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Indeed, the industry has been extremely resilient to changes in practices like capital allocations and raising, and has innovated to meet investor demands. But how has this resilience influenced how firms operate and will operate in the future? We reflect on how the last two years have shaped the industry and what this reveals about the future of alternative investments. 

— 

This blog’s insights are based on Episode 16 of our In Conversation with Convergence podcast, hosted by Convergence Co-Founder and President, George Evans. In this episode, George is joined by special guest speakers Joseph Fisher and John Budzyna from KPMG, who discuss their industry observations and what they foresee happening in the industry in the next few years. Listen via the Convergence website or scroll down to continue reading the blog.

The industry at large is seeing a paradigm shift

The last two years have proven that the investment industry is not only agile in its response to unavoidable changes but resilient and very nimble. Overall, industry players were able to recognize critical issues early in a newly decentralized environment and made moves to address them to ensure they didn’t affect outputs or productivity. 

The asset management ecosystem at large has seen ongoing reliance on service providers and consistent collaboration among front and back office personnel, ensuring that the ever-important flow of information is maintained, even virtually. 

How virtualization and decentralization have influenced the industry

Across the entire investment management landscape, investment in technology has been key. From AI tools to the digitally transformed ways in which we reach out to investors, the predominant amount of spend seen at alternative firms recently has been on these technologies, which are among the trends shaping the sector now. 

As the industry environment became increasingly decentralized, the adoption of new technology has been vital to the seamless transition to virtual. This has enabled firms to meet the important requirement of data centralization and aggregation and using centralized data formats so that employees can continue to access the necessary information they would typically only get at the office. This ease of access to shared data systems has been key to uninterrupted collaboration and business continuity. 

The War for Talent and the future of alternative investments

While the adoption of technological innovations has been critical for business continuity amidst the pandemic, it has also resulted in a greater demand for more niche skills, contributing substantially to the War for Talent. For example, the demand for data scientists that can navigate new front office technologies has increased among alternative asset firms. This demand will only grow as the future of alternative investments becomes more technologically complex, and as employees become increasingly specific about the types of careers they want.  

However, there are economical factors that could impact this in the future. If there’s a recession, the pendulum may swing back, and the workforce may see less reshuffling and resignations as employees trade job flexibility for job security. While potentially too early to tell, the future of alternative investments and the talent the industry requires will be heavily dependent on the economy and the changes it may bring to work habits in the near future. 

While the War for Talent has expanded the talent pool for firms beyond geographical boundaries, which has impacted things like firms’ real estate footprints, the key theme for a successful decentralized working environment, both now and in the future, is a well-maintained culture underpinned by continued collaboration. 

How are firms maintaining culture in a hybrid world?

A key question that’s emerged in this changing world is “how does a firm maintain the attributes that made it successful before the pandemic?”. A study conducted by KPMG in conjunction with AIMA found that diluting, or losing, culture in a remote/hybrid environment is a key concern for firms. But the reality is that employees are currently in the driver’s seat, and with a high percentage of staff craving the hybrid environment, firms need to strike a balance to be successful. 

Within the context of the war for talent, culture has been a further concern in that hybrid work now enables firms to access talent in disparate geographical locations, but they’ve needed to weigh up the benefit of this versus insisting on more collaboration and teamwork that enriches their company culture. 

Whatever their approach, if firms are to maintain their culture and continue to thrive in the hybrid model, protocols need to be defined and established. Employees need to be available and reachable during business hours, client needs still need to be met promptly, and communications need to be ongoing. Making efficiency, in the office or at home, an integral part of their culture will be key to firms succeeding while meeting employee expectations. 

Reimagining the investment management operating model for the future of alternative investments

Organizations like KPMG have seen an increase in side letters, transparent reporting, structural variations, fee allocations and changes in how fees are charged. These changes, along with a potential regulatory rework on the horizon, suggest that firms are truly studying their operating models and looking for efficiencies to enable future growth, all while monitoring and protecting their operating margins. 

For investment managers to be successful, they have to have an eye on monitoring and creating efficient operating models to maintain their margins, and this will have a far-reaching impact on the industry and its ability to sustain itself in this new construct. This is true, especially in light of additional factors, like a looming recession, and whether, for example, funds are below their high-water mark currently. These all affect the trajectory of future operating models and how managers are monitoring their operating model risks.

