Wednesday, 17 September 2014
Last updated 14 min ago
Apr 23 2012 | 7:35am ET
By Deborah Prutzman, CEO, The Regulatory Fundamentals Group -- At a time when investors are demonstrably concerned about the operational risks associated with an alternative asset investment, particularly an investment with an emerging manager, many managers shy away from addressing compliance and regulatory issues. This is a mistake. A proactive approach differentiates a manager from the pack, and can allay those often-unspoken investor concerns that frequently delay an initial allocation, reduce its size, or prevent it altogether. For the reasons discussed below, this approach will be a good investment over both the short and long term. The facts and figures say it all.
Studies Show Investors are Concerned
Two recent studies show that investors are more concerned about operational risks than ever. A new study to this effect has just been published in the Journal of Financial Economics (February 2012, Trust and Delegation by Stephen Brown et al.). Based on data from 444 hedge funds’ due diligence reports from 2003 to 2008, Brown and his team conclude that “high operational risk can potentially destroy investor value.” They write, “operational risk as we define it leads to direct and indirect losses that can be measured in terms of diminished performance. In extreme circumstances, operational failures can lead to fund failure.”
Likewise, a recent study by Citi Prime Finance focusing on current investor behavior concludes that day one and early stage allocators to hedge funds are acutely aware of operational risk. In that study, the investors’ top three concerns – track record, previous experience working together and investment team stability – were followed by a concern with the fund's operational infrastructure. (See Day One and Early Stage Investor Allocations to Hedge Funds, Citi Prime Finance, February 2012.) The study notes, “[t]here is growing sentiment that managers need to be more ‘institutional’ at launch to reflect a changing investor base.”
Given the results of these studies, fund managers should build the critical governance and business risk management foundation needed to attract investors from the start. As shown below, this can be a savvy business decision.
The Facts and Figures Say It All
A decision whether or not to build a strong operational infrastructure will impact the expenses, budget and profitability of a firm in many ways. Once in place, this infrastructure helps team members work together efficiently; promotes a common understanding of issues across the firm; assists in identifying the costs and risks associated with future business initiatives; and, in the end, actually saves investment managers money while enhancing credibility with institutional investors and their consultants.
Some of the quantitative implications are noted below.
1. Fee Concessions. Prospective investors who seek higher alpha or the diversification of returns associated with an early stage manager also seek substantial concessions. They justify these concessions as a price associated with their willingness to accept the additional operational risks. What if those risks were reduced or eliminated? According to Citi Prime Finance, nearly 40% of the investors sought a 75 basis point discount on management fees, and more than 10% of investors worldwide sought a 100 basis point or greater discount. The average management fee concession worldwide is reported to be 62 basis points. For a $10 million fund, that is an average of $62,000 forfeited in management fees each year. The same study also reports that the average performance fee concession is 5.02%. Assuming a 10% return, $50,200 is forfeited each year for a $10 million fund. This, together with management fee concessions, totals an average of $112,200 forfeited each year for the life of the investment. A state-of-the art compliance infrastructure can be developed for $100,000 or less (far less, in many cases). While there will be ongoing maintenance and upkeep costs, making this one-time expense significantly lowers operational risk, reducing the basis for management and performance fee concessions.
2. Pay Now…or Pay More Later. A successful fund will inevitably incur the expenses needed to build an institutional grade infrastructure at a future point in time: as assets under management grow, investors and/or regulatory requirements are likely to cause the adviser to implement at least a rudimentary governance and compliance program. However, by that point, the initial terms with early-stage investors, including any concessions, will be set. Furthermore, it is significantly more disruptive and expensive to repair an inadequate program later in the life of your firm than it is to establish one correctly from day one. Since a successful fund will eventually have to build such a program anyway, a savvy manager will implement an effective program early on.
3. Live Long Enough to Pay the Price. Asset management firms operate in an intense, complex regulatory environment. Firms without sufficient governance structures have felt the repercussions of regulatory scrutiny. Now more than ever, hedge funds and private equity funds are in the enforcement spotlight. Whether or not a fund is registered, regulators and enforcement personnel can come knocking at its door. The knock will not necessarily come from the SEC or the CFTC. The FBI or even state attorney generals may be interested in any number of circumstances. An unprepared firm will spend more time responding to an investigation, have more risk of potential liabilities, and be more susceptible to substantial fines and adverse publicity. An unprepared firm runs the risk of incurring legal fees for both the firm and individual staff members, as well as for consultants or even a monitor. Penalties and fines can be imposed on the firm and its principals. As if this is not bad enough, investor withdrawals can cause a fund to close.
How to Stand Out to Investors
Once a strong infrastructure that embeds compliance into the fabric of a firm has been established, how does a manager showcase it to potential investors? The manager who recognizes the importance of these issues to potential investors will seek, from the start, to instill investor confidence in the firm’s ability to manage operational, regulatory and other risks appropriately and efficiently. An investment manager’s capabilities brochure and pitch book should discuss these issues early on so that investors can then listen to the investment-oriented messages without further distraction.
Establishing an effective enterprise-wide infrastructure is within reach for a firm of any size and with any level of experience. Do not lose the chance to capitalize on this opportunity.
Deborah Prutzman is CEO of The Regulatory Fundamentals Group. RFG provides an enterprise-wide view of the US federal laws that impact alternative asset managers and others involved in the field. RFG supplements this with timely and relevant updates. To facilitate collaboration, a unique mapping feature tags key functions to specific requirements, allowing each person to understand his or her role in the context of the overall organization.
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