Q&A: Transparency Needed For Maligned Hedge Fund Industry

Mar 26 2009 | 2:41am ET

The recent spate of hedge fund collapses spurred by drawdowns, redemptions and Ponzi schemes have made much of the industry rethink its custodial risks, which is good news for Merlin Securities.

The firm, which services small- and mid-sized hedge funds, says its business has been booming since 2007, and it is looking to capture a bigger chunk of the market left behind by bigger prime brokerages. FINalternatives recently spoke to Steve and Aaron Vermut, Merlin’s father and son team, about how they’re doing it and why the industry needs better transparency.

FINalternatives: What’s the current environment like for Merlin in terms of attracting and retaining clients?

Steve: This has been a pretty interesting environment for us. Our business has prospered over the last 18 months as hedge funds have looked for ways to diversify their custodial risks, which has become a key focus for hedge funds and hedge fund investors. Firms that were single-primed felt the need from their investors to be multi-primed.

We have a multi-prime platform with JPMorgan Chase and Goldman Sachs as our clearing brokers. We can put clients in either or both places and we also have the reporting platform to provide analytics on assets held at multiple primes.

There’s also been a movement by some larger prime brokers to focus on the larger hedge funds, so they’ve been asking their smaller clients to leave. We’ve been a beneficiary of that as well.

FINalternatives: Have your clients suffered from the redemptions and liquidations affecting the rest of the industry?

Steve: Our typical client manages between $25 million and $1.5 billion. That marketplace has not been hit with the volume of redemptions that have hit the larger funds. A lot of the carnage that you’re hearing about is happening at a higher level than our market. The bigger hedge funds have a different client base, and when their funds of funds and endowment clients are down, they pull capital from everybody.

Aaron: We haven’t seen much of a decrease in new launches. One of the interesting things about the hedge fund space is that it doesn’t take a lot to start a fund. As people are transitioning out of their jobs at large investment banks, one of the popular options for them is to start a hedge fund. We’ve seen a lot of this activity at the smaller end of the market.

FINalternatives: How do you plan to capture an even bigger segment of this marketplace?

Aaron: One of our major advances over the last year was to launch Compass, a reporting application that lets clients see in real time where they are in their portfolio. Compass connects directly with hedge fund trading platforms through FIX protocol, and it takes real-time profit and loss to another level: We’re not just showing your positions and performance, but we’re also able to show some of the custom classifications and groupings that clients have built on the Web site.

FINalternatives: Speaking of transparency, Steve recently wrote an article about how hedge funds can better communicate with and protect their clients. Can you sumarise your ideas for us?

Steve: There are a number of ways to discourage frauds and Ponzi schemes, and transparency is clearly one of them. The more information that’s out in the public domain, the better it is for everyone. The Securities and Exchange Commission has not allowed basic information and data about hedge funds to be made public, and I think this is absolutely wrong. Transparency is an issue that the SEC needs to focus on, and we hope that they will do so.

There’s a greater good that needs to be served here, and that’s transparency of assets, performance and service providers. Investors should have the ability to go into a single database, look up a fund that they’re thinking of investing in and get an overview of what the fund’s performance has been, its strategy, its service providers. That basic level of transparency does not threaten anybody’s business.

If a fund said it is up 5%, the administrators and prime brokers can look at the number and know if it is accurate or not. The managers I’ve spoken to are concerned about Regulation D, which doesn’t allow them to openly communicate that information. Hedge fund managers aren’t as secretive as they’re made out to be, they just don’t want the SEC slapping them with a violation for sharing basic information about their funds.

FINalternatives: Could such a system have helped prevent something like the Bernard Madoff Ponzi scheme?

Steve: Bernard Madoff did not run a hedge fund. That’s a very important point that the media keeps missing. He was a broker/dealer who opened accounts for individuals and kept the money. There are a few byproducts of the Madoff scandal that may ultimately help to protect investors in the future. Madoff did not have an independent custodian and held all of the assets internally. He also did not have an outside auditing firm. Most funds of funds have learned their lesson that those are boxes that absolutely must be checked.

Hedge funds are painted with this Madoff brush and it’s unfortunate and inaccurate. There have been frauds in the hedge fund space, but they have been few and far between. There needs to be a better understanding of who made the mistakes and who didn’t. Hedge funds did not cause the market to decline by 50%. They were participants in the market and many of them were early in telling investors that we had a serious financial problem.

Too many times we want to shoot the messenger, but in many cases the managers were right. The obvious example is Greenlight Capital’s David Einhorn, who was right about Lehman Brothers, among other things. He was heavily criticized at the time, but those who listened likely avoided serious losses. When things turn bad, everyone wants a scapegoat, but the hedge fund industry is the wrong thing to blame.

FINalternatives: Still, hedge funds did lose their shirts last year along with just about everyone else. Why should investors continue to pay huge fees to managers who didn’t do their jobs when it counted the most?

Steve: I don’t know where the concept that all hedge funds are about absolute returns came from. I don’t think it’s reasonable or practical in a year like 2008 to compare hedge funds’ performance with absolute returns and other investors with run-of-the-mill [non-hedge fund strategies]. The truth of the matter is hedge funds did much better and most investors would have been much better off with hedge funds than other investments. You can’t really talk about hedge funds as an asset class because every hedge fund has different standard goals to meet their investors’ expectations.

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