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President's Working Group Outlines Principles for Private Pools of Capital

The President's Working Group on Financial Markets ("PWG") has updated its guidelines for hedge funds and other private pools of capital. PWG noted that the market has changed considerably since its last statement in 1999. PWG recognizes both the benefits that private pools of capital offer to the financial markets and the challenges they pose to market participants and policymakers. Market discipline is the best approach for protecting investors and limiting systemic risk, according to the statement. PWG also concluded that direct investments in private pools of capital should be limited to sophisticated investors. Investors in the pools should be able to identify, analyze and bear the risks, PWG advised.

PWG called for clear and meaningful disclosure by private pools of capital to enable investors to evaluate their decisions. Investors should evaluate the pools' investment objectives, strategies, risks, fees, liquidity and performance history. They should also evaluate the managers and personnel and whether the pools' service providers are independent from the managers. Investors should also consider potential conflicts of interest and whether the appropriate controls are in place to manage those conflicts.

PWG also called on both investors and investment vehicle fiduciaries to analyze the pools' valuation methodologies, their performance calculation processes and their business and operational risk management systems. They should also consider the extent of any independent audit evaluations of the processes and systems.

With regard to concerns about whether unsophisticated investors are being exposed to private pools through holdings of pension funds, fund-of-funds or other investment vehicles, PWG said that fiduciaries should follow sound practices and act in the best interests of the beneficiaries. Fiduciaries should consider the suitability of an investment by weighing investment objectives and risk tolerances. Fiduciaries should also evaluate the pools' management and personnel, its service providers and any conflicts of interest.

PWG noted that the financing terms provided by creditors and counterparties can be an important constraint on leverage employed by private pools of capital. Due diligence should determine the information that will be provided during the credit relationship. PWG said that creditors and counterparties should frequently measure their credit exposures to private pools of capital and assess the range of uncertainty surrounding their exposure estimates. PWG urged rigorous stress testing to quantify the impact of adverse market events.

PWG said that creditors and counterparties should seek information about both quantitative and qualitative indicators of pools' net asset value, performance, market and credit risk exposure, and liquidity. If sufficient information is not provided, PWG said they should tighten margin, collateral and other credit terms. PWG also urged creditors and counterparties to comply with industry sound practices to strengthen their processing, clearing and settlement arrangements for credit derivatives and other over-the-counter derivatives.

PWG said that managers of private pools of capital should ensure that high quality, material information can be delivered to creditors, counterparties and investors in a timely manner. The pools' risk management and valuation policies should comply with industry sound practices.

PWG advised that supervisors should actively monitor financial market developments and revise their guidance as needed. PWG also urged supervisors to use all available channels of coordination and cooperation across financial industry sectors and international borders in carrying out their responsibilities related to international institutions and their exposures to private pools and leveraged counterparties.