Additionally, firms are going to continue to reevaluate their real estate footprints in light of remote/hybrid working and identify which individuals are core to their operating model, before building their footprint around these factors. This is a chapter on the future of alternative investments, and the industry overall, that’s still being written as firms continue to reestablish normality post pandemic.

Changing investor demands

Equally driving change and growth in the industry is the unparalleled demand for customized portfolio construction from investors. 

Gone are the days of “here’s what I have to offer, join my flagship fund”; investors are being more specific about what they want and the form they want it in.  This could be separately managed accounts, co-investment strategies, particular jurisdictions with particular tax motivations, etc. and all of these create a tremendous amount of operational complexity that can’t be easily scaled. 

Similarly, as a result of the pandemic, new strategies have emerged in the private credit, hybrid, private equity and hedge fund spaces, which had previously not followed a cookie cutter approach in terms of operations anyway. In catering to the demands of the investor, these factors are putting a tremendous amount of pressure on firms’ existing operating models, which will influence how firms operate in the future of alternative investments.

Regulatory headwinds to further impact operations

Perhaps too early to predict, but there have been some prevalent regulatory headwinds that may manifest themselves in the coming months. Developments such as the SEC’s private funds rule proposal, which discusses quarterly statements and disclosures, annual audits, and fairness opinions on secondaries, the dealer rule proposals, and AIFMD amends are all factors that are going to put more stress on the operating model, specifically compliance and operations. 

Environmental, Social, and Governance (ESG) have also taken front and center on due diligence questionnaires, and disclosures need to be able to answer ESG-related questions in a transparent manner. ESG disclosures are prominent in the public sector and will most likely make their way to the private fund world, but for now, they are on almost every deep due diligence questionnaire, and firms need to be mindful of the influence ESG is having on the future of alternative investments. 

Not to be forgotten is crypto, which has found massive popularity in recent years, though currently experiencing a loss of favor. Considering factors like FASB’s moves to establish crypto asset accounting rules, greater governance around crypto is set to take shape in the coming months. 

Conclusion

Whether it’s the adoption of technology post the pandemic, the war on talent, investor tastes, or regulations that are constraining margins, firms need to reassess their business operating models in accordance with the future of the alternative investments industry, to maintain the performance success they’ve been experiencing despite waves of change. 

Moving forward, firms need to take the lessons learned from the pandemic and try to shape a more efficient business operating model that can align with, and help sustain, the future of alternative investments. 

Convergence League Table Summary

With every episode of In Conversation with Convergence, we report on the findings of the Convergence League Table for that month, tracking and comparing the growth of various asset management industry players through our comprehensive database. June’s Convergence League Table podcast, revealed the below findings for the period of May 2021 – May 2022.

In terms of fund administrators:

• While we saw a fund growth of almost 16%, admins ranked 1-5 increased substantially over that at 25%, showing market-level growth or better
• Admins ranked 6-10 just about matched fund growth at around 16%
• Admins 11-25 grew at 21%
• All other 600+ admins grew at about 5%

In terms of auditors:

• Everyone except the big four, which grew at about 8%, outpaced the market
• Auditors 5-10 grew at about 28%
• Auditors 11-25 grew at around 27%
• All other auditors came in at around 14% growth 

From a prime brokers perspective:

• Prime brokers 1-10 grew at a little over 4%
• Brokers 11-25 saw growth at close 7%
• All other prime brokers grew at around 13%
• There’s also a large growth number that’s unattributed to certain primes

In terms of custodians:

• The top 10 custodians kept pace with the market and saw growth of about 11%
• Custodians 11-25 fell behind the market with growth of only 1.5%
• All other custodians saw growth in excess of the market at about 16.5%

>> Get access to the Convergence League Table

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Convergence Annual Institutional Investor ODD – Operational Due Diligence Survey – 2017 Results

