Counterparty And Debt Rating Methodology For
Alternative Investment Organizations: Hedge Funds
Publication date: 12-Sep-2006
Primary Credit Analyst: Tanya Azarchs, New York (1) 212-438-7365;
tanya_azarchs@standardandpoors.com
Secondary Credit Analyst: Nigel Greenwood, London (44) 20-7176-7211;
nigel_greenwood@standardandpoors.com

As the hedge fund industry, along with other alternative investment industries, grows and reaches out to an expanding cadre of investors, it is meeting increasing pressures for greater transparency. Some investor classes are even requiring that the funds obtain credit ratings. In addition, some funds are accessing bank loans to boost their leverage. As a result, requests for credit ratings are increasing and can come in the form of counterparty ratings, as well as unsecured or secured debt, or bank loan ratings. In addition, various constituents, including prime brokers, fund of hedge funds managers (FOHFs), and equity investors take a keen interest in assessments of the operational risks facing the funds and their managers.
For our purposes, hedge funds are funds that can take both long and short positions in any instrument, in any cash or derivative markets without restrictions by regulators. Traditionally, their sale has been restricted to wealthy or institutional investors, though retail investors are increasingly gaining access, particularly in Europe. We recognize that there is a confluence among hedge funds and other forms of alternative investment companies. The instruments in which they invest may vary in liquidity. However, we use a separate methodology for funds that invest in extremely illiquid investments such as private equity, venture capital, and real estate.

Standard & Poor’s Ratings Services has developed methodologies to determine the creditworthiness of hedge funds and hedge fund managers. Creditworthiness is expressed as counterparty, debt, and bank loan ratings. The ratings reflect the likelihood of a fund defaulting on an obligation, such as a bank loan (whether collateralized or not) or other debt, or a counterparty obligation as a derivative contract.

The ratings incorporate all aspects of operational risk such as governance, risk management, valuation, liquidity management, and leverage, as well as performance to the extent that it affects liquidity. The credit rating, which could be a counterparty, debt, or bank loan rating, further incorporates the industry risk and the risks of the fund’s particular exposures. In other words, the operational risk assessment speaks to how well risks are managed, while the credit risk also incorporates the business risks undertaken.

Importantly, the ratings are not an explicit comment on the quality or performance of the investment portfolio. Rather, they speak to the fund’s ability to liquidate its portfolio at any given time, in an orderly fashion, after satisfying all of its creditors. The emphasis on liquidation analysis is greater for funds than it is for other types of operating companies in the financial sector because funds may open and close, or shift strategies as various strategies fall out of favor or cease to be effective. It is not so much its longevity that determines a fund’s ability to repay creditors, but its liquidity, which in turn, is in part a function of its performance during its life. Thus, the ratings are expected to be significantly more volatile than those of
more traditional institutions.

It is very important to note the differences between credit ratings of secured and unsecured obligations of funds from other types of hedge fund ratings Standard & Poor’s provides. Some fund obligations are pooled into structured vehicles (collateralized fund obligations, or CFOs) that sell tranches of debt rated at various levels to support those obligations. Standard & Poor’s also assigns “fund credit quality” and “volatility” ratings to the shares of fixed income hedge funds. Fund credit quality ratings, identified by an `f’ subscript (i.e., ‘AAAf’, ‘AAf’, ‘Af’, etc.), provide an indication of the level of protection that a fund’s holdings (investments) provide against losses from credit defaults. They do not address the fund’s ability to meet any “payment obligations.” Volatility ratings, identified by the ‘S1’ to ‘S6’ ratings scale, provide an indication of a fund’s net asset value (NAV) sensitivity to changing market conditions. Our Investor Services group provides other ratings that assess the investment performance characteristics and certain operational risk characteristics, but these are not credit ratings.

In assigning credit ratings, Standard & Poor’s receives substantial amounts of confidential information not disclosed to investors or the general public. For a generally secretive industry, Standard & Poor’s represents a credible intermediary for information that can be processed but not funneled through to the general public in any detail that would have competitive consequences for the funds. We rely on an open relationship to provide that information but if it proves inaccurate, or if we find that significant material information is withheld, we reserve the right to withdraw the rating.

The principal risks to creditors of alternative investment funds are:
–    Transparency risk;
–    “Key man risk” and the potential for fraud on the part of key individuals;
–    Liquidity risk;
–    Performance risk, which is closely tied to liquidity risk; and
–    Valuation risk.

