Can an operational rating from Moody’s help a hedge fund raise money?

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Buy-Side FeaturesFeature
27 Nov, 2011

Institutional investors expect institutional quality operations at the hedge funds they invest in. It was to provide a shorthand tool for checking the adherence of hedge funds to operational best practices that Moody’s introduced its Operational Quality (OQ) ratings service in 2006. If that issue seemed less urgent at the nadir of the crisis, the investors of the post-Lehman era have turned operational due diligence into a sine qua non of hedge fund investing.  However, it seems the reputation of the ratings agencies in the wake of the crisis has increased scepticism about the value of an OQ rating at the very time when it ought to be unquestioned.

 

Moody’s is best-known for credit ratings, and it first identified the hedge fund market as an opportunity for exactly that. It was late 2005, and the firm saw hedge fund credit ratings as a logical extension of the work the firm was doing in rating structured credit issues. But research among investors to identify what they saw as the major risks associated with hedge fund investing yielded a different opportunity. It soon became apparent that an overarching issue was operational risk, so the firm decided to introduce a product that looked at the operational quality of hedge funds ahead of offering them credit ratings. Operational risk, or what Basel II famously dubbed “the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events … [including] legal risk, but [excluding] strategic and reputational risk” - was certainly a topical issue. In 2003 CapCo had published its now legendary white paper, Understanding and Mitigating Operational Risk in Hedge Fund Investments, which suggested that half of all hedge fund failures could be traced to an operational cause. It was to address that anxiety that Moody’s set itself the goal of gauging the operational infrastructure and processes of hedge funds, and working out what bearing this had on the accuracy of reporting to investors. An Operational Quality (OQ) rating methodology was devised, and the first public ratings calculated by it were sold to a veritable Who’s Who of leading hedge fund managers - Brevan Howard, Marshall Wace, King Street, Citadel, Fortress, SAC and Millennium among them – in the first year. It was 2006, just as investing in hedge funds took on an increasingly institutional flavor, and hedge fund managers readily grasped the time savings and sales potential of offering institutional investors a third party stamp of approval. Investors, who used the service for free, devoured the information as fast as Moody’s could manufacture it. Initially, the business grew rapidly.

Early success prompted a decision to expand the size of the team working on the OQ ratings. The main challenge, before the financial crisis, was to persuade hedge fund managers o disclose information. However, Moody’s identified a small group of funds persuaded that it was more efficient to do the exercise once with a firm of the stature of Moody’s, and make the report available to all investors, than to engage in repeated operational due diligence exercises with multiple investors. Investors contacted by Moody’s also found a five level ratings scale that ran from OQ1 (“excellent”) to OQ5 (“poor”) with occasional plus and minus modifiers a useful and efficient means of differentiating between hedge fund managers. After all, the idea behind any ratings methodology is to simplify a complex series of risks into a single, easily comprehensible and comparable scale. OQ ratings enabled investors to put a number on operational risk at different hedge funds. In essence, an OQ1- rated fund had a lower risk of blowing up because of operational shortcomings. In that innocent, pre-Madoff era, Moody’s felt no need to capture the risk of fraud but only to reassure investors by checking that a hedge fund was following best practice in its operations.

Table 1: The Moody’s hedge fund OQ ratings scale

Rating level

Definition

 

OQ1

Excellent

OQ2+

OQ2

OQ2-

Very good

OQ3+

OQ3

OQ3-

Good

OQ4+

OQ4

OQ4-

Fair

OQ5+

OQ5

Poor

 

