Professional Documents
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April 2007
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Joel Levine
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This Moody's Special Report, dated April 13, 2007, is being republished as a Methodology.
The content of the publication has not been changed or updated.
Table of Contents
Page
Summary Opinion..................................................................................................................................... 3
Introduction .............................................................................................................................................. 3
The Hedge Fund Phenomenon .................................................................................................................. 3
Purpose and Focus........................................................................................................................................ 3
A Growth Sector within Asset Management ................................................................................................... 3
Increasingly, Part of the Establishment....................................................................................................... 5
Challenged by (and Contributing to) Markets Awash in Liquidity .................................................................... 5
Summary Opinion
As the scope and influence of some of the larger hedge funds grow, their organizational paradigm has steadily been
converging toward that of more established and diversified securities firms, not only in terms of infrastructure and risk
management, but even capital structure. There is now growing interest in accessing public capital markets for debt
and/or equity funding. In response, Moodys expects to rate the unsecured debt of some of these funds.
Despite some convergence, the orientation and structure of hedge funds remain materially different from those of
securities firms and asset managers, or even structured investment vehicles. Their unique characteristics lead to analytical challenges for those looking to assess their credit profiles, and generally work against high credit ratings. The
difference with the most significant implication for ratings is that the equity capital of a hedge fund is not permanent
equity investors can require the fund to redeem their investment, reducing the financial cushion providing support for
creditors. This put right held by equity investors can have an effect tantamount to subordinating unsecured creditors to the interests of equity investors.
Moodys analytic framework for rating hedge fund obligations rests on three pillars: Risk Management & Governance, Business Profile of the fund, and Financial Profile of the fund. Other qualitative considerations complement the
framework in order to create a structure flexible enough to handle the diverse universe of hedge funds. Integral to the Risk
Management & Governance pillar is an assessment of the operational quality of the hedge fund. Notably, in July 2006,
Moodys launched Operations Quality (OQ) ratings for hedge funds to specifically address this risk.
Given the growing interest among large hedge funds to introduce unsecured debt into their capital structures,
market participants have asked whether such issues could achieve an investment-grade rating from Moody's. Our view
is that investment-grade ratings are possible, although the typical structural and operational features of a hedge fund
make achieving one very challenging. Features consistent with an investment-grade rating (absent issue-specific covenants) involve diversification levels (strategy-, investment- and investor-), operational quality, redemption limits,
liquidity management, and other governance considerations.
Introduction
This report aims not only to present Moodys methodology for rating hedge fund unsecured debt, but also to put this
methodology in the context of the role hedge funds play in todays global capital markets, their development over time,
and how they continue to differ from other investment vehicles and institutions. The first half of this report therefore
lays out the groundwork for the methodology. We review the impressive growth and evolution of hedge funds, and
explore in detail the attributes that make them unique. We also look at hedge fund failures, which have been spectacular despite an appearance of success immediately before them. The failures have recurring themes, ranging from various types of fraud and inadequate operational controls, to lack of discipline in risk management and insufficient
liquidity. These failures help inform our approach to rating hedge fund obligations.
year-end 2006, with 5-year and 10-year CAGRs of about 12% and 8%, respectively1. Hedge funds are clearly a
growth sector within the asset management space.
10,000
1,200
8,000
1,000
6,000
800
600
4,000
400
2,000
Assets in US $Billions
12,000
200
0
19
50
19
71
19
87
19
93
19
95
19
97
19
99
20
01
20
03
20
05
20
07
17
18
19
20
Firm/Fund Name
Goldman Sachs Asset Management (New York, NY)
Bridgewater Associates (Westport, CT)
D.E. Shaw Group (New York, NY)
Farallon Capital Management (San Francisco, CA)
Barclays Global Investors (London, UK)
Och-Ziff Capital Management Group (New York, NY)
JP Morgan Chase (New York, NY)
ESL Investments (Greenwich, CT)
Cerberus Capital Mgmt (New York, NY)
Caxton Associates (New York, NY)
Campbell & Co. (Towson, MD)
Tudor Investment Corp. (Greenwich, CT)
Maverick Capital (Dallas, TX)
Citadel Investment Group (Chicago, IL)
Perry Capital (New York, NY)
Renaissance Technologies (New York, NY)
Highbridge Capital Mgmt (New York, NY)
Wellington Mgmt (Boston, MA)
Atticus Capital (New York, NY)
Moore Capital Management (New York, NY)
1.
