There is a yawning gap between the information required by investors to adequately assess the nature of a hedge fund and what the hedge fund industry has traditionally provided, whether from habit, lack of resources or proprietary concerns. That is now changing with interest from new kinds of investors and from regulators. Areas ripe for increased transparency include performance fee structures, equalisation, level of fees in funds-of-funds, foreign currency hedging between share classes and changes with the advent of International Financial Reporting Standards, to name a few on which we have suggestions...
Historically, the hedge fund industry has been characterised as secretive, cagey and cloaked – the less said the better, with information being given behind closed doors, in private marketing presentations to the elite high-net-worth or sophisticated institutional investor. With the advent of the institutionalisation of hedge funds, the demand for more and better information has grown. The price of spreading the hedge fund marketing net beyond the “elite few” to a wider investor base is the increasing demand for this information. Recent regulatory changes (e.g. Sarbanes-Oxley, EU Savings Directive, money laundering legislation, etc.) have given further impetus to encourage the hedge fund industry to open its doors a little wider and start telling the world its story.
While transparency is defined as “…easily detected or seen through” and “readily understood”, as applied to a hedge fund it means relevant, useful, concise and timely information in an appropriate framework and format that is easily accessible. For the hedge fund investor, it means a comprehensive and clear communication of what the fund manager seeks to achieve for investors and the progress being made towards those goals. This could involve communication via the internet so as to be timely and easily accessible, and a meaningful and comprehensive report, which would be relevant and useful to the user because it explains, defines, compares and predicts.
However, in the hedge fund context, these requirements must be tempered with the knowledge that the ability to achieve the stated investment goals may necessitate sacrificing timeliness and completeness of shared information. For example, hedge fund managers holding short positions or investing in an arbitrage strategy may need to keep their cards close to their chests in order to maximise the exploitation of market inefficiencies or knowledge obtained through their analysis. To do otherwise could result in a sharing of their sensitive information and their market play and negate the profits to the hedge funds involved.
The gap and minimum expectations
Currently, the usual information available to investors (or potential investors) in hedge funds would be annual reports, offering documents, promotional materials, road shows, websites and presentations. Certain hedge fund managers provide monthly communications to existing investors, which can vary from a broad discussion of how the markets have performed and how the fund performed during that same period to a detailed portfolio analysis, value-at-risk and sensitivity analysis and plans for the future investment period.
As to the information a hedge fund investor needs, there is no single, uniform answer. The information required is a function of the investor type (high-net-worth individual, fund-of-funds manager, pension fund manager, etc.) and what use they will make of that information. The requirements depend on the investor’s background, education and knowledge of investment management and whether they wish to be involved in the detail or seek less frequent, higher level commentary. Some investors may require little information on a monthly basis, but will require the annual audited report. Their view is that this is a longer term investment and an annual review should suffice, as they trust the manager to deal with the day-to-day operational and investment management issues. Others, including those in a fiduciary role or responsible to underlying clients (e.g. a pension fund manager or fund-of-hedge-funds manager), may require regular (e.g. weekly or monthly) information on performance, sensitivity analysis, risk analysis, exposure to various markets, operational issues with the administrator or other service providers and compliance reports.The informational requirements are usually agreed at the pre-investment, due diligence stage by an institutional investor and generally the hedge fund manager can comply with such informational requirements, subject to sensitive information being released in a less timely manner. However, this does not address the transparency of the industry as a whole to attract further investment from those who do not already participate in the industry, to assist regulators to understand and regulate the products and to enable those who are not high-net-worth individuals (i.e. the person on the street) to understand what they are all about. Even large pension funds have been slow to invest in hedge funds, and many that have done so have preferred the more costly fund-of-hedge-funds route to achieve diversification. There is a chicken-and-egg situation – the hedge fund managers want pension funds to invest, but the pension fund managers and trustees want transparency. Who will win the battle of wits?
