A new era is dawning on hedge funds in the wake of Long-Term Capital Management (LTCM) where transparency will become the norm, not the exception. Undoubtedly, many regulatory and commercial changes will result from the demise of LTCM (and other lesser-known hedge funds). Yet one thing hedge fund managers can be sure of is that investors will no longer tolerate the shroud of opacity used by alternative investment managers to conceal specific information about their firms and investment processes. Investors will want to know more than ever about the managers and the investment processes to which they allocate assets.
This search for transparency will be driven by a heightened, more rigorous due diligence process. Prudent investors will continue to recognize that hedge funds have an important place in a well designed investment portfolio but they will likewise recognize that they will only invest with asset managers who can meet their standards of due diligence.
This intensified due diligence process may present a challenge to those managers who have previously chosen to disclose little about their firms and investment processes. Yet it will present an opportunity for managers who are ready and able to provide investors with the information they seek. To realize this opportunity, hedge fund managers should follow the lead of their asset management brethren, the institutional money manager, and actively manifest an attitude of transparency in their marketing, sales, and client service efforts. They can concretely demonstrate this attitude by providing prospective investors with a completed "request for proposal" (RFP) document.
An RFP is a written document that is part of an evaluation process (often called by the same name) used by institutional investors. This process can be summarized as follows. Institutional investors determine they want to allocate a portion of their assets to a certain type of investment process. They then either publicly or privately solicit requests for proposal from appropriate managers. Those managers respond to this solicitation initially by completing a written RFP (often provided by the investor) by a certain date. The investor then reviews and evaluates the submitted RFPs, selects those managers it considers to be best able to meet its mandate, and interviews them. This interviewing process results in a "short list" of managers who are invited to make a finals presentation. Usually one manager is selected for the allocation.
Institutional investors use RFPs in manager searches because they provide investors with information on all aspects of a firm’s organization and infrastructure and the investment strategy in question. RFPs also provides them with a tool for comparing managers and investment strategies.
While investors in hedge funds may not engage in a formal RFP process, they will now demand the kind of information available on institutional RFPs. That is why I would advocate that managers who are to succeed in this new environment get in front of the curve and create such a document and make it available to the appropriate prospective investors.
At a minimum, this document should address four main topics. First, the document should provide a corporate overview. It should a make clear the genesis of the firm, its overall objectives, and legal and organizational structure. It should also discuss personnel issues such as turnover, compensation, and hiring and training strategies. In addition, it should describe in detail the firm’s product line and the characteristics of the fund in questions; it should also present a chronology of the asset under management and related account information. Finally, it should disclose any legal and compliance issues the firm has been involved in and provide appropriate references.
The next section should focus on the investment strategy. It should explain the underlying investment process (origin and evolution, sources of return, and value-added) and implementation issues (markets traded, portfolio composition, trading procedures). It should also explain how the firm measures and manages risk. The strategy’s performance should also be included in this section.
The third section should deal with operational and administrative issues such as reporting procedures, NAV calculation, technology, and disaster recovery.
The final section should present a summary of the firm’s distinguishing characteristics.
This document, used in conjunction with required documents like an offering memorandum and subsequent interviews, will provide investors with the type and kind of information they are likely to require in the post-LTCM environment. Specifically, it will allow investors to accurately determine the type and kind of market risk inherent in the strategy and, correlatively, the type and amount of manager risk presented by the firm.
Hedge fund managers typically are reluctant to provide a detailed account of their firms and strategies. (This is made clear by the tepid due diligence questionnaires currently distributed by some hedge fund managers.) Managers do not want proprietary information to get in the wrong hands. While managers need to be cautious when providing such information, they need to realize that investors have no desire (or facility) to internally replicate a manager’s strategy. They simply want to know get a solid understanding of the firm and strategy in which they may invest. To ensure confidentiality, managers could consider asking prospective investors to sign legal agreements that bind them to hold all information in private.
Managers must be prepared to perpetuate the transparency required in the manager evaluation process in the manager-client relationship after the allocation. Investors will require that managers provide them with open, accurate and timely reporting and communication. They will expect to receive information on the source of returns, the asset allocation of the portfolio, portfolio composition, investment view, and any changes that have occurred at the firm or in the investment process. Reticence and secrecy after an allocation may well result in a prompt reevaluation of the manager, with the redemption of assets a real alternative. Managers should take steps to prepare for such client services activities.
This attitude of openness should likewise apply to existing clients. LTCM’ demise is causing hedge fund investors to reevaluate (and, in some case, redeem) their allocations to specific hedge fund managers. Managers should recognize this and candidly explain how and why their firm and strategy differ from LTCM’s situation. This explanation will allow investors to make a decision based on knowledge rather than fear and should, if done properly and promptly, improve client retention rates. (One reason why investors in healthy, viable hedge funds are redeeming assets may be that they do not understand how the manager generates returns and just what these returns are.)
In sum, hedge fund managers should expect a new consumerism among investors. Prospective investors will demand more information from managers. Managers need to recognize this and actively prepare to meet investors’ expectations. Creating an institutional-quality RFP is one way a manager can meet these expectations. Such a document will indicate a manager’s willingness to treat investors properly--like bona fide partners.
Angelo A. Calvello, Ph. D.