But that, of course, was then. In 2006-07, even a large investor would be lucky to get past the investor relations people at a major hedge fund. Now, operational due diligence is the fastest-growing discipline in hedge fund investing, and a major drain on the time of capital-hungry hedge fund managers. The appetite for operational information is especially lavish at funds of funds, but virtually every type of investor now insists on doing their own operational due diligence. Simultaneously, hedge fund industry associations (the Alternative Investment Management Association and the Managed Funds Association) and official bodies (the Hedge Fund Working Group and the President’s Working Group) published a series of detailed recommendations on best practices for hedge funds, including many in the operational area. Unsurprisingly, these developments led to a searching re-examination of the Moody’s OQ ratings methodology, whose results were published by the firm in June 2009. They aimed to update the methodology to take account of what the firm had learnt in the crisis. The ten weighted sub-categories of the original methodology were reduced to five: Operations, Valuations and Risk Management Framework (which account for 70 per cent of the weighting), Corporate Functions (20 per cent), and Service Providers (10 per cent). However, the number of weighted sub-sub-categories was increased to 27, in an effort to make the findings more granular, and divided between issues susceptible to a binary answer and issues where qualitative judgments have to be made. The Risk Management Framework, for example, contains 12 sub-categories divided between Investment Risk Management (governance, tolerance and identification, monitoring and controls, ex-post outcomes analysis, communications to investors and links with liquidity risk management) and Liquidity Risk Management (asset liquidity, cash management, funding, collateral management, counterparty credit risk management and redemption terms).

The firm also added some questions which capped a rating. If a manager could not give the “right” answer to one of those questions, the ratings in that sub-category were not allowed to rise above OQ2 (“very good”), irrespective of the answers they gave to the other questions in that sub-category. A good example of such a question is one on the independence and stature of the risk management function relative to the size and complexity of the fund. Another is whether a fund is using an in-house fund administrator without appropriate safeguards, putting the accuracy of valuations at risk. There are some much more obvious markers of operational risk. A lack-up of systems back-up was one – and even quite substantial funds are apt to keep a single server, or park the back-up at the home of a managing partner.  A shortcoming on a key question can cap a score in a specific sub-category and, depending on how the scores add up across the weighted average scorecard, even cap the overall rating too. Moody’s insists that each of the scores in the sub-categories cannot be more than two notches away from the final score, to prevent providers that are good at 90 percent of operational tasks, but still poor at 10 per cent of them, from getting an OQ1 rating. The idea is to ensure that an OQ1 rating is based on scores that are at least OQ2+ across the full set of sub-categories. To be a top rated provider, in other words, a hedge fund manger needs to be good at everything. It is not good enough to be terrific at valuation, and hopeless at risk management.

The weightings of the different sub-categories (see Table 2) nevertheless seem counter-intuitive. In the Service Providers sub-category, for example, the exposure of a fund to prime brokers does not attract a heavy weighting. Indeed, third party service providers as a whole account for only a tenth of the weighting of the five categories as a whole. That said, Moody’s analysts insist on making calls and even site visits to all the prime brokers and fund administrators used by the funds they rate, to ensure their processes and data match those of the fund, and that they have adequate business recovery and continuity plans. Moody’s is more interested in how an operational process – say, reconciliations, or settlement – is done, rather than who it is done by. The presence of manual adjustments, for example, is more worrying than the fact they are made in-house. Gathering information in this detail and from third party providers as well is inevitably time-consuming, but six to eight weeks is usually more than sufficient for a small to mid-sized hedge fund to secure a rating. The timescale gets longer if the fund fails to make operational, risk management, fund accounting, compliance, IT and trading staff available promptly, and or is unwilling to let Moody’s take even non-sensitive documents (which never, incidentally, includes prime brokerage or ISDA agreements) off site. Scrutiny of a larger fund might entail a full week on-site, and three to four months in all to arrive at an initial rating.

 

Table 2: The Moody’s OQ Rating scorecard  

Category
Weighting
Sub-categories

 
 
 

Operations
25 per cent
Trading infrastructure (systems, people, process and documentation); trade flow (execution to settlement); wire transfers (controls around cash/wire transfers); investor relations

Valuations
25 per cent
Valuation process and controls; valuation policies and documentation; valuation oversight

Risk Management Framework
20 per cent
Investment Risk Management (governance, tolerance and identification, monitoring and controls, ex-post outcomes analysis, communications to investors and links with liquidity risk management) and Liquidity Risk Management (asset liquidity, cash management, funding, collateral management, counterparty credit risk management and redemption terms).

Corporate Functions
20 per cent
Compliance and legal; systems and business continuity; human resources; finance and tax

Service Providers
10 per cent
Level of external involvement/oversight of administrator; prime broker; auditors; other third party service providers.

