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Hedge Funds: The governance minefield

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Milan's ECPI assesses the sustainability of hedge funds' portfolios - and their business models. Martin Steward spoke to CEO Paolo Sardi

While there is a minority of hedge funds running long/short equity strategies in sustainable industries, or ‘activist' or ‘catalyst' strategies taking long-term majority positions in companies to improve their governance, it is not exactly what the industry is renowned for - far more pursue hard-driving, fast-trading portfolios whose be-all-and-end-all is the most efficient risk-adjusted return for investors.

So, perhaps, it is surprising that ECPI - which grew out of research into non-traditional risk factors at Milan's Bocconi University in 1997 and provides sector-exclusion, company ratings and indexation services for ESG-sensitive investors - should have been active in alternatives since 2005. Three large European pension funds and two large European insurers use its rules-based Manager Alpha & Risk Score (MARS) model to assess the sustainability of their alternative investment managers (in hedge funds, but also private equity, equity release mortgages and life settlements); and almost 50 single-manager funds, mostly US-based, also use it to monitor their own portfolios.

"Our universe increased as it became easier for managers to embed these methodologies into an investment process," says CEO Paolo Sardi, "and the increasing use of managed accounts creates an incentive to do so as transparency improves. It's surprising how often we assess a fund that is not sold as an ESG-compliant strategy that turns out to have a good ESG rating."

Those dozens of fund managers using MARS are testament to a significant recent evolution in the way it works. The model was initially conceived as an expansion of ECPI's expertise in assessing the sustainability of companies into the alternative fund manager selection process - where the fund managers effectively became the companies being assessed.

"Because our public equities analysis was so effective in reducing risk - we downgraded names like Enron and Parmalat years ago, and more recently AIG, Bear Stearns and Madoff - some of our clients asked us to develop similar risk-reduction tools in alternatives and, in particular, funds of hedge funds," says Sardi.

In 2005, allocation to hedge funds through funds of funds was reaching its peak, and the recent trend for position-level transparency via managed accounts had not taken hold. There was a niche for a service that could assess the sustainability of individual hedge fund managers - and therefore the funds of funds that allocated to them.

"To measure the sustainability of a manager - especially providers of non-UCITS products domiciled in the Caymans or BVI, for example, with lighter regulation and less transparency - we developed a rules-based checklist of 252 questions feeding into an objective scoring model," says Sardi. "It's similar to an operational due diligence questionnaire, but focuses more on aspects of corporate governance - shareholder structures, the relationship between risk and investment management, human capital, cost structures, compliance and past litigation."

ECPI warned its clients in advance of at least two of the recent major hedge fund accidents. The governance structures of Madoff Securities did not pass muster - which meant that feeders into its trading strategy got the red light from MARS, too. Similarly, ECPI downgraded investment bank Bear Stearns in March 2007, a few weeks before two structured credit funds run by its asset management arm were hit by the first defaults of the US sub-prime crisis. The asset management arm itself got the red light from MARS partly because its sole prime broker was Bear Stearns, but also because the captive asset management model gets marked down by MARS in any case.

"There are no longer many banks with their own hedge funds, because investors recognise the strong incentive that exists to move products from the bank's balance sheet onto that of the hedge fund," says Sardi. "It's a conflict of interest that only comes to light when things go bad."

However, less dramatic examples require a little more finesse. When it comes to the sustainability of an investment process - how much leverage can be applied, which instruments can be used, how performance fees are calculated, whether exposure limits are being respected - measurements and signals are clearly objective. But while the same objectivity can be applied to governance structures, investors are more likely to want to apply some discretion in this area.

As a recent Carne Global investor survey reveals, while there is considerable consensus on some questions (such as the preference for Ireland or Luxembourg over the Cayman Islands as a domicile, or the desire to see independents as the majority of board directors), on others, particularly the ideal size of a board or the desired mix of skills represented on it, there is much less. And, given that the best performance of a hedge fund manager often comes during its first few years - just when governance structures are still evolving - it is not entirely irrational for investors to want to cut them some governance-related slack.

Sardi argues that this is where MARS comes into its own. "There is no requirement that funds should be UCITS, for example - we recognise that some strategies work better in less-regulated frameworks," he explains. "Indeed, our methodology can help when you want to invest with managers that are not highly regulated or perhaps have some specific issue around governance. That is precisely where ECPI can inform your decisions about taking governance-related risks to achieve the best hedge fund returns. The assessment is always a mix of indicators, and we provide full disclosure of the indicators, so it's up to clients to decide whether they take the overall assessment from ECPI or focus on particular aspects that are most relevant to their concerns - or to act at all based on the signals."

More recently, ECPI has been able to integrate its equity issuer ratings even more closely with its work in alternatives. Whereas initially MARS assessed alternative asset managers in the same way as ECPI assessed other companies, increasing visibility into positions via managed accounts has opened up the opportunity to apply ECPI's ratings of more than 4,000 companies to draw detailed pictures of the ESG risk exposures that investors take on, at both manager level and position level, top-down and bottom-up.

The growth in ECPI's single-manager clientbase illustrates the commercial opportunity that this trend represents: as end investors begin to use ESG tools to assess the non-traditional risks in hedge fund portfolios, the more incentive there is to align governance practices and portfolio exposures to those criteria.

"This is the marketing message to these managers, and we are increasingly working at setting up hedge fund strategies that are sustainable, in the sense that they use our signals as part of the investment process," says Sardi. "The portfolio manager knows we are looking at these issues when they respond to a request from one of our clients, so the natural incentive is to hire ECPI to help them comply with the emerging regulatory and client requirements around integrating ESG. But it's important to emphasise that it is not ECPI's real objective to help with this kind of compliance - this is an effect, but the main incentive should be that the historical performance of our ESG analysis has been really effective in terms of risk control."
 

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