The Institutionalization of Hedge Funds and the Asymmetric Price of Reputation: Could Hedge Funds Be Spending Too Much To Prevent Fraud?

I. Introduction

Over the past decade, operating costs in the hedge fund industry have ballooned as the rate of new institutional investment in hedge funds has rapidly accelerated. These new institutional investors are demanding greater portfolio and  operational  transparency,  more  conscientious  compliance,  and  tighter internal controls.¹1.The Evolution of an Industry: 2012 KPMG/AIMA Global Hedge Fund Survey, KPMG Int’l (2012), http://www.kpmg.com/KY/en/IssuesAndInsights/ArticlesPublications/PublishingImages/the-evolution-of-an-industry.pdf; Hedge Fund Cost Survey, KPMG Int’l (Sept. 2008), http://www.kpmg.co.uk/pubs/109001.pdf; Global Hedge Fund and Investor Survey, Ernst & Young (2012), http://www.ey.com/Publication/vwLUAssets/Global-hedge-fund-and-investor-survey_2012/$FILE/CK0582_Global-HF-Survey-2012.pdf.

This correlation—between the institutionalization of hedge funds and their rising operating costs—can be explained by reference to the perverse incentives created by the prevailing principal-agent relationships of the industry. Because institutional investment managers put their reputations at risk through their investment decisions, they face higher “fraud costs” than the beneficiaries of the funds they manage (“retail investors”). They thus have an incentive to over-monitor their hedge fund investments in order to decrease the risk of fraud. The dramatic acceleration of institutional money entering the hedge fund industry has resulted in monitoring costs that are likely much higher than the real cost of fraud to ordinary retail investors. This inefficiency can be characterized as an agency cost of institutional investing.²2.For the classic treatment of how agency costs structure relationships within and between firms, see Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. of Fin. Econ. 305 (1976).

II. Agency Costs and Monitoring in the Hedge Fund Context

Agency relationships impose significant costs on the parties to a principal-agent arrangement. When a principal entrusts an agent with authority over the disposition of his assets, the risk that an agent will abuse that authority to the detriment of the principal imposes transaction costs on both parties. Even when low, the  mere  presence  of this risk  invites a  rational principal to  expend resources to monitor the agent. At the margins, if the cost of monitoring appears to exceed the surplus to be gained by the relationship, it may even dissuade  a  principal  from  entering  an  otherwise-positive-net-present-value relationship with a potential agent.  Both results are inefficient. The present structure of the hedge fund industry provides an interesting case study in how layering principal-agent relationships can result in further inefficiencies. As explained below, where principals in the first instance are in turn agents of a third party, monitoring costs themselves may be inefficiently inflated, constituting a further agency cost for the contracting parties.

In the hedge fund context, the primary risk that principals (investors) seek to avoid through monitoring is the risk of loss from fraud perpetrated by their agents (hedge fund managers).³3.Though the costs of other risks (e.g., bad investment decisions) are likely higher than the costs of fraud, these other risks are not targeted by investor monitoring since they cannot be reduced with more monitoring. It would make little financial sense for an investor to hire a hedge fund manager to monitor the soundness of his hedge fund manager’s investment decisions. Since the industry is very lightly regulated (largely by the common law principles of contract and fiduciary duty) investors in hedge funds bear the monitoring costs associated with their investments voluntarily—when these expenditures are lower than their fraud costs would be in the absence of monitoring.⁴4.Throughout this paper, “fraud costs” is used to mean the expected loss due to fraud in the absence of any monitoring (that is, the product of the probability of fraud and its cost in the event of its occurrence).

Monitoring in hedge funds is accomplished through in-house back-office personnel, in-house counsel, third-party custodians (often doubling as fund’s prime broker), third party administrators, and third-party auditors. The costs of monitoring the hedge fund manager are borne by the investors in the fund. These costs are charged as expenses of the fund and directly offset fund returns. None of these protections is required by statute or regulation; investors demand them and are willing to pay for them to reduce the risk of loss through fraud.

