By Mark Smith, Guest Columnist
Last Friday, a U.S. Court of Appeals struck down the need for hedge funds to register with the Securities and Exchange Commission. Is this a good thing for our industry? The SEC and Richard Blumenthal, the Attorney General for the state of Connecticut, don't thing so. They feel that there needs to be more regulation and control to protect the estimated $1.4 trillion in hedge fund investments. No matter how you might feel, this issue will come up again and again as long as fraudulent firms live among us and feed like leeches off of unsuspecting investors. This judgment by the courts keeps the SEC from knocking down our doors anytime they want, but they still have the power to prosecute, and prosecute they will.
As of this writing, the Senate is meeting to discuss hedge funds and the fallout from the Pequot Capital Management insider trading case. If we don't want the SEC breathing down our necks, then we must employ better operational and portfolio risk management procedures and reporting. Investors need to feel confident in our ability to perform and manage our firms like competent businesses with strict procedures and oversight. So where do you start? What is your first step?
You, as a fund manager or firm owner/partner, have to have a positive and proactive opinion about risk management. I have a saying I use over and over with my clients, 'the tallest pyramid has the widest base'. It's saying that you must have a good infrastructure and processes for which to grow your firm. Risk management is one very large brick in that infrastructure, whether it's financial, legal or operational, it will be extremely important for you to have the proper personnel and processes managing them.
Working for both the fund-of-funds and hedge funds, I have done hundreds of manager due diligence interviews over the years focusing mostly on risk management. Most of the time, the portfolio manager was also the risk manager. He would simply review reports from the firm's prime broker, and often the only documentation about risk management was one power point slide in the firm's sales documents. That is no way to attract new investors.
In order to have a value add risk management program in place you need to start at the top. You need to have 'buy-in' from the executive level of the firm. Everyone must be on board and actively participating in risk management processes or they will fail miserably.
Second, you need to have a written plan, a living document that is the foundation for all your risk management. This manual needs to address every person, action, and metric of how your firm utilizes risk management. A risk procedures manual at the minimum needs to lay out an operating plan including roles and responsibilities, metrics, parameters, escalation plans, reporting and transparency. It should contain specific information that is reviewable and quantifiable so you will be able to manage its effectiveness.
Once you have the risk procedures manual, then implementation and oversight need to be actively practiced. You might be saying: 'Having a procedures manual is a double edged sword, yes it will be a nice roadmap, but it's also something I can be held accountable for.' Well, yes you will! That is where the benefit is. We are showing the U.S. Congress, regulators, and most importantly, our investors, that we will be responsible and accountable for the firm's actions, its risk management and their money.
Not only is it good for your business to have a risk procedures manual, it is very helpful in the marketing of your firm to investors. It shows that you have taken the time and made the efforts to address and manage the risk management with a very specific plan.
Mark Smith is founder of Mark Edward Advisors, LLC. A Risk Management Service that provides daily independent Risk Management reporting and analysis to the alternative investment industry. Mark has developed risk systems and has been a senior risk manager for SAC Capital Advisors, Chang Crowell Mgr., and Parker Global Strategies.