Due Diligence Remains Essential

As states begin regulating hedge funds in 2011, don't assume 'registered' equals 'safe'

The writing is on the wall. With the Dodd-Frank Wall Street Reform and Consumer Protection Act now law, as of July 11, 2011, state regulators will be in charge of overseeing and auditing investment advisors (including advisors to hedge funds) with $100 million or less in assets under management (AUM). There is an exception for hedge fund and private equity advisors with less than $150 million under management utilizing the private advisor exemption.

Prior to this legislation, states have generally only regulated firms with $25 million or less in AUM and the Securities Exchange Commission (SEC) has generally been responsible for overseeing firms with AUM of $25 million and above. According to Pertrac’s 2009 Hedge Fund Database study, there are roughly 3,000 additional single-strategy hedge fund managers and roughly 1,500 additional fund-of-hedge fund managers that will come under state regulation next year with the implementation of the new Act.

Will States Be Up to the Task?

Clearly the number of investment firms in the $25-$100 million AUM bucket makes this a daunting task for state regulators. Now that the SEC will be eyeing the big fish and systemic risk, state agencies are busying adjusting to meet their new mandate. Still, questions revolve around each state’s capacity, capability, and process. For example, in a dismal budget environment, will agencies be successful in their attempt to win more resources to handle the workload? Additionally, will the states be able to hire the right kind of new regulators who truly understand alternative investment structures, risk management procedures, and operational technicalities of hedge funds? 

Don’t Assume “Registered” Equals “Safe”

To their credit, the states are evaluating options and instituting new policies to address resource constraints and consistency in process.  However, as the states take on more oversight it is reasonable to expect challenges in coverage and depth of examination out of the gate.  One of the unintended consequences of this change in “oversight” may be that the investing public, and some financial advisors, will become complacent and assume that “registered” equals “safe.”

While the growth of alternative asset classes and strategies has been robust over the last 20 years, the investment category and its reputation have been tainted by firms like Amaranth Partners, Bayou Fund, Long Term Capital Management, and, of course the uber-scoundrel, Madoff Securities. While we agree that regulation is necessary, due diligence from experienced investment professionals is a way for financial advisors to further mitigate the risk of the total loss of investors’ capital through fraudulent situations or risky investment strategies that go sour.

Hiring due diligence professionals (whether internally or outsourced) to do the heavy lifting when it comes to alternative investment managers makes good financial sense and provides a measure of business risk management. The headline and financial risk of investing in yet another “Madoff” is far greater than the expense of having well-vetted options at your finger tips that match the demands of your clients. In this field, honesty, clarity, transparency and thoroughness are the best policies. While we might be biased, we have seen the benefits firsthand.

A Fundamental Duty

The value of due diligence is crucial when allocating capital to single-manager hedge funds and funds-of- hedge funds. Financial advisors and wealth managers are faced with the ever time-consuming tasks of sourcing managers, selecting and monitoring managers, diversifying client portfolios, managing risk, and most importantly, servicing clients. It is imperative that advisors either allocate the proper resources internally toward professional initial and ongoing due diligence, or outsource that function to a consultant or fund-of-fund manager with the know-how and resources to do so.

The perennial debate between whether to utilize single-strategy hedge fund managers or funds-of-hedge fund managers to diversify a client’s portfolio can go on and on like a broken record. For most financial advisors, funds-of-hedge funds tend to be a more compelling option for several reasons. With funds-of-hedge funds, advisors get access to multiple single-manager funds (that may not be accessible on a direct basis), diversity across different investing styles and strategies, and an extra layer of due diligence provided by the fund-of-hedge fund manager selecting the constituent single-strategy hedge funds. The flip side of the coin relates to higher fees and the potential dilution of returns by stronger hedge funds in the portfolio.

In conclusion, due diligence by established investment professionals and experienced funds-of-hedge funds benefit both wealth managers and investors above and beyond what state regulators can possibly provide. In a financial world where alternative asset classes seem opaque, uncertain and segmented, we believe due diligence provides clear light, process and structure for wealth managers to follow as prudent advisors to their clients.

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