The Red Flag Group®

Hedge fund concern over reputational risk is most welcome

Hedge fund concern over reputational risk is most welcome

Who would be a hedge fund manager today? United States hedge fund Scion Capital LLC returned a US$2.5 billion profit to investors following the global financial crisis of 2007–2008. As depicted in the movie The Big Short, the fund’s eccentric founder and manager Michael J Burry managed to increase the value of his fund by a net 489 percent just as millions of Americans defaulted on their home loans. Burry eventually closed the fund, in part due to his disgust with the general state of the industry, and many have found it difficult to sympathise with the sector since then.

Hedge funds are investment funds that pool capital from a limited number of accredited individuals or institutional investors. For a long time, they managed to avoid direct regulatory oversight as they could not be offered or sold to the general public. During times of prosperity this was not deemed to be a problem, but it certainly didn’t help with public relations during a time of austerity.

Following the financial crisis, governments in the United States and Europe passed various regulations designed to grant them greater oversight of hedge fund activities. And, according to reports, the sector’s performance has deteriorated every year since then – culminating in this week’s extraordinary events.

Hedge funds differ from mutual funds in that their use of leverage is not capped by regulators, but where they are similar is in their employment of generous compensation schemes.

Investor disquiet over the management fees at Perry Capital was one of a number of ‘market headwinds’ cited by co-founder Richard Perry in a recent letter to investors explaining the reasons why its flagship fund was closing after 28 years in business.

According to the Financial Times, Perry’s assets under management peaked at US$15.5 billion in October 2007 before falling to US$10 billion in 2015 and US$4 billion this year. And his fund is by no means alone.

“John Paulson’s fund has fallen to US$12 billion from a peak of US$38 billion and Leon Cooperman’s Omega Advisors, now the subject of an insider-trading probe by the Securities and Exchange Commission (SEC), has shrunk to US$5.4 billion in assets from US$10.7 billion in 2014,” reports the FT.

You know a sector is in trouble when many of the largest players and industry veterans are struggling to make money. A number of funds have closed their books over the last 12 months, while investors have pulled more than US$50 billion already in 2016 according to eVestment data.

Reputation is everything

The news this week that as many as 10 hedge funds have cut their exposure to Deutsche Bank, after the German institution was accused of mis-selling mortgage securities, may have something to do with the recent rise in credit default swap prices. But the likes of Millennium Partners, Capula Investment Management and Rokos Capital Management have also imposed risk limits on the business they do with the beleaguered bank out of concern over reputational risk.

As ‘Deutsche’ knows only too well, reputational risk can have devastating financial consequences – its share price has fallen 55 percent in the last year due to concerns over its financial health and this week reached its lowest level since 1983.

Concern over reputational risk was also at the heart of Och-Ziff’s decision to pay US$413 million to settle charges that it engaged in foreign bribery in Libya, Chad, Niger, Guinea and the Democratic Republic of Congo.

Among the most vocal critics of the high management fees, and poor performances, currently on offer at many hedge funds are the public pension groups. According to the FT: “As of July 1, pension funds accounted for 37 percent of the assets Och-Ziff oversees, and foundations and endowments another 12 percent. Those groups are ‘the most concerned’ with reputational risk, according to Jefferies analysts led by Daniel Fannon.”

Och-Ziff is calculating that its decision pay US$2.2 million to settle the charges, nearly US$200 million in disgorgement and interest, and a criminal penalty of US$213 million will remove the uncertainty that has hung over the New York-listed hedge fund since it first disclosed that that it was under investigation by the SEC and the Department of Justice (DOJ) two years ago.

In the last 15 months of that period, the fund’s value has dropped from a high of US$48 billion to today’s US$39 billion valuation while its share price has plummeted by more than 70 percent before recently recovering.

While the fine against Och-Ziff is significant – and is only the second against a hedge fund for alleged bribery – it represents small change compared to the share price slump currently engulfing Deutsche Bank. Och-Ziff knows this, and its decision to focus on business value and not just regulatory compliance is a wise one.

Integrity risks can cause reputational damage to any organisation, and if the hedge fund industry is finally recognising that it is not immune from such consequences then that is no bad thing.

Risk management

Earlier this year, London-based Eversheds partner Neill Blundell said: “Governments have typically tried to fight bribery by deterring companies with high-profile prosecutions, but they need to work with the private sector to articulate the business case for anti-bribery.”

Successfully articulating this is a challenge, however, and this was recognised in an Eversheds report earlier this year, which called for ‘a more sophisticated conversation’ around bribery and corruption. Such a conversation needs to consider how an integrity ‘issue’ might impact investor sentiment or a company’s share price?

Reputational damage through integrity risks can arise either directly through the activities of the company itself or through a range of third parties with which it conducts business.

While it goes against the grain for many lawyers … if the company itself is liable, then admitting so early goes a long way to reducing community backlash and saving the company’s reputation. In such situations the company brand will bounce back much stronger, and it will likely reduce the angst associated with an incident. From a legal perspective, it also allows for your team to focus on the compensation aspects of a case rather than arguing about liability. Companies that do admit liability generally end up being – and, crucially, are remembered for being – part of the solution rather than part of the problem.

Similarly, the perception of being associated with someone of poor integrity should also not be underestimated. By bringing a third party into your partner programme, you have approved, endorsed and announced to the market that you trust it. When you include a company in your partner programme, you are letting it into the inner sanctum of your company. Before you do that, the question you need to ask is, What could that company do to hurt us?

The Red Flag Group focuses on helping companies successfully manage reputational damage that arises through integrity risks. And it helps companies select and manage the best third parties, always ensuring that they positively contribute to integrity and compliance programmes. It’s about selecting the right partner that will comply with the terms of their contracts throughout the life of the engagement.