The risks of hedge funds a priori are higher than those of more diversified financial institutions that have a variety of products and services that they sell to different client sectors. Hedge funds are essentially focused solely on proprietary investing, though the investing strategies may be diversified. Trading strategies can and do often evolve to keep up with market opportunities. As such, the portfolios change quickly, so that outsiders often do not feel fully apprised of those changes. Standard & Poor’s does not get daily reports detailing all positions, as they would be of limited value without access to the models and analytical tools used to design the trading strategies. What is useful to us, however, are risk reports that group assets by asset types and strategies and give overall risk characteristics of the portfolio for comparison purposes. These help us understand the strategies being followed and see concentrations of positions.

Thus, our ratings reflect a fundamental limit to the transparency of funds regardless of how good operational risk controls might be. Standard & Poor’s relies on the operational risk reviews and an appraisal of management’s ability to monitor and control risk, rather than on our ability to analyze the positions ourselves. It is, after all, in management’s interest to articulate and enforce policies to ensure risk controls (except, of course, if fraud is intended).
In addition, a large cushion of equity is generally behind creditors’ exposures. The main issue is maintaining a liquidity cushion sufficient to permit orderly sales in a declining market such that, even if investors loose everything, the creditors can be paid out. Very few funds have failed before paying off creditors, except for situations involving fraud. Most “failures” have involved liquidation and return of capital to shareholders. We count on a close monitoring of liquidity positions as well as frank and frequent dialogue with management to understand changes in investment strategies and liquidity positions. The highest rated funds are those that provide the greatest transparency and demonstrate the most developed infrastructure and culture of risk controls.

In order to address a hedge fund’s risks, Standard & Poor’s unsecured credit assessment pays close attention to the following broad areas:
–    Background of the fund, its legal status and the status of its key personnel;
–    Legal/regulatory issues;
–    Investment strategies (composition and distribution);
–    Risk management (investment and risk management policies, infrastructure, and methodologies);
–    Model risk (pricing/valuation model design and vetting; risk measurement models);
–    Liquidity (asset liquidity, collateral management, covenants and other triggers, and redemption risk);
–    Profitability/performance (shareholders’ total return, investment income, and expenses);
–    Leverage (borrowings/embedded leverage in instruments); and
–    Quality and expertise of personnel.

Hedge Fund Managers
Our criteria for the management companies that sponsor hedge funds borrow heavily from our criteria for asset managers. Hedge fund managers are, in general, somewhat insulated from the direct market risks of the funds. Their cash flows are dependent on the management and performance fees generated by the funds they manage. Fund managers earn annual management fees of about 1 % to 2% of assets under management, and performance fees of approximately 20% of the price appreciation, though there could be provisions for carrying forward prior years’ losses, or a “high water mark,” or minimum total return, or hurdle rate, to be reached before such fees are paid. Other sources of income could be investments in the funds themselves.

Thus, the focus of analysis shifts slightly to forecasts of cash flows available to cover obligations, including fixed and variable expenses. Leverage plays a key role in determining the cash flow coverage calculations.

Nevertheless, an analysis of the funds themselves is crucial to the analysis of the manager, as cash flow analysis depends ultimately on the performance of the funds.
The fund’s rating is the starting point for the fund manager’s rating. For a manager with a  mall number of funds, it would be hard to contemplate a rating above that of the funds as the closure of one of them would likely lead to the manager’s closure or failure. Higher ratings would require a large number of uncorrelated funds that could support the expense structure in the event one fund fails. On the other hand, high leverage could bring the manager’s ratings lower than that of the funds.

Conversely, the management company’s financial health is important to the fund’s health. When cash flows to the management company are insufficient to cover its costs and to adequately compensate the key employees, the likelihood is high that the funds will close, if not default. High leverage or inability to earn performance fees could result in such scenarios, not just a drop in NAV. A special case among management companies is the FOHFs managers. These are analyzed in the same way as other asset managers other than the close attention paid to the FOHF manager’s due diligence process for fund selection, which should mirror closely the due diligence process for our credit ratings. Reputation risk is high for FOHF managers. Their choice of funds for their managed accounts and funds of funds is the foundation of their franchise, not only in terms of performance but also in terms of headline news about losses due to management failings at those funds.

