Tuesday, January 20, 2009

President's Working Group on Financial Markets Issues Best Practices for Hedge Fund Managers

Against the backdrop of market turmoil, two committees established by the President's Working Group on Financial Markets have issued complementary sets of best practices for hedge fund investors and asset managers in the most comprehensive effort yet to increase accountability for participants in this industry. Given the global nature of financial markets, the best practices were designed to be consistent with the work that was recently done in the United Kingdom to improve hedge fund oversight

The best practices
issued for hedge fund managers embody principles of enhanced disclosure, proper valuation, risk management, sound infrastructure, and compliance. All these elements are intertwined, said the committee, since trade documentation and settlement procedures are critical to accurate valuation and disclosure to investors. In addition, adequate procedures to control the creation of counterparty relationships are a critical part of counterparty risk management.

While recognizing that no set of best practices can resolve the complex issues facing the financial industry, the committee believes that these events underscore the need for hedge funds to implement strong practices to manage their businesses. The committee also emphasized that, even with the dramatic changes talking place, hedge funds will continue to be an important source of capital and liquidity in global markets by providing financing to new companies and committing capital in times of both market stress and market stability.

Disclosure

Drawing from key elements of the public company disclosure regime, the committee urged hedge funds managers to disclose periodic performance information and provide a quarterly investor letter or similar communication and risk report. Managers should also provide both a qualitative and quantitative discussion of performance information so that investors can better understand fund performance. This discussion is intended to provide context to the manager’s performance and can be in any form the manager feels is most useful, such as part of the investor letter.

A fund manager’s disclosure framework should also address disclosure to counterparties, such as banks and broker-dealers. The relationship between hedge funds and counterparties is mutual and both sides must understand their respective credit exposures. Thus, both parties should agree on the types of information that will be made available. Information provided should be appropriate to the type of relationship between the fund and the counterparty, and be subject to protection of confidentiality.

Valuation

The committee urges hedge fund managers to adopt a valuation framework that provides for consistent and documented policies and the segregation of responsibilities between portfolio managers and those responsible for valuations. Funds should also establish a Valuation Committee with responsibility for monitoring compliance with the manager’s valuation policies.

FASB Standard No. 157 on valuation establishes a hierarchy of assets based on the reliability of available pricing information: Level 1 assets have observable market prices like NYSE stock quotes, while Level 2 assets have some observable market price information other than quoted market prices. Level 3 assets are illiquid and have no observable market price information. Believing that investors need to understand what portion of the fund is comprised of hard-to-value assets, the committee urges fund managers to go beyond the requirements of GAAP and provide a quarterly report on the percentage of their assets that are in each FAS 157 level.

Risk Management

The working group recommends that hedge funds adopt a comprehensive framework to measure, monitor, and manage risk consistently with the fund’s risk profile. Managers should identify risks to the portfolio, measure the principal categories of risk, such as liquidity risk, market risk, and counterparty credit risk, and adopt policies to monitor and measure criteria, and maintain a regular and rigorous process of risk monitoring by knowledgeable personnel.

Hedge fund managers should also regularly disclose risk information, including a qualitative discussion that will help investors understand how they view the fund’s risk profile. Recognizing that confidentiality is important to the manager’s business, the working group does not expect that investors will be provided with all information used to monitor risk.

Depending on the extent of the fund’s exposure, the failure of a counterparty could have serious consequences for a fund’s access to liquidity and overall success. Thus, asset managers should assess the creditworthiness of counterparties and understand the complex legal relationships they may have with prime brokers or lending or derivative counterparties and their affiliates.

Infrastructure

In recent years, strong trading and business operations have become more critical than ever to the sound and effective operation of hedge funds. Thus, the committee recommends a comprehensive framework for a manager’s trading and business operations, including naming a senior officer responsible for operations and backing up that officer with adequate resources.

In addition, there must be segregated functions, a process for documenting relationships with counterparties and infrastructure to accommodate the types of investments traded by the fund and adequate management of the fund’s internal operations. Managers must continuously assess the effectiveness of their operational and internal controls.

Hedge funds should also employ qualified, independent auditors, and should thoroughly investigate the qualifications of all service providers to the fund, including custodians, prime brokers, and third party administrators.

Compliance and Conflicts of Interest

Finally, hedge funds must make a strong commitment to compliance and controlling conflicts of interest. In this regard, hedge funds should have a written code of ethics and a written compliance manual, including a process for handling conflicts of interest. Since it is impossible to anticipate every potential conflict, funds should establish a Conflicts Committee as the focal point for reviewing potential conflicts and addressing them as they arise.

Most importantly, hedge funds should also name a Chief Compliance Officer supported by a culture of compliance in which every person in the firm feels empowered to raise concerns. The duties of the Chief Compliance Officer should include identifying compliance risks; monitoring compliance with the fund’s policies; and conducting an annual review and assessment of the compliance framework.

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