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Hedge fund evolution after the 2007 sub-prime crisis

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In summer 2007 hedge funds found themselves being the target of erroneous and adverse media coverage, implying that the sub-prime crisis – and the liquidity squeeze that followed thereafter – was s

In summer 2007 hedge funds found themselves being the target of erroneous and adverse media coverage, implying that the sub-prime crisis – and the liquidity squeeze that followed thereafter – was somehow caused by hedge funds. As a result, hedge funds (traditionally not very transparent and bashful of all PR and media contact) are beginning to realise that there are benefits of having “good PR”. This is clearly evidenced by the increasing respect attributed by securities regulators and hedge fund investors to organisations like AIMA and the Hedge Fund Working Group, which are leading the way in new initiatives to strengthen the character of hedge funds. 

The Hedge Fund Working Group, for example, has identified five key areas in this regard. These include disclosure to investors and counterparties, valuation, prudential and risk issues, fund governance and activism.

Out of these five key areas, two stand out as being especially important: valuation and fund governance. With regards to valuation, while uncommon in the vast majority of hedge funds, there are instances where fund directors have insisted on the establishment of specific provisions for unexpected losses arising from the irregular pricing of illiquid fund assets. The offset to these specific provisions is the deferral of a comparable percentage of incentive fees due to the manager. By recommending and organising such a provision, the fund directors are, arguably, acting prudently and responsibly, as the provisions will be released when actual sale proceeds for these assets are realised. This does not conflict with the use of model based pricing; investment banks use model based pricing but may also establish provisions where positions are not readily marked to market. It is recognised that these will not apply for all classes of illiquid fund assets but should be a good starting point in some cases and this mechanism is especially useful for close-end type funds or ‘closed’ open-end funds.

On the topic of fund governance, it is no good having external fund directors who have made it their professional career to be on the boards of as many funds as possible at a annual fee of as low as USD2,500. In these cases, it is not uncommon for limitation of personal liability clauses, which are aligned to their fees, to be embedded in their service agreements. Best practice would be for managers to have truly independent directors who are paid a higher annual fee and who can offer experience, knowledge on good governance practices and possibly investor contacts as well.

Sigma Partnership , a specialist compliance advisory and accounting services firm, has also made initiatives to better the role of hedge funds. It pioneered a series of monthly briefing notes in early 2006 on issues of topical interest to managers, investors, participants and other interested service providers and the current distribution figure is over 1,000. Many of these notes are subsequently re-distributed by recipients, often law firms, and the eventual coverage is a lot greater. Topics have ranged from guidance on the need to change LLP agreements due to new accounting guidelines, MiFID regulatory matters, and taxation and governance issues. Forthcoming briefings will include professional and pragmatic commentary on some of these key areas.   

It is clear that the role of hedge funds in today’s world needs to be more transparent and ‘user-friendly’. Initiatives described above are paving the way forward. 

By Joe Seet, Senior Partner, Sigma Partnership

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