No Stone Unturned: Operational due diligence at Signet Capital Management
Operational due diligence is a prerequisite for any fund of hedge funds (FoHF) nowadays as the industry strives to recover from the crisis and some of its high-profile links to Bernard Madoff. Charles Gubert speaks to Pierre-Emmanuel Crama, head of operational due diligence at FoHF Signet Capital Management about the challenges he faces.
Funds of hedge funds (FoHFs) were written off as obsolete following the crisis by some naysayer commentators. Fallout from the market downtown which included mass redemptions, gating and side pockets, as well as investments into Bernard Madoff vehicles hurt FoHFs badly – at the time, some said irreparably so.
These woeful predictions for FoHFs were partially backed up by the July 2010 report, ‘Funds of funds Vs direct investment: The Institutional Investor Perspective’ by research company Preqin. Preqin surveyed 50 global investors including pension funds, asset managers, insurance companies, family offices and banks – the findings revealed that 64% of investors initially put assets into both hedge funds and FoHFs. However, as things stand now, only 35% of respondents still invest solely through FoHFs with 34% stating a preference for both types of investment vehicles.
“In 2008 and 2009, many institutional investors liquidated portions of their hedge fund holdings and put further investment on ice until markets stabilised. When the time came to reinvest this available hedge fund capital, many institutions chose to invest directly in funds, avoiding the extra layer of fees they would be subject to if they invested in FoHFs,” adds the report.
However, the report acknowledges FoHFs do remain popular among investors seeking to diversify their portfolio holdings and for those who have limited amounts of capital to invest in the asset class.
The torrid time endured by many FoHF vehicles has prompted numerous changes – most notably, the massive improvements and increasingly rigorous due diligence checks carried out by FoHFs employees into their investments – to help ensure another Madoff calamity and serious investor losses do not reoccur.
Pierre-Emmanuel Crama, head of operational due diligence at multi-strategy FoHF Signet Capital Management, believes in-depth research and constant monitoring of investments are essential, especially post-2008. Proper due diligence is now a must-do exercise for any FoHF if it is to retain the confidence and backing of its investors during this slightly tumultuous post-crisis period.
Signet, which has research offices in Switzerland, the UK, US and Hong Kong, manages assets on behalf of a variety of clients including banks, insurance companies, pension funds, private wealth managers and family offices. Like many other funds with a bias towards fixed income, Signet suffered redemptions during the credit crisis despite having steered well clear of Madoff. However, it has recovered well since those dark days two years ago and currently manages $1.7 billion. It also boasts a very strong operational due diligence team comprising four members of staff.
Since 2008, the role of the operational due diligence officer has grown exponentially. Their voice in the boardroom is something that is taken very seriously. Crama says that his is very true of his outfit. “I shall not accept to be told an investment is going ahead if I am reluctant to invest due to operational concerns,” he warns.
So how does Crama go about ensuring Signet makes wise investment decisions? “I try to see if I feel comfortable to make an investment by looking at some of the operational issues and documentations. It is very much a question of getting comfortable with people you meet on site. It is about finding out ways to see if there is any way to corroborate information provided by the fund manager, administrators or third parties. And finally, it’s about getting background checks on the managers as you want to feel comfortable with them,” he says.
Hedge funds that Signet is invested in are subject to intense scrutiny – Crama acknowledges there are fundamental prerequisites that any fund must adhere to before approving a fund for an investment.
“There must be a clear segregation of duties between the front and back office, clear policy on compliance and cash management, clear middle office procedures and controls and an independent administrator who understands how to price these complex securities and over-the-counter (OTC) derivatives,” he says.
Alarm bells start ringing, he adds, if he visits a fund and things cannot be explained in a straightforward manner, such as big NAV (net asset value) restatement at the end of the month. Other areas that cause Crama consternation include weak service providers, no independent oversight, poor cash management, constant breaches of regulatory risk limits, large staff turnovers, complex fund structures, ongoing litigation issues and lack of an insurance policy to name but a few – all of these will raise eyebrows among Signet’s experienced operational due diligence team.
“When we do operational due diligence checks on managers, we want to make sure the management is capable of sustaining operations for the future. We are also looking at a new world with more regulation, transparency and liquidity. For the managers regulated, we try to get access to their regulatory reporting for review,” adds Crama.
