2008 was a watershed year for risk. The collapse of Bear Stearns and Lehman Brothers rocked the finan-cial markets while the exposure of the Madoff fraud alarmed investors and placed the spotlight on checks car-ried out by the SEC and auditors.
The effect of these high profile collapses and fraud cases has been to increase the focus on risk control measures and to highlight the fact investors cannot rely on external bodies – auditors or regulators – to provide evidence of a firm’s bona fides.
Families have necessarily responded by increasing their risk control expenditure. Some of the new checks investors are undertaking are quantitative or can be addressed through careful review of the documentation. This is costly and time-consuming but at least has a basis in fact rather than opinion.
Esoteric topics such as the rehypothecation of assets held by custodians and prime brokers have become eve-ryday concerns for investors, and considerable legal time has been spent in reviewing contracts to ensure exposure to these risks is limited. Likewise, it is no longer suffi-cient to know, for instance, the name of a hedge fund’s prime broker. Post-Lehmans, hedge funds increasingly have multiple prime brokers and families must consider each one as a separate counterparty risk and explore the terms each offers. Undoubtedly family offices are making greater use of legal and accounting advice before they approve an investment. Such checks are sensible but they only go so far.
A more significant, and even more arduous, aspect to risk control is the importance of knowing the manager, the entity and strategy first hand. This cannot be out-sourced to legal firms or reference checkers; in-depth knowledge of a manager can only be obtained by the investor or adviser directly. This too is a costly business but it is imperative for investors to meet their managers – not the marketing team – and to do so regularly. This entails visiting the office, talking with them at length, visiting any secondary offices, heading out to remote industrial estates to view their business continuity site, meeting the risk department and interviewing members of the team. All this takes time and money but is central to building up a true picture of an investment.
Investigation
Investors should also be making calls to their own con-tacts to seek references and following up with audi-tors, demanding to see audit reports not only on a fund but any sub-fund where appropriate. This can be particularly difficult because auditors are increasingly unwilling to have their reports used by third parties as evidence of anything and most have so many dis-claimers, no investor is able to place any reliance upon them. Nevertheless investors should demand to see these reports and if the auditor is unwilling to share them, they should reconsider the investment.
These steps go some way in allowing families to con-trol risks where they are invested through funds or other investment institutions. However, the other effect of the chaos of 2008 has been to encourage families to lose trust in the financial sector altogether. We increas-ingly hear of families looking for club deals, direct deals, co-investment opportunities – anything to avoid placing cash with a financial institution. This is under-standable but it must not be seen as a way to reduce risk. Indeed, in direct deals the risk remains considerable and in some ways is even harder to control.
There is great temptation to enter into a direct deal because a friend introduced it, but the tendency to over-look the necessary checks is commensurately greater. Furthermore, there are risks in direct deals, which tend not to be present in fund investments. Many direct deals we see involve higher risk development plays, higher risk jurisdictions or untested teams. All of these risks need to be weighed in the balance before a decision to proceed is taken. In addition, investors need to be con-scious of legislation such as the Bribery Act which will be binding on them as direct investors. The risks are at least as great in direct deals as they are in fund invest-ments so the growth in direct deal investing by fami-lies must be matched by a growth in expenditure on risk controls.
