By Bob Swarup, CAIA*
The alternative fund industry is remarkably immature – a fact that can be put down to its astounding success in raising assets and generating performance in recent decades.
This statement may seem fantastical, particularly in light of the success acknowledged above, but it is nonetheless true. When it comes to the thorny question of governance, the industry is a long way behind where it should be.
For many managers, regulation is a tiresome intrusion and compliance an exercise in repeatedly re-papering the office. New rules are quickly delegated to external parties, checklists and reports slavishly created, and stifling process becomes the lasting effect of this tryst
This piece is not a defense of regulation. Regulation has many flaws, not least its onerous complexity, but this should not detract from the fact that it is well intended. Regulation represents wider concerns about the financial world and the damage that its complexity does to the fabric of an economy in the absence of better understanding. Its thrust, therefore, is to force people to think harder about the decisions they make and about the consequences of these decisions.
That is no bad thing, even if execution in recent years leads something to be desired. In every sphere of human endeavor, a good business is one that plans effectively for the future. That means it thinks hard about the strategic decisions it makes; weighs up pros and cons; considers different scenarios; and always is aware of what can kill the business.
In other words, the business is focused on avoiding group-think and understands the value of risk management at the highest level. This does not require detailed checklists or paying lip service to external requirements or creating a series of emasculated cost bases that achieve little in practice. Rather, it means having effective governance and strong internal challenge.
From this perspective, most of the alternative industry is a dismal failure. The vast majority of managers may be talented traders but they are poor businesspeople in practice. Strong personalities dominate a fund entirely, often to the detriment of their longevity as investors flee as soon as said key person exits. Their time horizon rarely extends beyond the next quarter. The risk function is limited, conflicted and often toothless. Procedure regularly masquerades for rational thinking. And most importantly, there is often no culture from the top down that can provide effective internal challenge.
That alternative funds have survived so long despite these failings is testament to their remarkable performance on the investment side. Historically strong returns, coupled with poor pickings amongst traditional assets in recent years, have meant that investors have ignored many of these warning signs over the years in their pursuit of diversification and absolute returns. Consequently, the alternatives industry – hedge funds, private equity and their multiplying cousins – have fashioned for themselves an ivory tower where few question the sustainability of their model. Only in recent years has the glare of scrutiny suddenly turned on them, as evidenced, for example, by the fallout from Madoff, the relentless progression of AIFMD and the recent SEC move to set up a unit to examine private fund practices in the US.
Many will, of course, debate this. They will point to the excellent use of hedging to mitigate risk exposures in the hedge fund industry; the superior risk-adjusted returns all round; the proactive management of worsening positions in the PE industry; and so on. These are all true but they miss the point of risk management. All of the above are merely examples of managing one facet of risk management from a business' perspective.
Managing a business properly requires a holistic perspective that understands the deeper challenges of the fund in question and the future permutations that will impact its longevity. Every business, including a fund, has liabilities. Some will be tangible, such as the possibility of redemptions or that investors may be unable to meet drawdowns. Some will also have intangible aspects, most importantly, investor perception and expectations.
Running a fund as a business means understanding this basic tenet of your existence. Given the diversity of potential exposures and investments, alternative funds are complex risk-bearing and risk sharing entities, whose investment behavior directly impacts on the stability of financial markets. Additionally, these diverse risks are dynamic in nature and, therefore, need to be managed.
Investment risk, for example, is just one of the risks. As risks are hedged away, they do not disappear into the ether. Rather, they transmute into other forms of risk that are more qualitative such as counterparty risk, political risk, refinancing risk and so on. Thus, all the risks need to be understood and viewed in the context of one another.
These risks are also dynamic and will evolve over time. Alongside, financial innovation will always lead to the creation of new asset classes and instruments, placing a continual burden of understanding and analysis on both funds and regulators. That means always trying to understand the changing nature of the markets as well as its participants, whose behavior can have severe consequences for a business. Importantly, regulation can place prescriptive obligations on funds, but it would be a mistake to focus entirely on these to the detriment of managing the other risks a fund faces.
None of this is easy and there are insufficient words here to delve deep into the management of the core challenge for a fund: achieving its strategic business objectives alongside regulatory oversight and a myopic outside world.
But there is one key area, where every fund should start. And that is to look at its directors.
Any attempt at risk management, irrespective of regulatory edicts, is doomed to failure unless there is a proper risk culture in place. Most fund directors are not chosen currently for their expertise or their value-add. Rather, they are chosen to fulfill key legal requirements and to provide minimal challenge to the manager or GP. That is a pity and accentuates the long-term mismanagement of the industry noted earlier.
When funds were small, this was perhaps not a problem. But today, the flood of money pouring in means that the alternative industry has grown tremendously. And with this growth, its social, political and economic impact has grown as well. Whether we choose to like it or not, we are more complex entities now and far more subject to scrutiny. That means a more complex basket of risks – any loss now is less easily forgiven whilst regulatory requirements have multiplied – and the need for a deeper focus on internal challenge and holistic risk management.
That means starting at the top and putting in place people with relevant expertise and with opinions. That is not a bad thing. In the corporate world, independent directors are seen as an asset, not a cost base. They have expert knowledge that is relevant to the business.
They provide valuable networks. They safeguard shareholders interests, whilst also understanding the particular dynamics of the business. They provide important reflective surfaces for the senior management to bounce ideas and initiatives off, lending valuable additional expertise.
These are all areas that fund managers can benefit from. Hedge funds and private equity firms have very different risk profiles and exposures. High quality independent directors can help hem question, understand and ultimately mitigate their strategic risks, enhancing the long-term future of the business. They can bring in valuable outside perspectives on regulation, policy, investor dynamics, macro trends and so on – all of enormous importance to any manager looking to make money for the long run. They can help safeguard the rights of investors, a growing chorus line in today's environment, but without hobbling a business model, as prescriptive regulation would surely do after the next set of failures. Most importantly, they can help a business understand what might kill it. That allows managers to determine what steps are needed to mitigate said fate.
It's a question of cultural change. But do we have the courage to take the first step?
Bob Swarup is Principal at Camdor Global, a strategic advisory firm focused on investment strategy, risk management and regulation, that also provides independent director services. He is also the author of the critically acclaimed bestseller Money Mania (Bloomsbury, 2014), which looks at the lessons to be learnt from the last 25 centuries of financial crises. He may be contacted at: swarup@camdorglobal.com.