08/06/2011 Author: Vincent Vandenbroucke

Comment: Vincent Vandenbroucke

Adding value through engagement with hedge funds

With more institutions allocating capital to hedge funds, many leading industry players have taken significant steps to raise governance and operational standards. At Hermes BPK, we are playing a major role in driving this trend through our Operational Due Diligence process, specifically through our active engagement programme. 

Having re-calibrated the operational standards that we regard as the bare minimum framework for doing business (clean background checks, identification of assets, proper segregation of duties, consistent and documented valuation policies, sufficient and scalable infrastructure and the necessary legal and compliance support), we believe we can go significantly further through engagement by making best practice recommendations to hedge funds that help them reach the highest of institutional standards.

This engagement activity covers a wide range of topics but one of the critical issues we focus on is the requirement for all funds’ boards to have a majority of external directors creating true independence to strengthen governance and oversight – we have been able to realise this goal across all our invested managers. 

Another key issue we tackle head-on is the alignment of investment terms to the mandate of a portfolio where often we find non standard fee arrangements, redemption schedules, gates and performance fee calculation methodologies that we believe are either out-of-date or a legacy of the pre-financial crisis environment - to us this is not a fee level debate but a matter of structure and alignment. In a similar vein, we advocate alignment of portfolio managers’ investment terms to those offered to investors – we are highly averse to preferential terms that are detrimental to outside investors and seek alignment before investing. In many cases managers simply have not been asked to address matters that now require reassessment in light of the changed circumstances. 

Our engagement activities also focus on a manager’s processes and resources for conducting the core functions. The relevant level of seniority and competence is sought to undertake legal, risk and compliance functions and Hermes BPK will make recommendations to management teams where we perceive gaps or deficiencies. On occasions, some hedge funds will have contracted with service providers or counterparties which are not meeting their specific needs. By working with multiple hedge fund investments we are often in a much better position to recommend a provider that better fits a hedge fund’s strategy – this could result from a manager outgrowing their legacy service provider or shifting to a different investment strategy which the incumbent provider cannot adequately support. We will also make recommendations regarding automation of transaction processes which often have not been upgraded to deal with business growth or trade volume increases. 

Another major engagement focus is on transparency and at Hermes BPK, we have granted our Head of Risk Management a risk veto if transparency is below the levels that we expect – this covers the depth of data, timeliness of supply and access to risk personnel to query data. We do however actively work with managers to address transparency concerns and make them aware of our institutional expectations. 

As businesses often have several fund structures, we will also engage to ensure managers have transparent and documented trade allocation policies to ensure all investors are treated fairly – where these are not in place we will again seek alignment before investing. 

While many of our engagement activities are purely recommendations, we find that our proposals are generally well received and typically implemented; in large part due to our ownership structure and the ultimate backing of the BT Pension Scheme. We are regarded as an institutional investor whose views are likely to be aligned to those of other prominent institutional investors. 

Additionally and most importantly we have a philosophical aversion to special treatment through side letters and therefore expect any changes made by managers to be shared with all other investors based on a principle of fair and equitable treatment of investors. Our avoidance of bespoke agreements certainly resonates with managers even if it results in the alteration of a process or an approach that has been taken as standard for many years.  

Operational risk used to be defined as “risk without reward” – we believe our engagement activity creates “operational alpha” for Hermes BPK and all other investors, and importantly provides a long term benefit to hedge fund managers by making them a more robust investment proposition.  

Vincent Vandenbroucke is the Head of Operational Due Diligence & Partner at Hermes BPK Partners LLP.

Hermes BPK Partners is a fund of hedge funds and advisory boutique established in 2008 as a partnership with Hermes Fund Managers, an asset manager 100% owned by the BT Pension Scheme, the largest private pension scheme in the UK.