A recent Financial Times article opened with the following salvo against hedge fund managers, “Some hedge fund managers are taking salaries, private-jet expenses and entertainment costs directly out of the funds they manage…” So what? Is this necessarily a bad thing? Particularly if the fund’s are profitable.
To play devil’s advocate for a moment we could raise two points. Firstly hedge funds, in a variety of different ways, make a variety of fee disclosures. This generally includes disclosures about certain types of marketing and employee remuneration fees. While most prudent investors would likely agree that it is often not in the best interest of the funds, and therefore themselves, to have expenses such as employees salaries and private jets passed through to them, it’s not as if they hedge funds don’t disclose what types of expenses they can, and are charging, through to the funds.
Should hedge funds be criticized if investors perhaps aren’t performing due diligence on these expense disclosure language to properly vet the situation? Instead, it seems, some investors may be crying wolf because they trusted a hedge fund to be what they might deem to more prudent in the managing of these expenses, without doing enough homework up front. Furthermore, why is this even a surprise to anybody? Hedge funds have a number of discretionary rights, such as the creation of reserves, when it comes to the management of expenses and contingencies. If a manager feels expenses are in the best interest of the funds then aren’t investors a bit late to raise criticisms after they have been incurred since they knew the hedge fund managers rights in this area prior to investing?
“Wait just a moment,” some investors might argue. “Expense disclosures are too vague to be effective in preventing such lavish expenses,” the agreement might continue. Such a line of reasoning may indeed be correct. This bring us to the second point. While there may be a lag involved between the actual incurring of a fund expense (i.e. – paying the private jet bill) and it showing up in an area that investors could have insight into such expenses, such as in the audited financial statements, it’s not as if the expenses are never disclosed. Of course, investors may argue that such delays are too long to be useful. In reference to the audited financials in particular, investors may not have the necessary granular detail to fully vet these types of expenses. Some of this may vary based on the domicile of the hedge fund itself. For example, the details of fund expenses including marketing costs such as printing are typically detailed more clearly under standards such as UK GAAP versus US GAAP.
So what is an investor to do? Well perhaps a good start would be to perform some actual operational due diligence (ODD). Even better, how about ODD both prior to investing and ongoing operational due diligence after an allocation has been made? Joking aside, ODD can help investors become informed about how funds approach expenses in general. With this general understanding in place, investors can then dive into areas such as audited financial statements and conduct interviews with fund personnel regarding the types of fees charged to funds.
Of course, this initial ODD is not a guarantee that a hedge fund will not deviate from seemingly reasonable expense policies and begin charging expenses such as private jet flights, entertainment and salaries to fund. This is where ongoing monitoring comes in. To be clear, an investor performing ongoing ODD monitoring may not even be able to detect such expenses before they occur, but they are increasing the likelihood of being more informed about such changes once they happen. Whether or not an investor agrees with such lavish expenses being charged to the funds in which they invest, and likely most don’t and for good reason, ODD can help to ensure that investors are more informed about the expense policies of the hedge funds in which they invest. Articles such as the above referenced Financial Times article are good reminders of the need to conduct ongoing monitoring of funds in these areas, otherwise investors may end up paying for more than they bargained for.