A crucial role
Funds can still impose varying clauses in the documents with, for instance strict gate rules, liquidity restrictions or have variable pricing, or redemptions in cash or other form. Sifting through the documentation requires a forensic skill. “ODD is a very separate discipline,” says Aitken. “You need more of a forensic accounting background— you are dealing with huge documents which can be ambiguous, long and very long-winded. Lawyers have a unique knack of caveating everything and disclosing nothing. It is never quite black and white whether or not you give a veto.”
According to Aitken, regulations or no, ODD has always been crucial. “You’re not just investing in asset classes in the markets but businesses run by people. It’s not as simple as running an equity or bond investment portfolio.” Despite the good intentions the new reporting requirements might be something of a hindrance for investors. Chris Goodeve-Ballard, UK head of operational due diligence at Aon Hewitt which manages $1.5bn of global hedge fund assets on behalf of institutional clients, says that he has certainly seen an increasing number of questions from investors on the ODD function than there used to be.
“They want to know if you have control reports, what failures of due diligence there have been in the past, have you got access to the board of directors. We have absolute veto. A recent case saw a fund which would only let us approach the directors through the lawyers in writing so we immediately vetoed the investment.”
So what does the ODD process involve? There are various layers of examination, says Paciullo. The initial due diligence covers the organisational and legal structure of the fund, looking at offering documents, paperwork and operational documents. At the first stage the ODD team will look at the new managers, “go in and kick tyres to ensure operational integrity,” he says.
This is followed by a deeper stage analysis into the business, examining the historical asset growth, how the firm has fared, its people, how well it is staffed across front and back office, and how trades flow from front to back.
Examining whether managers have invested their own money into the fund as a sign of co-interest is also important, say Laven Partners, a fund management consultancy. Coupled with this the fee structure and remuneration policies can be a good indicator of a manager’s future behaviour. Deutsche Bank’s survey indeed shows that the majority of investors have little or no tolerance for expenses such as non-research related travel or employee compensation being charged to the fund these days. There has also been much more emphasis on independent governance in recent times. Nearly a quarter of respondents to the Deutsche Bank survey had vetoed an investment due to lack of independent governance.
ODD future
It is certainly a stricter environment than it used to be and the rules will make it more difficult for some hedge funds to attract investment than in the past. In particular the burden of ODD may have a stifling effect on smaller or start-up hedge funds that may not be able to provide as detailed a track record as those with better resources or longer history. “The concern is what this means for new start up managers,” says Robin Fuller, executive director at Dexion Capital in Guernsey. “It begs the question of whether, ultimately, investor choice will be impacted because start up managers cannot get funding to build a track record for new funds or investment strategies.”
However, says Aitken, investors should note that different funds can be in different periods of the lifecycle and the investor should not “impose the same standard on a start-up as a more mature fund.”
Also, says Goodeve-Ballard, if a manager is able to clear up any points that need addressing the company will look to reinvest with it in the future. “Surely it depends what the veto is about. For some—an example being where a manager had been sanctioned by the SEC—we wouldn’t ever invest. However for other things — for example where a fund didn’t have an independent administrator, but corrected this issue— we would invest if the matter is sorted out.”
Either way it is a strict new world that hedge funds are finding themselves in. Hopefully this will benefit investors without stifling the entrepreneurial hedge fund spirit.
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