Unhedged Commentary

Thursday, October 16, 2014

Unhedged Commentary: How Hedge Fund Directors Can Fight Cyber Crime

By Don Seymour and Neil Stone-Wigg

Willie Sutton, one of the most notorious bank robbers in history and one of the FBI’s most wanted men of the 1950s, allegedly said that he robbed banks “because that is where the money is.”

Fast forward to 2014 and “Slick Willie” would undoubtedly respond differently today, as banks are no longer easy places to rob and bank robbers no longer need a gun. The Internet is the platform for new communications — and new crime — in our highly data-driven and interconnected world. The trillions of dollars managed by hedge funds are now increasingly under attack from cybercriminals, whose tools of the trade are computers, technology networks and a devious mind.

Cybersecurity is a fast-moving, constantly evolving threat. It has caught the attention of regulatory organizations like the Securities and Exchange Commission and the International Organization of Securities Commissions, which are deeply concerned about such threats and predict “that the next big financial shock will come from cyber space.”

Cyber crimes have spawned a new breed of outlaws, who operate largely unseen and are very often difficult to recognize. Modern cybercriminals are highly intelligent, creative and determined. They present a dynamic and serious threat to fund investors. Bad actors could include criminals, foreign governments, military, activist groups or even competitors.

The range of risks includes not just fraud, bad publicity, or business continuity, but loss of material non-public information as well. The sheer volume of threats that could emerge from any fund information loss creates substantial risks for fund sponsors and investors.

In the eyes of the cybercriminal, hedge funds represent soft targets relative to banks because their smaller size might not afford them the scale required to invest in the people and sophisticated technology necessary to maintain strong cybersecurity controls, including those against the unique risks presented by mobile devices. This is not solely a concern for the investment manager, but for any service provider to the hedge fund, including its directors.

Hedge funds rely on a supply chain of service providers who operate with a steady stream of important and confidential fund information. Sophisticated cybercriminals can easily identify weak links in this information chain and exploit them.

An integral part of the fund information ecosystem rests with its board of directors. A well-functioning board of directors is essential to a well-managed hedge fund. Hedge fund directors need to be provided with the information required to properly engage and understand the risks relevant to the hedge fund from its investment and risk management professionals. They need to ensure that the fund information they receive strikes the right balance between a comprehensive macro perspective and the required level of detail when necessary.

These fiduciary obligations mean that hedge fund directors often have access to sensitive fund information and need the ability to properly synthesize — and protect — that information. If the hedge fund directors are truly involved in the affairs of the fund, they will ultimately collect and hold many gigabytes of digital fund information, inevitably making information security a major concern.

Any small piece of fund information in the wrong hands could be damaging to the fund. To a sophisticated cybercriminal, seemingly insignificant information could actually be the final piece of solving a puzzle that inflicts real losses on the fund investors whom hedge fund directors have a duty to protect.

Unlike deposits in banks, hedge fund investments are not guaranteed by the federal government. Instead, fund investors and the SEC are relying on the sponsor’s judgment in making sound decisions about the level of safety and sophistication of the fund’s service providers under Rule 206(4)7, which mandates that registered investment advisers develop and implement written policies and procedures to comply with SEC regulations. In today’s highly sophisticated industry, an unsophisticated service provider is a competitive disadvantage and even potentially detrimental to fund investors. The consequences of an unsophisticated approach to cybersecurity are foreseeable and unjustified. Prevention is always better than the cure.

Hedge fund directors should expect a marked increase in inquiries from fund investors focused on mitigating this threat, including requests for information regarding the ability of the directors to create the network transparency to assess risk, comply with SEC cybersecurity threat assessment and annual compliance reviews under Rule 206(4)7. Fund investors will also need to be assured that directors have the ability to invest in people, process and technology to properly manage and protect the fund information within their control. And, if the hedge fund does suffer an intrusion, directors should expect to be interrogated by the FBI and answer serious questions about the security of the fund information held within their control. Yes, the FBI. Welcome to the major league of crime. The threat is real and growing exponentially.

