Who makes the grade in Asia?

Since we set up our first Asian office in 2004, investor appetite for Asian hedge fund exposure has grown almost as quickly as the number of new Asian hedge funds. As a result, in the 30 months to March 2007, our due diligence analysts reviewed 67 Asian and Australian-focused hedge fund managers based in Asia, including Japan and Australia. They also visited Asian-focused funds based in the US and the UK providing some cross-jurisdictional insights.

The firm's operational due diligence process incorporates an on-site visit to the manager's office and a thorough review of the manager's systems and processes. Further verification and follow-up is equally, if not more, important. This includes requests for additional information on IT set-up and data recovery procedures, audit reports on processes, sample net asset value reconciliations and sample risk reports, etc. The managers covered here were responsible for managing 164 hedge funds or absolute return funds. This article is the first of two and highlights some of our key observations on structural and operational issues pertaining to these managers.

The universe of managers covered comprises either: funds that our strategy analysts had recommended that our clients include in their portfolios or funds that clients had requested due diligence on before they put money in. More than 25% of the managers we visited managed over $1bn of assets (see figure 2). Total AUM of the individual funds in our population is $50bn with the managers managing assets in excess of $160bn in total.

From a strategy perspective, long/short equity funds remain the dominant approach in Asia (figure 3). Even the multi-strategy funds, which account for 17% of the population, are equity linked. Others include fixed income, relative value, event driven and CTAs. It is interesting to note that funds with assets greater than $1bn represented 13% of equity long/short, 25% of macro, 33% of distressed debt and 20% of "others".

Overall, most managers had reasonable operations and technology infrastructure and processes, with the vast majority scoring at least a "C" grade, which is our average grade (figure 4).

The four managers with below-average scores for operations had poor segregation of duties and rudimentary systems. Portfolio managers were involved in managing the portfolio and the reconciliation processes and often lacked a strong person in the support functions, able to stand their ground. Systems used were rudimentary; their portfolio management systems are usually spreadsheets. The principal(s) often displayed a lack of interest in investing in support functions. These managers were all based in Asia.

At the other end of the scale, the four managers with A grades managed over $1bn. Three of them had the benefit of adopting the systems used by their traditional long-only funds. One of the managers was based in Australia, another in Hong Kong and the other two in the UK.

More managers scored below-average grades for technology infrastructure and processes. The managers that scored poorly in this area were those that generally have an unsecured server sitting out in the office, back-up tapes that are not taken off site on a daily basis and skeletal data recovery provisions - for example, working from the portfolio manager's home using the manager's laptop. Often these relaxed procedures and attitudes stem from the knowledge that the funds' prime brokers and administrators have the records they need. This stance is just about acceptable where the fund does not hold too many positions and does not trade its positions actively. Generally macro funds and multi-strategy funds have sensible provisions in place. Still on the technology front, approximately 45% of our population had in-house IT support, 95% had daily back-ups and 36% had a hot standby disaster recovery server.

 

ll the managers had compliance officers. Approximately 39% of the managers had regular reviews carried out by external compliance advisers. The rest rely on the monthly news updates from their legal counsels. The percentage of regular reviews is higher than one would expect, but this may be due to the constant change of rules and regulations in the hedge fund arena. In most if not all cases, the compliance officers are wearing many hats and do not devote their entire attention to compliance. In most instances, screening for anti-money laundering is generally performed by the administrators, with the managers providing a secondary screen.

Just under a third of managers have soft commission arrangements; however, we do see this disappearing in the UK as the FSA's requirements come into force. Of the 67 managers, 22% allow personal account trading without prior approval, 66% allow such trading with prior approval and 12% have a complete ban on personal account trading. As part of our review process we would try to establish the level of personal account trading and, where this appears high, it would be highlighted as a weakness.

No fund has side-pocketed any investments, although a couple have provisions in their PPM to do so. Only 11% of the population had issued side letters and these were mainly related to capacity or most favoured nation clauses. Less than one third of the 11% had signed side letters providing investors with lower fees and in one instance better liquidity terms.

On the transaction front, 41% of managers require only one signatory to instruct their administrator to transfer cash to outside parties. Of these, over 80% of managers are based in Asia/Australia. This is probably the weakest link in terms of cash movement. Trade-related transactions are usually for delivery versus payment or, if this is not the case, with creditworthy counterparties. Movements between the prime broker and the administrator are confined by account names. Is having one signatory a major risk? It is not an ideal arrangement, but the major outflows are to do with redemptions. There are controls over this because with any new subscription, administrators require bank account details to be provided for any subsequent redemption to be posted to.

 

Reconciliations of trades are generally performed every day but some managers do not do a full reconciliation of cash and positions every day. Generally the level of daily reconciliations of all three is high, in the region of 88%; the rest would reconcile cash every two to three days or once a week. Where NAVs are calculated by the administrator, every manager reconciles at least the month-end NAV advised to their own shadow records.

Risk management functions are operated independently by 54% of managers. In most of these instances, irrespective of geographical location, the CFO/COO/finance manager also wears the risk hat. The talent pool for risk management professionals continues to be small for hedge funds. Portfolio managers are closely involved in the risk process and, where there is no independent risk function, actively monitor risk.

One of the key aspects of our review is to understand the instruments traded in the portfolios and the complexity of these instruments. The quality of staff involved in the reconciliation process is also assessed as far as possible - the level of seniority, level of work experience, etc. Overall, managers based in the US, Australia and UK scored better than the other countries with no firm scoring below average (figure 5).

When we analysed managers' ratings by AUMs it seemed that managers are prepared to invest in their infrastructure once they get to a comfortable level of AUM. Figure 6 shows all the managers which scored A managed over $1bn.

All the funds in our population had their NAVs determined independently, except for two. Admittedly one of these "independent" calculations is an NAV lite, which means that the administrator will highlight any mistakes with the manager's NAV calculation. The valuation is not determined by the primary manager but nevertheless due to a sharing of economics, the valuations are not deemed independent. It may be interesting to note that the two funds that have their NAVs calculated internally are US-based and SEC-registered.

Six of the funds value a significant portion of their books internally. An outside administrator may sign off on the final NAV, but often it is the manager's models that are used. Four of these funds are distressed debt funds and two have either involved a third party valuer or asked their auditor to perform additional work. We believe that independent valuations are the right way forward.

Bill Gates should be a happy man because Microsoft Excel is widely used by the managers both as portfolio management systems and risk systems. The extent is shown in figures 7 and 8.

Generally where a manager uses Excel spreadsheets as its portfolio management system, it is unlikely that manager will score above average from an operational due diligence standpoint. While spreadsheets provide considerable flexibility they are hard to control and are subject to inadvertent input errors.

Our analysis in part one of this report shows that:

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The majority of managers have reasonable systems and procedures.

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NAVs are largely independently determined.

However investors need to be aware that:

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Single signatory required to transfer cash is relatively more common in Asia than in the US and UK.

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Over half of the managers in our population had independent risk management functions but these are largely staffed by CFOs/COOs/finance managers. The pool of specialist risk management talent is still relatively small in Asia.

Part two which contains our observations on the regulatory jurisdiction, service providers and key man issues will be covered in the next issue of IPA.

Debra Ng is a senior portfolio analyst with Albourne Partners, based in Singapore. Started in 1994, Albourne Partners is an independent global consultant specialising on hedge fund due diligence, manager selection, strategy timing, portfolio construction and risk management. Albourne has 118 staff globally assisting 100 clients with over $150bn in hedge fund investments. The full research report on Due Diligence in Asia was prepared by Albourne analysts Choo San Yeoh and Mimi Tong.