The New Standard of Investor Transparency and Accountability
By Joanna Conte, CPA, Partner, Assurance Services, Alternative Investment Group
Investors are demanding greater transparency from alternative investment firms. While the pendulum has shifted towards less opacity in the industry to a degree, managers still struggle to achieve the right balance between sharing information with investors and giving away trade secrets or proprietary details about the manager’s investment strategy.
Regulatory initiatives have played a role in furthering the cause of transparency, as the Securities and Exchange Commission (“SEC”) requires Registered Investment Advisers to provide Form PF and the European Union’s (EU) Alternative Investment Fund Managers Directive (AIFMD) also requires investment management firms to submit detailed reporting. The industry has been adapting to increased reporting requirements, which has contributed to the shift towards more sharing of information with investors.
This trend is important, as industry surveys indicate that a significant percentage of investors have declined to invest with at least one hedge fund or private equity fund due to transparency concerns.
This article discusses certain specific investor expectations with respect to transparency and how managers can address these expectations.
Investors Expect More Than Quarterly Performance Reports
Investors are demanding more than quarterly return reporting. Investors expect:
- More frequent reporting. Data indicates that a significant percentage of hedge fund investors are demanding performance reports on a weekly or daily basis while more than half of private equity investors are demanding reports on a monthly basis.
- More detailed reporting. Investors want to know more than how the fund performed. Increasingly, they want to know:
– Specific positions and concentration.
- A lengthier due diligence process. The selling cycle is getting longer, and investors are basing decisions on more than just a tear sheet. Once a fund has made the investor’s “short list,” it is not uncommon for certain institutional investors to conduct an extended due diligence process that spans years, not months, before an investment is approved.
– Prospective investors may also expect a manager to have engaged an independent auditor to verify the manager’s performance track record. External attestation from an independent accounting firm can be a differentiator to investors, for both smaller and larger funds.
Investors Expect More Than A DDQ
Manager selection requires justification beyond the numbers. Investors are no longer satisfied to collect a standardized Due Diligence Questionnaire (“DDQ”) with an organizational chart, a description of key personnel at the investment firm, and a listing of fund service providers. Investors expect:
- Completion of customized, detailed questionnaires. Managers may be asked to furnish information about the firm’s compliance program, chief compliance officer, results of regulatory inspections, procedures for monitoring personal account trading, legal proceedings to which the firm is or has been a party, transactions with affiliates, and potential conflicts of interest and more.
- An understanding of the manager’s investment process. This encompasses more than disclosure of a manager’s historical returns. This includes the manager’s investment philosophy and particulars about the process of assembling and maintaining the portfolio. How is the portfolio constructed? How does the manager balance the pursuit of alpha with capital preservation and risk management? This is equally important to smaller, individual investors as it is to family offices, fund of funds, endowments, foundations, and institutional plan sponsors. It is information that can be used, for example, by independent financial planning/wealth management firms to address the concerns of high net worth individual investors that are seeking an allocation to alternative investments but may require more than a performance track record to feel comfortable with the asset class.
- Fund administration outsourcing. This extends beyond hedge funds as investors are increasingly focused on outsourcing of the administration function for private equity and real estate funds. While data indicate that the majority of hedge funds outsource their fund administration, the percentage of private equity and real estate funds that do so is significantly lower in comparison, but it is growing. The trend of private equity and real estate fund administration outsourcing is being fueled in part by demands from investors, particularly institutional investors. Outsourced back office solutions deliver separation of duties and lend credibility to the accounting and reporting process. It’s also noteworthy that outsourced fund administration is not just for larger investment managers. New and smaller firms, with limited historic returns to attract investors, can gain a competitive advantage in the due diligence process by utilizing a third party administrator.
- Controls. Investor due diligence with respect to controls has evolved into much more than a “check the box” exercise. Investors are increasingly differentiating managers based on which managers have implemented controls that are considered “best in class.” Investors want to understand:
– Valuation process, including the process applicable to private and thinly traded investments. Investors may inquire about whether independent third party appraisers are utilized, a manager’s use of back testing as a validation technique for the valuations, and any adverse findings in the internal control reports issued for the manager or administrator. Investors may seek to understand valuation governance, such as whether the valuation function is sufficiently segregated and whether the valuations are subjected to review by a Valuation Committee or other governing body comprised of members that are independent from fund management.
– Risk management processes. Risk management considerations have taken on increasingly higher importance in investor decision-making. What is the manager’s approach to monitoring and managing leverage risk, liquidity risk, counterparty credit risk, market risk, operational risk, and legal and compliance risk? Investors want managers to demonstrate how each of these risk management categories is addressed at the firm.
