Wednesday, January 23, 2008

UK Hedge Fund Working Group Sets Standands for Fund Managers

The UK Hedge Fund Working Group has adopted voluntary standards and best practices for hedge fund managers. The standards are on a comply or explain basis and include valuation, disclosure, and risk management guidelines. The working group is chaired by Sir Andrew Large. The standards have an inescapable global dimension. For example, the Board seeks convergence of the standards with the hedge fund standards being developed by the US Treasury Department.

The working group also established a Hedge Fund Standards Board to be the custodian of the standards. The Board will publish an annual report on the hedge fund industry’s compliance with the standards. The Board will also maintain a registry of hedge funds that have signed on to the standards.

The standards encourage hedge fund mangers to deeply and broadly enhance disclosure, including disclosure of the investment strategies they employ and the risks involved, as well as the instruments, such as derivatives, that are likely to be included in the fund's portfolio. Investors should also be told how the fund would use leverage and the risks involved in such use. In addition, investors should be told the methodology used to calculate performance fees and the details of any other remuneration received by the fund manager. Fund managers should also disclose the existence of side letters which contain
material terms.

Hedge funds should disclose in their annual report how the fund has invested its assets in accordance with its published investment policy. The working group envisages that such a statement will comprise a high-level factual explanation as to how the fund has invested its assets during the period. It is not intended to be a review or confirmation of compliance with the fund's investment policy. The fund’s annual report should explain the management and performance fees in a way that allows investors to readily compare them.

Importantly, the standards call on hedge funds to establish an independent and well-documented valuation process designed to mitigate conflicts of interest in relation to asset valuation. A best practice would be to appoint a third party valuation service provider who reports directly to the fund’s board. For its part, the board should adopt what the working group calls a Valuation Policy Document, which should be made available to investors upon request on a confidential basis.

The board should also regularly review the document in consultation with the fund manager. The document should list the duties of each of the parties involved in the valuation process; as well as any procedures in place designed to ensure that conflicts of interest are managed effectively. Similarly, funds should disclose the controls and monitoring processes in place designed to ensure the satisfactory performance of any third party to whom the valuation function is outsourced.

With regard to hard-to-value assets, such as derivatives, the valuation procedures should ensure a consistent approach to determining fair value and ensure that such procedures are set out in the Valuation Policy Document. In addition, the percentage of the fund’s portfolio considered hard-to-value should be disclosed.

Another standard decrees that a risk management framework be established covering all relevant risk categories, including portfolio and operational risks. There must also be adequate governance of the risk function to ensure that potential conflicts of interest between the hedge fund manager and the investor are properly mitigated. Disclosure to investors that risk management practices are in place is also part of the standard. The process of monitoring risk management should be separated from management of the portfolio.

The standards call for hedge fund managers to produce a Risk Policy Document setting out the procedures they will employ in monitoring risk management. As part of their monitoring duty, hedge fund managers should conduct stress testing.

The guidelines also call for hedge fund managers to appoint an independent compliance officer to oversee all issues relating to regulatory compliance and market and professional conduct. The compliance officer should report regularly to a management committee or equivalent. Hedge fund manager should regularly provide to the fund governing body a report on regulatory compliance prepared by the compliance officer on a regular basis.