As hedge funds continue to become more institutionalised, sponsors are adjusting their risk management strategies to manage growth in a way that safeguards the firm’s reputation and maintains operational efficiency.

Firms are tailoring their risk management programs to achieve an optimum balance between fostering growth and ensuring proper control over investment and operational risks.

The 2004 PricewaterhouseCoopers Global Hedge Fund Valuation and Risk Management Survey is our second hedge fund survey, this time concentrating on governance, valuation, investment practices and operational risk management. In September/October 2004, almost 70 firms with investment offices in North America, Europe and Asia (the majority of which were in the US, in keeping with the industry’s composition) completed extensive questionnaires. These gathered detailed information on specific policies, procedures, reporting, tools and organisational structures. The findings provide insights into current industry practices and innovations, as well as data to enable participants to benchmark their own initiatives to improve controls and operational efficiency.

Key findings show survey participants are actively pursuing risk management, but their approaches are far from uniform:

• The survey confirmed that the governance structures of hedge funds have not altered significantly despite the forces of change that have impacted public companies and registered investment companies.

• All firms dedicate significant time and resources to valuation issues. However, despite expectations from investors and regulators, there are still large differences in the transparency and documentation of valuation policies and procedures, especially for nonlisted and less liquid products.

• Strong controls are sought over valuation, reconciliations and investment risk; however, there is a wide range in the size and organisation of resources used to support these functions and to maintain segregation of duties.

• Progress in establishing a risk infrastructure consisting of compliance, internal audit, risk management and IT/data management varies widely among firms.

Risk management prioritites

In assessing their organisation’s risk management priorities and how they align their professionals with those priorities, most of the responses were as expected:

• Control the volatility of returns within each strategy;

• Manage and mitigate operational risks (transaction processing);

• Enforce strict compliance (regulatory reporting and personal trading); and

• Provide oversight for the valuation process.

Unlike larger, more diversified financial institutions, the survey confirmed that certain risk management practices including counterparty risk management and formalised approval of new instruments appear to be a lower priority for hedge fund managers.

We were surprised by the lack of consensus regarding the definition of roles and responsibilities for risk management, as seen in Figure 1. In fact there were eight different responses to the question, “Who has the primary responsibility for risk management in your organisation?” Not all firms have a risk management committee. Many firms do not agree with the idea of an independent risk manager, because less than 30% have one (and these are more likely to be larger organisations).

Valuation policies and procedures

About half of those surveyed maintained “detailed” valuation procedures, which was surprising considering the increased regulatory scrutiny over hedge funds. Also, a much smaller proportion indicated that they have instituted a formalised pricing committee.

The survey questions made careful distinctions between determining, reviewing and approving valuation (at the portfolio level as well as at the asset class level). While the front office, back office and third party administrator had roles in many firms, for 20% of firms final approval authority rested either with the middle office/risk management unit or with the pricing committee. We still found that the front office ultimately approves valuations in 20% of the firms surveyed.

The survey probed procedures for obtaining and validating market prices and other input values. There were variations in the use of last trade, bid or mid-market quotes, especially for illiquid products. Nearly half the respondents stated that their process does not identify stale prices and more than half that they do not perform “acid” testing to compare a transaction price to a recent transaction price to the prior valuation price. In addition, in cases where dealers are an important source of prices, more than half do not distinguish between dealers who are trading counterparties and those with whom they do not trade.

Operational risk management

In our survey operational risk management refers to the controls and back-up facilities necessary to ensure accurate, efficient transaction processing, reconciliations and document management. Virtually all respondents stated that reconciliation processes are rigorous and documented. More than half of these processes are automated. The roles and responsibilities of prime brokers and third party administrators varied. However, more than half the respondents reported that their prime brokers/custodians and third party administrators did not have a SAS 70 or that they were unaware of any SAS 70. We believe that these reports will become more prevalent, and there are already indications of this trend. While 80% stated that they monitored the same back/middle office functions performed by these third parties, this suggests that 20% of respondents are not mitigating the risk of error due to outsourced functions.

Our survey data suggests that as hedge funds continue to become institutionalised, more firms are implementing robust tools and processes to manage operational risks and minimise errors in valuation and compliance. We will continue to monitor the industry’s progress, because managers are implementing these controls in a variety of ways. This disparity of practice is likely to lead to greater investor confusion and escalating investor demand for information, as more than half the respondents are already finding (see Figure 2 above). It is thus in the industry’s interest to standardise both some of the processes and presentation to ensure good business practice and also raise investor understanding and confidence.