FOF’s – Pension Plans – Endowments and Foundations – Have you invested in ODD from a Tools, Technology and Personnel Perspective? Have you created sufficient capacity and bandwidth to manage Operating Risk?
Convergence is pleased to present the annual results of our 2017 survey focused on Operational Due Diligence (ODD) practices and processes concerning investment allocations by institutional investors to alternative assets. Survey participants include a cross section of institutional investors with respect to type of investor, number of investment allocations to external managers and the amount of new annual allocations to external managers.
Survey findings suggest that a number of Institutional Investors rely upon periodic Manager or Consultant communication and loosely defined processes to monitor Operational Risk and Infrastructure changes regularly. Institutional Investors may have limited resources and tools available to proactively fulfill their Fiduciary responsibility in an environment of increasing regulatory scrutiny and operational Complexity.
Selected highlights of the study include:
Given continued regulatory focus and increasing manager operating complexity, investors should refresh their evaluations of the level of resources (staff and/or technology) dedicated to Operational Due Diligence, as well as their own current written policies and documentation requirements from managers. We note that current manager and new manager allocations have increased since our prior study, but dedicated resources (people and technology) have increased only marginally. Tool sets provided by Convergence lend themselves to small to medium-sized ODD teams challenged by capacity and bandwidth.
Investors should consider reviewing their level of focus and current processes for evaluating managers’ assessment and monitoring of service provider relationships, including manager practices of ongoing monitoring of their service providers, particularly for hedge fund manager allocations. Private equity managers will likely continue to increase their level of outsourced service providers, underscoring the need for this review. Service provider “best fit” is a key consideration.
With the considerable increase in new products and new avenues for product distribution by managers, investors should reevaluate those data points, metrics and sources of information for assessing manager operational complexity and risk. Consideration should be given to appropriate weighting of risk areas for “scoring” purposes, and scoring processes should be considered by those not presently doing such as part of their ODD process. Operating Model Complexity and Risk Profiling are paramount to active management of an Advisor.
Investors should consider reviewing and updating their policies, practices and processes for performing ongoing ODD monitoring and surveillance of hedge fund and private equity manager allocations. Consideration should be given to the level of proactive, data-driven processes in place to perform ongoing ODD.
Although 100% of respondents indicate their organization views ODD as a “value adding” activity that can improve returns and manage portfolio risk, we are concerned that this area is one in which investors may slowly continue to build resources, processes and technology. Investors should consider a complete review of dedicated resources for varied aspects of initial ODD and ODD monitoring and make spending decisions consistent with their assessment of risk across their portfolio, recognizing that manager OPERATING risk profiles are in constant change.

PARTNERING WITH CONVERGENCE

Convergence focuses on providing Fund of Funds, Pensions, Endowments and Foundations relevant Advisor data – INDEPENDENT of the Advisor.
Convergence enables its institutional investor clients to increase internal efficiencies, reduce third-party consulting costs and enhance ODD responsibilities through the use of customized technology tools which “push” material events communications to those responsible for ongoing ODD.
Institutional investors have a responsibility to their stakeholders to monitor material events in the private funds industry and those specific to their investment allocations. While the level of focus and resources allocated to ongoing ODD is increasing, current processes are generally (1) reactive in nature, (2) dependent upon requesting information or on periodic updates and (3) likely not all-encompassing, even with respect to specific fund allocations.
Convergence has identified 40 operating complexity factors which it captures and creates, all geared toward enabling investors to assess and measure the business risk profile of manager allocations, including the ability to compare and contrast with industry peers.

ABOUT CONVERGENCE

This 2017 survey was designed and compiled by Convergence, Inc. along with industry practitioners, including certain representatives of survey participants. Convergence, Inc. is a data and analytics firm providing subscription and research data on Registered Investment Advisor infrastructure, positioning ODD teams to evaluate Operating Model Risk.
Convergence has developed a data, analytics and surveillance platform that provides transparency and easily accessible information relating to the business operations and infrastructure of alternative asset managers. Convergence products include technology-based tools used to facilitate manager and industry research, analytics and surveillance across the universe of registered investment advisors, including assessment of their operating and business risk profile, comparisons to peers and competitors and analyses of their service providers. The company’s platform includes dynamic data and analytics on the entire universe of 16,000+
Registered Investment Advisors, 53,000+ private funds and the industry’s ecosystem of 6,000 service providers. The platform includes 2,000+ data points from regulatory filings and news sources and a significant amount of derived analytics and proprietary original content – most notably Advisor operating model COMPLEXITY PROFILING.
Institutional investors use the company’s products to research advisors and their business complexity and operations-related ecosystem prior to and throughout investment allocation. Convergence products benefit institutional investors focused on employing a dynamic, data-based, ongoing process of manager and advisor surveillance. These products, which are customizable based on an investor’s allocations and data specifications, include Market News, Material ADV filing surveillance, Operating Model Research, Service Provider Best Fit, COMPLEXITY profiling, Fund Expense Practices and Redlining of ADV Part 2 Brochures.
Contact George Evans at gevans@convergenceinc.com (215-704-7100) to set up a product demo and receive survey.