Investment Company Institute, Trends in Mutual Fund Investing, December 2006, and 2006 ICI Fact Book
Assets under
Management ($B)
29.5
28.0
23.2
18.1
17.0
17.0
16.8
15.5
15.0
13.9
13.8
13.6
13.0
12.1
12.1
12.1
12.0
11.9
11.3
10.2
The managers of larger hedge funds view access to longer-term sources of liquidity as a solution to creating more
robust businesses. Recently, hedge fund manager Citadel issued non-recourse (to the manager) debt -- through a
wholly-owned subsidiary of the hedge funds that it manages -- which was supported entirely by the assets of those
hedge funds, the first fund debt issuance of its kind. The primary purpose of the financing was to acquire a new source
of long-term capital to help manage the capital and liquidity needs of the funds' balance sheets and businesses.
Moody's believes that the desire for "longer-term, lower-cost" capital at the fund level that is not subject to discretionary investor redemption, and whose terms are locked-in for an extended term, is likely to generate interest in debt issuance at the hedge fund level, especially for the larger, more institutional-like hedge fund managers.
2.
For a glossary of the four primary securities laws that govern mutual funds, and which hedge funds are largely exempt by design, please refer to Appendix 2. On
December 26, 2006, the SEC proposed to expressly extend its antifraud authority under the Investment Advisers Act of 1940 to registered and unregistered investment advisers conduct relating to investors and proposed investors in pooled investment vehicles, which would effectively bring hedge funds under its oversight.
A securities firms sophisticated, institutional risk management discipline with independent reporting lines
is also applied to its proprietary trading
Rigorous internal controls, a strong compliance function, advanced trading infrastructure, etc., are
deployed in the proprietary trading operations
Proprietary trading utilizes only a portion of the capital of the enterprise, and trading losses could be offset
with capital contributions from the overall resources of the firm
Equity raised by a securities firm is permanent, and not subject to redemption as with a standalone hedge
fund. A securities firm could withdraw capital from proprietary trading under market stress or other circumstances, but would still have access to the capital of the enterprise in order to honor all of its counterparty obligations
Moody's views proprietary trading as one of the riskiest aspects of a securities firm's business (see Global Securities Industry Methodology, December 2006)3; it is also difficult to isolate the exact contribution from proprietary trading. However, the presence of other business lines (such as processing and asset management) will boost the credit
quality of a securities firm and help to lift its overall rating.
CAPITAL STRUCTURE
Equity Capital Features
Typically, a hedge funds capital structure consists primarily of equity capital contributed by investors who are
approved by the hedge fund manager, such as: high net worth individuals; institutions such as pension plans, foundations, endowment funds, insurance companies, etc; or fund-of-funds managers, who manage funds that invest in other
hedge funds. Equity capital is subject to a minimum lockup period, during which the investor cannot redeem any portion of his investment in the fund. Lockup periods typically range from being as short as one month to as long as several years, and within a given hedge fund there may be a distribution of investors across different lockup periods
creating a capital ladder that effectively defines the potential profile of its investor redemptions.
An additional layer of equity capital may be contributed by the hedge fund principals in the form of deferred manager compensation; this compensation typically follows a set schedule such as 2% of capital plus 20% of portfolio
3.
4.
A striking example of exposure to operational risk and risk management error related to proprietary trading was the rapid failure of Baring Brothers in 1995. A junior
trader, Nick Leeson, operated on the other side of the globe from Barings' London headquarters. Leeson was able to stray from simple futures arbitrage and build up
massive directional positions even selling options as a way of generating financing. Adverse market moves triggered massive variation margin calls that eventually
sunk the venerable firm.
Please refer to Moodys Rating Methodology: The Moodys Capital Model, Version 1.0, January 2004, for more information about SIVs.
returns above a high water mark. Hedge fund managers may contractually defer the receipt of their fees by keeping
them invested in the hedge fund for a mandatory period of up to five years, which acts the same way as a lock-out
period, and which may be subject to an additional subsequent deferral period. In some hedge funds, the amount
deferred may represent a significant portion of the total equity capital.
