Alternative Investments in the Investment Advisory Practice: Due ...
Alternative Investments in the Investment Advisory Practice: Due Diligence Best Practices March 28, 2016
Today’s Moderator Mark D. Perlow Partner, Dechert Mark is a partner in Dechert’s financial services and investment practice. He represents mutual funds, hedge fund managers, fund independent directors, investment advisers, and broker-dealers on a broad range of regulatory and transactional matters. Mark is a frequent author and speaker on securities law and investment management topics.
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Today’s Panel Josh Charlson Director of Manager Research, Alternative Strategies, Morningstar Josh is director of manager research for alternative strategies at Morningstar. In this role, he leads a team of three alternative investment research analysts. He is also editor of the quarterly newsletter Alternative Investments Observer. He is a member of Morningstar’s Analyst Ratings Committee for alternative strategies and the Stewardship Committee that oversees the Fund Research team’s assessment of fund companies.
Liam Croke Managing Director, Operational Due Diligence, K2 Advisors Liam Croke began his career in 1996 as a registered principal at John Hancock Funds in Boston. After working at Paloma Partners, Robert Half International and Weston Capital Advisors, in 2005, Liam joined ACAM Advisors where he was the Director of Risk Management and Chief Compliance Officer. He was responsible for the firm’s operational due diligence, compliance and fund operations and was a member of the firm’s Research and Investment Committees. Liam joined K2 Advisors in April 2010.
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Today’s Agenda • • • • •
OCIE Risk Alert Investment due diligence for liquid alternatives Operational due diligence for hedge funds Best practices Q&A
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Polling Question What are your firm’s assets under management? • • • • •
Under $1 billion $1 billion to $2 billion $2 billion to $5 billion $5 billion to $10 billion Over $10 billion
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Polling Question How do you use alternative investments in your practice? • • • • •
Most of our clients have significant positions Most of our clients have small positions Actively added to select client portfolios In a few portfolios upon client request only Not using currently
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OCIE Risk Alert “Investment Adviser Due Diligence Processes for Selecting Alternative Investments and Their Respective Managers” SEC Office of Compliance Inspections and Examinations January 28, 2014
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OCIE Risk Alert • Sections – Staff Observations: Industry Practices – Warning Indicators or Awareness Signals for Concerns For Advisers – Staff Observations: Compliance with Advisers Act
• Topics – Investment due diligence – Operational due diligence – Compliance programs 8
OCIE Risk Alert • Regulatory compliance issues: – Whether the adviser has performed due diligence consistently with its representations to investors – Whether the adviser has identified, mitigated and disclosed relevant conflicts of interest – Whether the adviser has procedures reasonably designed to prevent such violations – The SEC does not have the authority to regulate due diligence per se
• Part of the SEC’s larger focus on the private fund industry – Scrutiny and jawboning to change industry practices 9
OCIE | Investment Due Diligence • Trends – Position-level transparency – Portfolio information aggregators – Third-party administrator-issued transparency reports – Detection of manipulation of performance returns – Supplementation of investment-level decisionmaking – Investment fund redemption terms and liquidity of the portfolio – Onsite visit requirement 10
How Morningstar Evaluates Liquid Alternatives Josh Charlson, CFA Director of Manager Research, Alternative Strategies
©2015 Morningstar, Inc. All rights reserved.
Morningstar Analyst Ratings For Alternative Funds
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Philosophy
People
13
Process
Parent
Performance
Price
Ratings The 5 Pillars
►Process Transparent and repeatable Shorting process differs from long process: timing, position limits, etc Risk-management process is essential: top-down exposure limits; bottom-up position loss limits; steps to increase and reduce risk, etc. Diversification characteristics Trading/transaction cost considerations
14
Ratings The 5 Pillars
►People Hedge fund track records Experience with shorting and risk management Key-man risk Depth of support team Investment alongside fundholders
15
Ratings The 5 Pillars
► Parent Firm’s history of stewardship over client assets. Close eye on product launches and capacity constraints. Credible experience in alternatives. Board has expertise or ongoing education in alternatives.
16
Ratings The 5 Pillars
► Performance If there is a substantial track record, is outperformance due to luck or skill? Short mutual fund track records make analysis difficult. Some strategies outperform in certain market environments. Risk-adjusted/down-market performance. Lack of industry standard benchmarks. Capacity of a niche strategy/cyclicality.