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The Modernization of Due Diligence for Alternative Investments

April 5, 2017
Harvard Club of New York City
Register Today for Early Bird Rate of $695
Institutional Investors Complimentary

Look Who’s Raising the Bar on Due Diligence

• John D’Agostino, Managing Director, DMS Governance
• Benjamin Alimansky, Managing Director, Director of Manager Research, Glenmede
• Ranjan Bhaduri, Chief Research Officer, Sigma Analysis & Management, Ltd.
• Westley Chapman, CEO and Founder, AlphaPipe
• Kevin Edwards, Senior Investment Director, Hartford HealthCare
• Lionel Erdely, Head and CIO, Alternative Investment Solutions, Investcorp Investment Advisors
• Steven Kahn, Head of Operations, Talpion Fund Management
• Edward Lund, Senior Vice President, Institutional Sales, The Gemini Companies
• Judith Posnikoff, Founding Partner, Pacific Alternative Asset Management Company
• John Phinney, Co-President, Convergence Inc.
• Shakil Riaz, Managing Director, Head of U.S. Alternative Portfolio Management and Global CIO, Rothschild Asset Management
• Adrian Sales, Head of Operational Due Diligence, Albourne America LLC
• Alessandra Tocco, Managing Director, Global Head of Capital Introduction, Consulting and Content, J. P. Morgan

Join them for straight talk between institutional investors, managers and solutions providers. We’ll discuss the modern tools available to improve due diligence efficiencies and the latest thinking on evaluating culture, talent, transparency, alignment of interests, operations and ongoing diligence.
This educational program will highlight investor expectations of alternative investment managers and how managers are raising the bar with improved technologies, high touch client service and tailored solutions.