Fundamental principles
Organizational structure
As a general rule, Standard & Poor’s rates established, diversified funds with experienced management higher than other funds. The funds must be duly incorporated in an onshore or offshore jurisdiction with sufficient rule of law to provide creditor protection. The regulatory and reputational records of key personnel are also a part of the rating. The fund must produce audited financial statements on a regular basis. In addition, Standard & Poor’s will review the fund’s legal and regulatory framework as part of the rating process. Close attention will be paid to whether the fund is subject to any regulation, and if so, how comprehensive and rigorous the regulation is. When assigning ratings to a particular fund, Standard & Poor’s takes into consideration the structure of the entire fund complex and the implications that it might have for an individual fund. A large fund complex typically consists of a management company organized as a general partnership, and one or more large funds, which one could call “master funds,” organized as limited partnerships. These funds may also be the majority investors in several satellite funds representing specialized investment strategies. In contrast to more regulated mutual funds, hedge funds are not required to have an independent board of directors (except in some offshore locations). There may also be a broker/dealer subsidiary.

Outside investors could own shares of the master funds through “feeder funds” that invest all of their funds either in the master funds, or in some cases, directly in the satellite funds. To date, our ratings have generally applied to the master funds and their feeder funds, as their investments represent a multistrategy or diversified set of investments whose staying power is easier to get comfortable with.

The management company, or adviser, is responsible for investment strategies, risk management, and for allocating capital among the satellite funds. Trader and fund managers are typically employees of the management company rather than of the funds themselves. The management’s quality and expertise, its ability to constantly reinvent its strategies, stay ahead of the general market, and generate the kind of “positive alpha” (the ability to produce positive returns over a benchmark rate such as the risk free rate) that is its raison d’etre, are key to the funds’ ability to attract and retain investors.

Standard & Poor’s assesses the fund’s investment adviser, focusing on the adviser’s management, reputation, and solvency with a view to the impact that those issues might have on an individual rated fund. In view of the key man risk, we review management succession plans and personnel policies that help retain talent. Stock ownership by employees is another indicator. The management company’s source of profit is the management fees paid by the funds, as well as the performance fees. Also, it would likely co-invest in some of the funds. Standard & Poor’s generally views a fund that has more institutional elaboration as a stronger credit compared with a fund that relies on a single manager with no support staff.

The funds themselves normally have no employees of their own and rely on the adviser for portfolio management, research, distribution, and other services.
The better the adviser’s financial health, the better able it should be to provide high-quality support and service to the fund. Standard & Poor’s will not, however, assume that the adviser would provide any needed financial support for the fund, which is, or should be, a separate legal entity that cannot be consolidated in the event of the bankruptcy of the management company. However, problems at the management company, or potential negative publicity could cause a redemption and/or liquidity problem for the fund, and vice versa. In general, we would not assume that a fund would survive its manager’s demise, though the reverse would not necessarily be true if the manager had several funds whose fees it could continue to collect.

Standard & Poor’s also conducts operations and risk management reviews within the context of assessing a fund’s creditworthiness. A key review includes the portfolio management and investment research staffs in terms of size, organization, and experience level. We review the process for, and controls on, implementing trades, as well as portfolio pricing and other back-office operations. This includes operations that are performed at the fund as well as those that are outsourced to third parties. Standard & Poor’s examines the fund’s use of prime brokers and its relationship with those institutions as well as any operational capacity issues. Standard & Poor’s also reviews the composition and role of a fund’s governing bodies and the audit functions.
When assigning ratings, Standard & Poor’s examines the financials and performance records of each of the legal entities that are related in any way, through cross investments or loan arrangements. The performance of each of the funds, as well as their liquidity, contribute to the liquidity of the master funds, which are typically the funds being rated.
In the course of a risk management review, Standard & Poor’s considers the policies governing risk, the infrastructure surrounding risk monitoring and measurement, and the risk measurement methodologies.