 

A complete reluctance to divulge information would be odd, if a fund invites Moody’s to prepare an OQ rating, but the ratings process can still be prolonged if analysts run into sensitivities. Many hedge funds invite lawyers to meetings, which can make it hard to progress, as requests for documents are refused, rather in the manner of a crime show on television. Access to a particular document can become a subject of intense debate, only increasing the desire of the Moody’s analyst to see it. However, tensions are limited by the fact that a hedge fund gets to vet what is in the final report, and retains the option not to publish the initial rating. Indeed, one of the principal causes of delay is the time a manager takes to decide whether or not to publish a rating. Understandably, they want to be confident that it will not place them at a competitive disadvantage with investors because, once a report is published, every aspect of the rating becomes public, including any subsequent request by a hedge fund manager to withdraw the rating. The reports are 15 to 20 pages long, so they do not take long to read, but managers inevitably find something they do not like, including the phrasing of a particular point.  So long as it does not detract from the integrity and analytical rigour of the rating, Moody’s is willing to make changes at that point. Managers tend to focus on the conclusions, but the ratings documents aim to provide investors with a lot of other information, so they can make up their own minds. Despite the granular nature of the reports, there are points on which there is no black-and-white answer as to what is the right or wrong conclusion to draw.

Despite that judgmental component, the primary input into the OQ ratings process is the quantitative rating scorecard prepared by the Moody’s analysts. Its questions are divided between the categories and sub-categories listed in Table 2, and the answers are aggregated, averaged and weighted to produce a single score that corresponds to a particular rating. Elements which cannot be reduced to a single score - such as corporate governance and management experience, and particularly the degree of influence exerted over all decisions and relationships by the fund manager, as opposed to the board of directors – are the subject of a separate written report. However, as with any public rating by Moody’s, the final decision is made by a committee on the basis of a recommendation by the analysts that worked on the scorecard. Membership of the committee fluctuates as a matter of policy, and committees vary in size from seven to 15 people. There are in-house rules governing the mixture of experience and seniority on any committee, and it must include people who understand the type of business being assessed. Hedge fund ratings committees tend to be populated by analysts from the investment bank and broker-dealer ratings team, who can readily grasp the complexities and risks of basis trades and OTC derivative positions. The chairman of any committee is always a senior person, but all decisions are taken by majority voting, with junior members voting first, so their decisions are not influenced by the older members.

What any committee sees is a written memorandum prepared by the analyst of the hedge fund, which is submitted along with the scorecard. Unlike the scorecard, the written report has a degree of flexibility, and the analyst can highlight the issues he or she considers most important. This is where judgments are made. If an operational process follows best practice, it will almost always be awarded an OQ1 rating, while a process that is good but has limitations will probably attract an OQ2 rating.  Ratings committee discussions tend to focus on obvious weaknesses, or areas where an analyst has made an adjustment in a positive or negative direction. Moody’s maintains and extends a list of issues that cannot be captured by the scorecard, and how the committee resolved each one, so there is a body of precedent. Regular committee discussion points include under-performance or over-performance against a peer group, outsourcing of the management of a fund to a third party, and direct investment by fund managers in third party funds. These last two points inevitably raise questions about whether the analyst should visit third parties to assess the risk they pose as well. The answer varies according to the terms of the management agreement and the size of the exposure. Committees often reconvene if an analyst cannot give a satisfactory answer to such questions.

Committee decisions do not have to be unanimous. In fact, there is an internal appeals process at Moody’s, by which a member who disagrees with a committee decision can ask for it to be revisited by another group with at least some fresh minds on it. There is an external appeals process too, by which a hedge fund can ask for reconsideration of a rating if it disagrees with the conclusions of the committee, though it can exercise this option once only. Once a committee discussion is over, a press release is drafted and sent to the hedge fund manager. At that point, a fund can demand an appeal, and the committee reconvenes. If a hedge fund still disagrees with the conclusions of the committee, it has in the first year the right to settle the Moody’s bill and refuse publication. After 12 months without termination, or agreement to publish, or once a rating is published, the decision of the committee is binding, and the only action a hedge fund can take is to withdraw publicly from the ratings process, or oblige Moody’s to withdraw the rating by refusing to share the information necessary to renew it. Either is of course a deeply embarrassing step to take. It follows that, once a fund has secured a rating, it is always better to keep renewing it. The alternative is to suffer the indignity of a press release from Moody’s saying that the rating cannot be renewed.

