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Rating Methodology

April 2007
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Assigning Unsecured Credit Ratings to Hedge Funds

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

What Makes a Hedge Fund Different?....................................................................................................... 6


Comparison with Traditional Asset Managers ................................................................................................ 6
Comparison with Securities Firms ................................................................................................................. 6
Comparison with Structured Investment Vehicles .......................................................................................... 7
Capital Structure ........................................................................................................................................... 7
Equity Capital Features............................................................................................................................ 7
Collateralized Borrowing and Need for Liquidity....................................................................................... 8
Risk to Unsecured Creditors of Equity Puts........................................................................................... 8

Why Do Hedge Funds Fail? ....................................................................................................................... 9


Fraud and Lack of Operational Discipline....................................................................................................... 9
Liquidity, Liquidity, Liquidity........................................................................................................................... 9

Moodys Approach to Rating Hedge Fund Obligations.............................................................................. 11


Overview of Rating Framework....................................................................................................................... 11
Risk Management & Governance.................................................................................................................... 12
Operational Environment ....................................................................................................................... 12
Risk Appetite......................................................................................................................................... 13
Portfolio Risk.................................................................................................................................... 13
Performance Volatility....................................................................................................................... 13
Business Profile ............................................................................................................................................. 14
Investor Profile ...................................................................................................................................... 14
Investment Performance ....................................................................................................................... 14
Diversification ....................................................................................................................................... 14
Size....................................................................................................................................................... 15
Financial Profile.............................................................................................................................................. 15
Liquidity Risk Analysis........................................................................................................................... 15
Overall Quality and Risk of the Fund Portfolio ........................................................................................ 16
Portfolio Leverage and Capital Adequacy ............................................................................................... 16
Interest Coverage .................................................................................................................................. 16
Other Considerations...................................................................................................................................... 17
Legal Structure and Debt Covenants...................................................................................................... 17
Market Considerations .......................................................................................................................... 17
Manager Equity Participation in Fund .................................................................................................... 17
Manager-Related Considerations Beyond Operations Quality ................................................................. 18

Can A Hedge Fund be Rated Investment Grade? .................................................................................. 18

Moodys Rating Methodology

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.

The Hedge Fund Phenomenon


PURPOSE AND FOCUS
A hedge fund refers broadly to any (largely) unregulated private pool of capital whose investment manager is compensated primarily on the fund's performance, and which is managed with a primary goal of providing superior riskadjusted absolute returns. Hedge funds utilize a broad spectrum of investment styles, hedging strategies and financial
instruments, ranging from simple long equities to complex derivatives structures (please refer to "Glossary of Hedge
Fund Styles" in Appendix 1 for a description of common strategies).

A GROWTH SECTOR WITHIN ASSET MANAGEMENT


Globally, hedge funds manage about $1.4 trillion in total assets (as of December 31, 2006), comprising about 10,000
individual hedge funds ranging in size from less than $10 million to around $30 billion for the largest funds (see Table
1 for the list of the top 20 funds globally). The historical growth of assets invested in hedge funds have been quite
strong, with a 5-year compound annual growth rate (CAGR) of about 21% and a 10-year CAGR of about 27%, powered by both performance and positive net flows (see Figure 1). To put these statistics in perspective, in the U.S.
mutual fund industry, comprising over 8,000 mutual funds, assets under management totaled about $10.4 trillion as of

Moodys Rating Methodology

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.

Figure 1: Growth of the Global Hedge Fund Industry


1,600
1,400

10,000

1,200
8,000

1,000

6,000

800
600

4,000

400
2,000

Assets in US $Billions

Number of Hedge Funds

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

Year (as of January)


Number of Hedge Funds

Hedge Fund Assets in $ Billions

Source: Hennessee Group LLC

Table 1: 20 Largest Hedge Fund Managers


Rank 2006
1
2
3
4
5
7
8
9
10
11
12
13
14

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)

Source: Bloomberg, Hedge Fund Research (as of Sept. 30)

1.