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Convergence Inc. has released a full survey report to institutional investors based on its recently completed Operations Due Diligence (ODD) Effectiveness Study. The study included institutional investor participants responsible for over $700 billion of assets under management and allocated to external managers, including allocations to both hedge fund and private equity managers. 57% of participants reported having allocations to over 50 external managers. Survey participants included a cross section of fund of funds managers, public and private pension plans, endowments and outsourced chief investment officer organizations.
Survey findings suggest that a significant number of institutional investors rely upon periodic manager communication and loosely defined processes to stay abreast of material events at advisors with investment allocations. Convergence data indicates that managers of private funds file updated regulatory filings approximately 3 times per year on average for material events impacting their business and product profile. Institutional investors may have limited resources available to pro-actively fulfill their fiduciary responsibilities in an environment of increasing regulatory scrutiny and increasing operations-related complexity.
Selected highlights and results of the study include the following:
1. Many institutional investors do not have written policies with respect to operations due diligence (ODD).
Almost 40% of institutional investors who participated in the ODD survey report NOT having written ODD policies, including as part of their overall investment policies. Beyond performance and portfolio risk, operations-related risk and controls around managing regulatory risk should be significant considerations for allocators, and warrant a documented approach to reviewing such matters.
2. Dedicated investor resources to ODD activities are not adequate to address the post-investment monitoring of operations-related risk.
A significant majority (83%) of institutional investor respondents to the survey report only having 0-3 staff resources dedicated to ODD activities. In many follow on conversations with these survey participants, even the largest institutional investors have limited dedicated resources. In certain instances, internal staff resources may be augmented with external ODD service providers and/or technology tools. However, just 23% of institutional investors report outsourcing select ODD activities.
3. Service provider assessment and ongoing monitoring by institutional investors is not sufficient given the critical nature of those relationships to the control and operations-related environment of managers.
The top 3 vendor relationships of institutional investor focus include fund administrators, auditors and custodians. A full 89% of ODD survey participants cited fund administrators in their top 3, and complete a formal verification process to ascertain that vendor relationship. Institutional investors place significant reliance on SSAE No. 16 Reports and on vendor discussions to assess the quality and fit of the vendor relative to the needs to the manager. A full 55% of institutional investors cite a change in vendors as a material event or “red flag” in conjunction with their ongoing ODD processes.
4. Institutional investors should develop and incorporate a formal manager “scoring” process, including consideration of data-driven “peer” level benchmarking, into their ODD processes.
Approximately 53% of institutional investor respondents to the survey report they incorporate a manager “scoring” process into their initial ODD evaluation. This can be in the form of a “high, medium, low”, or 1-10 scoring scale rating with respect to matters of operational infrastructure and risk, following completion of initial ODD. About the same percentage of respondents report they incorporate peer level benchmarking into their ODD evaluation process. Much of this “benchmarking” is based on anecdotal data references, comparisons to other managers across the investor’s existing allocations and based on industry intelligence.
5. Given manager expansion into new product and distribution channels and a dynamic regulatory environment, institutional investor processes for ongoing ODD need to be re-examined.
Following initial ODD and the on-boarding of a manager, the intervals and practices for follow on, or “ongoing ODD” varies significantly, particularly based on allocation fund type (hedge funds v private equity). About 63% of institutional investor respondents to the survey report performing ongoing manager reviews (absent an interim “material event”) within a 24 month interval for hedge fund allocations, while just 24% report doing so for PE allocations. The top 4 practices in place by investors as part of their ongoing ODD include 1. Review of audited financials; 2. Monitoring industry news; 3. Review of ADV filings for changes; and 4. Review of fund administrator transparency reports. Only 21% of investors in the survey report using technology-based tools in their ongoing ODD processes.
The Appendix below and attachments include the results of two select questions from the Convergence ODD study pertaining to the professional expertise of dedicated ODD staff and the primary areas of focus in investor ODD practices.
PARTNERING WITH CONVERGENCE
Convergence focuses on providing Pension – Endowments and Foundations with the information they need to identify and manage risks that are changing in their Advisor’s business – INDEPENDENT of the Advisor.
Convergence enables its institutional investor clients to increase internal efficiencies, reduce third party consulting costs, and enhance ODD responsibilities through the use of customized technology tools which “push” material events communications to those responsible for ongoing ODD.
Institutional investors have a fiduciary obligation to protect the assets entrusted to them by their stakeholders, and overseeing and monitoring material changes specific to their allocations and within the industry is a must. While the level of focus and resources allocated to ongoing ODD is increasing, current processes are generally (1) reactive in nature, (2) dependent upon requesting information or on periodic updates, and (3) are likely not all encompassing, even with respect to specific fund allocations.
Convergence has identified 33 operating complexity factors which it captures and creates, all geared at enabling investors the ability to assess and measure the business risk profile of manager allocations, including the ability to compare and contrast with industry peers.
The Convergence platform captures and creates data on a daily basis covering the entire registered investment advisor universe. Custom data updates are pushed to institutional investors based on their customized requirements, including specific fund allocations and specific data artifacts based on their own assessment of operations-related risk.
ABOUT CONVERGENCE, INC.
Convergence has created an entirely new platform comprising (1) enriched and customized data; (2) research and analytical products; (3) surveillance/ monitoring services; and (4) advisory services, all providing transparency into the infrastructure of the alternative asset management industry.
Please contact George Evans at gevans@convergenceinc.com or Joe Dello Russo at jdellorusso@convergenceinc.com to learn more about the results of the Convergence ODD study and the Convergence platform and related technology tools available to institutional investors.
APPENDIX
The attached tables are extracts from the final Convergence ODD study report issued to institutional investor survey participants, which will be of interest to those with dedicated ODD staff and those allocating resources to ODD.
Introduction
ODD resources are clearly dominated by those with professional backgrounds in (1) accounting and finance, and (2) investment operations. These areas of expertise are consistent with the results below with respect to the allocation of time spent by investors in their ODD activities. However, given the very high focus on “compliance” activities, one could expect a trend of more compliance and legal resources being deployed in conjunction with investor ODD.
TABLE I. ODD Survey Question – What are the Primary Areas of Expertise of your Dedicated ODD Employees (select all that apply)?
Findings – The vast majority of ODD staff at institutional investors is comprised of accounting and finance, and investment operations professionals, as noted below. These skill sets suggest a critical need for focus on internal controls and operations-related processes. In addition, these areas of focus suggest a very “data driven” approach to ODD.
TABLE II. ODD Survey Question – Which Areas of Focus does your Firm Allocate the Highest % of ODD Time (select the top 5 areas)?
Findings – Virtually all institutional investor survey participants cite valuation as a “top 5” area of focus. Beyond valuation, the primary areas of focus revolve around regulatory compliance, the quality of staff and internal processes, and the quality of external service providers critical to the internal control processes of the manager. The Convergence platform enables investors to assess the complete business and operations-related profile of its manager allocations to manager peers.