When it comes to security control, hedge fund directors cannot simply set it and forget it. Set it today and it could be obsolete tomorrow, because cyber criminals are continuously looking for any weakness to exploit, no matter how small. The simplistic legacy technology approaches used in the past are now outdated and any gaps in information security could prove costly for fund investors. Sophisticated technology is the key.

No hedge fund director wants to be exposed as the Achilles heel in the hedge fund structure and the source of security breaches that cause fund investors to suffer losses. It would be unnerving, career-ending and potentially negligent. It’s a known risk that can be actively managed.

Don Seymour is the founder of DMS Offshore Investment Services, a fund governance firm. Neil Stone-Wigg is vice president of information technology at DMS Offshore Investment Services.

Wednesday, October 01, 2014

Unhedged Commentary: Leveling the Playing Field for Emerging Managers

By Bret Price

The Securities and Exchange Commission is increasing the number of its annual exams. Investor due diligence questionnaires are becoming longer, with more requests for detail. To meet these growing investor and regulatory best practice demands, hedge fund managers will need to embrace technology — and emerging managers in particular, a multitude of service providers.

Managers have to hire the staff to cope with these requirements and take on added duties themselves, while still making time for marketing and raising capital, not to mention squeezing out a return. These demands are tough for most hedge fund managers but are virtually unattainable for most emerging managers. As a result, we are seeing an industry drift into haves and the have-nots.

Citi produced a survey last year that stratified hedge funds by size and then published data related to their business expenses. After I read the survey, a vivid image came to mind of the emerging hedge fund manager pushing the proverbial boulder up a steep hill. How can such a manager ever compete with larger peers? For several reasons, it is almost impossible.

To start, management company expense for an emerging manager with assets of $100 million is an astounding 244 basis points, or 2.44 percent of assets under management. That factors in salaries for investment and business personnel and other amounts charged directly to the management company itself. The costs decrease dramatically as you go up the asset ladder; a $500 million fund averages 90 basis points, and a $5 billion fund averages a little under 60 basis points. The survey concluded that a fund needs to reach $300 million in assets before it can break even.

Another problem, according to the Citi survey, is that a $5 billion fund will spend, in absolute dollars, almost 15 times more on technology than a $500 million fund. While digesting this statistic, one should contemplate the implications. The fundamental question is: Why? Is it that the larger manager is needlessly spending money, or is it that the larger manager thinks it needs the technology? It is reasonable to conclude that the larger manager is responding to increasing business demands by investing in technology. Does the emerging manager have the same business demands? Presumably it does, so how does the emerging manager ever hope to compete?

The competitive landscape is further challenged if we consider the actual basis points involved when a fund manager charges third-party expenses directly back to the fund (known as chargebacks), rather than use management fees to pay for the expenses. Incredibly, a $100 million fund will charge back, on average, 46 basis points, but once the fund grows to $5 billion the fund chargeback is lowered to about 15 bps. While the actual dollar amount for the $5 billion fund is significantly higher, the proportion of remaining assets is actually less for the smaller manager, causing a dampening effect on an emerging manager’s net performance. It is worth noting that the pressure to compress management fees is causing more funds to increase their chargebacks. This hinders net performance for all managers, but again, this proportionally disadvantages the emerging manager.

As an industry we need to adapt, innovate and help emerging managers overcome these many challenges. If newer fund managers can’t compete for the invested dollar, we may witness the choking of our manager pipeline. Not only will this ultimately diminish choice for investors and stifle competition, but it will also have an adverse effect on the industries that support and serve the hedge fund market.

The cost of supporting disparate technology systems within an enterprise for separate areas of the business is high, even for multibillion-dollar hedge funds, though this has been standard practice for years. Many fund managers are running as many as four or five different systems. The cost to integrate, maintain, and build around and on top of these systems is affectionately known as "Straight-Through Processing", a label that makes it sound like a net positive for the manager. In the 1990s maybe that was the case, but today it could be more appropriately described as Financial Leakage, referring to all the money that is drained out of a firm to support and maintain all of these systems. But today there are technology platform providers that can design all-inclusive models that are as competitively thorough, or almost as thorough, as the best-of-breed systems currently in use. These all-inclusive systems cost much less than running multiple technology systems.

