May 12, 2016
Interviewed by: David Snow
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New Rule: Transparency & Sophistication Reign

Experts from RSM, Alpha Parity and Sprott Asset Management discuss the growing demand for transparency and sophistication by hedge fund investors.

Experts from RSM, Alpha Parity and Sprott Asset Management discuss the growing demand for transparency and sophistication by hedge fund investors.

New Rule: Transparency & Sophistication Reign
The New Rules of Hedge Fund IR

David Snow, Privcap: Today, we’re joined by Jeff Silverman of AlphaParity, Ed Coyne of Sprott Asset Management and John Hague of RSM. Gentlemen, welcome to Privcap. Thanks for being here.

Unison: Thank you.

Snow: The hedge-fund industry has changed tremendously over the past 10 years or so, largely as a result of regulation, but also as a result of increasing investor sophistication. All of you are in the midst of that change and that complexity, so I’m fascinated to hear your views about what is going on.

Ed Coyne, Sprott Asset Management: Sure. I think that one of the biggest things is really transparency—clients’ and investors’ demand for transparency, wanting to see that and the managers willing to open up their books and show that. How does it work from an operation standpoint? How does it work from a portfolio manager standpoint and what does that mean in totality to the managers and their process in general?

Snow: John, as someone who has many hedge-fund clients, you see across the industry and you must be very aware of what the pain points are for many of these firms. What are some of the recurring themes you see?

John Hague, RSM US LLP: One trend we’re seeing is that the back office needs to be more public-facing. There’s an incredible amount of due diligence being done on an ongoing basis and people aren’t stopping at the CEO level. They’re talking to the assistant controllers and the people who are actually pushing the buttons and executing the trades. That has increased the exposure, so to speak, of the people in the back office, which has made everybody get to their best game.

Snow: Can you give examples of what kinds of items the LPs are looking at when looking into the back office or your operations that maybe someone who is not in your position would find surprising or interesting?

Jeff Silverman, AlphaParity: We trade futures, so consider us a managed-futures firm. It’s the execution—the processing is quite streamlined when you compare it to less liquid strategies.

What the investors are looking for from us are policies and procedures, understanding the flow of business from trade generation to execution to clearing and to how that is posted at the administrative level and at the client level.

Hague: As compared to publicly traded securities, there are a lot of hedge funds out there that trade securities and investments that are much longer-term and much harder to value. So, the investors are going in there and they’re not basically sitting back and saying, “OK, we have a fair value methodology.” They’re asking what the details of that methodology are. They’re asking if you have a valuation committee or any oversight as it relates to the independence of that function. They’re getting into the details.

They couldn’t care less if you’ve got a cash-flow model. They want to know what the variables are and how you get the completeness and accuracy of the variables. They’re very sophisticated.

Snow: Let’s talk about a concept in hedge funds called the “breakeven point.” This has to do with the assets under management required for your organization to pay for itself to keep the lights on. I’m guessing that, with the great costs of doing business as a hedge fund, that’s now a higher breakeven point. What does that mean for a group that is a smaller or a newer hedge fund trying to establish itself?

Coyne: That’s where you’re seeing a lot of these liquid-alternative strategies come about, frankly. A lot of these smaller hedge-fund companies really can’t get the ball moving on their own in their own vehicle, so they’re looking to outsource some of that or bring some opportunities in‑house and act as a sub-advise manager on a lot of these liquid-alt strategies. If you look at a lot of the mutual funds out there now that offer liquid-alt strategies, it’s a combination of multiple managers of smaller hedge funds that have a strong track record, but are relatively small.

Silverman: Yes. There was a study done shortly after the crisis. One of the large money-center banks did a study that showed that the breakeven for a hedge fund had shifted higher, from $100 million of AUM closer to $250 million. I’m sure today that number is even higher to hit breakeven. We’re in an industry where the barrier to entry is still relatively low, but the barrier to success or to breakeven is increasingly getting higher.

Hague: To continue our theme, best practices are demanding that managers have best practice and they have to be able to demonstrate that. They have to have a code of conduct. They have to have policies and procedures, as we’ve talked about, an evaluation committee, an investment committee and corporate governance with potentially border governors overseeing everything, the conflict-of-interest policies and even the selection of vendors.

Snow: Let’s talk about the fact that, when you reach $150 million in AUM, you have to register with the SEC, yet, Jeff, to your point, that’s not the breakeven point for many firms.

