Insight

Culture: Hiding in plain sight – Part one

Lawrence Davis | Analyst
22/10/2019
4 min read
Download Article

Although a subjective concept, culture hides in plain sight and is readily observable if you know how to look. In a series of short pieces, Lawrence Davis, an Analyst on Aurum Research’s Operational Due Diligence team, explains the importance of a hedge fund manager’s culture to investors, the problems in defining and quantifying it, and how we overcome these problems to interpret it during due diligence.

Part 1: An introduction

As an analyst on Aurum Research’s Operational Due Diligence (“ODD”) team, it is one of my responsibilities to form an opinion as to how a hedge fund manager has built their business, identifying red flags that would prevent an Aurum fund investing safely with them.

We believe that the type of culture engendered by a manager is a key bellwether as to how we can expect investor capital to be safeguarded. It can be the underlying cause of major operational risk events, therefore must be taken into consideration when we perform due diligence.

The problem is that culture as a concept can mean different things to different people. This makes it difficult to define and quantify: one cannot pick apart and assess a manager’s culture the same way as a fund’s performance or annualised volatility. It is therefore arguably harder to form an opinion on, and is perhaps something more easily overlooked.

But why should a firm’s culture prevent investment into a hedge fund? If a fund is performing and otherwise passes due diligence, then should cultural observations warrant a second thought? For that matter, how does one even define or measure “culture”?

This is the first in a series of short articles that will attempt to explain the importance of a hedge fund manager’s culture to investors, the problems in defining and quantifying it, and how we overcome these problems to interpret it during due diligence. Drilling down into five areas of a hedge fund business, specifically governance, risk management, compliance, employees and investors, we will demonstrate how a manager’s culture can be observed through various lenses, drawing upon real life examples that we have come across during our research.

Although a subjective concept, culture hides in plain sight and is readily observable if you know how to look.

What is culture?

Some might argue that culture is best defined as the general feel and atmosphere in the workplace, or the way that the principals manage different teams and are held accountable for their actions. Others may say it is a reflection of the extent to which family friendly, progressive policies have been introduced for employees, or perhaps a firm’s approach to looking after the environment and donating to charity. None of these would necessarily be wrong answers.

It appears that breadth and ambiguity have historically been the usual policy. If you’ve studied business or economics, sat certain exams or ever perused a corporate management book, you may have come across Charles Handy’s quite impressively vague definition of company culture as being “the way we do things around here”. Whilst the sentiment behind this is fair, we would not ask a manager “how they do things around here” during due diligence as we would likely be met with an answer equally as vague.

In our opinion, culture permeates all levels of a firm, and is reflected in every aspect of how it has been built and is being run by its principals. A firm’s culture can therefore be simply defined as the design of its policies and procedures and their application in the working environment.

Observing culture – An ODD perspective

Our research into a fund touches on a myriad of areas encompassing the terms underpinning the fund offering; the legal entity structure; the scope and standing of the manager’s compliance function; the breadth and effectiveness of their risk management framework; and the composition and remit of different teams; as well as the design and operation of several key systems and controls. ODD can essentially be viewed as a massive fact gathering exercise.

We produce an ODD report for each fund prior to investment and again as part of ongoing monitoring, the latter typically being performed on a six-monthly or annual basis. Our reports contain factual information about the non-investment risks inherent within a manager and its funds, and an evaluation of the controls put in place to reduce these risks to an acceptable level.

Our team retains the right to exercise a veto over any prospective investment recommendation, and any fund in which Aurum is already invested. We can, and do, exercise this right citing “poor culture”, because it may well be that a structural weakness, major control failing or other risk event has been wholly or in part caused by the type of working environment fostered by a manager. As such, we must opine on this subjective area in order to conclude whether any issues identified during due diligence are indicators of poor culture and, as a result, are more likely to reoccur in the future.

The problem

As ODD practitioners we spend a great deal of time interacting with senior business personnel during our research of prospective investments and monitoring of invested funds, but always from the position of outsiders. One would be forgiven for questioning whether we can actually form an opinion on culture because, apart from it being rather ambiguous as a concept, we are not sat in a manager’s office on a daily basis, observing policies in action, interpreting team dynamics and witnessing first-hand the impact of decisions.

The solution

However, we are able to interpret culture through several different lenses, each giving us an insight as to how a business is being run. As stated above, in our opinion the most telling markers of this are the approach to governance, risk management, compliance, employees, and investors. The means by which we can interpret culture through these areas, as well as good practice we have observed during our research, are set out in the remaining articles in this series which will be published over the coming months. The next article will look at the analysis of a firm’s culture through their governance and compliance frameworks.

On a final note, it is important to underline that each firm is different and that there is not a “one size fits all” approach to the application of sound cultural practices. Recently launched firms may not necessarily have a culture which is as clearly defined as larger ones, who are able to deploy significantly more resources to this effort and who have been able to build their culture over a longer period of time. Proportionality is key, and at Aurum we accept that culture can vary hugely based on a manager’s individual circumstances.

You may also like

Arbitrage deep dive – Oct 22

07/12/2022

The period under review includes ‘the worst cross asset selloff since 1981’ with simultaneous declines across equities, commodities, corporate and…

Monthly hedge fund performance review – October 2022

21/11/2022

Hedge fund performance was largely positive in October. Strategies with a higher beta to equities outperformed other strategies, as most equity markets…

Macro deep dive – Sep 22

28/10/2022

Macro funds generated an average return of 2.2% in the 12 months through September 2022. Strategy AUM has fallen by $11.1bn, due to net outflows of $16.3bn…

Aurum’s quarterly review – Q3 2022

25/10/2022

All of Aurum’s managed funds and bespoke accounts delivered positive returns in the third quarter of 2022. Performance for Aurum’s commingled fund…

Monthly hedge fund performance review – September 2022

18/10/2022

Hedge fund performance was mixed in September, whilst equities and bonds sold off, particularly in the latter part of the month. Hedge fund performance…

Quant deep dive – Aug 22

06/10/2022

Quant funds generated an average return of 12.8% in the 12 months to August 2022 Strategy AUM has grown by $42.8bn, net profits contributed $47.8bn of…

Monthly hedge fund performance review – August 2022

22/09/2022

Hedge fund performance was largely positive in August, whilst equities and bonds sold off, particularly in the latter part of the month. Hedge fund performance…

Monthly hedge fund performance review – July 2022

18/08/2022

Hedge fund performance was generally positive in July, albeit with some exceptions, with narrower dispersion than in June. Strategies with a higher beta…

Does structure matter? Hedge funds v alternative UCITS – H1 2022 update

08/08/2022

Earlier this year we wrote about the growing performance gap that has emerged between hedge funds and their alternative UCITS (“alt UCITS”) counterparts…

Hedge fund industry deep dive – H1 22

01/08/2022

Hedge fund performance was down 4.0% YTD. H1 2022 has been an extraordinarily challenging time period, not only for financial markets, but also for the…

Aurum’s quarterly review – Q2 2022

26/07/2022

All of Aurum’s managed funds and bespoke accounts delivered positive returns in the second quarter of 2022. Performance for Aurum’s commingled fund…

Why manager selection is critical when building a hedge fund portfolio

21/07/2022

Manager selection is critical when it comes to investing in hedge funds or fund of hedge funds. In the latter part of 2021, we did a short note looking…