Policies Infrastructure Methodologies
An important aspect of risk management is the firm’s risk culture. Written policies outlining the responsibilities and authorities of personnel are only a formal manifestation of the risk management organization. More critical are the less formal aspects of how risk is communicated within the firm, how the risk appetite is defined and then enforced, and reinforced through incentives and/or disincentives. While the alternative investment funds are evolving, most do not have the kind of independent risk management organization found in commercial or investment banks. Rather, risk management is seen as the business managers’ responsibility, and is defined predominantly as the risk of not meeting investment objectives.
This is one aspect of risk management that could serve to depress ratings of the funds. However, Standard & Poor’s also inquires into the ways in which trading limits are assigned and monitored to prevent unauthorized trading and position concentrations. Also important is credit risk management and administration for counterparty risk in derivative transactions.

The firm’s risk infrastructure consists of systems that track, report on, and analyze risk positions. The sophistication and integration of these systems are important not only for the ability to design and analyze trading strategies for funds that are model intensive, but also to permit senior management to understand the positions. Back offices also need to have adequate resources to handle the volume of trades, and they need to be independent enough and with enough controls in place to preclude interference with the correct reporting of positions. We also look into the relationships with the fund administrators to determine the level and tracking of failed settlements, and the quality of the independent verification of valuations. Risk analytics are critical for firms with model-driven strategies. Standard & Poor’s evaluates:
–    The robustness of value-at-risk (VaR) models and other methodologies for assessing risk and/or providing risk limits;
–    Role of stress testing for gauging market, liquidity, and credit risk; and
–    Credit risk measurement for derivative instruments.

Valuation methodologies are a crucial issue to creditors, who need to be assured that the NAV is accurate.
They are especially critical to funds that deal in complex derivatives whose pricing is model driven, and less-liquid securities. Standard & Poor’s evaluates the robustness of the model vetting process. We also review the independence of checks on the model inputs as well as outputs. We cannot, however, provide an audit to verify the accuracy of the valuations.
Beyond the risk governance issues, we also look at the risk strategies:
–    Investment objective, philosophy, strategies, policies, and practices;
–    Permitted/eligible investments represented in the prospectus or other descriptive documents versus internal policies;
–    Approval and selection process of investments;
–    Diversification/limits by type of security, issuer, counterparty, and/or industry;
–    Specific trading strategies, including leverage and hedging;
–    Prohibited/restricted activities;
–    Actual mix of securities types and strategies;
–    Change of portfolio mix in light of market conditions; and
–    Percentage of illiquid or unregistered securities.
The review also encompasses the analysis of different portfolio asset classes and the factors relevant to each asset class’ particular potential market value volatility, such as:

–    Equity securities. Market capitalization, industry mix, liquidity, and domestic versus international exposure; long versus short exposures;
–    Money market, fixed income, credit derivative, and hybrid securities. Credit rating, maturity, duration, yield, call risk, issuer size, outstanding issue size, industry mix, and geographic mix;
–    MBS structure types. Domestic versus international exposure;
–    Derivatives activities. Specific strategy, counterparty risk, and long versus short positions taken for either hedging or position-taking purposes;
–    Other investing activities. “Side pockets” of less liquid investments such as real estate and/or private equity and bonds or bank loans funded through CDO structures.
Recognizing that each fund has a certain expertise and strategy, Standard & Poor’s reviews the fund’sinternal risk management reports and stresses them further if appropriate.

Standard & Poor’s views a relatively low-risk fund as one with an investment portfolio with a high degree of diversification and market liquidity. Even a well-diversified equity portfolio could be considered of low to moderate risk. Diversification among instrument types also could limit a fund’s potential market value volatility. Some single-sector funds or those that take large, unhedged positions probably would be considered high risk.
A substantial part of the credit analysis of alternative investment funds entails a detailed review of a fund’s investment portfolio, policies, and practices. Also key are management’s investment philosophy, overall strategies, and strategies in situations of market volatility and other changes in market conditions. The riskiness and concentrations of the managers’ strategies and the performance against benchmark indexes are considered in Standard & Poor’s analysis in that they are important indicators of the fund’s ability to attract new investments, and affect the pace of redemptions. These considerations, in turn, affect the fund’s liquidity, which is the key determinant of the fund’s ability to repay obligations. The rating is not, however, intended to be an assessment of the fund’s investment performance, past or future.

Standard & Poor’s recognizes that investment strategies can, and indeed should change over time. The industry is one that generates positive alpha often by taking advantage of inefficiencies in the marketplace. As trading strategies are copied and the marketplace becomes crowded with similar strategies, these inefficiencies tend to fade away, and profit opportunities degrade. Therefore, managers must be nimble and creative enough, to devise new strategies that will maintain their alpha. At the same time, they cannot lurch to new strategies for which they do not have management expertise.

