AIMA pushes for increased alignment
Eat your own cooking - that is the advice of CalPERS’s Kurt Silberstein, who recommends hedge fund managers add a little more of themselves to the pot if they want to entice pension funds to the table. In common parlance, hedge funds must do more to ‘align interests’ with investors.
This alignment of interests, in the form of ‘substantial investment’, can be accomplished in a number of ways, Silberstein writes. “The preferred way is for the hedge fund manager to be a co-investor in the fund and held to the same liquidity terms as that of its investors,” he says. He adds that, if the investor does not think the hedge fund manager has enough of his own capital invested in the fund, the manager should reinvest some of his performance fees.
Silberstein’s recommendations come as part of a guide published by global hedge fund association AIMA. It is presented as best practice, in light of the burgeoning institutionalisation of the hedge fund industry. The guide aims to highlight investors’ views, expectations and preferences on a range of issues that have become the focus of discussion.
The authors of the guide - all members of AIMA’s Investor Steering Committee - include Silberstein, who heads up CalPERS’s hedge-fund programme; Luke Dixon of the Universities Superannuation Scheme, who tackles the issue of governance; and Michelle McGregor-Smith of BA Pension Investment Management, who addresses ownership structures. Andrea Gentilini of Italy’s UBP examines risk, while Adrian Sales of Albourne Partners focuses chiefly on operational issues.
Other suggestions in the report - which AIMA takes pains not to endorse - include the construction of boards consisting mostly of independent directors, as well as the appointment of one of those directors as chairman. Dixon recommends that the board is ultimately responsible for valuation and is empowered to monitor and replace the fund’s service providers, including its investment manager.
Risk transparency also looms large. Gentilini says investors want “replicable risk” so that, given full-position transparency, they would be able to re-calculate all risk metrics and “arrive at the same numbers as those that appear in the report”. He concedes that a scenario where hedge funds regularly open their books to investors is “hardly practical. Nonetheless,” he says, “investors expect managers to provide enough transparency for investors to be able to arrive, in principle, at the same risk numbers that were provided for the entire portfolio.”
He says hedge fund risk metrics should be comprehensive, with leverage being reported in risk and accounting forms, the latter in gross and net forms. Risk reports should also be “appropriately granular”, where risk metrics in reports - as well as changes to those risk metrics - are “a fair reflection of the evolution of the risks taken in the portfolio”.
Gentilini also points out that investors expect hedge fund managers to specify a maximum portfolio risk budget. “While it is natural to expect managers to utilise the full risk budget during times when opportunities abound, investors expect managers to consider utilising less of the allotted maximum risk budget after a significant drawdown,” he says. In other words, investors expect some form of ‘stop-loss’ in the “broadest sense of the term”, and those stop-losses should be set so that a position is reduced or liquidated when a given trigger is reached.
Investors also want portfolio risks to be simulated. “Only by employing these tests can investors gather… an estimation of the strategy’s robustness,” Gentilini says.
On the issue of firm ownership, the notion of alignment of interests again bubbles up. McGregor-Smith tells us that “ownership aligned with strategy ensures stability”, and that it is important that key personnel participate fully in the firm’s success and capital is not “too intensively held in too few hands”.