Top 10 Areas of Operational Risk for the Buy-Side
Holly H. Miller and Philip Lawton, Stone House Consulting LLC, New York
Operational risk is a serious concern, not only to traditional and alternative investment managers, but also to their clients and the organisations that regulate buy-side firms. In worst-case scenarios, an investment firm’s failure to identify and mitigate operational risk can result in significant direct costs and a devastating loss of reputation. It may take years to reassure investors, regulators, and trading partners that the firm is well-managed.
So what exactly is operational risk? Castle Hall Alternatives calls it ‘risk without reward’. The Basel Committee on Banking Supervision (Basel II) defines operational risk as ‘the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events’, and states that the definition is intended to include legal risk, but exclude reputational risk, and lists as examples events ranging from data entry errors to earthquakes.¹ But operational risk is not something that can be easily identified by a generic checklist, nor is there a single, universally applicable approach to mitigating the operational risks to which a given firm is exposed. Different organisations will have different exposures (depending, for instance, upon their investment strategies, the markets in which they operate, and the instruments they employ), as well as varying tolerance levels for operational risk, just as they have with regard to investment risk.
Nonetheless, there are key areas to look for risk within an investment management organisation. In addition, there are some straightforward approaches to mitigating operational risk that can be deployed by large and small organisations alike. Many of these approaches will address several key risk areas at once.
In this article, Stone House Consulting will be covering the first of our ‘top 10’ areas of operational risk. The article includes suggestions for identifying whether these risks exist within your organisation and steps to mitigate them. Although there is no one-size-fits-all solution for operational risk management, we hope this article will help many organisations reduce their operational risk profile.
The following ‘top 10’ list summarises the areas where we most often see operational risk — which is not necessarily where the greatest risks lie for any given manager. Despite significant media attention to some of these areas, they keep popping up in operational reviews. Please note these areas are not presented in any particular order, and include:
• complacency;
• the ‘blind leading the blind’;
• novices, apprentices and soloists;
• dropped batons;
• naïve reliance on technology;
• playbooks;
• amalgamated assignments;
• reconciliation gaps;
• reading the fine print; and
• poor planning and slow response times.
We remarked that operational risk may be seen as ‘risk without reward.’ In this view, there is no upside for the firm, and operations managers are compensated on the pinball model: if they do very well, they get to play again. We’d like to suggest another perspective. Operational excellence, which starts with risk management, can create value by reducing costs, increasing client satisfaction, and maintaining sound business relationships with trading partners.
Evolving Hedge Fund Regulation in Korea
Jean Lee and Jae-Hak Kim, Kim & Chang, Korea
Background
In accordance with the passage of the historic Financial Investment Services and Capital Market Act (the FSCMA), which was enacted on 3 August 2007 and became effective on 4 February 2009, the Korean Government has released a series of related laws and regulations to implement the broad reform agenda established by the FSCMA. Specifically, the Presidential Decree of the FSCMA (the Presidential Decree) and other regulations were enacted, and became effective on 4 February 2009, simultaneous with the FSCMA. Following their enactment, the FSCMA and the Presidential Decree have each undergone further amendment, as the Korean Government and regulators work to fine-tune the new comprehensive regulatory framework governing capital markets in Korea.
The broad reforms ushered in by the FSCMA, and the laws and regulations promulgated thereunder, appear to lift certain regulatory obstacles that have, thus far, hindered the development of an active onshore hedge fund industry in Korea. In particular, a recent amendment to the Presidential Decree (the PD Amendment), which came into force on 21 December 2009, further permits Korean collective investment business companies to establish and operate onshore funds that employ leverage, although such funds may only be offered to certain qualified investors. In theory, the PD Amendment opens the door for the development of an onshore hedge fund industry, a change long-awaited by the Korean financial services industry. As a practical matter, however, current regulations continue to impose significant restrictions that continue to hamper true de-regulation of onshore hedge funds.
The comprehensive scope of the FSCMA, and its derivative laws and regulations, also includes rules affecting offshore hedge fund activity in Korea. Notably, the FSCMA imposes new registration requirements applicable to offshore hedge funds seeking to market to qualified investors in Korea. This expansion of regulatory authority initially generated considerable criticism from offshore hedge fund managers, as well as Korean investors, particularly with respect to registration qualification criteria, which many considered to be too onerous. Although regulators subsequently loosened the original registration qualification criteria, offshore hedge funds wishing to conduct marketing activity in Korea will continue to be subject to new registration requirements.