Even if strategy does not change, asset turnover rate could be quite high at a hedge fund. Therefore, for the rating process, we rely on understanding the investment strategies of the fund, the investing styles, and risk tolerances. We look at risk reports and allocations to classes of assets or investment strategies rather than at analyses of specific instruments, which can be of limited use if they represent only a small part of a multilegged trade. Standard & Poor’s expects to be notified by the rated entity of any material changes to the fund’s strategy and concentration limits. Standard & Poor’s believes that a broad diversification of investments reduces risk and increases investment flexibility. A fund’s track record in managing market volatility and the inflows and redemptions of funds also play a significant part in the rating process. While portfolio managers play an important role in managing a fund, other components such as market research and distribution must also be analyzed.
We evaluate a fund’s strategies both in terms of their inherent riskiness and their performance versus other similar funds. Fund strategies can fall into roughly three broad categories:
–    Arbitrage, whereby inefficiencies are exploited in the pricing of similar risks in different markets. Such funds frequently employ derivatives and cash markets to take positions that are “market neutral,” that is, they are fundamentally hedged but take a form of intentional basis risk to express a view that that basis risk will grow or diminish. The payoff derives from that gamble being correct. Various classes of arbitrage strategies include convertible and equity arbitrage, statistical arbitrage, relative value from credit trading, pairs trading, currencies, fixed income, and commodities, etc.
–    Event driven, whereby positions are taken in distressed situations in expectation of turnarounds, merger arbitrage as bets on the completion of announced merger, or other special situations awaiting legal settlements or other events that would improve pricing.
–    Directional, only partially hedged bets are taken on the direction of certain prices—long/short equity, global macro, managed futures.

