Hedge funds are bracing for the effects the current financial crisis will have on investor demands for further transparency. The brutal “one-two punch” in 4Q-08 of nearly 100 hedge fund managers activating redemption gates and then the unraveling of the Madoff fraud, have unleashed a torrent of investor anger and will likely result in increased industry regulation in the future. Already, hedge fund managers are reaching out to investors in various ways to mitigate the damage that a few have inflicted on the industry as a whole.

Investors wary of positive returns

As the Madoff fraud unfolds, it has become apparent that even funds that have achieved consistent, positive returns (perhaps especially funds with such returns), need to go above and beyond to assure investors in this environment.

New York based volatility firm Titan Capital Group this week notified prospective investors in its absolute return strategy that the fund would close to new investments at the end of the first quarter of 2009. The Fund has returned +20.35% YTD (as of 12/12) as well as 13% annualized return over the last 60 months and the firm has continued to raise steady assets even through the credit crisis. And yet, amidst this good news, the fund managers still saw the importance in adding the following statement to their announcement: “all of our products hold liquid instruments that are independently valued.

As a result, we provide quarterly redemptions with 30 days notice.” A telling sign of the investor wariness that fund managers find themselves facing.
“What’s most strange is that it would seem that basic due diligence would have uncovered the Madoff scam…at the least such a ‘perfect’ track record should have raised red flags but apparently greed got in the way of prudence. Now it’s important that the rest of the industry step up to ensure investors are protected from fraudulent conduct. A simple threshold solution is hedge funds having all securities independently valued with a truly independent audit conducted by reputable firms.” Titan’s Marc Abrams told Opalesque. “In the end the washout of these dishonest players, whether through increased regulation or more stringent private due diligence will be a positive for an industry with a history of providing superior, risk adjusted returns…”

Investor and regulator focus on valuations

As hedge fund managers activated gates due to their inability to unload illiquid securities, investors have begun to take a much more active interest in the types of securities which funds trade. In fact a recent Greenwich Roundtable study actually said hedge fund investors were “obsessed with liquidity”. The result of this new interest in liquidity will likely mean that those managers invested in illiquid instruments will see a growing interest in the exact nature of the valuation process of their portfolios.

“Everything going on in the hedge fund world right now is pushing towards more oversight, more due diligence, more of a push towards independent valuations and independent analysis in general,” Espen Robak, President of Pluris Valuation Advisors, says. “While the spectacular cases of fraud are interesting and instructive, the mass majority of problems in the hedge fund industry are faced by managers who are completely honest, and just have valuations which are stale or lagging or not showing the proper volatility.”

It can be in these gray areas of regulation that managers and investors both find themselves at the greatest risk as funds value their portfolios, especially for year-end auditing. “There is not a lot of market data available on illiquids, so you pretty much always have an issue trying to figure out what all of these things are.” Robak said. “The accounting rules are very clear. Unless the market is very active, you cannot just take the prices on the market, you have to adjust them and analyze them and try and get to the proper fair value. Just because something traded at a very low price at a given moment in time, you still have to look at it over a number of trades to find out where the market really is.”