Since the subprime crash of 2008 the alternative investment industry has been focusing in unprecedented detail on the issue of operational risk. This is being driven forwards from a number of quarters, including by regulators and investors concerned that assets might be placed in jeopardy as a consequence of future systemic failures. There is a general appreciation, however, that within the hedge funds industry there are systemic issues in the way business is being done that will need to be addressed if operational risk is to be reduced.
The investor community in particular is seeking solutions that will allow it to improve the efficiency of the hedge fund trade cycle, providing for enhanced interaction with fund managers and service providers like administrators and custodians.
Talk of ‘transparency’ is more prevalent than ever: we have statements to this effect from regulators and investors (e.g. in the recent survey of managers and investors published by Ernst & Young). But can we properly define what we mean by hedge fund transparency and produce a benchmark industry standard? Commentators have discussed the transparency of the trade, for example in equities pricing, but how can you translate this into hedge fund investments? In the post-Madoff environment, transparency now means proper verification of every stage of the trade, from the initial investment in the fund to where the assets are held.
From the perspective of the investor, for example a typical pension fund or family office, an investment in a hedge fund is treated as a security, and with that come concerns about liquidity: where is the investment held, what it is worth? How is it treated from a legal perspective?
In short, investors would like to be able to see their alternative investments alongside their other assets, be they exchange-traded securities or long only mutual funds. The problem is that hedge funds – and their private equity equivalents – are more opaque and are still seeking solutions that will allow them to deliver this degree of enhanced reporting to the investor community. It is difficult to get away from the spread sheet when it comes to managing an alternative investment portfolio: finding out what something is worth is hard enough using Excel; what about providing a confident measure of liquidity?