Each of these strategies has its different risks:
–    The arbitrage strategies, while they are thought of as market neutral, often involve high leverage. Even though the positions may be more or less hedged, the instruments may have embedded leverage (in that a dollar of option position may represent the risk of many dollars worth of underlying assets) that will serve to magnify any imperfection in the hedges. The trades may also represent bets on correlations among the positions in a world where correlations can be unstable. In general, the trades are designed by sophisticated models that expose the fund to model risk. The other risk is that the inefficiencies the fund is trying to exploit will eventually disappear as more players copy the trades. Such fund managers must be ever ready to recognize when the inefficiency has gone out of the market and have a ready supply of new trades to replace the spent ones. On the positive side, the instruments traded tend to be more liquid.
–    The event-driven strategies, other than merger arbitrage, involve less liquid assets, or positions that need to be held for a relatively long period of time for the strategy to come to fruition. The pricing volatility may also not be completely hedged and thus may be more volatile. On the other hand, when the assets were truly purchased at “distressed” levels, there is a survivors’ bias in that the losses on low-priced assets would be overridden by truly large gains on the positions that paid off. Distressed assets, while they themselves may be of poor quality, are not necessarily the most risky assets if priced attractively.
–    The directional strategies are perhaps the most risky. Often, these are bets placed on the notion that certain fundamental drivers in particular markets are changing. They may involve large and
sometimes leveraged positions. The outcomes of these bets tend to be uncorrelated to the direction
of broad market indices, so the strategy provides uncorrelated diversification to a multistrategy
portfolio. On the other hand, losses occur if markets go sideways or in the opposite direction from
the bets placed.
Liquidity is an important concept for alternative investments fund analysis. Several issues affect liquidity:
Liquidity of the investment instruments
An important source of liquidity is the ability to sell assets to meet payment obligations without having “fire
sales” in periods of market fragility. Some asset classes, such as exchange-traded common stock or
futures, are extremely liquid. At the other extreme are customized derivative instruments, investments in
private or bankrupt companies, real estate, where the time it takes to sell the asset could be very long, and
emerging market debt. In between are many asset classes whose liquidity can be variable, and subject to
bouts of illiquidity when markets become volatile. We look for the ways in which managements measure
the depth of markets in which they trade, and incorporate a consciousness of this issue in their risk
measurement models and liquidity reports.
In addition, we use statistical measures as proxies for asset liquidity such as the presence of serial
correlation. In liquid, efficient markets, the volatility of returns should be random; that is, there is no serial
correlation. If there is a nonrandom pattern to the variation in returns, the coefficients for autocorrelation
will be high. The most reasonable explanation for autocorrelation is that the portfolio contains illiquid
securities (cf the well-known scholar and author Andrew Lo). For example, if securities have no active
secondary market and must be marked to model, the result can be a smoothing effect on a price series
that would produce autocorrelation.
Fund complexes often set up side pockets to house especially illiquid assets, which are funded by
separate classes of shares with much more restricted redemption provisions. This financing arrangement
is more favorable than a commingling with other more liquid assets funded by shares with provisions for
frequent redemptions.
Several issues are relevant to balance sheet liquidity:
?? The amount of cash and liquid unencumbered (not segregated or pledged as collateral) assets
available to pay off obligations (trading liabilities, plus maximum potential swap obligations, other
payables, and borrowings) and meet a stressed level of redemption requests. Another indicator is
the ratio of such obligations to NAV. This analysis is done on a consolidated basis, including all
funds that are interrelated, in that one or more of the funds in a family of funds may be the majority
investor in the other funds.
?? The amount of debt, secured and unsecured, as well as counterparty liabilities is an important
consideration, in relation to the amount of equity.
?? The relationship between inflows of new money when the fund is able to attract new investment and
outflows due to redemptions. Redemption risk is one of the biggest risks for a fund as it can cause a
snowball effect. When heavy redemptions are most likely to occur (i.e., during a portfolio market
value slide), the primary source of funds to meet these redemptions, the sale of portfolio assets, is
also sliding in value, causing the fund’s equity base to evaporate very quickly. Standard & Poor’s
therefore takes into account the history of inflows and outflows, as well as the current pattern; the
redemption provisions, or “lock-up periods” (which can be e.g., for a month, a quarter, or a year),
and how these might be laddered over the course of the year to prevent a sudden call for
substantial amount of redemptions; and “gates” that can limit the amount of total outflows that can
occur at a given time. We take note of side letters and other ways in which the fund may yield to
pressure to permit investors to cash out early. We also track the notices of redemption that funds
get in advance of the end of the lock-up period.
?? The nature of the shareholder base. Redemption risk may be greatly heightened if share ownership
is not widely dispersed, but instead is concentrated in the holdings of a small number of
shareholders. If possible, it is helpful to analyze whether the holders have long- or short-term
investment horizons and to attempt to surmise whether the shareholders would readily redeem
given a sharp drop in NAV. It may be that a few large, sophisticated holders have certain incentives
to stay in a fund that is declining in value. Alternatively, large institutional shareholders, for example,
fund of fund investors, could redeem at the first sign that the fund is not offering a competitive
return.
?? The nature of the funding. If there is secured debt, important issues are the nature of the margin
and collateralization agreements the fund has with its prime brokers and other dealers and collateral
management processes. How much margin is required to post relative to other hedge funds for
each asset class? Is the dealer able to change those margin requirements at will? An analogous
issue is what kind of covenants or NAV (net asset value or the value of assets minus liabilities)
triggers there might be in any borrowing agreements. Another issue is collateral management, and
the way in which the fund assesses the potential for additional collateral calls.
?? If there is unsecured debt, we will consider its maturity distribution, as well as any covenants, call
features, or triggers that could accelerate the repayment or require collateral.
Performance is an important issue in the fund’s ability to attract and retain investors, and therefore, a
critical element of liquidity. We assess it in a variety of ways:

