Almost everyone has a flashback childhood memory of being threatened with not getting dessert (or even dinner, in this author’s case) without cleaning up the old bedroom first. Make the bed, clear out the dirty socks and underpants and get the stray toys and other garbage off the floor, and you’ll get your “allocation.”
It is abundantly clear that any hedge fund manager interested in receiving an allocation from an investor these days needs to do the same thing: clean up their room, or at least clean up their back-end operations, the two most important issues being reducing counterparty risk (and risk overall) and increasing transparency – the socks and the toys, if you will.
How to do that for many managers is easier said than done. While many are responding to the lessons of the global financial crisis by implementing different kinds of operational improvements, it’s tough to know what kind of standard to apply, and even tougher to know what kind of standards potential investors are expecting.
Even so, managers are trying their best to beef up their operations, with a particular emphasis on reducing counterparty risk, improving reporting and transparency and in many cases securing independent firms to handle their valuations and accounting.
Indeed, according to a recent survey by Greenwich Associates and Omgeo (click here to download the full White Paper from Omgeo’s Web site – a short registration process is required), roughly 70% of hedge fund managers surveyed have already done something to spruce up their operations to reduce counterparty risk – boosting their cash accounts, outsourcing their valuation methodologies to a third party and increasing the frequency and detail of their reporting to clients. (See chart below.)
Managers are also moving to revise policies and controls – a biggie on many a due diligence questionnaire. Most importantly, many are increasing the number of prime brokers they work with – 60%, according to the survey results – a move virtually all have done as a way to reduce counterparty risk. The chart below shows how counterparty risk concerns have pushed the majority of hedge funds to the “multiple-primes” format.
To be sure, the tables haven’t completely turned over post-crisis. A whopping 98% of respondents noted they have no plans to join a clearing house to further mitigate counterparty risk, choosing instead to still rely on their prime brokers and other agents to clear trades.
The trade-off to increased operational oversight, of course, is cost. Roughly one-fifth of the survey’s respondents have had to spend money to hire or upgrade internal operations staff, and more two-thirds noted their initiatives have required sinking more money into IT.
And what needs to be fixed and / or automated? Reconciliation, first and foremost, in addition to cash management, collateral management, pricing, accounting and reporting.
Still, most managers have already noted the benefits, namely being able to attract investors and assets.
Of course, there will always be managers who are seemingly too big, too successful and too well-allocated to bother with heightened operations standards that investors might expect. Likewise, there will always be investors willing to let their guard down and drop a few stipulations off the questionnaire because the strategy is great, the returns even better, the manager is finally open, because their peers are already allocated and because they really, really want to be in the fund. (Read our previous post on the risk-reporting chasm still prevalent between managers and investors here.)
But if Greenwich / Omego’s sampling is any sort of reflection of broader trends underway, the bar is likely to end up resting a bit higher for both sides than it used to be, with no one worse for wear.
In other words, a world of cleaner, tidier bedrooms, and more dessert – having your cake and eating it too.