17
Ratings The 5 Pillars
► Price Can this fund’s results be replicated for a cheaper price? Use net expense ratio for fund of funds. Relative to category and distribution channel. Managed futures funds charge fees not included in the expense ratios.
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Polling Question What is your current approach to investment due diligence for alternative investments? • Handled by a separate team • Integrated with process for other investments • Informal process
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OCIE |Investment Due Diligence • Warning Signals – – – – –
Unwilling to provide transparency Performance does not correlate with known factors Lack of clear research and investment processes Heavy portfolio concentration Personnel not knowledgeable about sophisticated investment strategy – Style drift over time – Investments are overly complex or opaque 20
OCIE | Operational Due Diligence • Trends – Separate account management – Third-party service provider verification of relationships and assets – Independent administration – Independent background checks – Regulatory history review – Operational due diligence focus – Legal documents review – Audited financial statements review 21
Operational Due Diligence Liam Croke Managing Director, Operational Due Diligence K2 Advisors
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OCIE | Operational Due Diligence • Warning Signals – Lack of adequate control environment and segregation of duties – Lack of known, qualified 3rd-party administrator – Lack of known, experienced auditor – Multiple changes in service providers – Concerns identified in financial statements – Problems identified in background checks – Identification of undisclosed background checks – Insufficient infrastructure, including compliance – Lack of robust fair valuation process
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Polling Question Do you have a written policy for operational due diligence for hedge funds? • Yes • No • Not applicable
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OCIE | Compliance Programs • Material deficiencies – Lack of annual review – Inaccurate disclosure of practices – Misleading marketing material
• Best practices – Detailed, written policies and procedures – Periodic reviews of service providers
25
OCIE |Code of Ethics • Limited offerings – Conflict of interest: access persons able to acquire interest in limited offering on better terms than clients – Decision to allow purchase by access persons must be documented
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Thank You for Attending Contact Us Investment Adviser Association 1050 17th St., NW, Suite 725 Washington, DC 20036 Phone:
202.293.4222
Email:
[email protected]
Web:
www.investmentadviser.org Please complete webinar evaluation 27
Today’s Moderator Mark D. Perlow Partner, Dechert Mark is a partner in Dechert’s financial services and investment practice. He represents mutual funds, hedge fund managers, fund independent directors, investment advisers, and broker-dealers on a broad range of regulatory and transactional matters. Mark is a frequent author and speaker on securities law and investment management topics.
2
Today’s Panel Josh Charlson Director of Manager Research, Alternative Strategies, Morningstar Josh is director of manager research for alternative strategies at Morningstar. In this role, he leads a team of three alternative investment research analysts. He is also editor of the quarterly newsletter Alternative Investments Observer. He is a member of Morningstar’s Analyst Ratings Committee for alternative strategies and the Stewardship Committee that oversees the Fund Research team’s assessment of fund companies.
Liam Croke Managing Director, Operational Due Diligence, K2 Advisors Liam Croke began his career in 1996 as a registered principal at John Hancock Funds in Boston. After working at Paloma Partners, Robert Half International and Weston Capital Advisors, in 2005, Liam joined ACAM Advisors where he was the Director of Risk Management and Chief Compliance Officer. He was responsible for the firm’s operational due diligence, compliance and fund operations and was a member of the firm’s Research and Investment Committees. Liam joined K2 Advisors in April 2010.