Onshore hedge funds
Fund categories
Under the FSCMA, all domestic collective investment schemes, or ‘domestic funds’, are classified into four broad categories:
i. funds offered to retail investors without restriction, or ‘public funds’;
ii. funds offered to 49 or fewer investors, or ‘private funds’;
iii. private funds offered only to certain qualified investors, or ‘onshore hedge funds’; and
iv. private equity funds, or ‘PEFs’.
As a general matter, the FSCMA regulates private funds and onshore hedge funds through the same regulatory framework applicable to public funds, but provides private funds and onshore hedge funds with various exemptions from the raft of rules with which public funds must comply. On the other hand, the FSCMA governs PEFs under a separate set of regulations, which generally permits greater latitude regarding who may be eligible to manage PEFs, and what types of investments PEFs may make.
The Hedge Fund of Tomorrow: Building an Enduring Firm (Part 2)
BNY Mellon and Casey Quirk & Associates
Please note: This article is in two parts, within two consecutive issues of Alternative Intelligence Quotient; this is the second section of the article, the first half was published in Issue #34.
Blueprint for the Enduring Firm
Summary
Flaws in the standard hedge fund business model have triggered investor demands for better alignment. These flaws must be addressed in a comprehensive fashion; selective tinkering will not solve the alignment conundrum. Our prescription involves redesigning liquidity terms, fee structures, and investment team compensation in the context of investors’ long-term objectives, starting by harmonising all three along a consistent time period, not necessarily a calendar year.
This means terms, fees and compensation will vary across managers and strategies and, therefore, the industry will move away from a standard and static structure. It also means some old dogmas, such as the high-water mark feature, have outlived their usefulness and should be let go. The result will be the Enduring Firm, a hedge fund business that has a real chance of surviving multiple downturns and becoming a multi-generational firm.
Beyond alignments, our blueprint for the Enduring Firm marks a clear break with hedge funds’ cottage industry roots and is characterised by excellence and balance across four functional areas: business management, investments, distribution and operations; each with their own set of best practices. These common attributes are applicable to a wide range of business sizes and types, and we outline four models which the Enduring Firm can pursue: single-strategy boutique, multi-capability platform, merchant bank, and converged traditional-alternative manager. Our conclusion is that the multi-capability platform model will see the greatest growth going forward.
We also explore a fifth emerging model, the alternatives holding company, which may facilitate growth and a form of ownership transition for single-strategy boutiques.
Finally, funds of hedge funds are facing their own set of unique business challenges. As outlined above, investors still favour funds of hedge funds as a means for investing in hedge fund strategies. However, we believe this demand relies upon funds of hedge funds adapting their product and service capabilities to meet new investor demands.
Hedge funds’ state of misalignment
The credit crisis has revealed the extreme degree of instability inherent to the hedge fund business model, largely a function of poor alignments between three parties: investors, hedge fund firms, and firms’ investment teams.
The legacy alignment structure has big flaws:
1. Business timing mismatch: A serious imbalance affecting all the alignment tools listed in the previous chart (liquidity terms, fees, performance measurement, performance payout, compensation structures) is the timing mismatch that has grown among them. For the majority of hedge fund strategies, there is little or no consistency within strategies for most of these tools. In times of stress, the result is, at best, investor surprise and frustration, and perhaps anger; at worst, a breakdown in a manager’s ability to remain a going concern, as survival comes to depend on locking assets against investors’ wishes.
2. Destructive incentives: Much has been written about the asymmetry in hedge fund managers’ potential payout, and the high-water mark was one way to reduce this asymmetry. Unfortunately, rather than protecting the investors, the high-water mark has become a toxic incentive, setting the three stakeholders against one another and leading to a vicious cycle of destructive behaviours: excessive risk-taking in an attempt to make up losses, fund (or firm) closure, and investor redemption due to fears of the first two. Any investment with a performance-fee component can never have completely symmetrical payouts, but we believe there are better ways to mitigate the payout asymmetry than with a high-water mark.
Looking for an Independent Director
Geoff Ruddick, International Management Services Ltd.
One of the first considerations when looking for an independent director is the underlying reason behind your search. Probably, given the spectacular hedge fund and corporate collapses in recent years, part of the reason is the desire for effective corporate governance. Or perhaps the driving factor is to assist with the tax planning of the investment manager or to secure the fund’s offshore tax status by ensuring that the jurisdiction in which the mind, management and control of the company is exercised, is clearly offshore. Regardless of the reason, a qualified, experienced, independent director will assist in meeting the underlying requirements. The question remains, however: how do you go about the selection process and determine who is the right person for the job?