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Less Common Expenses Funds Are Levying On Investors

HFMWeek/Convergence investigation highlights the most popular “uncommon” expenses funds are charging
BY CHRIS JOSSELYN
The fund expense practices of hedge funds have come under scrutiny in recent times, not least as regulators have taken a tougher stance on con icts of interest and disingenuous, inconsistent and unclear approaches by managers.
Investors, too, are perhaps paying more attention to the disclosures in Part 2 of Form ADVs before investing in order to avoid being liable for expenses that they may feel are not their business to pay for.
However, new research of SEC data, conducted by data analytics firm Convergence on behalf of HFMWeek, suggests that parts of the hedge fund sector are still not being as consistent in the type of costs they are disclosing as fund expenses as some investors would like them to be.
Investors who have been shown the research have also highlighted the prevalence of expenses that they would consider as being a management company, rather than a fund, expense.

BREAKING DOWN EXPENSES 

The research is based on the Form ADVs of more than 2,600 advisers, of which almost half (1,288) are hedge funds.  The remainder are private equity funds, real estate funds, venture capital funds, and hybrid funds, which were researched for comparison purposes.
Convergence collected the data by parsing expense disclosures from Part 2 of Form ADVs and creating a dynamic dictionary of term objects that the advisers use to describe their expense disclosures.
Convergence co-president John Phinney says: “After separating the funds into peer groups, we identify what we call ‘common’ and ‘less common’ expense group disclosures among peers in order to determine any unusual tendencies.”
Of the most common expenses, hedge funds had the highest level of advisers disclosing across six of the 10 most frequently used categories, suggesting they disclose more consistently across these common expense groups. The common categories where hedge funds were the top disclosers were audit expenses (100% of the hedge funds analysed disclosed this), fund accounting and administration (92%), general administration (79%), investment related (94%), legal expenses (82%), and performance fees (78%).
For many of these “common expenses”, there is little debate about these being charged to the fund.
“Anything that’s providing a direct service to the fund is clearly a fund expense,” Gordon Barnes, senior director of business risk management at Cambridge Associates, tells HFMWeek.
“The fund auditor clearly should be charged to the fund. Fund administrator, same thing. Legal, organizational costs, the setting up of the fund and ongoing structural maintenance are certainly are a cost of the fund. And directors – they’re representing the fund investors, and that’s clearly a fund expense.

HEDGE FUNDS AND UNCOMMON DISCLOSURES

When it came to less common expenses – often costs traditionally associated with the management company – hedge funds represented the highest percentage of four of the top 10 less common expense categories.
The categories of unusual expense disclosures that were more common in hedge funds than in other asset classes may leave some investors puzzled as to what rationale there is behind charging them to the fund: adviser employee compensation (8.7% of the hedge funds analysed disclosed that they may charge investors for this), data and data management (16.6%), printing expenses (17.9%) and technology (23.8%).
Other ‘less common’ categories include communications expenses, compliance expenses, marketing, pricing and valuation services, subscriptions, and adviser overhead expenses.
“Then you get into things that could be seen as overhead for a business, and there’s a kind of in-between,” explains Cambridge Associates’ Barnes.
“Research is an interesting one; some groups argue that research is [a fund expense] as it provides a benefit to investors to have a Bloomberg terminal and things like that.”
This becomes more ambiguous where managers receive services through “soft dollars”, where brokers provide certain amenities in exchange for the managers directing business their way.
“What’s tricky here is that they could be charged to the fund, in the form of a direct fund expense, or through soft dollars – ultimately it’s being paid by investors because they’re essentially overpaying for commissions and getting credit back from their brokers to spend on certain research related-tools,” adds Barnes.
Most allocators are aware of and comfortable with the concept of soft dollars. However, what they demand is transparency.
Another area that is likely to come on to the radar in future is any charges associated with cash management, given the regulatory pressures on institutions holding cash.
“We’re entering a world where [cash management costs] are going to become a reality and so the additional costs associated with MMFs or cash custody is something that will be absorbed into a fund expense,” Daniel Burdett, senior analyst within Aksia Europe’s ODD team told HFMWeek.

