Two years on from the financial crisis due diligence and trust remained important topics of debate at the Campbells Cayman Fund Focus Conference, closely followed by investor concerns over liquidity.

Since the financial crisis, the significance of due diligence and the demand for transparency from investors has increased considerably and become a practical issue the fund industry has to tackle as part of everyday business.

Constellation Investment Consulting’s Boris Onefater says investors are looking for more information on a consistent basis. He believes that while many practitioners in the industry use the AIMA due diligence questionnaire, it can only serve as a basis. Specifically, operational due diligence, which has become much more of a focus recently, is not something covered by the AIMA questionnaire at the level of depth that is demanded today, he said. As a result, most questionnaires have evolved to fill these gaps.

Scott Elphinstone, an investment manager and partner with Five Continents Financial, also sees increased demand for information and transparency but believes that up to this point it is reasonably manageable.

“The fool in the room”

However, he does not think that checklists are the appropriate due diligence instrument when selecting an investment manager because the things that are most important, such as the personality of a manager or culture of an organisation, are very difficult to capture.

“You really have to get an idea of how they are going to behave when the chips are down and that is really hard to get from a checklist,” he said.

Stating that a checklist is more of a “covering your rear-end kind of exercise”, Elphinstone shared with delegates the example of a fund manager who looked into investing with Bernie Madoff. 

The manager did all the due diligence and ran all the checklists. And although he had Madoff over for dinner at his house and visited Madoff’s office, where he received “royal treatment” and went through all the numbers in great detail, “in the end his gut just was not right and he did not invest,” said Elphinstone. “He saved me a pile of money.”

On the institutional side, the difficulty is to read the culture of an organisation rather than the personality of a single manager or team.

“Any American investment banks, I will not give discretionary authority over anything, because their culture is very clear,” he said, referring to mortgage backed securities and the subprime crisis.

“It is to find the fool in the room and stuff him full of crap. That’s the culture of the organisation and if you don’t know who the fool is, it is probably you.”

Elphinstone acknowledged that he trades with US investment banks and benefits from excellent liquidity and choice, but for the cultural reasons mentioned he would not buy any of their funds.

Elphinstone concluded that “if you give someone money to manage on a discretionary basis and you don’t have a feel for who it is and you don’t have a relationship of trust with the manager, you are taking a real risk.”

David Bree, managing director of dms, argued that trust also plays a part in the relationship between investors and independent directors.

“We open up our internal documentation system to them to create a degree of transparency that explains to them exactly the nature of work that we are doing on the particular funds in which they are invested.” Bree added that his firm helps investors understand how the business is managed in such a way that it provides a resource to investors.

“And what you find is when you create that type of trust and comfort, it is not unlike the trust and comfort that Scott [Elphinstone] was speaking about with regard to the investment manager.”

Such an exercise will also create goodwill with investors and establish the director as a “known quantity” to them. 

What are investors asking about?

Bree noted that most investors typically ask questions that relate to their experience during the financial crisis, including: Under what conditions would you suspend redemptions? What is your perspective on investors holding voting shares versus the investment manager holding voting shares? And the favourite question, to whom is your duty owed? 

“You have to be able to put your answers into a proper context that does reinforce the fact that you recognise your responsibility to the company as defined by the investors,” Bree said.

The main challenge for independent directors based in the Cayman Islands is to build relationships with investors and investment managers that will enable them to work through issues that might arise, he added. “A lot of times it comes down to who does a manager or investor feel comfortable with to work through a problem, either over the phone or meeting in person.”

This is achieved initially through web demonstrations of how the business is run and how the directors have worked with other funds on a no-name basis to get investors comfortable about how directors would work with them through issues. 

For the same reason, managers are now engaging their own investors a little bit more when it comes to the selection process of directors to ensure that independent board members are acceptable to their investor base.

Elphinstone agreed that investors are looking for independent directors. However, while independent directors are very useful when something goes bad, “by the time the directors are actually taking action, they are probably trying to save the last half of your money,” he said. 

“I prefer to try to invest in a way that I can keep the first half as well as the last half.” He would therefore concentrate on finding the right manager and the right strategy to protect the first half of the investment, he said.

Speaking about Cayman’s service providers in general, Bree concluded that “we have to view due diligence as an opportunity and not as a burden. Cayman is the number one jurisdiction, and due diligence is a way that we can show that.”

No new fund structures

Ethan Johnson, a partner in Morgan Lewis’ investment management and securities industry practice, noted that there may be more due diligence, but not many changes to the fund structures in response to liquidity and transparency demands. “We don’t see as many changes in the template as we all thought we might.”

In a product that is largely the same it was five years ago, investors are looking for “performance and pedigree” instead, he said.

Liquidity now priced correctly

In terms of liquidity, “people are trying to describe a lot more how they are going to deal with illiquidity issues”, said Campbells Partner Ian Dillon. The use of side pockets is still prevalent, although they might be called differently at times.

Elphinstone said that investors will have to be realistic and sacrifice liquidity if they want performance.

“That is the nature of the beast.” To a certain extent liquidity also explains the popularity of UCITS funds, he said.

“Investors see it as a more liquid instrument and accept lower performance.” By the same token, managed accounts are more in demand, albeit not for every type of investment class.

“The issue with managed accounts versus a fund is two-fold: it is liquidity and it is transparency,” Elphinstone said.

Liquidity is important because clients have now realised what it feels like not to have liquidity, and 2008 was a good reminder of that. As a result, liquidity is now more valued than it has been in the past, when instruments that were illiquid were not offered at much of a discount, Elphinstone said.

“[Investors] bought them at premium price. When liquidity failed, people realised liquidity was valuable. So in part the demand for managed accounts is demand for greater liquidity.”

The second aspect reinforcing demand for managed accounts is transparency. Transparency is important to investors when constructing portfolios in which all individual elements must have certain characteristics. “All the pieces have to work in a certain way to make money and to protect the downside,” Elphinstone said.

“The biggest threat to client portfolios is when pieces don’t behave in the way we expect them to behave.”

Both liquidity and transparency are dealt with by managed accounts because it allows an investment approach on a security by security basis.

Ultimately, however, investors will have to be realistic and know that for performance they will have to sacrifice liquidity, he said. 

“What you are seeing is that investors are carving up their portfolio into parts that are very liquid and others that are less liquid.”

With regard to hedge funds he concluded that if investors want to have liquidity, they will have less invested in this asset class.