The days when hedge fund managers gradually built assets under management one high net worth client at a time are long-gone. New firms have to hit the ground running with tens of millions in seeding capital just to be viable, and can see assets under management rocket with just a handful of institutional and fund-of-fund allocations.
Keeping the operational risk capital base up-to-speed with that growth is a challenge – which is why putting professional indemnity insurance in place to provide a quasi-capital injection when something goes wrong is becoming a standard for the industry. The fact that Basel II and the European Capital Requirements Directive, which came into force in January 2007, allow firms to use such insurance to offset some of that capital base makes it all the more attractive. What makes it all the more necessary is the increased inflow from pension funds: the big ones can afford to take you to court; their fiduciary responsibilities may mean they can’t afford not to.
Robert Kelly, managing partner of specialist hedge-fund insurance broker Baronsmead, saw the opportunity early. He set up in 2002 after a career in financial-lines insurance with Chubb and Lloyds, seeing in hedge funds’ lean, entrepreneurial culture a perfect niche for a tailored advisory service.
“They just want to get on and do their own thing, so they rely on good, dependable advice,” he says. “Since we started, the number of managers without professional indemnity insurance has dropped considerably. But many still don’t get legal advice on their insurance products. You’re paying a lot of money for a product which is potentially going to have to pay you millions of dollars, so spending time with your lawyer looking closely at the quality of cover is certainly something we recommend to clients.”
Although fewer than 20 insurers offer specialised hedge fund products, plenty will offer generic investment-management insurance recommended by brokers hitching on the hedge fund bandwagon. Go for what looks like the cheapest option and in fact, if brokers and underwriters do not understand the industry’s unusual risk profile, you can end up overpaying for the wrong cover.
Hedge fund managers have considerably less regulatory and litigation exposure than traditional asset managers. In the UK they are regulated by the UK Financial Services Authority – but their products are not. They cannot be sold direct to retail investors who are protected by the regulator, and therefore there is no statement or implication that the products are suitable for those buying them.
“A hedge fund manager simply produces a prospectus describing what they do, and the investor alone decides on suitability,” Mr Kelly observes. “As long as you do what you say you are going to do it’s difficult to find liability.”
In Europe, at least (Baronsmead’s clients are chiefly located in the UK, Channel Islands, Ireland and Switzerland), if an investment idea goes wrong, or the basis risk on a hedge blows up, or your strategy just happens to be rubbish, there is no recourse for the investor unless some egregious form of style drift, or breach of investment mandate or the duty of care, is involved.
“But if there’s low risk on the investment side, on the operational side, because of the volumes they trade hedge funds are statistically certain to have a trade error at some point,” says Mr Kelly. “We’ve seen significant trade error losses since we set up.”
This is where insurance needs to focus. Settlement backlogs in derivatives have the potential to become a litigation issue, says Mr Kelly, and directors with ultimate responsibility for the valuation of illiquid assets currently have “really tough decisions to make” affecting investors trading funds at what they take to be fair NAVs [net asset valuations].
As important, because they are the most likely to happen, are “fat-finger” errors: simply buying the wrong stock, the wrong number of shares, or the wrong type of instrument. The FSA has made it clear that those costs cannot be passed on to investors, and that it does not like contractual exclusion clauses.
For that reason, Mr Kelly expects to grow his client base, which already consists of some 70 management groups and hundreds of fund-only contracts. The AUM range of those clients starts at $25m, but Mr Kelly would like to see more start-ups thinking seriously about professional indemnity – after all, they are the ones most at-risk of operational failure.
