President's Working Group Committees Issue Best Practices for Hedge Fund Managers and Investors

Two private-sector 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 recommendations are open for public comment for 60 days. Based on the comment, the committees may revise the best practices and standards.

The committee on asset managers called on hedge funds to adopt comprehensive best practices in the critical areas of disclosure, valuation of assets, risk management, business operations, compliance and conflicts of interest. The investors’ committee recommended best practices that include two guides. A Fiduciary's Guide provides recommendations to individuals charged with evaluating the appropriateness of hedge funds as a component of an investment portfolio. An Investor's Guide provides recommendations to those charged with executing and administering a hedge fund program once a hedge fund has been added to the investment portfolio.

Both sets of best practices recommend broad innovative practices that exceed existing industry standards. The recommendations complement each other by encouraging asset managers and investors to hold each other accountable.

Analogizing from the key principles of public company disclosure, the asset managers committee urged hedge funds to provide investors with a comprehensive summary of their performance, including a qualitative discussion of hedge fund performance and annual and quarterly reports. The funds should also timely disclose material events.

Another crucial practice is to produce independently audited, GAAP-compliant financial statements so investors can get accurate financial information. Specifically, fund managers should provide financial information supplementing FASB Standard No. 157 to help investors assess the risks in the valuation of the fund’s investment positions. Although FAS 157 is not required to be fully implemented until the end of audit year 2008, fund managers should work closely with their auditors throughout the year for purposes of implementing it and the related practices.

Depending upon the extent to which the fund manager invests in illiquid and difficult-to-value investments, the disclosures should occur at least quarterly and include the percentage of the fund’s portfolio value that is comprised of each level of the FAS 157 valuation hierarchy. Level 1 is comprised of assets with highly liquid market prices, while Level 2 assets have no quoted prices but there are similar assets with quoted prices. Level 3 is for illiquid assets that have to be priced using models.

Because it is impossible to anticipate every potential conflict of interest relevant to the hedge fund industry, the report urges fund managers to establish a Conflicts Committee
to review potential conflicts and address them as they arise. For example, funds should segregate the functions between portfolio managers and non-trading personnel who are responsible for implementing the valuation process.

Fund managers should also establish a comprehensive valuation framework to
provide for clear and consistent valuations of all the investment positions in the fund’s portfolio, while minimizing potential conflicts that may arise in the valuation process. A best practice would be to set up a Valuation Committee with ultimate responsibility for reviewing compliance with the fund manager’s valuation policies and providing objective oversight of those policies. Further, independent personnel should be in charge of the valuation of the fund’s investment positions.

The report also urges fund managers to establish a comprehensive risk management framework that is suited to the size, portfolio, and investment strategies of the funds. Managers should identify the risks inherent in their investment strategies, and measure and monitor exposure to these risks. The risk management framework should be communicated to investors to enable them to assess whether the fund’s risk profile is appropriate for them and how the investment is performing against that profile.

As part of risk management, hedge funds should assess the creditworthiness of counterparties and understand the complex legal relationships they may have with them. The fund manager should monitor the exposure to counterparty credit
risk, including prime brokers and derivatives dealers, and understand the impact of potential counterparty loss of liquidity or failure.

The investors committee strongly urges hedge fund investors to conduct due diligence tailored to their individual circumstances and objectives and to the particular risk
and reward character of each hedge fund investment. They should also evaluate the risk management framework employed by a hedge fund manager.

Similarly, investors should obtain a full understanding of valuation since this can be the key to deciding whether to make an investment. Each investor should also develop a comprehensive philosophy regarding the payment of fees and expenses for all investment management services, relative to the returns sought and risk taken by an investment strategy.