The capital structure of a hedge fund is very different from that of a typical financial institution because of the
impermanence of its equity capital. Absent any protective covenant, unsecured creditors are exposed to the risk that
equity investors can redeem their investment in the fund and get paid out prior to the debt being paid off. Under a
stress scenario, investors might all head for the exit door, and with potentially depressed asset values, the fund could
find itself with barely sufficient assets remaining after investor redemptions to pay off the outstanding debt, with exposure to further losses in asset value ongoing. Many funds have provisions that act as brakes on investor redemptions,
such as: (1) a notice period that typically ranges from one to six months, prior to withdrawing funds, (2) penalties on
redemptions in excess of a specified amount, (3) "gates" that limit the total amount that may be redeemed at any one
time, and (4) discretionary (by the hedge fund manager) suspension of investor redemptions. We would expect these
provisions to buffer unsecured creditors if judiciously deployed.
5.
6.
An NAV trigger is a provision that takes effect if the net asset value (NAV) of the fund declines by a specified percentage. The NAV may decline because of a combination of negative portfolio performance and investor redemptions.
The risk remains that an adverse market move could cause the value of the collateral to be insufficient to protect the counterparty from loss should the hedge fund
default before a transaction can be terminated, and the lender would then have an unsecured claim on the funds assets for any residual amount.
Year of
Failure or
Wind-up
1994
1998
2000
2000
2000
2002
2002
2005
2005
2005
2005
2006
2006
2006
Liquidity, leverage
Liquidity, concentration
Concentration, leverage
Alleged Fraud
Alleged Fraud
Alleged Fraud
Alleged Fraud
Alleged Fraud
Investment performance, leverage
Concentration, leverage
Investment performance, leverage
Concentration, liquidity
Concentration
Operational error
Granite Fund
LTCM
Tiger Funds
Maricopa funds
Manhattan Fund
Lipper Convertible Fund
Beacon Hill Asset Management
Bayou Hedge Funds
Bailey Coates Cromwell Fund
Marin Capital
Aman Capital
Amaranth Advisors
MotherRock LP
Archeus Capital
*Based on Moody's review of published accounts in the press
Understanding and Mitigating Operational Risk in Hedge Fund Investments, A Capco White Paper, March 2003
tion because of its ballooning size -- relative to the total outstanding market -- and its lenders threatened to cut off its
credit. Ultimately, the fund was forced to sell its energy book at a loss. Similar to Amaranth's experience, MotherRock
LP decided last year to wind down its fund after its bets on natural gas resulted in large losses as the spread between
contracts expiring at different dates went against the fund.
Amaranths failure illustrates the second main mortal danger for hedge funds after fraud or operational failure: a
quick loss of liquidity due to a market event. In the loss of liquidity scenario, the cycle starts with a large concentration
in one or a series of related risk factors (in the case of Amaranth, it was natural gas futures). As prices move against the
position, two things happen: (i) other traders in the market get market intelligence on the situation and start betting
against the fund and (ii) prime brokers and derivatives counterparties ask for more collateral against the trade and/or
change the terms of financing (and eventually start liquidating the positions). Once the cycle has started it becomes
very difficult for the fund to finance itself.
Moodys is aware that the asymmetry in a hedge fund managers compensation structure and/or the managers
strong desire to wipe out previous trading losses may become incentives to build concentrated positions. The management of a funds liquidity is thus one of its most critical functions, because lack of liquidity can bring down an otherwise
solvent fund. We understand that Amaranth was able to meet its obligations, but not without having to conduct a virtual fire-sale of its assets, and effectively going out of business.
In another infamous case back in 1998, Long Term Capital Managements (LTCM) fund had to be rescued with
an extraordinary $4.3 billion capital infusion from a consortium of its creditors, to bolster a colossal shortfall in capital
and liquidity. In LTCMs case, the loss of liquidity stemmed in large part from a lack of recognition that many seemingly unrelated markets could become closely correlated under a severe stress scenario, such as was the case during the
Russian government bond default in the summer of 1998. At the time, investor appetite for risk was collapsing across
all markets, sending credit spreads spiraling upward, increasing implied volatility in most markets, and causing US
treasury rates to plummet from a widespread flight to quality.
