Moody's Rating Hedge Funds? Snore...

After much buzz and anticipation, Moody's announced that it had finally rated its first hedge fund - the $335 million (AUM) Sorin Capital Management. Clarity. Transparency. Objectivity. This is going to change the world, right? Really step up that hedge fund scrutiny and push towards transparency of the hedge fund marketplace, right? Wrong. To me this new rating system isn't going to create a whole lot of value for a whole lot of people, in essence amounting to a whole lot of nothing. I am not sure that those driving hedge fund asset growth - the institutions - are really going to care, or that those whom are the primary recipients of these institutional dollars - large institutional multi-strategy complexes - will have their asset-gathering ability impacted in any way by receiving such a rating. Quite simply, I don't see this news representing a shift in the way the investors that matter conduct due diligence. Period. Maybe I'm a cynic but let's take a critical look at this program below.

Let's be clear about what's going on here - Moody's is opining on the operational risks of Sorin. The article in yesterday's WSJ lays it out pretty well. Please note the bolded text as these represent themes that I believe warrant some discussion.

Moody's Investors Service today will publish its first public rating on an individual hedge fund's risk, in a closely watched move that could shed light on a fast-growing industry that traditionally has avoided outside scrutiny.

********************

In this case, Moody's is rating neither the hedge fund's debt nor its return. It is rating the "operational risk" of Sorin Capital, essentially, how well Sorin runs the nuts and bolts of its business, from its back-office systems to the controls it has in place to avoid experiencing sudden losses. Moody's also conducts background checks on managers.

These issues are of concern to investors in the wake of alleged frauds at firms such as Bayou Management LLC and Wood River Capital Management LLC

********************

While many hedge funds want to show their investors and lenders that they run quality businesses, they also don't want to reveal too much information about their strategies and internal operations to competitors or regulators. A recent federal-court ruling that hedge funds need not register with the Securities and Exchange Commission could give some funds reason to remain on the sidelines when it comes to public disclosure.

That could change as hedge funds attract more money from institutional investors, such as pension funds, endowments, and insurance companies. These conservative investment vehicles usually require checks to be performed on a fund before they invest their money.

The ratings companies believe they can profit from the growing desire for scrutiny.

They are staying away from analyzing hedge funds' investment strategies or the riskiness of their portfolios, in part because they see that as difficult to monitor and because many funds would be unwilling to share that information.

********************

To persuade more funds to be rated, Moody's has been offering what it calls "indicative" ratings in which fund managers can get a preview of their rating before deciding whether to proceed.

Mr. Witt notes that this approach would allow funds with less-favorable reviews to avoid public scrutiny. That means there might not be many funds with low public ratings in the near future, "unless this becomes something of a market standard," he said.

Ok, got it. Now, who is driving the growth in AUM in the hedge fund industry? Any guesses? Right - institutions. While high-net worth individuals were the dominant component of hedge fund AUM in the 1970's and 1980's, institutions such as pension funds and endowments have really provided the pop in AUM growth from the mid-1990s onward. The institutions are generally referred to, as, what? Oh right, sophisticated.

This means that one of two things happens when they consider investments in hedge funds:

1. They are smart enough to know what they don't know and hire an expert like BAAM, PAAMCO or others to help them out. These fund-of-hedge funds (FOHFs) provide asset allocation, portfolio construction and due diligence expertise to their investors. Unless I'm mistaken, I can't imagine Tom Hill of BAAM or Jane Buchan of PAAMCO turning over responsibility for operational risk assessment to Moody's. Sorry, it just ain't happening.

2. They are both sophisticated and adequately staffed in order to perform the asset allocation, portfolio construction and due diligence functions themselves. As with the FOHF example, I can't imagine CalPERS, PennSTERS or UTIMCO ceding operational risk assessment to a ratings agency. Their fiduciary responsibility is just too great to give over this role to anyone, and while a Moody's rating might provide a "belt and suspenders" double check, this value-add is of very limited value.

So lets say, for arguments sake, that Bayou and Wood River had received Moody's ratings. Would they necessarily have been terrible and so off-putting as to stop people from investing? Possibly. There was definitely some credentials inflation (read: falsification) that may have been picked up via background checks, if the checkers were doing their jobs. Fact of the matter is that the institutions and FOHFs that invested in these funds should have done the checks themselves - most good ones do. Or more to the point, the issue isn't so much Bayou and Wood River but whether or not what Moody's is doing will prevent fraud. Bottom line, whether one is assessing risks across Corporate America, mutual funds or hedge funds, if someone wants to perpetrate a fraud they will, and neither Moody's nor a Big 4 audit will catch it. The way the pros address this issue is to spend real time with the managers, conduct detailed (read: DETAILED) and thorough background and reference checks, watch the managers settle trades with counterparties at the end of the day, mark their books, and speak to their prime brokers, among other things. This stands a better chance of detecting the character and propensity for fraud than any checklist-type ratings system. You simply can't assign this responsibility away, particularly if you are acting in a fiduciary capacity.

Now let's spend some time thinking about Moody's method for building its franchise - allowing a preview of one's rating in order to decide whether or not to move forward. Ok, I get it. So, if you flub the ratings process and your indicative rating comes up looking like crap, you can say "Ha, just kidding. I didn't really want that rating anyway." I'm sorry, but this just isn't right. While Moody's may not (legally) be in the position of a fiduciary, the role they are performing is, in fact, similar to that of a fiduciary (at least morally and ethically, in my opinion). Some people might be relying on their assessment, and while I am certain that the small print of their review will say "We don't represent that...," being in the possession of knowledge that a firm running other people's money has poor controls and not disclosing this fact is just lousy business. Can you imaging an auditor being told "Hey, you know those dates we had on those stock options that looked kind of funny? We're changing them to coincide with the employees' hire dates. Don't worry about it." Do you think the auditor is burying this fact? If they are, they are facing a massive class-action lawsuit.

So is the objective of rating the operational risks of hedge funds a total waste of time? No. The question is for whom does it matter. As I've written about previously, I believe that the hedge fund industry will evolve into the shape of a barbell - a bunch of $10 billion+ AUM players who look like and act like institutional asset management firms (sustainable franchises, multi-strategy, world-class controls, best practices for asset valuation and side pockets, etc.), and sea of >$500 million single strategy and emerging funds. I think a Moody's-like rating system for emerging funds makes a lot of sense, especially since they tend to take in high-net worth individuals' money who don't have the due diligence ability of a FOHF or a large institutional investor. Further, I think they can actually help these funds set up control infrastructures by providing the Moody's guidelines to achieve a target rating, and then verifying and testing that these controls have actually been put in place and are operating successfully. While this portion of the market will come to represent a small piece of the overall pie, I think that Moody's will be providing a real service and protecting the investors who really need their help - the individuals.

I think what Moody's has set out to do is admirable and has its place - I just want people to understand the real scope of its impact and to consider that Moody's approach could be improved by following the very principles of transparency and clarity they are rating.

Comments

[Yaser Anwar]

Just like a strong credit rating on a company doesn't guarantee a solid share price in the future, a rating system for hedge funds is unlikely to replace detailed ongoing diligence. As more & more pension funds, endowments and charities want to put more money into the fast growing $1 trillion hedge fund industry, they worry that hedge fund managers & how they make money.

As instruments have become increasingly complex, so too have Hedge Fund valuation models. Such complexity could be illustrated when one needs to differentiate valuing the operating risk where there is limited knowledge about strategies used and price from valuing a transaction compared to when one has reasonable price discovery.