Outsourced Due Diligence Teams Gaining Ground…and Power

(July 3, 2013) — The changing regulatory environment is the main driver of expanding due diligence by hedge fund investors, according to Deutsche Bank’s latest survey.

The bank’s hedge fund consulting group polled 68 institutional investors from around the world, whose assets totaled $2.13 trillion with a hedge fund allocation of $724 billion. Nearly three-quarters of respondents ranked a fund’s compliance and regulatory framework as their top priority for 2013.

The large majority (70%) of external operational due diligence (ODD) teams had explicit veto authority in the investment decision making process, and 63% of investors said they would not consider allocating to a fund previously vetoed by an ODD team. Investors reported conducting an average of 50 manager reviews a year, and 80% said they have a dedicated ODD group.

The survey also found the majority of respondents had little to no tolerance for expenses such as non-research related travel or external employee compensation.

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Those surveyed preferred hedge fund boards to be heavy on independent directors. Investment in human capital and proper segregation of duties ranked as investors’ top two operational wishes when assessing start-up managers.

“This survey demonstrates the critical importance of operational due diligence to hedge funds as the industry experiences an ongoing evolution,” Pam Kiernan, Deutsche Bank’s global head of hedge fund consulting said. “Our results show that these teams have advanced in sophistication and provide valuable insights as to how managers can prepare for the road ahead.”

(July 3, 2013) — Static interest rates are bad news for pension funds, resulting in a 2.5% increase in liabilities a year, according to research released by UK consultants Redington.

The findings may come as a surprise to some investors, who typically think more bilaterally about interest rates: if they go up I win, down I lose.

Alice Cheung, an associate at Redington, explained there’s more to it than that. The value of a pension fund’s liabilities is calculated using the current yield curve and the implied forward rates.

At the moment, the yield curve is steep, implying that the forward rates are higher than the current interest rates.

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This, Cheung said, means that current yields need to move up as projected by the forward rates, just for the liability value to stay constant.

“In other words, in the event that these higher forward rates do not materialise but simply stay constant, the liability value will rise (assuming other factors remain constant), because discounting happens at a lower rate than expected,” she added.

Redington calculated that in a situation where interest rates stay constant, pension fund liabilities would increase by approximately 2.5% a year.

“With little or no hedging, the expected deterioration of a pension fund’s funding position should rates remain at current levels is what we refer to as the rolldown effect,” said Cheung.

“Roll this up over the 10 years or so of the fund’s recovery plan, and this is the pensions equivalent of trying to run up a downward escalator; sweating your assets just to stay in the same place. Now if we factor in market volatility, imagine there’s a guy at the top of the escalator throwing rocks at you.

“Similarly, when a pension fund is interest rate hedged, the hedge in place would earn the 2.5% carry on the rolldown of the yield curve. A partial hedge would at least lower the incline of the upward climb to full funding.”

Cheung’s full article can be read here.