The embarrassing press release, which has to be explained to investors, can and does happen for a variety of reasons. In September 2009 Moody's announced it had downgraded from OQ1 (“excellent”) to OQ1 minus (still “excellent”) the ratings assigned to four fund families managed by Marathon Asset Management, on grounds “Marathon's investment and liquidity risk monitoring processes, although very strong, could be enhanced by incorporating additional shocks into a global stress test. In Moody's view, such additional stress testing would have strengthened Marathon's ability to cope with the market dislocation over the past year.” In June 2010 Moody’s announced that it had withdrawn the OQ1- ratings assigned to the four fund families for “business reasons.”  This – “business reasons” - was also the reason given by Moody’s in February 2009 when withdrawing the OQ ratings of four hedge funds managed by Sorin Capital Management; in January 2011 when withdrawing OQ ratings from a family of macro funds managed by Fortress Investment Group affiliate Drawbridge; and in April 2011 when it withdrew ratings assigned to four funds managed by S.A.C. Capital Advisors. But funds that have stayed with the ratings process can have it withdrawn for a more meaningful reason. In September 2010 Moody’s announced it had withdrawn the September 2008 OQ1 (“excellent”) rating assigned to the MW TOPS Limited fund managed by Marshall Wace just a month after it was reaffirmed in July 2010, following the liquidation of the fund at an EGM a month later.

Those funds that do agree to publish the rating find its maintenance is not without effort, though in theory it gets easier after the initial review. The majority of the work necessary to obtain a rating occurs in the first year, when the Moody’s analysts are getting to know the fund manager, and understand its business. In terms of monitoring, Moody’s go back every year for an on-site visit, and produce a new report, but “rating action dates” are not annual (see Table 3). Hedge fund managers also complete quarterly questionnaires that review staff changes and progress with automation projects. The Moody’s analyst in charge of a rating is expected on his or her own initiative to scan news services and company announcements and registrations for any developments that might affect the rating. The names and contact details of the analysts are published on the reports, and investors are free to telephone them, so they have a further incentive to stay on top of the news about their clients. Investors, particularly of the institutional kind, do ask detailed and telling questions, such as whether the firm reviewed the compliance manual. That said, rated fund managers can insist that Moody’s keep certain information confidential. The sensitive areas tend to revolve around value at risk, litigation, and especially investment strategies. This is why Moody’s rate funds – see Table 3 - and not fund managers. Different funds run by the same fund manager can also handle operational issues differently, partly because investment strategies and asset classes vary between them too. However, the pricing on an OQ rating process by Moiody’s will reflect the overlap.

Inevitably, the ratings committees are not as busy now as they were in 2006-07. The latest list of funds with OQ ratings published by Moody’s is dated May 2011, when five Brevan Howard funds renewed their ratings, but the seven fund managers is lower than the nine with OQ ratings at the end of last year. A number of smaller funds are understood to have chosen not to publish. It is not easy for non-investors to assess what use investors are making of the reports, since downloads ad download data are accessible only by accredited investors. They and other rated hedge funds doubtless distribute copies to investors themselves. Though private banks and funds of funds occasionally suggest to Moody’s that it rate a particular hedge fund, and Moody’s is not averse to a commercial discussion of that kind with investors, it remains unusual for the request for a rating to come from investors. Investors have yet even to express the view that they prefer to invest in OQ1 funds. As in other aspects of the ratings industry, OQ ratings are ultimately driven by the sell-side, and in particular by their willingness of a hedge fund to disclose information to Moody’s analysts. This inevitably mitigates their value to investors, and so reduces the appetite for disclosure among hedge funds.

If this sounds more surprising now that it would have in 2007, when hedge fund managers chose investors rather than vice-versa, it reflects the continuing commercial realities of the ratings industry. In an issuer pays model, the hedge funds have to want to be rated. Indeed, it is telling that - as with credit ratings – Moody’s gives hedge funds the right in the first year to insist a rating remain private. To limit the risk that analysts tailor their conclusions accordingly, the price a hedge fund pays for a rating is never disclosed to the analysts. But it would obviously make the OQ ratings a lot more successful in penetrating the hedge fund industry if investors drive the process. The curiosity is that investors do not, yet. At a time when hedge fund managers that have survived the great shake-out of 2007-08 are anxious to raise fresh money to manage, and are more willing than ever to share information than ever, greater engagement by investors is the most obvious route to a sustained resumption of interest in the Moody’s operational ratings. Of course, widespread scepticism about the value of the contribution of the ratings industry in general in the wake of the financial crisis does not help. There is a world of difference between an OQ rating and a credit rating of a structured credit instrument, but investors are not in the mood to explore nuances of that kind. However obsessed hedge funds are with raising money right now, not many of them are yet convinced that an OQ rating from Mody’s well help. It is obvious that Brevan Howard considers the maintenance of its rating worthwhile, but this may reflect its need to manage investors clamouring for access to its funds rather than proving it is worthy of their affections.