3
Today’s Agenda • • • • •
OCIE Risk Alert Investment due diligence for liquid alternatives Operational due diligence for hedge funds Best practices Q&A
4
Polling Question What are your firm’s assets under management? • • • • •
Under $1 billion $1 billion to $2 billion $2 billion to $5 billion $5 billion to $10 billion Over $10 billion
5
Polling Question How do you use alternative investments in your practice? • • • • •
Most of our clients have significant positions Most of our clients have small positions Actively added to select client portfolios In a few portfolios upon client request only Not using currently
6
OCIE Risk Alert “Investment Adviser Due Diligence Processes for Selecting Alternative Investments and Their Respective Managers” SEC Office of Compliance Inspections and Examinations January 28, 2014
7
OCIE Risk Alert • Sections – Staff Observations: Industry Practices – Warning Indicators or Awareness Signals for Concerns For Advisers – Staff Observations: Compliance with Advisers Act
• Topics – Investment due diligence – Operational due diligence – Compliance programs 8
OCIE Risk Alert • Regulatory compliance issues: – Whether the adviser has performed due diligence consistently with its representations to investors – Whether the adviser has identified, mitigated and disclosed relevant conflicts of interest – Whether the adviser has procedures reasonably designed to prevent such violations – The SEC does not have the authority to regulate due diligence per se
• Part of the SEC’s larger focus on the private fund industry – Scrutiny and jawboning to change industry practices 9
OCIE | Investment Due Diligence • Trends – Position-level transparency – Portfolio information aggregators – Third-party administrator-issued transparency reports – Detection of manipulation of performance returns – Supplementation of investment-level decisionmaking – Investment fund redemption terms and liquidity of the portfolio – Onsite visit requirement 10
How Morningstar Evaluates Liquid Alternatives Josh Charlson, CFA Director of Manager Research, Alternative Strategies
©2015 Morningstar, Inc. All rights reserved.
Morningstar Analyst Ratings For Alternative Funds
12
Philosophy
People
13
Process
Parent
Performance
Price
Ratings The 5 Pillars
►Process Transparent and repeatable Shorting process differs from long process: timing, position limits, etc Risk-management process is essential: top-down exposure limits; bottom-up position loss limits; steps to increase and reduce risk, etc. Diversification characteristics Trading/transaction cost considerations
14
Ratings The 5 Pillars
►People Hedge fund track records Experience with shorting and risk management Key-man risk Depth of support team Investment alongside fundholders
15
Ratings The 5 Pillars
► Parent Firm’s history of stewardship over client assets. Close eye on product launches and capacity constraints. Credible experience in alternatives. Board has expertise or ongoing education in alternatives.
16
Ratings The 5 Pillars
► Performance If there is a substantial track record, is outperformance due to luck or skill? Short mutual fund track records make analysis difficult. Some strategies outperform in certain market environments. Risk-adjusted/down-market performance. Lack of industry standard benchmarks. Capacity of a niche strategy/cyclicality.
17
Ratings The 5 Pillars
► Price Can this fund’s results be replicated for a cheaper price? Use net expense ratio for fund of funds. Relative to category and distribution channel. Managed futures funds charge fees not included in the expense ratios.
18
Polling Question What is your current approach to investment due diligence for alternative investments? • Handled by a separate team • Integrated with process for other investments • Informal process
19
OCIE |Investment Due Diligence • Warning Signals – – – – –
Unwilling to provide transparency Performance does not correlate with known factors Lack of clear research and investment processes Heavy portfolio concentration Personnel not knowledgeable about sophisticated investment strategy – Style drift over time – Investments are overly complex or opaque 20
OCIE | Operational Due Diligence • Trends – Separate account management – Third-party service provider verification of relationships and assets – Independent administration – Independent background checks – Regulatory history review – Operational due diligence focus – Legal documents review – Audited financial statements review 21
Operational Due Diligence Liam Croke Managing Director, Operational Due Diligence K2 Advisors
22
OCIE | Operational Due Diligence • Warning Signals – Lack of adequate control environment and segregation of duties – Lack of known, qualified 3rd-party administrator – Lack of known, experienced auditor – Multiple changes in service providers – Concerns identified in financial statements – Problems identified in background checks – Identification of undisclosed background checks – Insufficient infrastructure, including compliance – Lack of robust fair valuation process
23
Polling Question Do you have a written policy for operational due diligence for hedge funds? • Yes • No • Not applicable
24
OCIE | Compliance Programs • Material deficiencies – Lack of annual review – Inaccurate disclosure of practices – Misleading marketing material
• Best practices – Detailed, written policies and procedures – Periodic reviews of service providers
25
OCIE |Code of Ethics • Limited offerings – Conflict of interest: access persons able to acquire interest in limited offering on better terms than clients – Decision to allow purchase by access persons must be documented
26
Thank You for Attending Contact Us Investment Adviser Association 1050 17th St., NW, Suite 725 Washington, DC 20036 Phone:
202.293.4222
Email:
[email protected]
Web:
www.investmentadviser.org Please complete webinar evaluation 27