Investment Company Institute, Trends in Mutual Fund Investing, December 2006, and 2006 ICI Fact Book

Moodys Rating Methodology

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

INCREASINGLY, PART OF THE ESTABLISHMENT


Some large hedge funds are increasingly adopting more discipline to their processes and establishing the corporate
functions that are typically found in more well-established financial firms such as global securities firms or asset managers. These institutional features include trade compliance, financial and risk reporting, formal risk management
processes, liquidity planning, etc. There are fundamental trends that explain this institutionalization of large hedge
funds:
More institutions such as pension funds, endowments, foundations, and insurance companies are either
beginning to invest in or increasing their allocation to hedge funds. These new investors are accustomed to
the institutional approach of well-established money managers and other providers of investment services
and they come with higher expectations than those of the high net worth investors that used to constitute
the core of hedge fund capital. As a result, the level of funds reporting and the formality of the description
of their investment strategy and risk management discipline may need to rise.
As large hedge funds become more mature, they need a more stable capital base and access to liquidity in
order to weather changes in market conditions without significant disinvesting to satisfy redemptions or
margin calls from prime brokers or derivative counterparties. Hedge funds recognize the importance of
incorporating longer-term capital and liquidity on their balance sheet, and of having repo financing margins and other terms locked-in for an extended period. We expect more hedge funds to seek to optimize
their capital structure so that they begin to resemble well-established financial institutions balance sheets.
In fact, some hedge funds are aspiring to look more like securities firms in terms of the scope and quality of
their business operations.
As more hedge funds begin to access the debt capital markets, and in some cases become SEC registrants,
investors will expect these funds to take on a more institutional approach to their business. Many of the
investors in hedge fund debt will be the same types of institutional investors as mentioned previously, bringing their higher expectations. Other hedge funds that would like to be better positioned to access the equity
and debt capital markets will be similarly motivated to raise their profile in the same areas. As an example,
Fortress Investment Group, LLC, which manages about $30 billion in assets, priced its IPO in February,
which should promote more institutional-like discipline on the firm.
Lastly, most financial institutions -- such as prime brokers, derivatives dealers and banks -- that lend to
hedge funds need robust internal risk rating systems to determine appropriate capital haircuts under the
Basel II and CSE (Consolidated Supervised Entity) capital frameworks. Firms are able to determine their
regulatory capital requirements by means of approved internal credit models, but they may be requested by
their regulator to defend their internal hedge fund ratings. It would be easier for these institutions to align
hedge funds that operate on a more institutional basis on a risk rating scale than more informally-managed
hedge funds. Hence there should be some pressure on the hedge funds to raise their game and become
more institutional.

CHALLENGED BY (AND CONTRIBUTING TO) MARKETS AWASH IN LIQUIDITY


Capital markets seem to be awash in liquidity today. Private equity funds have been raising record amounts of capital,
and there's evidence that some of these funds feel the need to increase their leverage in order to achieve an acceptable
return on their investment. Credit spreads have stayed tight as investors continue to reach for yield, interest rates and
volatility remain relatively low, and banks are still lending on easy terms. Stock buy-backs are widespread as companies
are finding fewer investment opportunities that can provide a rich enough return on investment for shareholders, and
so they are returning excess cash. Hedge funds have contributed to this surplus in liquidity, which they often deploy in
stressed or developing markets to earn big returns. But, with a lot of available liquidity in the capital markets today, it's
become more challenging to find investment opportunities with an acceptable risk/return profile.
At the same time, hedge funds are dependent on financing to carry out their investment strategies, and they are
exposed to the risk of a market shock causing a strain on their own liquidity. In response, hedge fund managers have
been pressing their prime brokers for better financing terms (lower haircuts, longer loan maturities, lower repo rates,
funding of riskier investments). Without more permanent sources of financing, hedge funds remain heavily dependent
upon their prime brokers' decisions to renew the lending agreements from one period (typically 60 to 90 days) to the
next. In case of a market stress event, prime brokers can decide to liquidate the collateral and terminate all funding
arrangements on very short notice. This underscores a fundamental, structural mismatch in the funding strategy of the
typical hedge fund today: the financing of assets, including positions that may be expected to be held for longer periods
of time, is very short-term in practice.