– Investment sourcing and monitoring processes, including processes applicable to investments in other investment funds. Allocators and fund of funds should be prepared to demonstrate to investors the procedures in place related to initial and ongoing investment due diligence. Which procedures are undertaken by the manager prior to making the investment? Which monitoring procedures are carried out after the investment is made?
Investors Want To Know About Transactions With Affiliates
When it comes to transactions with affiliates and potential conflicts of interest, both regulators and investors expect full disclosure from managers. Specifically, investors expect:
- A complete description of the entities of the manager and their ownership structure.
- If the firm manages multiple funds, co-investment vehicles or separate accounts:
– What are the manager’s trade and expense allocation procedures?
– Is there any cross-trading between related entities or any other transactions?
- Disclosure of any affiliated service providers, including any affiliated broker-dealers or execution agents that charge commissions.
– Disclosure of any affiliated fund investments.
– Does the manager or its affiliates sit on the board of directors or otherwise have the ability to control or exert influence over portfolio companies in which the fund is invested?
- Disclosure of any fee or expense arrangements involving affiliates. On this subject, there has been a recent focus on private equity funds. With respect to private equity funds, investors want to know:
– Are any “broken deal” expenses allocated to the fund?
– Does the manager receive any monitoring or consulting fees from portfolio companies in which the fund is invested? When a portfolio company is sold, will the manager be entitled to any termination or equivalent fees? Investors expect to be informed about any fee arrangements between the manager and portfolio companies that have the potential to impact the value of fund investments or the proceeds from their disposition.
- Disclosure of any related party investors in the fund and the amount of any related party interest in the aggregate.
– Does the manager enter into side letters with any investors? Do any investors receive fee or redemption terms that are more favorable than the terms described in the fund’s offering documents?
- Does the manager engage in any other businesses apart from investment management?
The importance of providing complete disclosure to investors about transactions with affiliates has been underscored by recent proceedings brought against managers by the SEC, concerning insufficient or non-disclosure of related party fees and activities. In one recent case, the SEC reached a settlement with a manager that failed to disclose a fund’s investment in a related entity and the associated impact to the fund’s expenses. Although the manager did ultimately disclose the arrangement in the fund’s audited financial statements, the SEC noted that there was insufficient disclosure of the matter in the fund’s offering documents; furthermore, the fund’s audited financial statements were delivered 9 months after they were required to be delivered pursuant to the Custody Rule 206(4)-2 of the Advisors Act.
It cannot be overemphasized that investors expect complete information on conflicts of interest and an understanding of how the manager addresses these conflicts.
Cybersecurity: An Emerging Area of Investor Focus
Investment management firms, like all businesses, are confronted with cybersecurity threats. Investors have this on their radar and want to understand the steps that have been undertaken by a manager to prevent and minimize damage from cybersecurity breaches. In addition to potential legal liability in the event of a breach, managers that fail to implement reasonable cybersecurity protocols are exposed to significant reputational risk. In recent years, the SEC has imposed sanctions against managers for failing to adopt policies and procedures reasonably designed to protect confidential client information, resulting in hackers gaining access to customers’ names and social security information.
Cybersecurity threats include the risks that arise from external hackers but also include internal threats. Investors are increasingly interested in knowing what measures are in place to prevent an internal security incident, including the manager’s policies around employee access to secure client data. Investors want to hear about protections beyond just anti-virus software and firewalls. Investors expect managers to demonstrate cybersecurity preparedness, including how the IT function is handled (outsourced or in-house), how the manager identifies risks, and which safeguards have been implemented.
It is clear that transparency in the investment management industry is a theme that is here to stay and a topic that resonates with investors. Investment managers and other financial industry professionals should be aware of the new standards of transparency and accountability to investors. This will be increasingly key to attracting capital, including institutional money. A robust culture of transparency can serve to positively differentiate a manager and presents a branding opportunity. Investor demand for transparency and accountability is a global phenomenon, as investors in the United States, Europe and Asia are requesting more information both during the due diligence process and subsequent to making an investment. Investors are sophisticated and want to make informed investment decisions based on an analysis of returns and risks. More than ever, managers should be prepared to disseminate information to investors and to operate in a manner that is transparent and displays accountability.
The topic of investor transparency will be explored in further detail at the 2017 Marcum Alternative Investment Manager Forum to be held in New York City on November 1, 2017. The forum will include panel discussions on the subjects of operations and compliance, effective utilization of service providers, and marketing of alternative investment funds. Click here for details on how to register to attend the Forum.