As investors across the global markets all tried to raise liquidity at the same time, there were few bids on many of
the funds positions, which tended to be investments that were then out of favor; its lack of liquidity was compounded
by the massive size of its positions owing to the extreme leverage that had been applied. Margin calls, increased haircuts on borrowings, mark-to-market losses that required more collateral, etc, all conspired to create a large liquidity
gap at the fund. Ultimately, after the fund was rescued, many of the losses reversed and numerous trades subsequently
became profitable. However, as John Keynes famously quipped, Markets can remain irrational longer than you can
remain solvent. Unfortunately for LTCMs investors, the manager underestimated the length of time it could take for
so-called convergence trades (e.g., basis between cash and futures markets) and reversion to the mean trades to snap
back to normal.
10
Other Considerations
Legal Structure and Debt Covenants
Market Considerations
Manager Equity Participation in Fund
Manager-Related Considerations Beyond Operations Quality
11
Operational Environment
As highlighted previously, one common reason for hedge fund failures is a lack of operational focus. Hedge funds are
typically founded by former traders who used to rely on the infrastructure provided by a large firm (either an investment bank, a bank or a fund manager). As competent as they may be in identifying and executing winning trades, these
traders do not typically master the supportive tasks inherent in securities operations such as settlement, clearing and
booking. Rapid business growth and changes in trading strategies can quickly compound the complexity of these tasks.
All hedge funds eventually need back-office, trade administration and valuation services, an organizational structure, a
technological infrastructure, legal, audit and accounting services, trade reconciliation, etc. Operational functions must
be sophisticated enough to handle the business with adequate controls. Many of these risks are not inherently quantitative and must be approached in the context of the fund's strategy and complexity.
In its assessment, Moodys focuses on the following operational areas:
Valuation process
Accounting controls
Regulatory compliance
Risk reporting and control
Legal and financial structure
Human resources (including key-man risk)
Systems infrastructure
In addition, special attention is paid to the role played by key service providers such as administrators, auditors and
prime brokers.
In July 2006, Moodys launched Operations Quality (OQ) ratings for hedge funds9. The rating levels range from
OQ1 to OQ5, with OQ1 at the top of the scale. The OQ rating is the result of an in-depth assessment of the categories highlighted above. The rating process also includes periodic on-site visits, additional communications with the
fund and its service providers, and background checks of key personnel.
Rating Level
OQ1: Excellent
OQ3: Good
OQ4: Fair
OQ5: Poor
8.
9.
12
OQ Rating Description
Funds at this level must have a very strong valuation process tailored to their investment strategy. Operations policies
and procedures are extensively documented, precisely executed and strongly enforced. All key service providers are
judged to be independent of the fund, highly proficient and well-qualified. Compliance risk is judged to be minimal.
The investment managers internal risk reporting and control is independent of portfolio management, comprehensive
and appropriate to the strategy. Background checks revealed no unresolved issues of concern.
Funds at this level have a strong valuation process appropriate for their investment strategy. Operations policies and
procedures are well documented, well executed and enforced. All key service providers are judged to be
independent of the fund, proficient in their contracted areas of responsibility and well-qualified. Compliance risk is
judged to be low. The investment managers internal risk reporting and control is independent of portfolio
management and appropriate to the strategy. Background checks revealed no unresolved issues of concern.
Funds at this level have sound operations throughout and a valuation process that is credible given their investment
strategy. Key service providers are judged to be of generally good quality and not dependent on the fund in any
discernable way. Compliance risk is not judged to be high. The investment manager has an internal process to
systematically report and control risk. Background checks revealed no unresolved issues of concern.
The valuation process of funds at this level is adequate but may have some deficiencies. Key service providers are
judged to be of generally acceptable quality and are not dependent of the fund in any obvious way. Compliance risk
may be moderately high. The investment managers internal risk reporting may lack independence or may not be
practiced systematically. Background checks revealed no unresolved issues of concern.
Funds at this level may have an inadequate valuation process. Some key service providers could be of low quality
and/or dependent of the fund. Compliance risk may be high. Risk reporting may be lacking or absent. Background
checks could have revealed unresolved issues of concern.
An operations assessment of the fund by Moodys is an integral input to the overall debt rating process. Generally
speaking, we would expect an operations assessment of Excellent (as defined above) for an investment grade debt rating.
