Sophistication and complexity
Hedge funds are the most complex area of the investment management industry, trading all categories of global securities and being the first to sample Wall Street’s latest innovations. Widespread use of sophisticated securities creates operational challenges at every stage of the middle and back office cycle.
Size and structure
Hedge funds are a paradox: despite the complexity of their businesses, virtually all managers are small, entrepreneurial companies. There are only a handful of standalone managers which employ more than 500 people, and the vast majority have 5 - 50 staff. As a result:
- Investors in hedge funds cannot rely on the depth of resources and controls – or deep pockets – which can be taken for granted at a major asset management company or global financial institution.
- Most hedge funds are founded by traders who, while skilled at managing money, may not be effective business managers.
- The asymmetric 2 and 20 fee structure creates conflicts between manager and investor interests, particularly related to valuation.
- There is a complete lack of a standard business model: operational practices vary widely even with respect to basic controls such as wire transfers, portfolio valuation and oversight from independent administrators.
Theft and Fraud
It is unfortunately the case that numerous hedge funds have failed for operational reasons: in all, Castle Hall's proprietary research has identified more than 200 operational "blow ups". Cases such as Bayou, Lipper Convertibles and Lancer remind us that there are no simple red flags that can warn investors of trouble ahead. Hedge funds have failed for operational reasons despite having substantial assets under management, long operating histories, top tier service providers, or having attracted other well-known investors.
We believe that an investor's best defense against unexpected losses is effective due diligence. With better information, investors can avoid operationally deficient firms and take more informed investment decisions, where the risk / return profile includes an assessment of operational risk.