Hedge funds currently manage over two trillion dollars in assets worldwide, and they are an increasingly prominent feature on the investment landscape. The size of the hedge fund market has grown dramatically in recent years, and issues arising from hedge fund investments and management now have broad implications for the entire financial industry. Hedge funds often involve complex, illiquid or opaque investments and investment strategies. These investments, however, receive little regulatory oversight. Thus, hedge funds are suitable only for sophisticated and prudent investors who are able to identify, analyze and bear the associated risks, and follow appropriate practices to evaluate, select, monitor, and exit these investments.

The Investors’ Committee of the President’s Working Group on Financial Markets consists of representatives from a broad array of investors and investor advocates. The first assignment under its Mission Statement has been to develop “detailed guidelines defining ‘best practices’ for hedge fund investors,”1 which are set forth in the report below. The Committee has designed these guidelines “to enhance market discipline, mitigate systemic risk, augment regulatory safeguards regarding investor protection, and complement regulatory efforts to enhance market integrity.”2 This report builds on existing industry work and on the Principles and Guidelines Regarding Private Pools of Capital, which the President’s Working Group on Financial Markets released in February 2007, particularly Principles 4, 5, and 8.

This report addresses the decision to invest in hedge funds and the management and oversight of hedge fund investments. It contains both a Fiduciary’s Guide and an Investor’s Guide. The Fiduciary’s Guide provides recommendations to individuals charged with evaluating the appropriateness of hedge funds as a component of an investment portfolio. The Investor’s Guide provides recommendations to those charged with executing and administering a hedge fund program once a fiduciary has decided to add hedge funds to the investment portfolio.

This publication corresponds with guidelines promulgated by the Asset Managers’ Committee of the President’s Working Group on Financial Markets, which identified best practices for the alternative investment industry with respect to the management and administration of hedge funds, including practices regarding disclosure, valuation, and risk management systems.

Hedge funds invest in a wide variety of financial instruments using a variety of investment techniques. They often profit through exposure to risks that are not typical of, or proportional to, those of traditional investment vehicles. These alternative investments have the potential to offset a portfolio’s exposure to traditional market risks, or to add to a portfolio’s absolute return, but they also may introduce new dimensions of risk and uncertainty.

Therefore, before making a hedge fund investment, investment staff should engage in a due diligence evaluation that is appropriate and effective in light of the risk tolerance of the institution or individual they represent. Once a hedge fund investment is made, staff should continue to monitor the investment to identify any newly introduced risks and to weigh them against the potential impact on overall portfolio risk and the expected effect on portfolio returns.

Many individuals and institutions considering hedge fund allocations will determine that they do not have the resources or the expertise necessary to successfully incorporate hedge funds into their portfolios. This is often the most appropriate decision. No one should feel obligated to invest in hedge funds. Many successful investors never invest in hedge funds, and including hedge funds in a portfolio is not required for effective and responsible portfolio management.

Thousands of institutional and individual investors meet the legal requirements to invest in hedge funds, but it is not always appropriate for them to do so. Prudent evaluation and management of hedge fund investments may require specific knowledge of a range of investment strategies, relevant risks, legal and regulatory constraints, taxation, accounting, valuation, liquidity, and reporting considerations. Fiduciaries must take appropriate steps to determine whether an allocation of assets to hedge funds contributes to an institution’s investment objectives, and whether internal staff or agents of the institution have sufficient resources and expertise to effectively manage a hedge fund component of an investment portfolio.

Hedge funds use a broad range of portfolio strategies and are exposed to a similarly broad range of risks. Moreover, because strategies can ebb and flow in terms of popularity within the hedge fund universe, the risks and considerations identified here cannot be considered complete.

Further, new (and sometimes severe) market conditions may over time shed new light on the role hedge funds play in investors’ portfolios. The Investors’ Committee is committed to reflecting in the final version of these recommendations a timely and thoughtful response to any fundamental changes in market conditions (e.g., a changing role of leverage among major financial intermediaries) or structural changes in hedge funds themselves.

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REPORT OF THE INVESTORS’ COMMITTEE
TO THE PRESIDENT’S WORKING GROUP ON FINANCIAL MARKETS
April 15, 2008

Table of Contents:

