Hedge Fund Group Issues Report On Sound Practices

By: Conrad G. Bahlke and Brian Fortune

This article was originally published in the SR&Z Spring 2000 issue of Investment Management Developments.

On February 7, 2000, a group of five of the largest hedge fund managers (the "Hedge Fund Group") issued a report, "Sound Practices for Hedge Fund Managers," containing recommendations for hedge fund managers in the wake of market events in the summer and fall of 1998 (the "Report"). The Hedge Fund Group, consisting of representatives of Caxton Corporation, Kingdon Capital Management, LLC, Moore Capital Management, Inc., Soros Fund Management LLC and Tudor Investment Corporation, made 34 recommendations intended to enhance market stability by strengthening hedge fund management and reducing the risk of default or failure. The recommendations were divided into four major sections addressing: (1) the responsibilities of senior management; (2) risk measurement and monitoring; (3) disclosure; and (4) documentation and other legal and compliance issues.

Russia’s devaluation of the ruble and declaration of a debt moratorium on August 17, 1998 caused severe disruptions in debt markets around the world and led, ultimately, to the near-collapse of a large hedge fund run by Long-Term Capital Management, L.P. ("LTCM") in September 1998. LTCM’s difficulties resulted in extensive examination by government and private sector groups aimed at determining how LTCM’s investment positions became so highly leveraged and large enough to pose a risk to the global financial system and how to avoid such systemic risk in the future. Reports were issued by, among others, the President’s Working Group on Financial Markets (the "Working Group") and the Counterparty Risk Management Policy Group (the "Counterparty Group"). These studies generally agreed that creditors and counterparties failed to adhere to sound credit risk management policies in allowing LTCM to obtain excessive leverage, resulting in an unacceptable degree of systemic risk.

The Report was issued in response to the Working Group’s report, "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management." The Working Group’s Report, issued in April 1999, recommended, among other conclusions, that "[a] group of hedge funds should draft and publish a set of sound practices for their risk management and internal controls." The Working Group suggested that such a report should focus on, among other things, measurement and management of market and liquidity risk, segregation of duties and internal controls, and an assessment of performance against sound practices for counterparties. The Counterparty Group’s report, "Improving Counterparty Risk Management Practices" (the "Counterparty Group’s Report"), was issued in June 1999 and contained recommended best practices for risk management from the perspective of dealers in complex financial instruments. The Report was intended to complement, from the perspective of the hedge fund manager, the Counterparty Group’s Report.

The Hedge Fund Group identified certain "key points" as fundamental to its recommendations, including:

• Risk Allocation and Assessment.
Senior management, in assigning portfolio management and trading responsibilities, should allocate capital and risk based on defined investment objectives and risk parameters, and control the allocations based on information supplied by an independent risk monitoring function. The ultimate monitoring of risk is conducted by senior management and should not be divorced from decisions to allocate risk.
• Interplay of Different Types of Risks.
Hedge fund managers must recognize that market, credit and liquidity risks are interrelated, requiring the hedge fund manager to analyze the consequences of a fund’s exposure to these risks in combination.
• Stress Testing and Liquidity.
Hedge fund managers should assess how funding liquidity may be compromised during periods of stress and seek to establish reliable sources of financing in order to enhance financial stability during volatile market conditions. In particular, the hedge fund manager should assess how unexpected events may cause losses that may force the liquidation of positions, and the potential "spiral" effects of such a forced liquidation on the value of the portfolios under management and on sources of liquidity.
• Use of Risk-Based Leverage Measures.
Recognizing that the importance of leverage is the impact it can have on market risk, credit risk, and liquidity risk, hedge fund managers should focus on "risk-based leverage" (i.e., measures of leverage that relate the riskiness of the portfolio to the ability of the fund to absorb that risk). Hedge fund managers should consider tracking the degree to which a fund is able to modify its risk-based leverage, by tracking the relation between the fund’s market risk and actions taken. Hedge fund managers also should track traditional, accounting-based measures of leverage, because those traditional measures provide insights into the source of risk-based leverage and how that leverage could be changed.
• Development of Informational Reports for Counterparties.
Each hedge fund manager should work with its counterparties to provide periodic reports that will strengthen relationship stability and, in doing so, contribute to market confidence.
• Work with Regulators.
Hedge fund managers should work with regulators to address their specific market concerns and objectives. As significant participants in a broad array of global markets, hedge funds, like other major financial institutions and other large investors, should be prepared to cooperate with relevant regulators interested in monitoring the markets to reduce systemic risk while preserving the confidentiality of proprietary information.
• Development of Consensus on Public Disclosure.
Hedge fund managers should coordinate with counterparties and regulators to reach a broad consensus on public disclosure which takes into account the benefits and costs of disclosure to investors, creditors and the markets.
• Documentation.
Each hedge fund manager should seek to standardize its approach to negotiating transaction documentation in order to achieve appropriate levels of consistency with its different counterparties and so that the legal consequences of unexpected losses or market crises (e.g., collateral calls, defaults and termination events) are known and may be reflected in stress/scenario testing.

The recommendations of the Hedge Fund Group are likely to have an impact on: (1) risk management systems used by hedge funds; (2) the types of risk management and documentation requested by banks and broker-dealers with which hedge funds do business; and (3) what type of disclosures, if any, hedge funds will ultimately need to make about their activities to counterparties, regulators and the public. n

Conrad G. Bahlke (212) 756-2506

Brian H. Fortune (212) 756-2353

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