Risk Appetite
Portfolio Risk
At a high level, the risk philosophy plays a very important role in the strategic alignment of the firms risk appetite with
its return objectives. Moodys emphasizes the importance of a framework to manage the total risk appetite of the fund
with a waterfall system of limits to manage and monitor the risk of the portfolios and the strategies on an ongoing
basis. Among financial institutions, the Value at Risk (VaR) calculation has become an integral tool for market risk
measurement. Other statistical measures such as expected shortfall10 are better estimators of the tail risks than VaR.
Although, we recognize the various limitations of VaR as a risk measure, Moodys believes that all funds should have
some form of aggregated portfolio risk measure. Moodys assesses risk at the portfolio level, business unit level (based
on the organizational structure of the hedge fund), strategy level, and concentration risk at the asset class level.
Willingness to assume concentration risk is another important dimension of a funds risk appetite. The funds discipline (or lack thereof) with respect to limiting the size of individual bets underlies this risk, and the proportion of the
top five holdings as a percentage of NAV of the fund is a good indicator of concentration risk. In addition, Moodys
performs a review of the portfolio at the fund level, strategy level, etc. from a profit-and-loss point of view in order to
gain an understanding of the sources of returns and relate them back to the risk measures. A combination of the risk
measures and source of returns provides a comprehensive sense of the risk/return profile of the fund, and helps
Moodys assess its overall performance.
The real test of a fund's risk management is how it responds to a stress situation. Stress tests measure the sensitivities of a portfolio to large changes in risk factors. All funds must perform periodic analyses of the impact of stress scenarios on the expected returns as well as on the liquidity of the portfolio. Moody's focuses on the structure of the
assumptions made in the evaluation of the event impact as stress situations tend to change the relationships between
risk factors (correlations break down), and create a different environment for decision making (behavioral shifts).
Stress analysis should be done at the portfolio level as well as strategy level. Funds should also consider multiple types
of scenario analyses such as historical stresses (for instance, the credit spread blowout of the fall of 1998) and hypothetical scenarios (such as a decline in real estate values of 30%). Moody's analysis emphasizes the importance of the performance of a fund during past historical stress events. A close analysis of historical returns can help explain whether
the fund was quick to take action to minimize losses under stress situations.
Moodys does not rely on any single metric to compare the level of risk between hedge funds. However, we
believe that best practice risk management frameworks include a common currency for measuring risks across businesses, which can be used to aid risk-adjusted decision-making. This common currency is typically economic capital.
Economic capital can be calculated using a number of methodologies. Moodys views a simulation approach that
incorporates stress tests and scenario analyses and relates these to a given confidence level, as best practice. A sound
economic capital process provides a very powerful framework for the consistent management of both strategy-level
and portfolio-level risks.
Performance Volatility
Hedge fund managers are usually compensated with both fixed and performance-based fees, which may encourage
asset gathering behavior or induce excessive risk-taking. At the same time, the imposition of investor lockup periods,
redemption fees, etc., which limit investor liquidity, affect the fund managers ability/willingness to assume liquidity
and other risks in the fund. Given the complex dynamics between all the contractual features, it is difficult to predict
the likely future return volatility of a fund. Therefore, an examination of a funds largest historical drawdowns (i.e.,
peak to trough drop in NAV of the hedge fund, which represents the cumulative worst loss over the period being measured) together with the length of time it took the fund to recover, is one of the best methods to get a handle on performance volatility. Moodys also focuses on trailing volatility over five-year time periods and over historical stress
periods.
10. Expected shortfall, at a given confidence level, is the average amount of losses expected to be realized assuming that a loss occurs at or above the specified confidence level. Thus, expected shortfall provides insight into the distribution of losses in the tail as opposed to just indicating what the maximum loss amount is for a
given confidence level.
13
BUSINESS PROFILE
The Business Profile pillar examines the strength and sustainability of the franchise, viewed at the fund level. This is
important to the creditworthiness of hedge fund debt since the ability of the fund to retain capital and remain viable is
necessary to protect creditors from the inevitable portfolio losses that will result from both expected and unexpected
volatility from shocks to the capital markets.
Investor Profile
One key rating factor is the investor profile of the fund. Typical investors in hedge funds include high net worth individuals; family offices; pension funds; endowments and foundations; financial institutions such as insurance companies
and investment banks, etc.; and FOF managers. Some investors tend to take a longer term view of their investment in
hedge funds, while others invest on a more opportunistic basis; the greater the stickiness or patience of the investors in the fund, the greater the stability of its equity capital.
