Ernst & Young Global Hedge Fund Survey Reveals Investors Want Greater Board Responsibility and Accountability in Key Areas [Professional Services Close – Up]

Global hedge fund managers and investors agree on key industry issues, but disagreement still exists in some areas, according to Ernst & Young's fifth annual survey of the global hedge fund market compiled by Greenwich Associates.

In a release, Ernst & Young noted details of the report:

The report, which juxtaposes the views of managers and investors, indicates that the two groups differ on some matters such as governance, fund expenses, administration, succession and capital raising.

-Governance. Only 45 percent of investors said that their funds' Boards of Directors are very effective at carrying out their duties to funds, while almost 70 percent of managers feel the board is very effective.

-Fund expenses. Seventy-six percent of investors want shadow accounting, but only 35 percent are willing to pay for it.

-Administration. Three-quarters of investors said that a hedge fund should completely outsource valuation to an administrator, but 71 percent of managers perceive risks in this.

-Succession. Two-thirds of investors feel that having a well- articulated succession plan is important to their investment decisions, while only 38 percent of managers agree.

-Capital raising. There appears to be a lack of clarity between investors and managers about the loss of mandates. Almost 40 percent of managers say they do not really know why they lost a mandate. Investors point to concerns about risk management policies, inconsistency of information presented and lack of independent Board or administration.

The Company reported that the findings in the report, Coming of Age polled 92 hedge fund managers who manage some US$600 billion, and 42 institutional investors with over US$130 billion allocated to hedge funds.

"The recovery of the hedge fund market has been encouraging, but as the industry comes of age, investors are getting increasingly interested in governance and supervision where there remains considerable gaps in perception and in reality," says Ratan Engineer, global leader of Ernst & Young's Asset Management practice. "To continue satisfying investor demands and foster compliance, we need to ensure that hedge fund investors and managers are on the same page."

Despite several opinion gaps, investors and hedge fund managers agree on several issues, including their top concern: the impact of regulation, which is cited as the chief worry of 48 percent of hedge fund managers and 36 percent of investors.

In addition, Ernst & Young noted some key findings from the report:

Although managers and investors agree that independence is important for good governance, investors remain wary of boards' effectiveness. Sixty-eight percent of managers say the Board is effective in carrying out its duties, but only 45 percent of investors agree. Three-quarters of managers say the board is accountable to investors, but only 38 percent of investors say the same.

Investors want greater board accountability; they desire board responsibility for investment guideline compliance (36 percent), reviewing and approving NAVs (29 percent), resolving disputes over valuations (19 percent) and setting risk policies and thresholds (38 percent). However, most managers (69 percent) say that they, rather than the board, currently have responsibility and accountability for compliance with investment guidelines, and 72 percent say they establish overall risk policy and thresholds.

"Investors still feel their Boards are most interested in serving the interests of managers, rarely challenging them on issues that really matter to investors such as valuations, risk and style drift. There is a need for a closer consensus with Boards acting neither as lap dogs nor dictators to the managers," says Engineer.

Higher costs for compliance, regulatory reporting and other infrastructure items coupled with the increased trend of outsourcing and shadowing have resulted in margin compression across the industry. Hedge funds are increasingly evaluating how expenses should be shared between the investment manager and the fund. However, managers and investors differ on what costs should be passed through. While most investors agree that it is important to perform shadow accounting, almost two-thirds of investors object to passing on the cost of shadow accounting; yet, more than one- quarter of managers said that they currently pass on these costs.

Fee and margin pressures are also causing more managers to offer graduated fees in return for larger mandates. More than twice as many hedge funds as last year say they have offered graduated fees for larger mandates.

"We see in these survey results a definite call to action for hedge fund managers to align their fund expenses to what investors expect and are willing to pay," says Arthur Tully, co-leader of Ernst & Young's Global Hedge Funds practice.

Nearly all managers use administrators in some capacity, and nearly two-thirds of both groups agree that administrators have a positive impact on investor confidence. However, most investors (74 percent) said it is important that managers completely outsource valuation to an administrator, but most managers (71 percent) perceive risks in fully outsourcing this function. Despite this, one in four managers or investors is confident that administrators can accurately value Level 3 assets.

Shadowing is prevalent, and is often deemed to be a necessity 76 percent of investors cite it as important. However, in many cases shadowing results in a replication of the work that administrators are performing, which then requires reconciliation between the fund's and the administrator's systems.

"The findings reveal a significant duplication of efforts and a business model that is expensive and unique to the hedge fund industry. Over the long term, hedge funds will likely re-examine their shadowing activities and begin to create a control environment that takes advantage of the administrator's strengths while building in controls to address any shortcomings," notes Tully.

Managers underestimate the importance to investors of a succession strategy. Nearly two-thirds of investors said having a well-articulated succession plan is important to their comfort level. However, only 38 percent of managers said they thought a well- articulated plan is important to retaining investors. Only 39 percent of managers said they have a well-developed succession strategy, while 50 percent of investors said they are confident with their hedge funds' succession strategies.

Hedge funds and investors also view loyalty differently. Over half of managers believe investor loyalty lies with the founding principals. However, 55 percent of investors say their primary loyalty is to individual portfolio managers.

Investors also are more likely than hedge fund managers to want founding principals to increase their equity stakes. Eighty-three percent of investors say they want founding principals to have "skin in the game" and leave significant assets with the fund upon transition. However, only 60 percent of managers say the same, instead focusing on positioning certain professionals as the face of the firm, which is important to only 17 percent of investors.

Capital raising/due diligence

Due diligence processes have changed. While long-term investment performance remains a priority, investors say they are more concerned with operational due diligence and internal controls. Nearly two-thirds of investors say that the most important criterion when selecting a manager is the portfolio management team. Yet only half of managers feel the same. Managers instead identify long-term performance as one of the most important criteria (72 percent), but only 43 percent of investors agree.

"Many managers feel they are not getting a straight answer when an investor passes on a mandate, leaving them guessing at the reasons why," comments Tully. "There is a significant opportunity to improve communications between managers and investors so managers can better provide investors with what they need to make good decisions."

Ernst & Young financial services professionals provide integrated assurance, tax, transaction and advisory services to asset management, banking, capital markets and insurance clients.

Ernst & Young is a global company focusing on assurance, tax, transaction and advisory services.

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