Entrepreneurial spirit is alive and well in the investment industry. Last year 84 new hedge funds running at least $50 million were launched in the United States, which is the largest total since 2006. Many emerging managers employ seasoned professionals who are fully vested alongside their clients. From the markets' perspective, these dedicated individuals augment efficiencies with their free-thinking investment styles and their skin in the game, which aligns their interests and incentivises prudent risk management practices. They possess skills that institutional investors choose not to keep in-house and which most traditional brokers simply cannot provide to individuals.
While this growth is meeting a need, firms are finding it difficult differentiating themselves from the competition. Marketing materials focused on strategy and performance is the most common approach but does not provide the transparency that the post-financial crisis client is looking for. Investors expect performance reports to be comprehensive and provide granularity to assist them in making their investment decisions.
Organizational best practices are becoming a driving force behind the transparency movement and a way for firms to lend greater weight to their performance.
Investor demand for higher standards in transparency, governance, compliance and institutionalization is not being reciprocated by managers as the industry holds on to its traditional approach. Firms need to embrace operating best practices with the same eagerness as they have in marketing their performance returns.
Evaluating their current state of operational controls in areas of performance, fund accounting, and valuation to name just a few, would be the first step in the process. The second and third steps would be to develop the controls in order to meet industry best practices and implement them. For example, some areas that investors will focus their review on include:
- Segregation of tasks- The manager needs to demonstrate a clear segregation of tasks and levels of staffing given the complexity of the strategy and its risks. An emerging manager can implement an adequate separation of duties by clearly defining roles differentiating the front office, back office and compliance functions.
- Procedures- Developing controls also requires that the emerging manager document them via procedures. The procedures need to be periodically updated and kept current at all times.
- Conflict of Interest- A hot button topic globally surrounds the area of conflict of interests. To satisfy investors' demands, the emerging manager must possess and document their conflicts policy and the required actions taken to identify, manage and monitor.
- Compliance Culture- The tone at the top sets the manager's guiding values and ethical climate. A manager needs to establish a robust compliance program that includes procedures, surveillance and training.
Whether it is done internally or employing an independent third party specialist, the key is to begin. All this is not new to the world as we have seen this story before. In the 1960s the automotive industry was facing a similar situation when it came to seat-belts and safety. It took a Swedish manufacture, Volvo, to fully embrace safety as a standard feature and as a marketing tool, leaving the big US auto giants scrambling to catch up to the growing demand for safety. Managers must avoid being complacent like the US auto giants were and must become proactive in adopting and marketing their implemented best practices.
Thinking Outside the Box
There are some managers who have had the foresight to think outside the box. Not limiting themselves to implementing industry best practices, they also employ independent third party firms to evaluate their performance and conduct a mock due diligence to ensure that they are maintaining the standards they worked so hard to reach. These efforts greatly mitigate reputational risks and heighten odds at winning investor mandates.
"You only get one chance to make a first impression" as the saying goes. Emerging managers must therefore make a complete commitment ahead of investor due diligence, not afterwards. They should lend greater weight to their strategies and returns with the transparency only available through adopting best practices. Investors are going the way of the automobile owner where safety features have become so important that it is a focal point in advertising. How soon before every firm is speaking and advertising their controls to the ever increasing sophisticated investor.
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