In an effort to increase the transparency reported from fund managers, investors may have noticed that the SEC now requires fund managers to report more information included in revised Form ADV disclosures. The SEC’s goals in crafting these revised disclosure requirements seemed well intentioned at the time they were enacted. Indeed, at first glance, enhanced disclosures and transparency from fund managers seem to be an inherently positive development for investors. Investors are not alone in this quick rally around additional reporting requirements.
However, before becoming too excited about these enhanced ADV disclosures, we encourage investors to proceed with dose of measured caution. Certainly, the more due diligence the better, however even a neutral evaluation of the types of information contained in the revised ADV disclosures suggests that the SEC may have sacrificed quantity of required disclosures, in the place of quality information.
While, investors may find these additional disclosures can be very informative, the guise of enhanced transparency can actually foster a dangerous environment in which investors may become too comfortable with fund managers, and believe the government is keeping sufficient watch. This wolf in sheep’s clothing syndrome may result in investors mistaking transparency for due diligence, and can result in investors not performing sufficient operational due diligence or even worse ignoring it all together.
Returning to SEC disclosures, it is worth considering what such additional disclosures actually accomplish at all? For example, as part of the new ADV disclosures fund managers are now disclosing more details about their service providers’ relationships, including prime brokers and auditors. The government forcing fund managers to disclose this information seemingly now puts the onus on investors to act upon it. So this begs the question — what are investors doing with this data? Such a question presupposes however, that investors are now receiving this information for the first time. This is patently absurd.
Investors should be performing operational due diligence before investing with a fund manager be it a hedge fund, private equity fund or some other type of manager. The operational due diligence process includes a review of a fund’s service provider relationships. In conducting these service provider reviews it is certainly essential to know the identity of these providers. If a fund manager would not disclose this information in response to investor operational due diligence requests then an investor should run, not walk, away from the manager.
The fact that the SEC did not previously require fund managers to put the identity of fund service providers, and a whole lot of other information, in writing is perhaps representative of an endemic trend of lack of transparency to regulators. However, it’s not all the SEC’s fault. The goals of the government are complementary to the goals of investors during the operational due diligence process. The government, in part, wants to prevent illegal activity (including fraud) and protect investors from exposure to this activity.
The goals of the investor during the operational due diligence process should not only be to avoid exposure to funds involved in illegal activity, such as fraud, but to evaluate the quality and appropriateness of a fund’s operations. A fund manager can be a perfectly honest person, but can still have internal operations which deviate from best practices. There are many areas which can lead to significant fund losses, and are typically covered during an investor operational due diligence review, which still remain unaddressed in the revised SEC ADV disclosures.
One example related to fund cash oversight. It is not illegal for a fund manager not to conduct a daily cash reconciliation - but it is certainly advisable. A manager who does not perform these daily cash reconciliations could have issues at month-end in reconciling cash statements and positions which may result in delays in producing NAVs. These delays could contribute to unhappy investors who redeem capital and put the fund out of business. This is the type of poor operations management that the government might not detect under the new regulations but whbich investors performing operational due diligence certainly should.
Another example relates to hedge fund valuation practices. It would generally be perfectly legal for a hedge fund to maintain a sole valuation policy which is contained in the offering memorandum of the funds it manages. These policies are often intentionally drafted by lawyers to be vague and broad enough to give the fund manager discretion in valuations. When a fund administrator is utilized, typically as long as they sign off on valuations the fund manager has complied with the terms of the offering memorandum.
But consider the situation where a fund trades a considerable amount of illiquid positions. Under vague offering memorandum policy, the fund could simply mark those positions any way it sees fit and provide backup documentation of these marks to the administrator. The administrator may or may not have the ability, or even be required to, independently confirm these manager marks. Such a situation would raise concerns that the fund manager could manipulate the marks in their favor. Alternatively, an honest fund manager could simply inappropriately value securities based on shaky assumptions or model inputs. In either situation, there is significant potential for fund and investor losses when incorrectly valued positions are eventually marked down. Nowhere in the SEC ADV disclosures is a fund manager required to disclose any sort of detail in this regards. To detect and avoid these types of situations investors need to go beyond the Form ADV disclosures and perform deep dive due diligence on these operational details.
Form ADV also completely ignores other key fund risk areas. An example of this is business continuity and disaster recovery (BCP/DR). This has become an increasingly important area for hedge funds in recent years, particularly high frequency traders. Aside from the threat of large scale events, such as terrorism or natural disasters, which could disrupt fund operations, there are a number of more mundane ways that fund operations can be disrupted or data can be lost. These can include regional storms that result in downed power lines and the failure of certain pieces of hardware, such as servers. Recognizing the importance of this area, hedge funds have continued to develop sophisticated BCP/DR plans that often include offsite hardware locations and alternative worksites. Disclosures about such plans are not required on Form ADV, yet there are often very real consequences for investors in funds that do not have appropriate BCP/DR plans. While there are other SEC provisions that address fund BCP/DR plans, even these do not get into much detail regarding the quality or appropriateness of such plans. Once again, it is up to investors to source this information themselves, rather than expecting the Form ADV to provide the necessary transparency.
In summary, investors should not mistake an environment of enhanced fund disclosures and supposedly increased regulatory oversight for proper operational due diligence. Enhanced transparency on regulatory filings such as Form ADV should be viewed as a tool in the operational due diligence arsenal, and not a crutch which would obviate the need for investor’s to perform their own operational due diligence.
Jason Scharfman is managing partner at Corgentum, a consulting firm which performs operational due diligence reviews of fund managers and works with investors including fund of funds, pensions, endowments, banks and family offices.