I. EXECUTIVE SUMMARY ...................................................................................................... 1
II. INTRODUCTION .................................................................................................................... 2
A. Statement of Purpose .......................................................................................................... 2
B. Background........................................................................................................................ 3
C. Notes to the Reader............................................................................................................. 4
III. FIDUCIARY’S GUIDE............................................................................................................ 6
A. HEDGE FUND INVESTMENTS AND ALLOCATIONS................................................ 8
1. Certain Characteristics of the Hedge Fund Industry..................................................... 9
2. Fees ............................................................................................................................... 9
3. Considerations Prior to Investing in Hedge Funds ..................................................... 10
4. New Hedge Fund Programs and Managers ................................................................ 10
5. Roles in the Portfolio .................................................................................................. 10
6. Allocation and Diversification.................................................................................... 11
B. HEDGE FUND INVESTMENT POLICY....................................................................... 12
C. THE DUE DILIGENCE PROCESS................................................................................. 12
1. Legal, Tax and Accounting Considerations................................................................ 13
2. Ongoing Monitoring ................................................................................................... 14
D. CONCLUSION................................................................................................................. 14
IV. INVESTOR’S GUIDE............................................................................................................ 16
A. THE DUE DILIGENCE PROCESS................................................................................. 17
1. Personnel..................................................................................................................... 19
2. Business Management ................................................................................................ 20
3. Investment Performance Track Record ...................................................................... 20
4. Style Integrity.............................................................................................................. 21
5. Model Use................................................................................................................... 22
B. RISK MANAGEMENT.................................................................................................... 22
1. Investors’ Risk Management Programs ...................................................................... 22
2. Hedge Fund Risk Management Programs .................................................................. 23
3. Investment Risks......................................................................................................... 24
4. Liquidity and Leverage Risk....................................................................................... 28
5. Measurement of Market Risks and Controls .............................................................. 30
6. Management of Risk Limits........................................................................................ 31
7. Compliance ................................................................................................................. 32
8. Operational and Business Risks.................................................................................. 32
9. Prime Broker and Other Counterparties ..................................................................... 33
10. Fraud and Other Crime ............................................................................................... 34
11. Information Technology and Business Recovery ....................................................... 35
12. Conflicts of Interest..................................................................................................... 36
13. Other Service Providers .............................................................................................. 36
C. LEGAL AND REGULATORY........................................................................................ 37
1. Investment Structures.................................................................................................. 37
2. Domicile of Hedge Fund and Investments.................................................................. 38
3. Terms of Hedge Fund Investments ............................................................................. 39
4. Fiduciary Duties (including ERISA) .......................................................................... 41
5. Regulatory Aspects ..................................................................................................... 42
6. Rights of Other Investors / Side Letters...................................................................... 43
D. VALUATION................................................................................................................... 43
1. Valuation Policy.......................................................................................................... 44
2. Governance of the Valuation Process ......................................................................... 45
3. Valuation Methodologies............................................................................................ 46
4. Valuation Controls...................................................................................................... 48
E. FEES AND EXPENSES................................................................................................... 49
F. REPORTING.................................................................................................................... 51
1. Reporting and Transparency ....................................................................................... 51
2. Performance Reporting ............................................................................................... 53
3. Funds of Hedge Funds Performance Measurement .................................................... 54
4. Aggregate Portfolio Performance Measurement ........................................................ 55
G. TAXATION...................................................................................................................... 55
1. Unrelated Business Taxable Income (UBTI).............................................................. 55
2. U.S. and Foreign Tax Withholding............................................................................. 56
3. Changes to Capital Gain Allocations.......................................................................... 56
H. CONCLUSION................................................................................................................. 57
V. APPENDIX............................................................................................................................ 58

INTRODUCTION:

The Investors’ Committee of the President’s Working Group on Financial Markets offers the following principles and practices as a guide for responsible investment in hedge funds. These draw upon insights from the President’s Working Group on Financial Markets, relevant professional associations, and a wide range of institutional investors and financial services professionals. This report outlines the primary components of a robust process for the evaluation, engagement, monitoring, and disposition of hedge fund investments.

A. Statement of Purpose

The goal of this document is to define a set of practice standards and guidelines for fiduciaries and investors considering or already investing in hedge funds on behalf of qualified individuals and institutions. For the purposes of this document, the term “fiduciary” refers to those with portfolio oversight responsibilities, such as plan trustees, banks or consultants. The term “investor” narrowly refers to investment professionals charged with implementing a hedge fund program.

Addressing the dissimilar needs of such a broad range of participants is challenging. No single set of best practices applies uniformly to every hedge fund investment, and the burden of applying the practices set forth in this document falls upon the institutions and individuals who are considering or engaged in making such investments. This is a disparate group with different resources and objectives, and the hedge fund arena provides a wide array of investment strategies from which to choose. Thus, individuals and institutions considering or managing hedge fund allocations must evaluate the best practices described below, determine which apply, and implement the recommendations that are reasonable given the resources available to the investor, its objectives and risk tolerance, and the particular investments under consideration.

The selection and implementation of these best practices must be consistent with the particular obligations and goals of the individual or institution making the investment, and with the particular investment in question. Fiduciaries and investors are in the best position to prioritize these factors, and they must evaluate the specific best practices set forth below in light of their own responsibilities, needs, portfolios, and circumstances.