III. Recent Trends in Hedge Fund Growth: Bloated Monitoring and  Institutionalization

There is strong evidence that, in what has traditionally been an exceptionally lean industry, monitoring costs have risen sharply in the past five years. Furthermore, these rising costs have been linked to the increasing number of institutions investing in hedge funds. In its 2008 Hedge Fund Survey, KPMG found that “investors exert increasing influence on costs,” reporting that the proportion of costs spent on “corporate control” increases significantly when a fund manages mostly institutional money.⁵5.KPMG Int'l, supra note 1, at 4.  KPMG also reported that 80% of the funds it surveyed felt that investors were placing more emphasis on back and middle office functions—those aspects of fund management associated with monitoring. The costs of corporate control (which comprise  compliance,  legal,  finance,  risks,  secretarial  and  audit  fees,  but exclude fund administration) were estimated to constitute 18% of a fund’s total costs in 2008.⁶6.Ernst & Young, supra note 1, at 4.

These trends have clearly accelerated. In its 2012 survey, KPMG reported “dynamic growth” in the global hedge fund industry fueled mostly by “increased institutional investment [from] pension funds and university endowments,” noting that institutional investors now represent a clear majority of assets under management.⁷7.KPMG Int'l, supra note 1, at 4. An Ernst & Young survey of 50 of the largest global institutional investors revealed that the overwhelming majority of investors report that they would either maintain or increase their allocations to hedge funds in 2012.⁸8.Ernst & Young, supra note 1, at 5 (reporting that 87% of institutions surveyed will either maintain or increase allocations to hedge funds). Furthermore, in ranking their most important screening criteria in selecting hedge fund investments, these same investors continued to rank “risk management policies” above even “long-term investment performance.”⁹9.Id. at 8. Not surprisingly, the amount of time managers said they spent handling due diligence inquiries from investors doubled since 2008,¹⁰10.KPMG Int'l (2012), supra note 1, at 5. and the demand for portfolio and operational transparency skyrocketed, along with their associated costs.¹¹11.Id. at 14. One third of KPMG hedge fund respondents and over 40% of Ernst & Young respondents reported plans to increase staff headcount to accommodate this demand.¹²12.Id. at 15; Ernst & Young, supra note 1, at 15 (“Overall, roughly 40%-45% of hedge funds are adding headcount in support functions—middle office, back office, risk management and legal and compliance—to support expected growth, client demands for transparency and the increased regulations.”).

One wonders if these monitoring costs are too high. Has the risk of fraud increased between 2008 and 2012? Was this risk underappreciated just four years ago, or is it overestimated today? Unfortunately, data on the hedge fund industry are too scarce to make any accurate estimation of its fraud costs. However, where data is lacking, a study of incentive structures may provide an answer to whether these costs are currently overpriced. The hedge fund industry’s incentive structure strongly suggests that institutional investors (now holding the majority stake in hedge fund assets) have a perverse incentive to over-protect against the risk of fraud. That is, monitoring expenditures may currently be much higher than optimal.

Over the past two decades, the hedge fund model has evolved from an investment vehicle primarily for high-net-worth individuals to a money management tool for institutional investors—university endowments, mutual funds, pension funds, and insurance companies. This trend has been called the “institutionalization” of the industry.¹³13.Institutional Demand for Hedge Funds: New Opportunities and New Standards, Casey, Quick & Acito, The Bank of N.Y., (Dec. 2004), http://www.eurekahedge.com/news/04dec_archive_BNY_Casey_Quirk_paper.asp. However, as the SEC noted as early as 2003, it also represents a profound “retailization.”¹⁴14.Implications of the Growth of Hedge Funds, Staff Report to the United States Securities and Exchange Commission, U.S. Securities and Exchange Comm'n, 80 (Sept. 2003), http://www.sec.gov/news/studies/hedgefunds0903.pdf. Through the intermediary of an institutional fund, ordinary “retail investors” have taken on significant exposure to hedge funds. As a result, the principal-agent problem in the hedge fund context has become more complex.

Increasingly, the principals in a hedge fund are, in turn, agents in their own right. The retail investor entrusts (say, through a pension) assets to an institutional fund manager who, in turn, entrusts a portion of those assets to a hedge fund manager. Since the true beneficial owners of the hedge fund stake are not direct investors in hedge funds, they do not set the terms of their investment. In particular, they do not negotiate audit, custodial, administrative or other back and middle office arrangements. In sum, retail investors do not determine the amount of monitoring associated with their exposure to hedge funds. Institutional investment managers, on the other hand, have tremendous influence over monitoring costs and are increasingly exercising that influence.¹⁵15.See supra note 12 and accompanying text.