The operational due diligence team is also in favour of working on site as much as possible when conducting tests. For new, emerging managers, Crama will dedicate up to six hours on-site speaking to senior and more junior people, as well as watching and evaluating the fund’s working patterns. This enables the team to get a representative reflection of the day-to-day operations. This also ensures the manager is transparent with the investor – something that wasn’t as forthcoming several years ago, he says. “We like to see more than just the head of the department but also other staff. We ask them what they do with the trade booking reconciliation and NAV reconciliation, as well as how they operate especially with their administrator,” Crama adds.
Control is everything, he says, be it a well-established manager or a start-up – control must be in place and the operational due diligence team will test it out vigorously. “We want to make sure the firm is sensible and what they are telling us in their marketing documents is accurate. It’s all about testing.” Tests include monitoring the middle and back offices and identifying how assets are reconciled and counterparty risk minimised.
If the tests Crama’s team run do not reflect what is in the operations manual or fund’s business plan, it is unlikely he will allow Signet to proceed with investing with that manager. His team will identify any investor restrictions outlined in the fund’s prospectus and check whether there are any breaches – due diligence, he says, cannot be taken for granted.
It would be hard-pressed to find someone in a FoHF that was not adversely affected by the events of 2008. This is something Crama feels strongly about. He will not encourage his managers to invest in strategies where Signet’s understanding or expertise is minimal. “Even if there are juicy returns, if there is a strategy that we don’t understand, we won’t look at it,” he says.
Signet does, however, have a diversified portfolio that includes credit long/short, fixed income, relative value, high yield, macro, distressed and emerging markets. Despite this variety, Signet is reluctant to invest in certain strategies including CTA and systematic managers – “we don’t invest in these strategies because we cannot aggregate risk as there is little transparency,” he says. However, Crama acknowledges Signet could possibly consider a CTA strategy wrapped in a Ucits fund.
While Signet’s head of operational due diligence is steadfast in his stance on certain investment principles, his team are willing to give some managers another opportunity to improve their operations if they are initially rejected. “We like to provide feedbacks – if a manager is rejected due to an operational point of view, we like to tell them why they failed our test. We often like to revisit them after six to 12 months after they take on board our recommendations. In some instances, we come across talented managers and after a few months, if they take on board our recommendations, we could give them an allocation,” says Crama. “I’m proud that we do this,” he adds.
Any hedge fund Signet invests in must have outstanding operational competence and solid risk management. One concern among many institutional and sophisticated investors is the exposure some fund managers had and still do have to single prime brokers – spreading counterparty risk has been elevated hugely since the Lehman default in September 2008. “We usually prefer not to invest in funds with a single prime broker but it is not a deal-breaker,” Crama says.
He elaborates that Signet works with numerous managers with assets of between $50 million to $100 million thereby making it rather inefficient for these individuals to have multiple-prime brokers. One of Signet’s aims, he says, is to “grow with the manager and get into an early relationship with them.” It is therefore understandable that these emerging managers might not have the resources to pay for multiple-primes. However, if the manager’s assets grow to a respectable sum, it is expected that they shift away from the single prime broker to reduce the counterparty risk, Crama adds.
The firm also is not complacent about investing into Ucits structures. One common misconception some people have with Ucits, says Crama, is that they assume it is a fault-proof and risk-free investment. It isn’t. Occasionally, some managers will attempt to wrap illiquid strategies into Ucits wrappers. Ucits, in fact, seems to make Cramer’s operational due diligence work as onerous and difficult as for offshore funds.
“The key is to find out who does the pricing and who is the valuation agent. We want to know if they can price OTC derivatives. If someone is pricing a mutual fund and they take on a Ucits long/short where everything is OTC – they can’t short physical securities so they must be careful. This gives more responsibility to the administrator so they must be tested. Also, we need to look at their counterparties and make sure they are all sound financially before committing money,” says Crama.
Due diligence is undoubtedly here to stay for the foreseeable future. But will people’s memories of 2008 fade and will the mistakes of the past return to bite? Crama says not at the moment but concedes people have short memories and might forget what happened in 2008. “We might see people who have been criticising illiquid credit now getting back into illiquid credit as they want to generate alpha in the future, for example,” he says.
While some investors and FoHFs with fewer resources might try and curb expenditure and cut down in their due diligence and proper risk management, this is unlikely to happen at Signet. As Crama concludes, “we won’t be complacent as it puts our name at risk.”
Pierre-Emmanuel Crama is head of operational due diligence at Signet Capital Management. Crama was previously a partner at Fairway Capital Partners, where he was in charge of strategy and manager selection. Prior to this, he was responsible for operational due diligence, valuation, currency hedging and cash management at La Fayette Investment Management. Crama holds a Bachelors degree in economics and management from Pole Universitaire Leonardo de Vinci in Paris.