Conflicts of interest for hedge fund managers

February 14, 2013

Previously published by Thomson Reuters

by Martin Lovick

Managing conflicts of interest is currently a significant area of focus for regulators, who see it as a critical aspect of good behaviour by financial services firms. In November 2012 the Financial Services Authority (FSA) published a Dear CEO letter on conflicts of interest between asset managers and their customers which, as a recent Compliance Complete article pointed out, has serious implications for already over-stretched compliance officers.

The term "conflicts of interest" is not new: it was central to the thinking behind the MiFID regime introduced five years ago, and managing them is enshrined in Principle 8 of the FSA's Principles for Business, and detailed requirements are also set out in SYSC and COBS. The essence of the MiFID requirements was that it was no longer enough to disclose potential conflicts to customers: they must now be actively managed, with disclosure only to be used as a last resort.

Regulators have certainly been displaying a renewed interest in conflicts of interest recently. The "Dear CEO" letter said: "Confidence in the integrity of asset managers when acting on behalf of customers is central to the relationship of trust between the industry and its customers." This is classic stick and carrot: establish a framework for managing conflicts now, and be rewarded with greater consumer confidence in yourselves and your industry.

Potential conflicts of interest for hedge funds

Hedge funds are likely to encounter conflicts of interest in a number of areas. Many will be recent start-ups, at a relatively early stage of organisational development, and compliance may just be one of a number of functions handled by a small team. Senior investment personnel often have a sizeable portion of their personal wealth tied up in the fund, and may initially find it hard to comprehend that the interests of their clients might be any different from their own. The following potential areas of conflicts should be discussed with hedge fund clients:

Personal account dealing Hedge funds are typically staffed by high-net-worth individuals who are risk-takers by nature. Are their best ideas being used by the fund? Do they spend more time worrying about their own positions rather than the state of the fund (particularly during periods of market stress)?

Outside business interests These are quite common among senior hedge fund personnel, for example, portfolio managers will sometimes sit on the boards of their own funds. Are employees required to disclose their outside business interests? Is there analysis and oversight on how these may conflict with the interests of investors? Where there is the possibility of conflict, are individuals required to cease the activity, and are those at the top of the firm setting the correct example on this matter?

Allocation of trades and cross trades Are all funds and managed accounts treated equally/fairly (bearing in mind that they may have different investment strategies), particularly where there are differences in incentive and management fees? Is there any trading of assets between funds (particularly popular with high-frequency traders) and, if so, how is it scrutinised? In the latter example, the provision of liquidity by one fund to satisfy redemptions in another fund (typically in illiquid assets) is a particular no-no.

Dealing errors Who takes the losses (and profits) for any dealing errors incurred by the manager? Are there satisfactory procedures for the identification and resolution of such errors? The FSA has stopped short of banning managers from passing on the cost of dealing errors to their funds, but it has warned that where funds restrict compensation to errors caused by gross negligence, "repeatedly making the same or similar errors might in itself amount to gross negligence".

Use of dealing commission for corporate access Introductions to their best corporate contacts were traditionally seen as part of the whole package that came with engaging, and indeed remunerating, a stockbroker. Such introductions were regarded by many as crucial to the "original thought" and "intellectual rigour" beloved by COBS (11.6) The FSA did not share this opinion, however, Although it has again stopped just short of a full ban for now (although there have been suggestions that this might change), the regulator has observed that "firms were unable to demonstrate how access to company management constituted research or execution services". In other words, "we are sceptical until convinced otherwise".

Gifts and entertainment Does the manager have a policy for giving as well as receiving? Does it distinguish between entertainment used to enhance business relationships and pure "freebies"? And is it consistently applied across the firm, from senior partner to the lowliest analyst?

Remuneration Arguably, this is the biggest potential conflict of them all. It relates, not only to the total numbers, but also to the alignment (or otherwise) of the investment objectives and attitudes to risk of the managers versus those of the fund investors. Surprisingly, the FSA did not even touch on this in its recent paper, although it has had plenty of coverage elsewhere.

Conflicts of interest management

Firms must be able to demonstrate that they are managing any conflicts of interest appropriately. In short, firms should:

  • Have a policy, clear and simple, tailored to their own business. This should identify the main headings for conflicts of interest and how they will be managed.
  • Have clear lines of reporting and accountability.
  • Build conflicts into their governance framework, with periodic reports to senior management, the board and external auditors.
  • Document everything, including specific issues arising, and how they were resolved.
  • Review these procedures annually, or whenever a significant new business line is added.

Alternative Investment Fund Managers Directive

The Alternative Investment Fund Managers Directive (AIFMD) also has much to say on conflicts of interest, and this is another reason why regulators are revisiting the area. The concept has changed slightly, however. Whereas MiFID has been concerned with managing conflicts between the firm and its clients, or between two or more clients, the AIFMD has introduced a further dimension: the AIFM, the AIF and the AIF's investors.

One potential conflict identified by the Level 2 Regulation concerned how the AIFM exercises any voting rights held within an AIF, specifying that this should only be for the benefit of the AIF and its investors. AIFMs will be required to disclose their policy on conflicts of interest to their investors, either in a durable medium or on a website. Managers preparing for AIFMD should include a thorough review of their practices in this area in any information provided.

Last, but not least, asset managers who received the letter of attestation which was attached to the "Dear CEO" letter back in November must verify their compliance with FSA rules by February 28, 2013. The letter itself is a clear warning that supervision visits (and, by implication, enforcement actions) in this area will follow.