Culture: Hiding in plain sight – Part two
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 2: Governance and compliance
In Part 1 of this series, we introduced the concept of examining culture when performing hedge fund due diligence and looked at the challenges of defining and observing it. This second article demonstrates how a manager’s culture can be interpreted through a review of their governance and compliance arrangements.
Some of the most useful barometers of culture are portrayed through a manager’s governance framework. These can include the structure, composition and mandates of committees, the delegation of authority across the business, and a fund’s fiduciary arrangements.
Committee composition and mandates
Committees that comprise a broad cross-section of staff are more likely to be able to draw upon different experience and knowledge from across the firm. The involvement of various employees from different teams will also facilitate knowledge transfer and individual empowerment. Clearly defined, wide-reaching mandates, which bestow meaningful authority onto committees, demonstrate the extent to which the principals are open to their decisions being challenged. We would consider a manager to have fostered a collaborative culture with a committee structure such as this.
Delegation of authority
Delegation of authority indicates trust. We assess whether control is retained by one or two individuals in a centralised hierarchy, or is instead delegated to teams across the business. We typically see the former in firms that have recently launched, though this is perhaps not surprising given the need to “get things right” when starting up. In this case, we would expect the principals to delegate more authority to their team as the business grows in size and complexity. If they do not delegate, can we really expect the larger and more complex business to be as effectively managed? And if the principals do not trust their staff to make decisions, why should we as investors have faith in them either?
At a fund level, the choice and ongoing involvement of independent directors indicates whether a manager intends to be meaningfully held to account. This is because they may just be seen as a hoop to jump through to facilitate investment from institutional groups. It is a red line of Aurum’s that all funds must have independent representation, ideally a majority. However, we also question our managers as to the rationale of certain independent director appointments. We evaluate what involvement directors have with the fund, what questions they ask, and when they have pushed back against decisions. The choice of directors reflects the maturity of a manager’s culture. It demonstrates whether or not a manager wishes to leverage experienced and knowledgeable professionals who will both provide advice and challenge decision making for the benefit of the fund’s investors.
The priority assigned to compliance by the principals shows us the extent to which regulatory responsibilities, as well as the implications of non-compliance, are understood. This is where Handy’s “the way we do things around here” definition of culture, mentioned in Part 1 of this series, is actually very apt. Generally speaking, we anticipate that employees will adopt the same view of compliance as those running the business. The tone from the top is therefore critical: it is the type of culture engendered within an organisation that determines the importance attached to compliance by employees. This culture is reflected in the composition, seniority and reach of the compliance function as well as the control it can exercise over the investment process. We can also interpret culture by looking at past regulatory action against the firm, funds or employees, along with the response to such action.
Composition and seniority
The composition and seniority of the compliance function will naturally be dependent on a firm’s size. It is not unusual amongst smaller firms, particularly those in start-up mode, for a senior manager, such as the Chief Operating Officer, to multi-hat as Chief Compliance Officer in order to manage costs and workloads. Managers growing in assets under management and/or moving to a multi-PM model are expected to set up a standalone function which can cater for increased size and complexity.
If and when full-time compliance resources are hired, their seniority indicates the importance placed on the function. If hires are more junior in nature, we may question whether they can really be expected to push back against more senior members of staff. Alternatively, we could surmise that certain hires, regardless of seniority, have been made on the basis that they aren’t “table thumpers”, and won’t make life difficult for the investment team.
Compliance consultants may also be engaged to strengthen the function rather than staff being added to the payroll. Whilst consultants may not be as deeply ingrained in the business as full time employees, they bring with them expertise and experience built through working with a breadth of clients. They also feedback timely information and advice to their client base, which can help managers prepare for upcoming regulatory changes. Compliance consultants can be highly useful partners and they demonstrate a manager’s desire to stay abreast of developments in the regulatory landscape.
Reach and authority
A firm’s compliance framework will be strategy dependent, with the likes of discretionary equity long/short managers requiring stronger controls to prevent insider dealing, for example. Regardless of strategy, the compliance framework’s design demonstrates the reach that the function has over the business. If its remit is narrow, this could reflect the principals’ desire to limit interference with the investment process.
It is important to understand the tools that compliance have at their disposal, for example software to aid trade and communications surveillance. These tools broaden the function’s reach, providing a better view of what is happening within the business, making it easier to identify potentially suspicious activity.
Compliance staff will ideally have appropriate authority to, for example, chaperone research meetings, challenge trade rationale, or restrict trading in certain names. This is an indication that the principals have fostered a culture that appreciates the need for such a regime and duly accepts the function’s authority.
We attempt to understand whether investment staff approach the compliance function with questions, concerns or for guidance in carrying out their roles. How much this is done is similarly strategy dependent. However, a manager whose compliance team do not interact with investment staff either shows a lack of desire to involve compliance in the investment process, or alternatively a lack of respect for the function’s knowledge and experience.
When performing our research we always ask managers to walk us through the past interactions they have had with their regulators. These interactions may include routine or unannounced inspections and examinations, fines or sanctions. In theory, any of these could present an insurmountable red flag to investors such as Aurum, because they could imply a poor compliance culture.
It is not always that simple. If a firm has undergone a regulatory event, it does not necessarily mean that its attitude towards regulation is lacking. In larger firms, for example, it becomes harder to keep tabs on every employee. The risk of “bad apples” is unavoidable, no matter how strict pre-employment background checks and surveillance programmes are. As such, regulatory events are not always indicative of a firm’s compliance culture as a whole and, particularly in the case of larger firms, arguably come with the territory.
A more important demonstration of culture, and indeed tone from the top, is how firms respond to regulatory events. Do they refuse to change, or do they accept previous failings and take drastic action to overhaul working practices? We have seen world class compliance functions being put in place in response to regulatory events, something we look highly favourably on as investors. We approach regulatory events against a manager on a case by case basis. We discuss any that do arise at length, understanding the nature of the event and whether any action was taken to prevent reoccurrence. Whilst in some instances it can be, past performance is not necessarily an indicator of future bad form.
At Aurum we believe that a hedge fund’s governance and compliance frameworks are strong indicators of manager culture. However, there are other key lenses we can use to interpret it. In the next article we will explore hedge fund culture through the perspectives of employees and fund investors.
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