IV. Explaining Over-Monitoring: Institutional Reputations and Asymmetrical Fraud Costs

In the face of rising monitoring costs, it seems appropriate to wonder whether institutional investors have an incentive to over-monitor their hedge fund agents. A few observations suggest they do, for at least two reasons.

The first, though less compelling, explanation is that an inefficient regulatory scheme has created perverse incentives. Unlike hedge fund managers, some institutional mangers are restricted in their ability to charge performance fees, giving them an incentive to avoid risks that their investors might welcome. Section 205(a)(1) of the Investment Advisers Act of 1940 restricts the ability of registered investment advisers to charge performance fees.¹⁶16.15 U.S.C. § 80b-5. Thus, the compensation structure of many institutional money mangers comes only from management fees.¹⁷17.Investment Company Institute, Investment Company Fact Book (2012), http://www.icifactbook.org/fb_ch5.html. Perhaps out of fear of the heightened regulatory scrutiny it may bring, many institutional managers are reluctant to use performance fees, even with the strict bounds allowed by law.¹⁸18.Alistair Barr, Mutual Funds Shun Performance Fees: Many Companies Cautious After Regulatory Scrutiny, Wall Street J. Market Watch, http://www.marketwatch.com/story/mutual-fund-%20firms-still-cautious-on-performance-fees. In the absence of a performance fee structure, institutional money managers are likely to be more risk averse than their investors.¹⁹19.Both institutional managers and investors in institutional funds are likely to be relatively risk averse. My contention is not that pensioners are risk-lovers; only that their pension managers are slightly less risk tolerant than even they. With a fixed management fee and no performance fee, they do not capture the upside of their investment decisions as their investors do. Thus, although over-monitoring is costly, institutional money managers may be more willing to bear these costs than their investors, since doing so limits the downside risk associated with unexpectedly high fraud costs.

Ultimately, however, this explanation is not compelling. A large portion of institutional advisers are permitted to receive compensation on the basis of fund performance. Section 205(a)(1) applies primarily to mutual funds, is limited in the scope of its restrictions, and contains numerous exceptions under SEC rules. Significantly, Rule 205-3(c) makes an exception for investment advisers whose only clients are qualified clients.²⁰20.17 C.F.R. 275.205-3 (2012). This category includes institutional managers of university endowments or employer pension funds, which, in practice, utilize performance pay quite liberally. For example, in 2010, 90% of the compensation of the Harvard Management Company was performance-based.²¹21.Endowment Managers' Pay Reported, Harv. Mag., http://harvardmagazine.com/2012/05/%20harvard-endowment-managers-pay-disclosed. In the same year CalPERS was criticized for the magnanimity of its performance bonuses, paid out in a year that the fund lost $59 billion.²²22.Cathy Bussewitz, Top CalPERS Employees Get Bonuses While Pensions Plunged, Associated Press, http://www.scpr.org/news/2010/09/21/19457/top-calpers-employees-got-bonuses-%20pensions-value-d/. In defense of the CalPERS compensation decisions, it is standard practice in the industry to compensate fund managers according to the performance of the fund over a five year period. Such a scheme encourages strategies directed to long term growth.

As opposed to regulatory distortion, an alternative, and much more compelling, explanation is that fraud costs are asymmetrically distributed between institutional money managers and their beneficiaries. Suppose, for example, that a retail investor suffers a loss of ten cents on the dollar in his pension fund because a hedge fund manager made unwise investments. To him, this costs exactly as much as a loss of ten cents on the dollar because the hedge fund manager cooked the books. The retail investor is indifferent between equal losses on bad investment strategies and fraudulent investment schemes. The fact that the loss came through fraud imposes no additional cost in its own right. However, for the institutional money manager, losses due to fraud carry with them high reputational costs not associated with losses due to poor management. Entrusting your clients’ money to a con man looks much worse, and results in far more diminished career prospects, than entrusting it to a mere dunce.

