A recent article by a prominent fund of hedge funds illustrates the external research requirements that hedge fund investors are demanding from hedge funds. The standards apply broadly to all independent research, not just expert networks. The increased compliance demands on hedge funds is prompting the larger funds to bring capabilities in-house, reducing reliance on external research providers.
Hedge funds have described to us the scrutiny they receive from their investors if they use expert networks. When they are visited by fund of funds staff, one of the first questions asked is whether the fund uses expert networks, and if the answer is affirmative, there are pages of follow up questions.
The article published in COO Connect outlines the standards required by Pacific Alternative Asset Management Company (PAAMCO), a large fund of hedge funds. PAAMCO does not ban its managers from using experts, but “it is essential for us to hold managers to a higher standard and demand that they implement specific practices.”
Although the standards are framed for expert networks, independent research boutiques are included in the definition of experts: “Expert research consultants, independent research boutiques and expert networks (collectively ‘experts’).” Hedge fund investors are scrutinizing the use of all independent research, not just expert networks.
The requirements specified by PAAMCO are:
- Compliance must approve all experts. This includes reviewing and approving the expert agreement, which should explicitly ban material non-public information. Note that independent research is included in the definition of experts.
- All information received from experts must be documented by the receiver and then reviewed by compliance. Furthermore, if possible, compliance personnel should be present during any conversations between managers and experts. It is recommended that all phone conversations with experts be recorded, reviewed or documented by compliance.
- Asset managers should have annual formal compliance training for all employees interacting in any fashion with experts.
- Compliance should be monitoring trades associated with experts, as well as more general trade monitoring.
In addition, the article stresses the importance of a quality compliance culture led by a qualified chief operating officer and chief compliance officer. Also highlighted is the importance of up-to-date and detailed compliance manuals, which spell out the procedures for using experts.
One of the ironies of the insider trading investigations is that the added compliance requirements have made it easier for the larger funds to bring the expert sourcing in-house, reducing their reliance on outside expert networks. By sourcing experts internally, the larger funds have control and documentation of the process, as well as reduced costs associated with outside expert networks. They might still use outside expert networks for difficult assignments or geographies where they do not have internal sourcing expertise. Expert networks have been hit by a bifurcation in their hedge fund client base, where the largest clients have brought the sourcing in-house, and many of the medium-sized clients have disappeared leaving small start-up hedge funds which have limited budgets.
The standards outlined by PAAMCO are reasonable, and have become accepted industry practice for expert networks. There are additional safeguards regarding expert networks that asset managers have put in place, that are not covered in the PAAMCO article.
What is not generally understood, however, is that the heightened compliance standards don’t just pertain to expert networks. PAAMCO explicitly includes ‘independent research boutiques’ in its definition of experts. All research providers will be held to a much higher compliance standard, just as their clients are.