Likewise, hedge funds do not represent a single asset class, but are a type of investment vehicle that provides exposure to a range of investment strategies. Hedge funds come in different sizes and have different management strategies and styles. They follow different administrative, valuation, and disclosure practices. Therefore, management of a hedge fund portfolio must be appropriate for its particular investments. However, because hedge funds all have in common a low level of regulatory protection for their investors, there are minimum levels of diligence required for all hedge fund investors. Beyond this minimum, hedge funds pursuing higher risk strategies – for example, funds making significant use of leverage, or funds investing in illiquid assets, will require more extensive investor sophistication and oversight.

The initial responsibility for fiduciaries considering hedge fund investments is to determine what role a hedge fund allocation might play within the overall investment portfolio. This is a critical decision-making process, but this document does not detail the potential uses of hedge funds within a portfolio. It also does not discuss the risks and potential rewards of specific hedge fund investment strategies. Instead, it outlines the basic factors that one should consider when deciding if a hedge fund investment is appropriate, and it provides a framework for conducting investment evaluation and oversight.

It is not the Committee’s intention to persuade investors that hedge funds are a necessary part of a successful investment program. Nor are we seeking to dissuade investors from gaining exposure to the returns and risk characteristics that hedge funds offer. Our aim is simply to offer both current and prospective investors a practical guide for ascertaining whether there is a role for hedge funds in their portfolios and for managing hedge fund investment programs effectively.

Finally, the best practices described below should be read and understood within the context of this entire report. They are not isolated recommendations, but components of an integrated approach to hedge fund investing.

B. Background

The President’s Working Group on Financial Markets (“PWG”) was formed by Executive Order 12631 on March 18, 1988 in order to “[enhance] the integrity, efficiency, orderliness, and competitiveness of our Nation’s financial markets and [maintain] investor confidence.” There are four members on the PWG: the Secretary of the Treasury and the chairs of the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. On February 22, 2007, the PWG published a set of Principles and Guidelines Regarding Private Pools of Capital, which includes hedge funds. Later in 2007, the PWG sponsored two private sector committees to build upon the Principles and Guidelines: an Asset Managers’ Committee charged with developing best practices specifically for managers of hedge funds, and an Investors’ Committee charged with developing best practices specifically for those making hedge fund investments.

This document is the product of the Investors’ Committee. Most recently, on March 13, 2008, the PWG issues its Policy Statement on Financial Market Developments, which underscored that “investors must demand and use better information about investment risk characteristics, when they buy and as they hold”.

The Investors’ Committee comprises senior representatives from major classes of institutional investors including public and private pension funds, foundations, endowments, organized labor, non-US institutions, funds of hedge funds, and the consulting community (see Appendix for a listing of committee members). Each of the members has reached out broadly to other institutional investors as well as to professional associations and financial services professionals to gain an informed perspective on the best practices for hedge fund investments. It is anticipated that the Investors’ Committee will meet semiannually and issue clarifications and additions when appropriate.

The Asset Managers’ Committee has similarly developed best practices that can promote strong disclosure, valuation, risk management, trading, and compliance practices. The Investors’ Committee report and the Asset Managers’ Committee report each acknowledge that both the investor and the hedge fund manager are accountable and must implement appropriate practices to maintain strong controls and infrastructure to support their activities. We worked closely with the Asset Managers’ Committee and believe that together our reports can result in better educated investors and better managed hedge funds.

We are pleased that the Asset Managers’ Committee has included in its best practices that hedge fund managers use the Investors’ Committee report as a guideline for their interaction with investors. Similarly, investors should use the Asset Managers’ report as a guide for their interaction with hedge fund managers and fund of hedge fund managers. We believe the hedge fund community can and should serve as a strong partner for ensuring that investors adopt suitably strong and appropriate practices to support their investments.

C. Notes to the Reader

For the purposes of this document, the term “hedge fund” refers to an investment pool that provides exposure to a set of financial risk factors not typically associated with traditional (equity and fixed income) long-only investments. This may include investments in limited partnerships, limited liability corporations, or other vehicles. These vehicles carry out the investment program under the direction of an investment manager. For purposes of this report, the term hedge fund may also refer to the manager of the investments of a hedge fund.

Historically, hedge funds have focused on publicly traded securities, commodities, currencies, and their derivatives in such a way as to be “hedged”, in large measure, from material changes in stock and bond markets.

Increasingly, however, hedge funds have exposure to a broader investment spectrum, including not only traditional markets but also sectors typically associated with other investment vehicles, such as private equity and real estate. We note that the Investor’s Guide targets sophisticated investors, and the Investors’ Committee assumes that those investors are familiar with general investment terms.

We have not attempted to define ordinary investment terms, except where there are several possible meanings or our usage is not common among investment professionals.

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