So, where do you start?
Your legal counsel and administrator are a good starting point, and will have a shortlist of those individuals they recommend. Once you have their recommendations, you should make additional enquiries to find the individual who is right for the fund. Investigate your options and don’t limit your search to the first name on the list. Keep in mind that independent directors come with varying backgrounds, experience, qualifications, styles, interpersonal skills and corporate support — check around to compare and contrast. You will have some questions for the prospective director, and should expect that they will have some for you in return.
Now, what should you be asking?
There are obviously no hard and fast rules or an all encompassing list of questions you should ask; however, a suggested ‘top 10’ for consideration follows. Add or subtract as you will; the list is by no means all-inclusive, but it will hopefully point you in the right direction:
1) Independence
Is the prospective director independent of the investment manager, administrator, and other service providers?
Independence is the ‘Holy Grail’ of effective corporate governance. If a director is not independent, conflicts of interest will inevitably arise, and interfere with the director’s ability to act in the best interests of the fund.
2) Experience
Does the individual have relevant industry experience and experience with the fund’s strategy specifically?
You will get a good idea of their experience from their biography, which will eventually appear in the offering document of your fund. You will also want to ask if they have sat on boards with similar strategies. Independent directors do not need to be experts; however, a general understanding of the fundamentals of the underlying strategy is essential.
3) Qualifications
Does the individual have relevant professional qualifications?
You will possess academic credentials and qualifications of your own, and expect it of the people you employ. You should require it from an independent director as well. Remember, the directors are ultimately responsible for the oversight of the fund’s affairs. A legal, accounting, compliance, investment or other relevant qualification, combined with experience, will provide a good indication of where their specific expertise lies and how they will add value.
4) Capacity
How many boards does the director currently sit on and how many manager relationships do they service?
Everyone wants to know the magic number. Unfortunately, there is no definitive number as every relationship will be different and have its own nuances and complexities. If you receive a vague response or, worse yet, they just don’t know the answer, it will be an indication of the level of responsiveness you can expect to receive from them. Directors should know exactly how many relationships and corresponding fund boards they serve on at any given time. You need to be able to assess if they will be able to devote enough time to fulfil their duties.
Hedge Funds and the Securities and Investment Business Act
Robert Briant and Anton Goldstein, Conyers Dill & Pearman, British Virgin Islands
The Securities and Investment Business Act, 2010 (SIBA) was brought into force in the British Virgin Islands (BVI) on 17 May 2010. While the legislation makes some sweeping changes to the regulatory landscape in the BVI, only limited changes have been introduced which are relevant to hedge funds and their functionaries. SIBA has also been supplemented by the ‘Mutual Fund Regulations’. In due course, a ‘Public Funds Code’ (applicable to public funds) is also expected to be issued.
This article highlights some of the key changes brought about by SIBA and the Mutual Fund Regulations, and the positive steps that need to be taken by hedge funds to ensure compliance. A more general overview of the new legislation is available in a separate publication on our website (www.conyersdill.com) entitled A New Regulatory Regime in BVI: SIBA 2010.
A change of legislation; not regulation
As stated above, SIBA and the Mutual Fund Regulations do not bring about any dramatic changes to the regulation of hedge funds. The new regime largely retains the structure of the current regime — in particular, the definition of ‘mutual fund’ and the categories of public, private and professional funds remain the same. Furthermore, many of the ‘new’ requirements introduced by SIBA and the Mutual Fund Regulations were, in fact, already required by the practice of the Financial Services Commission (the FSC).
The Mutual Funds Act, 1996, which previously regulated all hedge funds, was repealed and replaced with Part III of SIBA. The registration of public funds and the recognition of private and professional funds was automatically continued under SIBA. As such, there is no need for hedge funds which were recognised or registered under the Mutual Funds Act, 1996 to take any action to continue their existing licences.
Key changes for private and professional funds
SIBA and the Mutual Fund Regulations introduce the following key changes for private and professional funds:
• Audit requirement: All private and professional funds are required to have an auditor and to submit audited financial statements to the FSC annually. Such financial statements must be prepared in accordance with IFRS, US GAAP, Canadian GAAP or UK GAAP, or another internationally and generally accepted accounting standards equivalent to these accounting standards.
• Authorised representative: Unless the fund has a significant management presence in the BVI, it is required to appoint a local ‘authorised representative’, which will be a BVI entity or individual certified by the FSC for this purpose. The authorised representative acts as the liaison between the FSC and the licensee, and is required to maintain certain records.