IOSCO’s Fund of Hedge Fund’s Guidelines – Useful Guidance or Vague Hindrance?
The International Organization of Securities Commissions (“(IOSCO“) has published a new document called, “Elements of International Regulatory Standards on Fund of Hedge Funds Related Issues Based on Best Market Practices.” Simple enough title. Here is the link to the full report.
This guidance is reminiscent of a piece I wrote entitled, “Analyzing Your Financial Advisor’s Due Diligence Process: 10 Questions Every Investor Should Ask.” (link to Conde’ Nast article discussing it). It also seems to touch on issues I wrote about in my guest article for the Hedge Fund Law Report, The Fund of Hedge Funds Regulatory Loophole.
This current IOSCO report is essentially an update of a previous report put out by IOSCO entitled, Fund of Hedge Funds – Final Report, which was published in June 2008. That report is available here. This old report focused on two key areas:
1)the methods by which fund of hedge funds managers deal with liquidity risk
2) the nature and the condition of the due diligence process used by fund of hedge funds managers prior to and during investment
It is the second, due diligence, element above which bears further scrutiny. In this new publication IOSCO gives further clarification on the way in which fund of hedge funds managers should proceed in their due diligence. The problem with these guidelines is that they are vague and stale.
Example of some of the guidelines include:
1) “Establishing and implementing appropriate due diligence procedures for the purpose of investment into hedge funds which are reviewed regularly”
This is fine in principal but as Madoff and the slew of other recent Ponzi schemes has demonstrated, the definition of “appropriate due diligence procedures” is a floating standard at best which varies among managers based on a number of factors including fund of hedge fund investment styles, assets under management, use of operational due diligence information in the asset allocation process, regional considerations etc. Trends in some of these areas are discussed in my research paper, “Analyzing Operational Due Diligence Frameworks In Fund of Hedge Funds.”
The recommendations continue…
2) “assessing the specific legal and regulatory requirements applicable in the hedge fund’s jurisdiction” – ok nothing new here.
And this gem…
3) “carrying out appropriate due diligence on the underlying hedge fund whenever it is considered necessary”
I have already discussed the dis-service done to readers of this report by providing vague advice utilizing the “appropriate” language however for this element we should focus on the “whenever it is considered necessary.” I would pose the question to IOSCO, when is due diligence NOT necessary? Isn’t that the point of due diligence? You don’t know if its “necessary” until after you perform it?
The next section of the IOSCO report deals with, “Adequate resources, procedures, and organization structures necessary for the purpose of carrying out a proposer and robust due diligence.” Included in this section is advice that fund of hedge funds employ, “the resources, procedures and organization structure to deal with ANY anomalies identified by due diligence system, to take the necessary corrective action and confirm that all procedures and traceable and have been catalogues;” (emphasis added). It is frankly unrealistic to outline that a fund of hedge fund be prepared for all due diligence eventualities.
For example, in the course of the operational due diligence process a fund of hedge funds may come across a hedge fund with a certain business continuity issue. The fund of hedge funds may not employ a full time technologist skilled in various business continuity and disaster recover technologies. According to IOSCO a fund of hedge funds is supposed to employ this person. Looking at the economics of the fund of hedge fund industry it is cost prohibitive, and this is just one small example. This is why outsourcing the operational due diligence process to specialist operational due diligence firms such as Corgentum, which cover a multi-disciplinary series of risks makes sense, particularly for fund of hedge funds.
IOSCO provides guidelines for outsourcing such processes. These guidelines are fully detailed in a document called, “Principles on Outsourcing of Financial Services for Market Intermediaries.”
While IOSCO’s heart is in the right place, unfortunately, the standards leave their recommendation vague with little actionable advice for fund of hedge funds. This begs the question to whom are these standards directed at? Fund of hedge fund practitioners or perhaps a marketing tool for fund of hedge funds to utilize in promoting their compliance with IOSCO due diligence standards?….
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Good post – IOSCO’s guidance is useless for the most part and dangerous at best!
Enjoyed this post too – it seems as if no one really reads these guidelines people put out too carefully to get to the substance of it