(The article featured
below is a selection from Hedge
Funds and Private Equity: Risk Management and Regulatory Update, which is
available to subscribers of that publication.)
President's Working Group Committees Issue Best Practices for Hedge Fund
Managers and Investors
Two private-sector committees established by the President's Working Group on
Financial Markets have issued
complementary sets of best practices for hedge fund investors and asset managers
in the most comprehensive effort yet to increase accountability for participants
in this industry. Given the global nature of financial markets, the best
practices were designed to be consistent with the work that was recently done in
the United Kingdom to improve hedge fund oversight The recommendations are open
for public comment for 60 days. Based on the comment, the committees may revise
the best practices and standards.
The committee on asset managers called on hedge funds to adopt comprehensive
best practices in the critical areas of disclosure, valuation of assets, risk
management, business operations, compliance and conflicts of interest. The
investors' committee recommended best practices that include two guides. A
Fiduciary's Guide provides recommendations to individuals charged with
evaluating the appropriateness of hedge funds as a component of an investment
portfolio. An Investor's Guide provides recommendations to those charged with
executing and administering a hedge fund program once a hedge fund has been
added to the investment portfolio.
Both sets of best practices recommend broad innovative practices that exceed
existing industry standards. The recommendations complement each other by
encouraging asset managers and investors to hold each other accountable.
Analogizing from the key principles of public company disclosure, the asset
managers committee urged hedge funds to provide investors with a comprehensive
summary of their performance, including a qualitative discussion of hedge fund
performance and annual and quarterly reports. The funds should also timely
disclose material events.
Another crucial practice is to produce independently audited, GAAP-compliant
financial statements so investors can get accurate financial information.
Specifically, fund managers should provide financial information supplementing
FASB Standard No. 157 to help investors assess the risks in the valuation of the
fund's investment positions. Although FAS 157 is not required to be fully
implemented until the end of audit year 2008, fund managers should work closely
with their auditors throughout the year for purposes of implementing it and the
related practices.
Depending upon the extent to which the fund manager invests in illiquid and
difficult-to-value investments, the disclosures should occur at least quarterly
and include the percentage of the fund's portfolio value that is comprised of
each level of the FAS 157 valuation hierarchy. Level 1 is comprised of assets
with highly liquid market prices, while Level 2 assets have no quoted prices but
there are similar assets with quoted prices. Level 3 is for illiquid assets that
have to be priced using models.
Because it is impossible to anticipate every potential conflict of interest
relevant to the hedge fund industry, the report urges fund managers to establish
a Conflicts Committee to review potential conflicts and address them as they
arise. For example, funds should segregate the functions between portfolio
managers and non-trading personnel who are responsible for implementing the
valuation process.
Fund managers should also establish a comprehensive valuation framework to
provide for clear and consistent valuations of all the investment positions in
the fund's portfolio, while minimizing potential conflicts that may arise in the
valuation process. A best practice would be to set up a Valuation Committee with
ultimate responsibility for reviewing compliance with the fund manager's
valuation policies and providing objective oversight of those policies. Further,
independent personnel should be in charge of the valuation of the fund's
investment positions.
The report also urges fund managers to establish a comprehensive risk management
framework that is suited to the size, portfolio, and investment strategies of
the funds. Managers should identify the risks inherent in their investment
strategies, and measure and monitor exposure to these risks. The risk management
framework should be communicated to investors to enable them to assess whether
the fund's risk profile is appropriate for them and how the investment is
performing against that profile.
As part of risk management, hedge funds should assess the creditworthiness of
counterparties and understand the complex legal relationships they may have with
them. The fund manager should monitor the exposure to counterparty credit risk,
including prime brokers and derivatives dealers, and understand the impact of
potential counterparty loss of liquidity or failure.
The investors committee strongly urges hedge fund investors to conduct due
diligence tailored to their individual circumstances and objectives and to the
particular risk and reward character of each hedge fund investment. They should
also evaluate the risk management framework employed by a hedge fund manager.
Similarly, investors should obtain a full understanding of valuation since this
can be the key to deciding whether to make an investment. Each investor should
also develop a comprehensive philosophy regarding the payment of fees and
expenses for all investment management services, relative to the returns sought
and risk taken by an investment strategy.
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