After wrapping a mid-August discussion with senior executives at a New York-based hedge fund on their new clients’ recent efforts to validate the fund’s business continuity programs prior to investing, I remembered a scene in Stanley Kubrick’s 1987 war film, “Full Metal Jacket,” where the character Animal Mother confronts the movie’s protagonist, Joker, in an attempt to size him up, asks, “You talk the talk. Do you walk the walk?”
Fast forward back to 2008 and buy-side firms, specifically hedge fund managers in the US and Europe, can just as easily be asked that same question. Today, however, that has little to do with personal bravado and more do to with risk and risk management. In fact, the same managers who paid this issue scant interest only a few years ago are being forced to see if they can actually “walk the walk” because increased continuity and risk management concerns on the part of large institutional investors are forcing fund managers to adapt to the changing environment and create capable, if not improved, risk mitigation strategies.
When compared to the sell side, the buy side has taken a more laissez-faire attitude to risk management, ensuring compliance with sector-wide initiatives on continuity and risk management – but rarely moving beyond mandated regulatory requirements. Being content with the status quo, fund managers and regulators rarely delve deeper than the obligatory, often simple questions addressing a disaster recovery site or co-location facility. Even investors paid it little mind, not bothering to investigate beyond cursory reviews with accompanying check marks on the pre-investment questionnaire regarding business continuity and operational risk management.
With few buy-side disasters to speak of during the past 10 years, this complacency was allowed to flourish while assets under management (AUM) grew and skyrocketing rates of return hit all-time highs. This, combined with the SEC’s general lack of interest, ensured that “talking the talk” was all anyone felt required doing. This does not mean that the SEC was disinterested in fund managers’ risk and continuity programs. On the contrary, the SEC and other regulators issued a series of new rules and opinions regarding operational resiliency and continuity including the most influential of these the Interagency Paper on Sound Practices to Strengthen the Resilience of the U.S. Financial System, as well as NASD Rule 3510 and 3520 and NYSE Rule 446. On the whole, however, individual regulator interest in the topic could best be described as tepid. After all, to paraphrase a fund manager of a few years ago, “Why rock the boat? Everyone’s making money, and everyone’s happy.”
Unfortunately, it turns out that at the same time the government was fine with simply “talking the talk,” the institutional investment community began demanding that funds begin “walking the walk.” In a surprising turn around of events corresponding to the recent credit crisis and downturn in capital markets, the high profile list of fund failures in 2008, such as the failure of the Carlyle Capital fund or the Amaranth hedge fund, and the overall general malaise within the economy, investment managers now demand a greater commitment to risk management, business continuity and disaster recovery. No longer today can hedge funds’ CEOs and senior managers shrug off investor concerns regarding operational risk management and business continuity with a few select buzzwords, a few poorly focused documents and a reassuring comment about their shared co-location site somewhere in Upstate New York. Suddenly, merely “talking the talk” is no longer sufficient. Too much money’s at stake.
Driving this trend is a no-nonsense change – call it a paradigm shift, if you will – in the basic nature of those investing millions of dollars with buy-side firms, especially alternative investment houses actively courting larger pension funds and institutional investors. To maintain growth, hedge fund and private equity firm CEOs are forced to turn to large institutional investors with major shareholders and boards of directors who tend to be far more selective – as well as cautious – with their investments. And these institutional players ask point-blank, upfront, to review a fund’s risk management program before deciding to invest.
Gone are the days of simply attracting new investment based on positive growth and ROIs. In the months and years ahead, fund executives will need to clearly demonstrate that they can provide positive growth and ensure that funds under their protection are safe, secure and accessible, no matter what operational problems may occur.
On a personal level, it is safe to assume that hedge funds’ CEOs spend considerable amounts of money installing the latest, most comprehensive, fault-redundant security systems for all their homes in order to protect their families’ safety and their personal assets, forcing their security system vendors to “walk the walk” to win the business.
For the same buy-side firm executives who want to “walk the walk” professionally, they need to demonstrate that they understand risk management and have a genuine, not merely a lip service, interest in ensuring the safety and security of their investors’ funds. More than merely pinpointing the location of a co-lo site on a map, for example, they need to be able to explain in both layman’s as well as technical terms a clear understanding of how they intend to use it . They need to clearly demonstrate that in the event of a crisis, regardless of its size or type, natural or man-made, their organization as well as their staff can ensure investors’ funds are fully protected as well as accessible – that you can “walk the walk.”
In the end, it all really comes down to executive decision-making, fiduciary responsibility, proper planning, nuts-and-bolts details, implementation and testing. Investors need to invest with buy-side firms that can uncompromisingly demonstrate that they know how to run a business, that they pay attention to details and that they take risk management responsibilities seriously. In today’s volatile markets, investment managers are being more diligent, seeking not only high ROIs but the assurances that when buy-side firms and funds begin to implode as many have recently and may well will continue to do so, that their investments are safe and secure.
In bottom-line terms, the next time an investor submits a pre-investment questionnaire with questions covering business continuity, buy-side firm managers should think twice before recycling the same, old, worn-out language about business-impact analysis, hot sites and recovery times. Instead, it’s time to seriously examine what you have done and ask, are we just “talking the talk” or can we really “walk the walk?”
Kubrick and Animal Mother would appreciate that…