducted over the past two years. Seeking to identify what improvements have been made, and where room for improvement remains, we’ve interviewed approximately 70 institutional investors, regulators, hedge fund managers, administrators, prime brokers and directors. Our research reveals the sector to be in the midst of a ‘trust and transparency’ transition, for which the broad framework is in place but not complete.

Change driven by the actions of regulators, investors and lawmakers has profoundly impacted the industry, especially when you consider how globalised the hedge fund industry has become. Whether managers are based in the U.S, Europe or Asia Pacific, they are all experiencing similar challenges and opportunities. Each region is developing at a different pace and has different nuances. For example, US managers naturally tend to have the most developed operational infrastructures, as they’re more established than their counterparts elsewhere. At the same time, many only started to hire independent administrators in the past few years and the discussion about effective governance is in its early stages – both lagging Europe’s approach to these topics. And in Asia, the fast-growing high-net-worth investor base might give managers the option of choosing not to institutionalise their operations if they’re content to remain relatively small in size, although those looking to attract institutional capital are working to develop world-class infrastructure In Europe, managers are bracing themselves for eventual changes under AIFMD , while more and more are developing global brands and expanding internationally.

The US version of our survey, published in June and following the Asian and European versions, focused on the elements needed to be a ‘trusted hedge fund advisor’. It identified five conceptual elements that we believe breed trust: transparency, credibility, reliability and alignment of interest – combined with low self-orientation.

The “trusted hedge fund advisor” equation¹
TA = T+C+R+AI
  SO

TA = Trusted Hedge Fund Advisor; T = Transparency; C = Credibility; R = Reliability; AI = Alignment of Interest; SO = Self-Orientation

Five measures for raising trust

More specifically, we identified the five areas that we think hedge fund managers and their service providers need to focus on in order to complete the emerging ‘trust and transparency’ framework. These are:

  • Pro-active partnership and alignment of interests across the value chain
    Managers need to build a spirit of proactive partnership with investors. Going beyond standard reporting and communication, some managers are giving investors far greater insights into their businesses and even becoming virtual extensions of their investors’ organisations.
  • Standardization of investor reporting and operational due diligence, balanced with the necessary level of customisation
    Following the 80/20 rule, managers need to standardise the basic information they give to investors, in order to focus on customising the information that investors find most useful.
  • Institutional-quality infrastructure and controls
    Probing investor due diligence and broader and more intense regulatory scrutiny have combined to encourage managers to upgrade their infrastructures. Reviewing whether it’s as good as you think it is will give reassurance that it’s fit for purpose.
  • Robust processes underlying the valuation and safekeeping of assets
    Administrators’ transparency reporting, such as price and asset verification, is well-received, but there is room for more standardisation. Prime brokers have a challenge to develop innovative but safe ways to use collateral.
  • High standards of fund and corporate governance
    Managers need to respond to emerging fund governance standards, as calls for independent oversight increase. Proposals for governance are beginning to extend to US limited partnership structures.

Completing the shift to ‘trusted hedge fund adviser’

The hedge fund sector is in a period of rapid evolution as managers and their service providers work to build trust. As they do so, they’ll need to make further refinements and to make the process of giving investors and regulators transparency more efficient.

By concentrating on the five key points highlighted above, we believe that hedge fund managers will be able to demonstrate the high credibility, reliability and alignment of interest, all combined with low self-orientation, that lie at the core of being a trusted hedge fund advisor.

Note: Our studies have led the debate about hedge fund trust and transparency, leading to comment on CNBC and in the Financial Times, as well as other publications and at industry conferences. Please follow the links to see full versions of the: Asian, European and US studies.

¹The above equation is based on the well-known “trusted advisor” equation (source: http://trustedadvisor.com) but modified to suit the hedge fund industry.