Due Diligence on Managed Accounts - Essential or Irrelevant?
One of the core topics at the recent GAIM Ops Cayman conference was, unsurprisingly, managed accounts. One speaker at the conference gave the statistic that, of an industry that may top $4 trillion in assets by 2015, 25% of this is expected to be in managed account structures. Like them or loathe them, managed accounts are clearly here to stay.
There is broad agreement that managed accounts provide the well known benefits of TLC - transparency, liquidity and control. We completely agree with these principles although, like many good ideas, the devil is in the details, and the details are in the execution. Liquidity, in particular, is a very tricky topic: the same panel at GAIM Ops Cayman included a representative from a manager who raised a range of thoughtful questions in this area. One issue was whether a manager holding hard to value securities could actually face a conflict with his fiduciary responsibility to his fund investors if he allowed a managed account to redeem during a market crisis when the flagship fund was gated. A very good point.
From our side, we would like to raise some high level points related to operational due diligence on managed accounts. Is operational due diligence on a managed account necessary, or simply a waste of time?
At one level, there is an argument that ops dd on a managed account does not add value - after all, the investor controls the account and, in particular, has full confidence that the assets actually exist in the investor's own PB / custody account. If we have prevented the risk of another Madoff (assuming - ahem - that you don't open a managed account where the assets are held in the manager's related party broker dealer!) why bother with ops dd at all?
In our view, this position illustrates a broader disconnect as to the purpose and benefits of effective operational due diligence. In our discussions with investors, we frequently note that the objective of operational due diligence is not solely to protect against the risk of fraud: in our view, operational due diligence is really about the broad category of business risk, rather than narrow concerns of only operations and accounting. Even more specifically, ops dd is certainly about more that simply a focus on fraud and only fraud.
To illustrate some of our thinking, we would like to highlight five areas where we believe operational due diligence on a managed account can add value.
1) Reputational Risk. We agree that a managed account provides proof that assets exist (at least for custodied assets - existence comfort can break down if the account holds participations back to the master fund for assets such as bank debt). Moreover, the account can be structured so that a manager has no power to move assets out of the PB account. These are powerful advantages: but, even with these benefits, a managed account does not isolate the investor from broader reputational risk.
In the worst case scenario, let's say the manager is a fraudster, his main fund blows up, and the manager is last seen en route to his Brazilian plastic surgeon. Yes, the managed account provides asset protection and clearly places the managed account investor in a vastly superior position - he still, we assume, has his money. However, once the initial euphoria of avoiding disaster fades away, end investors will still ask difficult questions - why was any allocation made to the underlying manager at all? Why was it that no-one knew the guy was a crook even as we deployed significant capital to the firm? Did the investor rely on the managed account at the expense of asking necessary questions about the underlying manager? In the final analysis, allocating even a cent to someone who turns out to be a crook could create pervasive, reputational damage.
In our view, this means that managed account investors still need to know a lot about what happens in the main fund. If, for example, the manager's flagship fund is valued in an entirely different way than the managed account, the least worst outcome will be tracking error, as we note below. At worst, you don't want to be in a position investing with a manager who turns out to have faked prices in the flagship vehicle, even if your investment was ring fenced from fraud. Your reputation may be damaged and - even worse - with all that managed account transparency is there any risk that you might get sued too?
2) Business Risk. As we noted above, we view operational due diligence to be about much more than operations: good due diligence should consider a comprehensive spectrum of business risk issues. Whether you allocate through a managed account or via a commingled fund, many, identical questions at the asset management company remain. Who owns the firm, and is that ownership structure stable? How is compensation arranged? Is there an effective alignment of interests between manager and investor, especially in the area of reinvestment of personal capital? What is the culture of the organization? Is there excessive staff turnover? Is the CFO and / or COO appropriately qualified, experienced and empowered?
More generally, managed account investors are exposed to similar risks in areas of compliance and disaster recovery. Even if investing via a managed account, investors should still understand, for example, the quality of compliance documentation, the experience of the CCO, the outcome of recent regulatory inspections, and controls in key compliance areas such as personal trading, soft dollars, and conflicts of interest. Equally, it would remiss of an investor not to understand a manager's disaster recovery and business interruption planning, especially if the manager is in San Francisco or Florida, facing natural hazards.