Generally speaking, we consider family offices and certain types of high net worth individuals (HNW) to be the
more permanent investors, with institutional investors tending to be somewhat less patient, and FOF managers tending to be the least patient, although there can be exceptions. Of particular concern are those investors that come into
the fund through externally managed structures that use leverage. In those cases, there may be automatic redemptions
when the fund experiences losses, or if other funds the externally managed structure invests in suffer losses, which
would tend to exacerbate risk from a creditor's perspective. Moody's looks at the fund's concentration in the less
patient type of investors as an indicator of the stability of the fund's capital. In addition, Moody's looks at the length of
time that each type of investor has been invested in the fund as another indicator of capital stability.
Another important consideration for the investor profile is the diversification among external investors (by nature,
internal investors i.e., key fund principals may represent a large proportion of total equity). The presence of any
large concentrations by investor is in general a credit negative, since the withdrawal of a single large investor can be
very disruptive and devastating to a manager and the fund. Diversification of investor by geography also improves the
overall stability of the equity capital.
Investment Performance
Investment performance, of course, is vital to attracting and retaining equity capital in a fund. Moody's examines the
investment performance of a fund relative to its "style" using hedge fund indices. This can be very challenging, especially for a multi-strategy fund that has the ability to rapidly change its investment mix. Metrics such as the Sharpe
ratio and Sortino ratio can be useful in comparing risk-adjusted returns of funds in similar strategies11. Performance
outliers, either negative or positive, generally bear further investigation to determine whether the manager is adhering
to his articulated investment strategy and/or risk appetite. Performance attribution analysis by the manager can be
helpful in understanding how the fund is generating its returns and whether they are consistent with the fund's stated
strategy. Trends can be particularly important in discerning style drift, which can be an indicator of a manager moving
away from his area of competency or over-reaching on risk exposure.
Diversification
Diversification by investment strategy is another key driver in the Business Profile pillar. Multi-strategy funds that are
reasonably balanced across strategies will tend to have lower volatility and risk of extreme loss, all else being equal,
than single strategy funds. Exposure to different asset classes and well balanced risk exposures (e.g., large cap, interest
rates, commodities, credit spreads, equity volatility, etc.) will tend to produce lower overall fund volatility than funds
that rely on a small number of strategies or sectors to produce alpha12. Not confined to a particular strategy or to a
sector falling out of favor, managers that have the ability to move in and out of different sectors and risk exposures will
be better positioned to avoid large exposures to market bubble bursts and other shocks. Being a multi-strategy fund or
having excellent diversification is one of the key positive differentiators between investment grade and non-investment
grade hedge funds.
Correlation of the hedge funds returns with traditional market sectors (e.g., small cap, value, interest rates, etc.)
may be an indicator of a consistent long or short market bias, which can ultimately result in unexpected volatility and
lead to investor disapproval. Also, hedge funds that tend to be less correlated with other hedge funds provide greater
diversification benefits to equity investors and therefore tend to be more highly valued by them and have greater
investor commitment.
11. These ratios have their limitations, such as failing to capture optionality (e.g., non-linear returns caused by options positions) in the fund, and they may need adjustment for serial correlation of fund returns because of illiquidity or smoothing in the fund's valuation, which dampen the fund's underlying volatility.
12. Alpha measures the extra return that a fund generates above the market level return. It represents the benefit of active investing vs. passive index investing.
14
Size
Size -- in terms of net asset value (NAV) -- of the fund is also a consideration, but primarily in terms of the fund being
large enough to support a robust infrastructure of risk management, compliance, controls, technology, etc. These
considerations are related to the Risk Management & Governance pillar, so we will not discuss them here. In fact,
depending on a funds investment strategies, being too large can become a disadvantage because of liquidity concerns
and the market impact of trading by a fund with large market positions.
FINANCIAL PROFILE
To assess the financial profile of a hedge fund, Moodys examines the following elements of a funds portfolio:
Asset and funding liquidity13
Overall asset quality and risk
Leverage and capital adequacy
Interest coverage
15
Highly-liquid collateral is defined as those securities which can be sold or pledged immediately with no market
impact. Liquid collateral is those securities which can be sold or pledged within one week with no market impact.