 

 

 

Table 3: Hedge Funds with Operational Quality (OQ)  Ratings as at May 2011

 

 

OQ Ratings
Rated Fund
Rating
Rating Action Date

 
 
 
 

King Street Flagship Funds
King Street Capital, L.P.

King Street Capital, Ltd.

King Street Capital Master Fund, Ltd.
OQ1 Excellent

OQ1 Excellent

OQ1 Excellent
30 October 2009

30 October 2009

30 October 2009

King Street European Funds
King Street Europe, L.P

King Street Europe, Ltd.

King Street Europe Master Fund, Ltd.
OQ1 Excellent

OQ1 Excellent

OQ1 Excellent
30 October 2009

30 October 2009

30 October 2009

Brevan Howard Fortress Macro Master Fund LP unds
Brevan Howard Master Fund Ltd.

Brevan Howard Asia Master Fund Ltd

Brevan Howard Emerging Markets Strategies Master Fund Ltd.

Brevan Howard Equity Strategies Master Fund Ltd

Brevan Howard Credit Catalysts Master Fund Ltd
OQ1 Excellent

OQ1 Excellent

OQ1 Excellent

OQ1 Excellent

OQ1 Excellent

 
24 May 2011

24 May 2011

24 May 2011

24 May 2011

24 May 2011

Marshall Wace Market Neutral Funds
Market Neutral TOPS Fund

MW Market Neutral TOPS Fund

MW Market Neutral TOPS (US) Fund

 
OQ1 Excellent

OQ1 Excellent

OQ1 Excellent

 
15 July 2010

15 July 2010

15 July 2010

 

Marshall Wace Core Funds
Core Fund

MW Core Fund
OQ1 Excellent

OQ1 Excellent

 
15 July 2010

15 July 2010

 

Marshall Wace Americas Funds
Americas TOPS Fund

MW Americas TOPS Fund

MW Americas TOPS (US) Fund
OQ1 Excellent

OQ1 Excellent

OQ1 Excellent

 
15 July 2010

15 July 2010

15 July 2010

 

Millennium Funds
Millennium Partners, LP.

Millennium USA, LP

Millennium International Management, LP.
OQ1 Excellent

OQ1 Excellent

OQ1 Excellent

 
27 August 2009

27 August 2009

27 August 2009

Citadel Funds
Citadel Funds Citadel Kensington Global Strategies Fund Ltd.

Citadel Wellington, LLC
OQ1 Excellent

OQ1 Excellent

 
9 June 2010

9 June 2010

Fortress Partners Funds
Fortress Partners Fund LP

Fortress Partners Master Fund LP

Fortress Partners Offshore Fund LP
OQ1 Excellent

OQ1 Excellent

OQ1 Excellent

 
12 November 2007

12 November 2007

12 November 2007

Fortress Macro Funds
Fortress Macro Onshore Fund LP

Fortress Macro Fund Ltd

Fortress Macro Master Fund LP
OQ1 Excellent

OQ1 Excellent

OQ1 Excellent

 
8 November 2010

8 November 2010

8 November 2010

Fortress Commodities Funds
Fortress Commodities Fund LP

Fortress Commodities Fund LTD
OQ1 Excellent

OQ1 Excellent
8 November 2010

8 November 2010

Drawbridge Special Opportunities Funds
Drawbridge Special Opportunities Fund LP

Drawbridge Special Opportunities Fund Ltd.
OQ1 Excellent

OQ1 Excellent
26 January 2007

26 January 2007

 
 
 
 

 

Source: Moody’s Hedge Fund Operational Quality (OQ) Rating List, May 2011

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