3) Accounting Risk. One of the more important due diligence issues we have seen over the past year is the impact of managed accounts on existing operational infrastructure. In more than one instance, we have seen situations where a back office has been well organized and has a successful history working with a single administrator and a set group of PBs and counterparties. However, the manager then accepts three, four or five new managed accounts, introducing new administrator relationships and potentially new PBs. What was once an effective back office suddenly becomes stretched and unfocused, as the team is forced to respond to ill informed questions from right and left. This can particularly be a problem when new administrators without an understanding of the strategy (and potentially with less capable systems and people) try to implement their own accounting.
Other accounting risks include the need to handle more trade allocations, more accounts within the general ledger, and more reconciliations. As an overarching observation, investors should recognize that $100 million though a new managed account unavoidably creates a greater operational and infrastructure burden than an additional $100 million subscription to the flagship fund. The impact of a new managed account across multiple areas of a manager's back office should, therefore, be a key focus for due diligence.
4) Administration Risk. A related point for the managed account investor is the need to understand the quality of procedures performed by your own administrator. For your own account, will the administrator complete full service accounting, or is the admin really offering some form of month end NAV Lite? If there is full service administration, will the admin complete accounting monthly, weekly, or daily?
The biggest issue here relates to a short cut we see far too frequently: many administrators working with managed accounts seek to populate their accounting records with a download from the PB, which is then reconciled back....to the PB. In too many cases, the administrator accepts this entirely circular process and never gets a trade file from the manager, with the outcome that the admin never completes a three way (manager to PB to admin) reconciliation. As such, the admin's work is limited to a representation of information already in the PB's systems. In this circumstance, it becomes vital to understand whether the manager is at least reconciling their records to the PB because, without this check, the admin could be caught in a predictable, "garbage in, garbage out" trap. Once more, this information can only be gathered through onsite discussion with the manager and their back office team.
5. Tracking Risk. Our final point is to highlight the need to monitor tracking error between the flagship fund - the reference entity - and the managed account. This can highlight many areas of potential operational risk, even if tracking error is anticipated.
At one level, any managed account introduces the need for effective trade allocation policies. Does the manager allocate pre trade or post trade, and are there any wrinkes like odd lot fills, rebalancing flows and cross trades. Thinking more suspiciously, what control prevents a manager allocating certain choice trades to the flagship fund and not your account, assuming that you have negotiated a keener fee structure?
A separate trade issue is the need for pre trade compliance, especially as most managed accounts will introduce at least some, long-only style investment restrictions. Issues should as leverage limits, sector concentration limits, no sin stocks, environmentally responsible investing etc. may be common in the long only world, but very few hedge fund managers have installed a Charles River or MacGregor style pre trade compliance module. Moreover, very very few hedge fund managers are used to thinking about pre trade compliance issues before they pull the trigger on a new position. Does the manager have something beyond an Excel spreadsheet in place to monitor trade instructions?
We have already touched on the issue of valuation above: for any hard to value security, there could easily be material differences between manager, administrator and custodian marks. Has a valuation procedure been put in place and, for anything tricky, will it be the manager or your administrator who will price the portfolio? Moreover, even if the administrator seeks to value (or verify value) for the portfolio, will it turn out that the manager will still have material involvement in hard to value securities? Have you reviewed the manager's valuation policy and are you comfortable that the manager's valuation committee is actually meaningful rather than a simply a "looks good in the marketing presentation" rubber stamp?
As a final point, another source of tracking error is the difficulty of replicating more complex counterparty arrangements. Who will be responsible for negotiating ISDAs and within what time frame? Again, hedge fund managers are not used to thinking about allocation issues, and a key source of tracking error can be the one off trade allocated in the main fund on swap through JPM, when it turns out that an ISDA with JPM has not been negotiated for the managed account.
Our hope in our discussion above is to at least pose questions and illustrate the scope of due diligence issues which can arise, even in a managed account structure. As always, the purpose of due diligence is to provide better information and make the investor more informed about risk - even if we remain entirely comfortable to accept that risk. In this framework, we certainly see due diligence, even on a managed account, as something which can help avoid unexpected questions - let alone monetary losses - further down the line.
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Hedge Fund Operational Due Diligence
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