Some hedge funds utilize a "side pocket" to facilitate the acquisition of illiquid and/or difficult-to-value assets and support the liquidity management of the fund. New investors in the hedge fund do not share in the investment performance of the existing asset in a side pocket, and when equity investors who do share in the performance of the side
pocket asset redeem their interest in the fund, they receive part of their net asset value in the form of a claim on the
future liquidation value of the side pocket asset. Thus, the lack of liquidity of the side pocket asset is offset by the
deferral of the payment of cash to the redeeming investors until it is actually realized by the fund. The presence of side
pocket assets and their terms and conditions can be an important element in the analysis of the fund's liquidity and valuation.
This stress test creates a comprehensive picture of the sources and uses of fund liquidity from the onset of the crisis through the first 90 days and identifies periods within those 90 days where liquidity may be tight. By rolling the test
forward to a year, it acts as a "bridge" to the cash capital test. To achieve an investment grade rating, a fund must be
able to survive this scenario and continue to operate as a going concern.
Interest Coverage
Hedge funds, and other financial institutions that operate in a mark-to-market regime, can often rely on sales of liquid
assets to repay debt obligations. Therefore, depending on the liquidity profile of the underlying investment strategies
16
of a hedge fund, interest coverage ratios may be a secondary consideration when assessing credit quality of highly liquid strategies. However, for those strategies that don't generate as much liquidity, we monitor the ratio defined as:
realized returns less fund operating expenses divided by debt interest expense. This ratio backs out fair value gains and
losses and provides some insight into the ability of the fund's strategies to generate sufficient cash returns to cover
interest expense without requiring asset sales, i.e., that the fund can cover its cost of carry. Generally, we will seek to
"normalize" the numerator of the interest coverage ratio to adjust for non-recurring items, and we will consider the
potential for volatility in the ratio induced by the underlying investment strategies and risk management.
OTHER CONSIDERATIONS
The factors included in the remaining section of Moodys rating framework fall under our very broadly labeled other
considerations. These less-quantifiable factors can be virtually unlimited in scope, but commonly will involve:
The issuance structure (legal organization and indenture specifics)
Market considerations for the funds strategy
The amount of wealth the principals have invested in the fund
Any other unique manager qualities and circumstances
While not anticipated to be major rating drivers, these considerations still have the potential to move a hedge fund
rating significantly from the issuer rating indicated simply by the three pillar analysis alone. They can be viewed in
terms of either rating positives or negatives measured in "notches" above or below the issuer rating. Structural subordination and covenant packages are the factors most likely to have a sway on a rating outcome.
We discuss the more common other considerations below.
Market Considerations
Fund managers will, of course, be dealing in markets that will experience times of great stress, lack of liquidity, or even
complete collapse. Depending on the managers chosen strategies and asset classes, the potential for a market to experience stress may also impact our rating evaluation. Generally speaking, if the funds key markets are experiencing a
spike in volatility and/or lack of liquidity, etc., rating pressure should be expected.
17
nificant amount of personal wealth tied up in the equity of a hedge fund may create an incentive for the principals to
take excessive risk in the fund, which would not be in the best interests of unsecured creditors. Moodys believes that
principals who defer their compensation and invest it in the equity of the hedge fund subject to long-term lockups
would tend to be better aligned with creditors interests, and we would view that type of manager investment as a positive rating factor.
18
Related Research
Rating Methodology:
Global Securities Industry Methodology, December 2006 (101401)
Special Report:
Moody's Approach to Evaluating and Assigning Operations Quality Ratings to Hedge Funds, October 2006
(SF77845)
To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report
and that more recent reports may be available. All research may not be available to all clients.
19
Appendix 1
GLOSSARY OF HEDGE FUND STYLES14
Convertible Arbitrage
This strategy is identified by hedge investing in the convertible securities of a company. A typical investment is to be
long the convertible bond and short the common stock of the same company. Positions are designed to generate profits from the fixed income security as well as the short sale of stock, while protecting principal from market moves.
Emerging Markets
This strategy involves equity or fixed income investing in emerging markets around the world. Because many emerging markets do not allow short selling, nor offer viable futures or other derivative products with which to hedge,
emerging market investing often employs a long-only strategy.