What is the minimum amount of information an investor should seek prior to committing capital to a hedge fund manager? The prospectus or offering document should be read and reviewed in detail and generally the investor should attend a presentation by the hedge fund manager. This presentation offers the investor the opportunity to get more details on the exact nature of the investment strategy, the types of investments to be bought and their liquidity and risk levels, the actual use of leverage anticipated, confirmation of the key service providers and their reputation and the nature of communication about the investment to the investor. Any queries on the structure of performance-related fees, other fees and/or expenses to be charged to the fund and equalisation or foreign exchange currency share class hedging should also be explained to avoid confusion later. Fund-of-hedge-funds managers generally have a very detailed due diligence list which will include the additional information they require in determining whether the investment meets their needs and benchmarks for quality and risk.
On an ongoing basis, monthly information from the manager is generally considered appropriate. This should contain details of how the fund performed for the period, the portfolio listing or, at a minimum, a geographic and sectoral analysis by investment type so the investor can assess the exposures, as well as management commentary on why the fund has performed the way it has and versus a benchmark if appropriate. The investor should be provided with details of the value of their position, gross performance, fees, equalisation and foreign exchange currency class hedging as applicable. Any tax related breakdown of information should also be provided at year-end as required by the investor.
Information is only useful to the investor if relevant and tailored to their requirements and needs. Otherwise it is mere data overload – volumes of paper can be produced, but if it is irrelevant, not timely or lacks the detail required, then it is useless in the investor’s hands. A practical solution to tailoring information to each investor would be to include a section in the subscription documents that outlines the information available, the timeliness and content of that information and lets the investor select what they require. Transfer agents and administrators could then co-ordinate with the manager to meet those informational needs as frequently as requested.
The hedge fund reality and ideal on key issues
Some of the key areas where hedge funds could be providing more transparent information to investors include performance fees, equalisation, level of fees in funds-of-hedge-funds, and foreign currency hedging between share classes. The International Financial Reporting Standards will bring changes and, although Global Investment Performance Standards guidelines have not yet been finalised for the hedge fund industry as they have for the private equity industry, investors will be looking for increased comparability of performance presentation as they evaluate hedge funds. It behooves hedge fund managers to consider these areas and how they can improve transparency about them in their investor communications. An open line of communication between the investor and either the hedge fund manager or their service agent should facilitate queries, as no single report can ever meet all the informational requirements of each investor.
Performance fee & equalisation structures:
With the passage of time, performance fee structures have evolved and can be quite straightforward or quite complex depending on the fund. There are a number of equalisation mechanisms in use, although most in the industry have defaulted to one or two most common mechanisms. The prospectus usually provides details of the proposed fee structure, equalisation and a verbal description of how it operates. To enhance the transparency, a worked example in the prospectus is considered best practice, because describing the equalisation, high watermark and hurdle rates in words alone can be confusing. Worked examples in an appendix in the prospectus, illustrating how the fee and equalisation will operate under various scenarios, are easier to understand and, therefore, more relevant and transparent to the investor.
Ongoing communication about fees and equalisation should focus on making the information as user-friendly and understandable as possible. Any investor who needs to incorporate their valuation in further analysis or financial information needs to understand the level of accrued fees and the meaning and amount of equalisation from the information provided to them on a periodic basis.
Level of fees in funds-of-hedge-funds:
A fund-of-hedge-funds prospectus or presentation often makes a one-line reference to the fact that there may be other fees at the underlying fund level as well as at the fund-of-hedge-funds level. Investors may not completely understand the full implications of this. If they do, they may fear the worst. Hedge fund managers should be as clear as possible when investing in underlying funds to explain to investors the fee structure of the underlying fund, as well as the fund-of-hedge funds. For example, a fund-of-hedge-funds may have a management fee and a performance fee of 10% of the performance above prior high net asset values. The underlying funds in which the fund-of-hedge-funds invests may also have management and performance fees and this results in a “layering” of fees to investors as they pay fees at the underlying fund level via a lower net asset value reported to the fund-of-hedge-funds, and then also pay fees at the fund-of-hedge-funds level. Investors are wary about fee levels and being straight at the outset with potential investors demonstrates that the hedge fund (or fund-of-hedge-funds) manager has nothing to hide. Certain accounting standards or regulations now require disclosure of such information for funds-of-hedge-funds in the annual financial statements.
