Deutsche Bank study highlights investor red flag areas

16 Jun, 2014

Lack of transparency, inadequate compliance procedures, poor segregation of duties, inexperience and inappropriate valuation policies are the five most frequently cited red-flags in operational due diligence, according to a Deutsche Bank Global Prime Finance survey of investors with assets totalling $2.72 trillion.

Opacity is no longer an option for hedge funds. A survey of fund managers by Preqin, a London-based data provider, said investor demands for greater transparency around risk and performance was the biggest change to impact the industry, putting it ahead of regulation. This transparency entails more granular and frequent reporting with 23% of managers telling Preqin they reported to their investors more regularly.

A growing number of investors are also scrutinising fund expenses. Sixty-four per-cent of respondents to the Deutsche Bank survey said they would investigate miscellaneous expenses and impose limits. Investors have little tolerance for employee compensation, marketing and non-research related travel being charged to the fund.

Regulators globally are adopting a more aggressive stance towards fees. The Securities and Exchange Commission (SEC) has said it is looking at how fees and expenses are charged to investors in hedge funds and private equity vehicles.   The UK’s Financial Conduct Authority (FCA) recently announced that asset managers can only charge underlying clients for research through trading commissions if it is original or has a meaningful impact on trading decisions. 

Research costs have been under pressure from the FCA for two years now. In 2012, the FCA’s precursor – the Financial Services Authority (FSA)  - wrote to the chief executive officers (CEOs) at all of the major asset management houses in London asking them to explain by February 2013 how they managed conflicts of interest with a particular emphasis on the use of client commissions to pay for equity research.

In a speech at the FCA’s annual asset management conference in October 2013, Martin Wheatley, CEO at the FCA, criticised managers for stretching the definition of what constituted research to cover non-eligible services and then charging these costs to investors instead of paying for it themselves through the management fee.

The Deutsche Bank survey also said 81% of operational due diligence teams would provide feedback to managers to enable an investment. This is open to debate. While this may be true if the managers’ transgressions are minor, the same cannot be said if the red flags are glaring.  

The study also said outsourcing was an acceptable practice for emerging managers. A number of firms, struggling with the rising operational and regulatory costs, are electing to outsource  more to third party service providers.  Deutsche Bank’s survey in July 2013 found 66% of allocators tolerated managers outsourcing the compliance function, for example. The study highlighted the emergence of specialist compliance consultancy firms and the increased quality of these service provider offerings were the key driver for this growth.

Valuation remains a hot issue, with 38% of allocators stating it was one of the most significant areas of focus. Allocators universally said they review a fund’s valuation policy during an operational due diligence visit and 78% would verify the valuation procedures during an on-site review.

Compliance, unsurprisingly is an area where investors are exploring in more depth. Seventy-three per-cent of allocators said they would increase their focus on compliance and regulatory frameworks in 2015. The surge in global regulation has prompted more operational due diligence teams to appoint staff with compliance or legal backgrounds.

Fund managers are facing a deluge of regulation. While managers have been filing Form PF with the SEC and Form CPO-PQR with the Commodity Futures Trading Commission (CFTC) in the US for some time now, there is still a considerable amount of work to do.

In the European Union, the Alternative Investment Fund Managers Directive (AIFMD) comes into play on July 22, 2014, while the European Market Infrastructure Regulation (EMIR), which requires firms report details of their exchange traded derivatives and over-the-counter (OTC) derivatives to trade repositories has proved challenging. Furthermore, the Foreign Account Tax Compliance Act, a piece of US legislation designed to clamp down on wealthy Americans failing to pay their income tax is set to come into force too.

Despite all of these challenges, investors remain enthusiastic about emerging managers with 68% telling Deutsche Bank they would allocate into one. However, investors are slightly more likely to veto an emerging manager than an established hedge fund, it added.