Event-Driven
This strategy is defined as equity-oriented investing designed to capture price movement generated by an anticipated
corporate event. There are four popular sub-categories in event-driven strategies: risk arbitrage, distressed securities,
Regulation D and high yield investing.
Risk Arbitrage: Specialists invest simultaneously in long and short positions in both companies involved in a
merger or acquisition. Risk arbitrageurs are typically long the stock of the company being acquired and
short the stock of the acquirer. The principal risk is deal risk, should the deal fail to close.
Distressed Securities: Fund managers invest in the debt, equity or trade claims of companies in financial
distress and generally bankruptcy. The securities of companies in need of legal action or restructuring to
revive financial stability typically trade at substantial discounts to par value and thereby attract investments
when managers perceive a turn-around will materialize.
Regulation D, or Reg. D: This subset refers to investments in micro and small capitalization public companies that are raising money in private capital markets. Investments usually take the form of a convertible
security with an exercise price that floats or is subject to a look-back provision that insulates the investor
from a decline in the price of the underlying stock.
High Yield: Often called junk bonds, this subset refers to investing in low-graded fixed-income securities of
companies that show significant upside potential. Managers generally buy and hold high yield debt.
14. Source: Lipper HedgeWorld's Education Center, which follows Credit Suisse Tremont LLC's series of sub-indices
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Global Macro
Global macro managers carry long and short positions in any of the world's major capital or derivative markets. These
positions reflect their views on overall market direction as influenced by major economic trends and/or events. The
portfolios of these funds can include stocks, bonds, currencies, and commodities in the form of cash or derivatives
instruments. Most funds invest globally in both developed and emerging markets.
Long/Short Equity
This directional strategy involves equity-oriented investing on both the long and short sides of the market. The objective is not to be market neutral. Managers have the ability to shift from value to growth, from small to medium to
large capitalization stocks, and from a net long position to a net short position. Managers may use futures and options
to hedge. The focus may be regional, such as long/short US or European equity, or sector specific, such as long and
short technology or healthcare stocks. Long/short equity funds tend to build and hold portfolios that are substantially
more concentrated than those of traditional stock funds.
Managed Futures
This strategy invests in listed financial and commodity futures markets and currency markets around the world. The
managers are usually referred to as Commodity Trading Advisors, or CTAs. Trading disciplines are generally systematic or discretionary. Systematic traders tend to use price and market specific information (often technical) to make
trading decisions, while discretionary managers use a judgmental approach.
* See Moodys Approach to Rating Collateralized Funds of Hedge Fund Obligations, July 2003, for information on rating securitization of FOFs
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Appendix 2
Securities Laws Related to Mutual Funds
FOUR PRINCIPAL SECURITIES LAWS GOVERN INVESTMENT COMPANIES
The Investment Company Act of 1940
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Appendix 3
Uniqueness of a Fund of Funds (FOF)*
The risk management and governance of a FOF manager itself is only indirectly
related -- through its due diligence practices -- to that of the underlying hedge fund
managers and we would not have visibility into its constituent hedge funds. In addition, since the diversification of the FOF by manager serves to significantly reduce the
FOF's exposure to the impact of any single hedge fund manager, we consider the FOF
manager's performance on this pillar to be less important to the FOF's credit rating,
and would therefore reduce its weight and redistribute it to the other two pillars.
The investment performance risk profile of a FOF is likely to be better than that of a
single manager fund because of its diversification by both strategy and manager. Its
volatility is likely to be lower and, by construct, it is less exposed to the risk of style
drift.
Liquidity in a FOF must be managed solely with respect to its redemption rights in
each underlying hedge fund, which will typically have very limited investor liquidity,
unlike that of a single manager fund, which can look to the actual trade positions.
Diversification by hedge fund manager may provide some liquidity risk mitigation,
provided there's no systemic liquidity crisis.
Leverage in a FOF is primarily a function of the leverage employed in the underlying
hedge funds into which we will not have visibility. Diversification by manager largely
mitigates the risk of excessive leverage.
* See Moody's Approach to Rating Collateralized Funds of Hedge Fund Obligations, July 2003, for
information on rating securitization of FOFs
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Report Number: 102552
Author
Joel Levine
Judy Torre
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