Service providers and technology firms are also starting to offer flexible pricing models. Notably, they are increasingly setting up agreements to share in financial exposure by offering short-term financing, which allows the new manager to actively participate in this new era and attain a higher degree of institutionalization.

In the end, it is in everyone’s interest to find ways to adapt and support our manager pipeline, so that emerging managers can compete on a level playing field.

Bret Price is the hedge fund practice leader at ClearStructure Financial Technology, a financial software provider in Danbury, Connecticut.

Thursday, September 18, 2014

Unhedged Commentary: The Death of Hedge Funds? Not Yet.

By Mark Anson

Recently, CalPERS, the nation’s largest pension fund, decided to shut down its hedge fund program. The fund cited costs and capacity as the reasons for the move. These are hardly new issues in the hedge fund world or, for that matter, in alternative asset management generally. Despite CalPERS’ well known influence among institutional investors, and pension funds in particular, I’m not betting on a mass exodus from hedge funds anytime soon.

The fee issue, for example, has long been a sticking point for institutional investors. The standard “2 and 20” fee structure is deeply embedded in hedge fund culture. But it’s important to remember that this fee structure is not unique to hedge funds. Private equity, venture capital, and real estate funds all have similar fee structures — sometimes even more expensive — and these funds represent a significant portion of every pension plan’s portfolio.

So, was it really the fees that bothered CalPERS? In my view, it has less to do with costs and more to do with the short-term nature of hedge fund trading strategies. “Long Term Value Creation” is the promise of almost every private equity marketing deck that has come across my desk. It is a neat selling point that you can take an undervalued company, add value through leverage, operational expertise, acquisitions, or management change, and then sell if for a profit. Conversely, hedge funds seem more commercial because their value-add is often based on short-term investments rather than the development of private asset values. For better or worse, some investors prefer the value creation of private equity to the trading strategies of hedge funds.

But, of course, there is a price for this value creation approach — illiquidity. Yes, many hedge funds have one-year lock ups, but private equity funds have 10-year lock ups (plus 2 to 3 years in potential extensions). Private equity, venture capital, and real estate are the least liquid investments in any institutional investor’s portfolio. And this illiquidity typically comes on top of a fee structure that looks a lot like what most hedge funds offer. It should also be noted that many hedge fund strategies have the advantage of reducing volatility compared with the broad stock market. Recent reports peg the hedge fund industry at $2.7 trillion — a dramatic increase from ten years ago. Based on that scale and growth, capacity would not seem to be a major issue for investors. But access to the most successful hedge funds is limited. The best hedge fund managers know the capacity limits of their trading strategies and limit the amount of capital that they accept from investors. Sometimes, you have to stick with a good hedge fund manager for awhile before capacity opens up.

Contrast this with the private equity industry, where there is almost no capacity limit. Capacity can be an issue in venture capital, but as a percentage of private investing, VC represents a very small portion of the illiquid asset world. Private real estate funds are similar to PE funds in that they need large amounts of capital to be successful. This is precisely why private equity firms and real estate firms court the large public pension plans — they have the biggest investment purses.

The key point is that hedge funds, private equity, venture capital, and real estate all play important roles in diversified portfolios. Some institutional investors emphasize the liquid strategies of hedge funds, while others concentrate on the illiquid value creation of private assets. The right balance amongst all of these depends upon a variety of factors, including the institution’s liability stream, risk tolerance, need for liquidity, understanding of these strategies, and access to the best managers.

There is no right or wrong answer, no one-size-fits-all allocation. CalPERS decided that the right strategy for its own portfolio was to exit the trading strategies of hedge funds but keep its illiquid strategies in private equity and real estate. For a public pension plan with long-term liabilities, this is a prudent decision. But other pension funds, endowments, foundations, and family offices will continue to reach very different conclusions.