Foreign currency hedging between share classes:
Funds that have more than one currency share class will often engage in foreign exchange hedging of the currency exposure of certain classes. For example, in a US dollar-based fund, the euro share class might be hedged to eliminate the currency exposure to the US dollar fund in which it is invested. The mechanisms for doing this are varied and generally are not disclosed in the prospectus or at presentations. Unless an investor asks specifically about the calculation and hedging mechanism being used, it is unlikely that the information will be provided, yet this calculation has a direct impact on the return reported to each share class.
This is just one example of a lack of transparency in a key calculation that has an impact on the bottom line. Investors generally are not aware of the detail behind the calculation or the type of instrument being used (e.g. forward currency contract, a swap, a currency future or perhaps no instrument at all, in the case of ‘synthetic’ hedging).
International Financial Reporting Standards (IFRS):
With the demand by certain investors for onshore, more regulated investment vehicles, Europe is seeing an increase in the demand for hedge funds in EU-domiciles. An EU Directive is currently being implemented by the member states, which will require all “consolidated financial statements of publicly listed entities” to be prepared in accordance with IFRS by 2005. This will have an impact on not only the group company, but its consolidated subsidiaries. It is up to each member state to determine whether the scope of this directive will also include investment funds.
Nevertheless, with increased momentum towards enhanced and simplified cross-border accounting and reporting information, it likely to be only a matter of time before these standards do become obligatory for all entities within the EU.
One might aspirationally hope that the advent of IFRS would improve transparency and reporting by hedge funds in the member states and in other countries that also chose to move towards acceptance of these accounting standards. However, there are a number of challenges and difficulties with the use of IFRS by hedge funds.
IFRS example: Debt versus equity
One example is that IFRS may require “shareholders’ equity” (i.e. investors’ funds) to be defined as a liability (i.e. debt) rather than equity in the financial statements. This could mean that there is no concept of Net Asset Value per Share, no Statement of Changes in Shareholder’s Equity of relevance to investors in the fund and a changed layout for the profit and loss account.
IFRS example: Master-feeder accounting
Those familiar with the financial reports for a feeder fund in a master fund under US GAAP will expect to see a single line in the feeder’s balance sheet that is “Investment in master fund” and, similarly, on the profit and loss account single lines for “Share of master fund income”, “Share of master fund expense” and “Share of master fund realised and unrealised gains/losses”. IFRS would eliminate this US GAAP-form of reporting and require the master fund’s entire activity (portfolio of investments, assets, liabilities, income, expenses and gains and losses) to be consolidated into the feeder’s financial statements.
IFRS will require that the financial statements include a Statement of Cash Flows, allowing the investor to see the cash flow movements of the fund for the period and ensuring that cash balance reconciles back to that presented on the balance sheet. In addition, IFRS requires Earnings per Share to be disclosed, providing some earnings information on a pershare basis for the investor. Also, to the extent that more and more funds are preparing their financial statements in accordance with IFRS and also to the extent that US GAAP and IFRS (the two most commonly used accounting standards globally) continue to converge, consistency of presentation should improve.
The drive for transparency will continue to gain momentum with the institutionalisation of hedge funds. A gap has been in place for some time between the information available and the information needed by investors to be educated and informed about the industry and their investments in hedge funds. The informational requirements are a function of the type of investor so there is no quick fix or easy answer to the amount and nature of information to be provided. There are a number of areas where lack of transparency is an issue for investors – from performance fees and equalisation to the type of accounting standards being used in reporting by hedge funds. As existing and potential investors continue the push for increased and enhanced transparency, and as hedge fund managers strive to protect the value in their strategies via reticence, a balance must be struck. The current gap that exists requires that potential investors take a leap of faith in their investment decision – so “Mind the (transparency) gap!”
CFA, Senior Manager
Tel: +353 1 704 8719+353 1 704 8719