Culture: Hiding in plain sight – Part one

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.