Mark Anson is the chief investment officer for Acadia Capital and previously served as president of Nuveen Investments, in addition to holding the CEO and CIO roles at Hermes Pension Management and the British Telecom Pension Scheme. From 2001 to 2005 he served as the chief Investment officer of the California Public Employees’ Retirement System, where he spearheaded the pension’s hedge fund investment program.

Friday, August 22, 2014

Unhedged Commentary: Don’t Cut Corners on Corporate Governance

By Ingrid Pierce

   Ingrid Pierce, Walkers

We know all too well the difficulties in getting a start-up fund in position to launch. The demands of the current regulatory climate and the cost of compliance have caused many to rethink their strategic plans for managing third-party money. Start-up funds are balancing the desire to be on-market against the cost of establishing a blue-chip corporate governance regime from the outset. There are plenty of competing priorities for a new manager, including premises, infrastructure and recruitment, not to mention implementing robust compliance procedures.

But unless a new manager is blessed with a demonstrable track record at a previous shop or is so well-known in the industry that launching is a breeze, in today’s climate cutting corporate governance corners during the embryonic launch process could spell the fund’s speedy demise. Essentially, managers must avoid substituting short-term gain for long-term pain.

Plenty of column inches have been devoted to investors’ increased demands for independent oversight, so this should come as no surprise to managers. We spend a lot of time discussing the retention of independent directors for offshore corporate funds with managers. There is an annual cost to the appointments; this can be material for a start-up fund. Managers will, not unreasonably, often ask whether it is possible to avoid the expense unless and until an investor raises the question or requires the fund to engage an independent board. The answer is yes, although two considerations come to mind. One, will any investors decline to invest in the absence of a wholly or partly independent board? Two, will changing the board to add one or more independents down the road raise any flags?

As to the first question, we have seen several cases where institutional investors have demanded a level of independence prior to making an investment. Some investors have a list of potential independent directors and will invest only if one of those names serves on the board. As to the second question, while adding independence should be far from a red flag, any change to the fund’s directors will involve additional time and expense in updating offering materials, notifying investors and making the relevant filings with the government and the regulator. In short, it is possible to defer this expense although it may not be possible to avoid it altogether.

Walkers’ survey of new hedge funds formed for our clients in 2013 showed nearly 80 percent had some form of independent representation on the board. Furthermore, there is early evidence of a developing trend toward fully independent boards, although that has yet to take hold as the typical governance structure.

The recent Statement of Guidance issued by the Cayman Islands Monetary Authority (CIMA) on the expected standards of corporate governance for Cayman-regulated investment funds is widely seen in the industry as the barometer for best practice, although well-run funds of a certain size and complexity will already be following most of these steps. The governing body of a fund has always had ultimate responsibility for overseeing and supervising the activities and affairs of the fund, and all funds should therefore require regular reports from their service providers to assist the board or other governing body in fulfilling its responsibility. The Cayman Islands has also introduced a new law to deal with the registration and licensing of directors of regulated funds, but other issues relating to director capacity and a potential database of fund directors are still to be determined.

The climate for new hedge fund launches for a start-up manager is as good as it has been at any point since the end of the global financial crisis, and while good governance with independent oversight is not exactly a silver bullet to a successful launch, you certainly can’t expect one without it.

Ingrid Pierce is Global Managing Partner at Walkers, an international law firm. She is based in the Cayman Islands office, where she also heads the Cayman Investment Funds Group.

Thursday, July 17, 2014

Unhedged Commentary: Japan’s Commitment Issues

   Jason Mitchell co-manages the GLG Global Equities Fund

By Jason Mitchell

Japan’s great experiment in Abenomics remains as divided now as a year and a half ago, when Shinzo Abe won re-election. Gains in the Topix have been impressive but less so when adjusted for the weaker Yen. And while central bank measures have supported U.S. and European recoveries, Japan by comparison still struggles with how to get the reflation narrative right. That structural reforms, the third arrow of Abenomics, have lost momentum hasn’t helped.