The reasons that investing in fraud has higher reputational costs than other poor (but equally costly) investment decisions are various and mostly beyond the scope of this paper. For starters, the media scrutiny of fraud is likely to be much more intense than that of mere incompetence.²³23.Media coverage of large frauds is likely to be not only intense but also interminable. To cite just one example, a recent article in the Boston Globe detailing new investor concerns over hedge fund investments was accompanied by a large photograph of Bernie Madoff—the mastermind of a ponzi scheme uncovered over four years before the publication of the piece. Beth Healy, Some Investors Rethinking Stakes in Hedge Funds, Boston Globe, Dec. 16, 2012, http://bostonglobe.com/business/2012/12/16/are-hedge-funds-dead/6ec5MIAaJNFoozUAfdEljM/story.html. Moreover, the coverage in the popular press will often include the names of duped investment managers. See, e.g., Madoff's Victims, Wall Street J., Mar. 6, 2009, http://s.wsj.net/public/resources/documents/st_madoff_victims_%2020081215.html. Moreover, poor returns can always be excused, at least in part, as the result of bad luck; defrauding investors can never be blamed on luck. Furthermore, beyond even these immediate reputational costs, investing in a fraud also carries with it the serious prospect  of  investigations  for  legal  liability,  especially  if  the  institutional investor is one of the last to leave the fund before the fraud is exposed.²⁴24.For example, dozens of institutional investors were named as defendants in suits brought by the trustee of Bernie Madoff’s estate, and several are under criminal investigations. The mere fact of being associated with a fraud creates additional risk not associated with being associated with bad investments, even when the losses on each are equal. See, e.g., Peter Lattman & Michael S. Schmidt, Madoff Trustee Sues Mets Owner, N.Y. Times Dealbook, http://dealbook.nytimes.com/2010/12/07/%20madoff-trustee-sues-mets-owners/. Legal proceedings, in turn, do collateral damage to a fund manager’s reputation, regardless of their result. Since fraud costs are higher for institutional money managers than they are for their beneficiaries, institutional advisers have an incentive to pay more to avoid becoming the victims of fraud than the investors in their fund would prefer they spend. This disparity would manifest itself in higher monitoring costs, which, as we have seen, have risen nearly in lock-step with increased institutional interest in hedge funds.

The extent to which monitoring costs are currently inflated may be very difficult to measure. Though these costs have been characterized (above) as increased investments in back- and middle-office personnel and third-party administrative and auditing services, another, less obvious (and less quantifiable) source of these costs may the incentives for inefficient institutional behavior, namely, institutional skittishness surrounding fraud. An institutional investor overly worried about fraud may be tempted to cash out his hedge fund investment at the slightest indication of fraudulent activity. This imposes costs in three ways: First, the investor who cashes out early because of high fraud risk aversion foregoes higher returns if the early signs of fraud turn out to be red herrings; second, because other institutional investors are in the same position, collective skittishness can result in severe liquidity crises for funds that have raised even the smallest, most improbable red flags;²⁵25.The example of D.B. Zwirm & Co. demonstrates this point well. Imogen Rose-Smith, The Agony of Dan Zwirn, Institutional Investor, Nov. 24, 2008, http://www.institutionalinvestor.com/%20Popups/PrintArticle.aspx?ArticleID=2053676. finally, hedge funds, understanding this phenomenon, may be tempted to use more severe “gates” in times of irrational (or, strictly speaking, inefficient) institutional concern, passing those liquidity costs on to their investors.²⁶26.Though fraud was perhaps not their primary concern, Michael Burry’s investors suffered liquidity costs when their collective skittishness prompted him to put up gates in 2007. The story is related in Michael Lewis, The Big Short 187-193 (2010).

Institutional money managers are perversely averse to the risk of fraud because for them it carries a reputational cost that is not borne by the beneficiaries of their funds. Since investing in a fraud has an added reputational cost for an institutional money manager, he has an incentive to spend more to protect against fraud than investors in his fund would prefer. For this reason, the layered principal-agent structure of the hedge fund industry has likely produced inflated monitoring costs, costs which ultimately accrue to the detriment of retail investors. Though this paper does not make policy suggestions for reform, it points to a few promising areas for further research.