In terms of the absolute level of returns and alpha, as well as in terms of the volatility and
distribution of returns in the recent and the longer-term past.
In terms of relative returns compared to other funds with similar strategies.
In terms of return on risk.
The standard deviation and VaR indicate volatility levels, while kurtosis, skew, and expected shortfall
further describe that volatility, or the distribution of the returns: what is the shape of the tail of the
distributions; have the returns tended to spike to very high levels, or did they remain in a certain bands?
Returns are defined as the increase or decrease in net assets resulting from realized or unrealized market
appreciation and/or depreciation (i.e., before considering net inflows/outflows of funds), minus expenses. A
large component of operating expenses for a fund is the management fee. Other significant expenses may
be distribution fees, transfer agency fees, custodian fees, and debt service.
Volatility can also depend on the portfolio’s diversification in terms of the different strategies that are
followed. Hedge funds sometimes pride themselves on being market neutral and their ability to produce
positive absolute returns in any market (alpha). However, based upon data for indexes that represent the
performance of a wide variety of strategies, one can see that the strategies vary in terms of their volatility
and their correlation to each other and to various market factors. For a fund, Standard & Poor’s calculates
expected returns (µ) and a volatility factor (sigma) for the returns over varying periods of time, hopefully
covering a period of stress. A lower volatility (sigma) indicates better diversification (more imperfectly
correlated positions). We examine the distribution for skew and kurtosis as well, and calculate a VaR and
expected shortfall. Higher expected returns for each unit of volatility, or a higher Sharpe ratio, indicate
better optimization of the portfolio, which promotes more investor confidence.
We also calculate a correlation factor for the fund versus an appropriate benchmark index for that strategy.
Such volatility analysis can be an indicator of “style drift,” or a change in the appetite for risk. A high or
rising beta can also be an indicator of potential maturation of a particular investment strategy that has
ceased generating the kind of positive alpha it once did.
Standard & Poor’s looks at Sharpe ratios, which we calculate as the return over the relevant broad market
index, over the standard deviation of returns. Returns are often thought to deteriorate after funds reach a
certain size. Trading ideas have a certain capacity to them before they become crowded either due to the
size of the markets involved or because others copy them. Therefore, optimum size is a function of the
diversity of the trading strategies and ideas. Diversification can increase the staying power of funds, and
larger funds are generally more diversified. However, there could be a size at which diminishing returns
would jeopardize longevity.
Generally speaking, a fund’s net assets are its capital base, which may be viewed as available to cushion
against creditor losses. In their claim on the net assets, the fund’s debt holders and contractual
counterparties are in a senior position to the fund’s equity holders. As long as NAV is positive, and the
assets liquid, creditors can be paid out. An issue arises, however, because that equity base can change
radically in a short time, either because of net redemptions or because of changes in the market value of
the assets. Moreover, these factors would likely occur in tandem, in the negative case exacerbating any
equity decline. Therefore, the analysis of capital must be tied to judgments on the portfolio assets’ potential
market value changes (see the Performance section above) and the severity of redemptions.
When analyzing the potential for shareholder redemptions, we evaluate the expected volatility and Sharpe
ratios. The track record on investment inflows and outflows is important, as well as the nature of the
shareholder base. A base that has concentrations of single owners, or groups of owners who are more
likely to be quick to redeem, such as funds of funds, are considered a negative.
Leverage can come in forms other than capital markets and bank financing. Many investment strategies
depend on instruments that are inherently levered, such as derivatives or subordinated tranches of
securitizations that, for a relatively low-cost basis, represent the risk associated with a much more
substantial equivalent investment in cash instruments. This type of leverage is more difficult to quantify.
Ideally, the notional amount of assets, net of any short position, would represent the equivalent position
had it been expressed as a cash instrument. However, such information may not be produced by the
funds’ position systems. Standard & Poor’s will evaluate the level of leverage in the fund from an absolute
basis, debt to equity, but will also adjust this ratio based on several factors, including embedded leverage
of the instruments and the volatility of the asset values. Exceptional volatility of results compared to similar
strategy funds is also an indication of leverage.

The rating is a blend of all of the above qualitative, operational and financial considerations. The
operational elements play a very large role and set the ceiling for ratings. That is, stellar financial attributes
cannot override serious operational flaws. The fundamental business risks that are generic to the hedge
fund industry—the mutability of the investment portfolios and exposure to market risks, the limited
transparency relative to public institutions and the small size of the operations that preclude an elaborate
infrastructure, also play a role in the ultimate ratings.
Analytic services provided by Standard & Poor’s Ratings Services (Ratings Services) are the result of separate activities
designed to preserve the independence and objectivity of ratings opinions. The credit ratings and observations contained herein
are solely statements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make
any other investment decisions. Accordingly, any user of the information contained herein should not rely on any credit rating or
other opinion contained herein in making any investment decision. Ratings are based on information received by Ratings
Services. Other divisions of Standard & Poor’s may have information that is not available to Ratings Services. Standard & Poor’s
has established policies and procedures to maintain the confidentiality of non-public information received during the ratings
process.

Ratings Services receives compensation for its ratings. Such compensation is normally paid either by the issuers of such
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