But while tax, labour, and regulatory reforms all suffer from high expectations, corporate governance reform remains comparatively modest. Thus far, progress has been measured by improved board representation, a rise in Western-style activism and a reset in governance norms like the recently-passed Stewardship Code.

But there’s a larger effort underway that treats corporate governance and capital efficiency as interdependent. The Nikkei 400, which weighs return on equity, profitability and governance, marks the latest move with its effects already apparent. Reacting to its exclusion from the index, Amada announced plans for a 100 percent payout ratio over the next two years to make its ROE more competitive.

In April, the Ministry of Economy, Trade and Industry published the ITO Review of Competitiveness and Incentive for Sustainable Growth, addressing capital efficiency and governance as an interlinked problem. Better governance, the logic goes, leads to improved capital allocation.

The emphasis on ROE isn’t surprising. Declining corporate profitability, excess capacity and low reinvestment form the productivity gap that Abenomic reflation means to close. Persistent deflation removed pressure on managements to put corporate balance sheets to work, leaving almost half of Topix companies at the end of 2013 sitting on net cash positions, up from 35 percent a decade ago.

How can investors play this? Attempts to correlate governance criteria and share performance have yielded mixed results at best, particularly in the case of Japan, where studies even show companies with lower governance scores outperforming higher-scoring companies. The same applies for returns where high-ROE companies have historically underperformed the Topix. Companies with rising ROEs fare better, but the relative outperformance applies only to the top quintile.

Another way to test the ITO Review’s recommendations is to view companies’ capital efficiency targets as a commitment signal. Like the electoral pledges that politicians make, companies are similarly constrained — and incentivized to fulfil — their commitments to investors. Should they miss these targets, they lose market credibility. While most companies already publish sales, operating profit and net income forecasts, few issue returns guidance. In fact, we found only 86 companies that commit to ROE or return on assets (ROA) targets.

What do companies who formally commit to capital efficiency targets reveal? Considering the persistent, equal-weighted outperformance of the group relative to the Topix over the past 10 years, there are several messages.

First, the market appears to reward companies that formally commit to return targets with higher relative valuations. With the group’s earnings growth lagging the Topix, outperformance owed itself entirely to a higher valuation rating on a price-to-earnings and price-to-book basis. The group went from trading at a valuation discount to the Topix to ultimately a premium over the 10 year period.

Second, this signal modulates across different market regimes, lagging during Koizumi’s 2006 reform agenda, the 2009 global economic recovery and the start of Abe’s term in 2013. It’s consistent with the idea that higher quality companies underperform during reflationary periods, when markets are less discriminating.

Third, the commitment to a financial return target appears to matter more than the target itself. Companies that issue unambitious targets — defined as a 100 basis points or less improvement relative to their long term average — outperformed both the Topix and the companies that issue ambitious targets.

Finally, leadership appears to drive broader adoption in sectors. Companies like Ajinomoto, Komatsu and Mitsubishi Heavy all led by example, establishing return targets later adopted by peers. These often outlined transformational change to the capital structure. Like Amada, these say more about better asset allocation than any underlying change to business.

Japan’s challenges are already well defined: an aging demographic, energy dependence, geopolitical pressure from China, weak corporate governance, a deflation-conditioned national psyche and unprecedented monetary expansion. With the Bank of Japan priming a 2 percent inflation target, investors will likely demand greater accountability for a company’s capital structure. Correlations between share outperformance and companies committing to return targets should prompt greater attention to those signalling their seriousness about re-evaluating their capital structure.

In short, conflating capital efficiency and corporate governance carries significant advantages for Japan. It reinforces the integrity of Abenomic reform and positions Japan for further rerating. On a price to book value basis, Japan’s 9 percent ROE implies a 7.5 percent equity risk premium, well above that of the US and Europe at 4 to 5 percent. If Japan improves its ROE to Europe’s level, its risk premium should narrow, providing substantial further market upside.

Jason Mitchell co-manages the GLG Global Equities Fund and oversees GLG’s sustainability investment strategies.

*Unless stated otherwise all market data is from Bloomberg.

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