Silverman: Sure. We live in a different world. You can look at the launches today and there are common threats. Many of them are being launched by very well-to-do founders, investors that have had a high degree of success and achievement in their career and they have the personal capital to fund the business for two to three years out of their own pocket.

The other types of launches we’re seeing are those that are being launched with the help of strategic partners—either institutions or wealthy individuals committing large sums of AUM for a period of two or three years. In some cases, just AUM. In some cases, working capital as well.

Snow: As a hedge fund gets closer to either that breakeven point or that more expensive life as an SEC-registered organization, I would imagine that the investors pay extra attention to whether or not they’re going to be able to handle that new set of realities.

Hague: I think it’s almost “the chicken or the egg.” You would have to go back and have best practices to be able to build your assets under management to get to the point where you’re eligible for registration, otherwise the investors are going to go with a smaller investor.

Snow: You can’t say, “We’re going to up our game when we get to that higher level.”

Hague: Absolutely not.

Snow: Can you give some examples of types of information or frequency or format that investors are demanding that perhaps, again, 10 years ago, they might not have?

Coyne: I think the big thing is the “why?” Why do you own this? Why are you shorting this? Why are you taking this position? It’s not just we had this in the black box. “We know you’re a great manager. We’re going to give you our money and we’re going to trust you’re going to do well with it.” Understanding the reasoning behind taking a position is probably at the forefront now in a way that it’s never been before.

Snow: How does your firm handle that kind of request?

Silverman: I think firms today have no choice: you have to deliver that transparency. You need to open up the kimono and, to Ed’s point, let investors understand why decisions are being made. Things need to stay consistent. This is my process for making the decisions and what you will see will be consistent with that. I think there are firms that have been around for a long time, certainly in our space, the quantitative investing space, that don’t have to offer that.

Snow: John, a follow-up question for you. Actually, a question for anyone: what role does technology play now in the IR function? Talk about the different levels of sophistication you’ve seen within hedge funds in deploying that technology from “none” to “highly.”

Hague: There’s plusses or minuses. The plusses: obviously, it allows you to move data quicker and provide information to your investors quicker. It also allows for [increasing] the transparency as it relates to the data, both on the timeliness and completeness. The flip of that is the risk involved with whether you have cybersecurity controls in place, etc., because once you start playing in the IT world, there’s a whole bunch of risk out there that you have to manage, which adds to your cost.

Silverman: I would agree with John completely. It’s access to data on an almost instantaneous timeframe.

Snow: It’s the investor being able to reach into your portfolio and see exactly what’s happening in real time.

Silverman: Absolutely. Correct. It’s access to the data that we can provide via our website. It’s also accessing the administrator’s website, getting their capital-account statements from independent sources. Making that available is very helpful.

Snow: John, you mentioned IT security, cybersecurity. What’s an example of a breach of cybersecurity that would be particularly harmful to a hedge fund? Would it be a rival hedge fund having the information on your portfolio? Would it be your investors’ account details being in the hands of the wrong people? Or is it all of the above?

Hague: Obviously, there’s the black box out there; there are stories as to being able to hack these fast-trading firms out there. Supposedly, there’s rumor that a cybersecurity breach is actually getting ahead of some of these orders before they even hit the exchange floor and taking advantage of that. It hasn’t been confirmed, but there are good theories, in fact, authored by the FBI, that it’s happening. So, you’ve got the investor side, the investment side and then you also have the confidentiality of the investors’ information.

Coyne: I would add to that: that’s a critical threat, because a lot of these companies are thinly traded. So, having that instantaneous access to that information is a huge advantage from a trading standpoint when these stocks can move multiple points off a single trade order. That is something they have to be very focused on. That’s what the real concern is, obviously, as you open up your books and people can see what you own are people getting ahead of your trades, whether it’s through fraud or just through…while you’re looking at the balance sheet and the portfolio and saying, “Hey, I know they had this position.” That’s an issue, for sure.

Snow: Without naming names of firms or anything like that, what are some other cybersecurity risks or incidents you’ve heard of?

Hague: I’m not sure that all the firms that have been affected and impacted by cybersecurity are no-names, because one trend we are aware of is the fact that somebody will get into your systems and prove to you that they’ve gotten into your systems, but not necessarily use or sell the data. Instead, [they’ll] extract some kind of ransom.

By and large, we understand there are firms that are willing to pay that ransom because the reputational risk—particularly in this industry of having investor detail information available or, again, to get ahead of the black box—could be critically important to the success of the manager.

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