RESEARCH-RELATED AMBIGUITY

Research-related travel expenses is another ambiguous area. “Travel expenses for the analysts to go see the companies and do due diligence on them – that used to be a lot more common,” says Cambridge Associates’ Barnes.
“With travel, there’s potential conflicts that can arise. At the end of the day, why don’t you just charge a higher management fee? It would be a lot more transparent – if you need this extra travel cost, why don’t you just add 10 basis points to your management fee and be very transparent?”
Regulators are focusing on this as it becomes a greater investor concern. The SEC requires that disclosures be specific in ADV documents, and in 2012 it charged long/short equity hedge fund Lion Capital Management and its manager Hausmann-Alain Banet for using investor funds to pay unauthorised personal and business expenses.
Trade body Aima has also published guidance on hedge fund expense due diligence, in which it highlights that “getting the full picture of the various expenses is rarely easy and requires careful review and analysis during initial and ongoing investment manager due diligence”.

“All of the fees outside of the management fees are generally not disclosed very well,” says Mark Renz, CIO at Florida-headquartered Socius Family Office, which has $200m in AuM and $150m under advisement.
“It’s difficult to break out where a lot of the underlying fees come from – typically they’re buried in financial statements and other disclosures, and even there it’s not always very clear.
“Many people are just starting to wake up to a lot of this. People talk about 2&20, but really it’s not 2&20; it’s far more than two because typically that 2% management fee doesn’t actually cover any of the expenses. You could say it’s an advisory fee, just allocated to the investment managers as pure compensation, but it doesn’t cover any of the expenses – it’s not apples to apples.”
Renz adds that managers have a lot of scope for being creative in categorizing expenses.
“On the partnership side they have a lot of discretion – there’s no best practice or standard practice for disclosing these fees, and there’s a lot of discretion – it’s really up to the manager as to what they want to charge and how they charge it. The statements are so broad that it gives them the latitude to shove whatever they want in there.”
The research suggests that the depth, breadth, and quality of expense disclosure varies widely between managers. However, it does highlight the prevalence of certain expenses many investors would hope to see paid for by the management company being paid at fund level.
Convergence’s John Phinney says: “This could be due to a creeping of expenses to the fund that were previously borne by the adviser because of a trend towards lower management fees and increasing regulatory, compliance and investor expenses or simply an attempt by advisers to create more distinction between expenses related to the investment versus non-investment process.”
This move may also have been triggered by investor activism aimed at lowering fees, according to Phinney. “Advisers are under more fee and expense pressure driven by investor activism and greater regulation and may seek to offset, in part, the negative impact on management fees by charging the funds they advise more expenses that may be considered a cost of the fund,” he explains.
“At the end of the day, it’s not only an issue of transparency, but it’s [also] an issue of consistency,” concludes Socius’s Renz. “There has been something of a change – some managers have been willing to reduce their fees or negotiate – I just don’t think that it has translated over to the expense side.”
Conversely, Cambridge Associates’ Barnes says unusual expenses that many investors think should be charged to the manager, rather than the fund, are more prevalent in older managers “that have been around for 15 to 20 years”, rather than newer vehicles.
He adds: “When they launched this was standard practice, and over time, some of them are still doing it, especially the ones that have great performance, whereas new fund launches over the past couple of years, are pretty much in line.
“These businesses are very profitable, and it’s an expense of doing business. There are certain circumstances where we see a several-billion-dollar fund, and they’re extremely profitable. There’s no reason to be passing through a basis point here and a basis point there of certain overhead expenses – it doesn’t make sense.”

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