Best Practices & Standards

The hedge fund industry has experienced trying times over the past few months. Year-end redemption requests have flooded the sector. Scandals such as the so-called "ponzi" scheme allegedly carried out by Bernard Madoff resulting in billions of dollars in losses have shaken the industry. The need for hedge fund managers to strengthen their practices so as to regain investor confidence and to avoid regulatory intervention is now more urgent than ever.

To date, various alternative investment organisations have come up with guidelines and principles in an effort to set out a framework of best practices for participants in the industry. Two of the main initiatives are set out below.

1. US President's Working Group Report

The Asset Managers' Committee of the US President's Working Group (PWG) issued a report entitled Best Practices for the Hedge Fund Industry1 on 15 April 2008. The objective was to promote best practices for fund managers by setting out a blueprint for building a solid business infrastructure and an effective risk management system in an unregulated industry. The report calls on hedge funds to adopt best practices in all aspects of their business, particularly in five key areas, namely:

Disclosure: Investors should be provided with all the information they require not just for making an investing decision, but also to monitor their investments, the risks associated therewith and to gauge when to exit.
Valuation: Managers should coordinate with services providers responsible for valuation to lay down a robust valuation process (including a specific focus on hard-to-value assets). Segregation of responsibilities between portfolio managers and those responsible for valuations is recommended.
Risk Management: A comprehensive risk management framework, suitable for the size and investment strategy of the fund(s) being managed and emphasising the measurement, monitoring and management of risk, should be put in place.
Trading and Business Operations: Managers should establish sound and controlled operations, supported by adequate resources with checks and balances that continuously assess the effectiveness of their operational and internal controls.
Compliance, Conflicts and Business Practices: A set of rules should be established to address conflicts of interest, while promoting strict professionalism and a culture of compliance. The best practices set out in the report are not binding and do not have the force of law or regulation. 

2. UK Hedge Funds Standards: Final Report

The UK Hedge Funds Working Group published its final report on hedge fund standards on 22 January 20082. The report sets out 28 best practice standards for hedge fund managers (Standards). The Standards address five areas of particular concern for the industry which are not dissimilar to the areas covered by the PWG report, namely disclosure, valuation, risk management, governance and shareholder conduct (including activism).

Unlike the PWG standards which are purely voluntary, hedge fund managers that sign up to the Standards will be expected to adopt the Standards on a "comply or explain" basis. It is hoped that adoption of the Standards on this basis will encourage even the smaller hedge fund managers to sign up, since it would provide them with flexibility to "explain" in the event that they are not able to comply with any given Standard. It would also allow non-UK manager signatories the flexibility to "explain" where certain actions required by the Standards are inconsistent with local law and regulation.

The Standards are maintained by the Hedge Fund Standards Board (HFSB).

Other industry guidelines which seek to self-regulate the hedge fund industry include the following:

AIMA's3 Guide to Business Continuity Management for Hedge Fund Managers
AIMA's Guide to Sound Practices for European Hedge Fund Managers
AIMA's Guide to Sound Practices for Hedge Fund Valuation
AIMA's Offshore Alternative Fund Directors' Guide
IOSCO's4 Principles for the Valuation of Hedge Fund Portfolios
MFA's5 Sound Practices for Hedge Fund Managers
Hedge Fund Matrix

The various reports, guides, principles and practices issued by these industry bodies have resulted in a large number of sources from which a hedge fund manager may obtain guidance. There are many areas of overlap and hedge fund managers are often uncertain with which set of standards they should comply.

In a project which brought together some of the world's leading industry organisations, the Hedge Fund Matrix (Matrix) was launched on 9 October 2008. The Matrix is an initiative of AIMA, HFSB, IOSCO, MFA and the PWG. It is an online resource that strives to bring together the sound practice guides of the various bodies mentioned above. It seeks to enable a user to compare the core principles throughout the various guides and drill down to the relevant guidance.

The objective of the Matrix is to offer a first step towards harmonization of existing hedge fund industry sound practices to all stakeholders: hedge fund industry practitioners, institutional investors, policy makers and regulatory authorities.

The Matrix is freely available to all and includes information on creating and managing a hedge fund management business; the investment process and portfolio risk management; portfolio administration and operational controls; raising capital and investor relations; and hedge fund structure and organisation.

The Matrix is located at www.hedgefundmatrix.com