Moodys Rating Methodology

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.

What Makes a Hedge Fund Different?


COMPARISON WITH TRADITIONAL ASSET MANAGERS
Some of the unique characteristics of hedge funds can be best understood by contrasting them with the typical mutual
fund. Hedge funds and mutual funds are both pooled investment vehicles that benefit from economies of large-scale
investing, but there are major differences between the two:
Mutual funds are registered under securities laws2, and may be sold to the general public, while hedge funds
are typically unregistered, may be sold only to financially-qualified (as defined under SEC regulations in the
US) investors, and cannot be marketed to the public.
Mutual funds generally must be diversified, be invested primarily in liquid assets, provide daily liquidity to
investors, comply with disclosure and governance-related regulations, and are limited in the types of investment strategies they may employ. Hedge funds, on the other hand, because they are offshore or theyre
exempt from most of these regulations by construct, can employ virtually any kind of investment strategy,
and may use leverage for the purpose of hedging as well as to increase exposure to risk. With hedge funds,
liquidity for investors is set by the hedge fund manager, and investors may be prohibited from redeeming
any portion of their investment for a period of years i.e., lockups.
Mutual funds may use only limited amounts of leverage in their portfolios. The Investment Company Act
essentially caps the amount of leverage a mutual fund may use to 150% gross leverage (i.e., long positions plus
short positions as a percentage of net assets). Hedge funds, by contrast, can use very high levels of leverage,
restricted only by the willingness of its counterparties to lend and by the amount of collateral they require.
Mutual fund fees for manager compensation are generally limited to a fixed percentage of assets under
management (AUM), but may include a contingent component that is not directly linked to the amount of
profits generated in the fund. Hedge fund managers compensation is normally a combination of a fixed
percentage of AUM plus a percentage of the returns generated by the fund e.g., 2% fixed plus 20% of
returns (above a high-water mark).
Mutual fund investment objectives normally seek out-performance relative to a particular market index,
whereas hedge funds attempt to provide double-digit absolute returns regardless of how market indices are
performing (hence the hedge in hedge funds).

COMPARISON WITH SECURITIES FIRMS


A comparison between well-diversified securities firms and hedge funds provides some useful context for Moodys
approach to rating hedge fund debt. Large global securities firms today, to varying degrees, engage in proprietary
trading using the firms capital, while they are also increasingly setting up their own hedge funds. This activity is analogous to operating an internal hedge fund. However, all else being equal, proprietary trading within a well-diversified
securities firm -- or managing a hedge fund business within one -- is a better credit risk than a standalone hedge fund
for a number of reasons:
Securities firms are subject to effective regulatory oversight, must meet minimum capital standards, and
depend on frequent capital market access on an unsecured basis, which requires that they consistently operate within a conservative financial profile
Most of a securities firms trading is customer-driven and initiated in pursuit of short-term market-making profits as opposed to position-taking in accordance with a particular investment strategy. This creates
captured spread that can cushion losses on positions

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.

Moodys Rating Methodology

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.

COMPARISON WITH STRUCTURED INVESTMENT VEHICLES4


Finally, it is also helpful to compare hedge funds against Structured Investment Vehicles in order to understand
Moodys approach to rating hedge funds. A Structured Investment Vehicle (SIV) is a limited purpose investment or
finance company that funds a diversified portfolio of highly rated assets with Aaa/P-1 rated Medium Term Notes
(MTNs) and Commercial Paper (CP). Capital Notes, which provide an expected return to investors of Libor plus a
spread in the neighborhood of 200 basis points or more, are also issued. Some vehicles have the ability to issue Mezzanine Capital Notes, typically assigned public ratings in the A category. Although SIVs have many features in common
with structured finance transactions such as market value CDOs, structured finance programs such as ABCP credit
arbitrage programs, and operating companies such as banks, hedge funds and arbitrage funds, they belong to a class of
their own.
The principal objective of SIVs is to provide stable returns to holders of Capital Notes through investment in
diversified portfolios of highly rated long-term assets, managed to strict parameters designed to maintain asset quality
and immunize the vehicles from market risk. The ability to issue senior liabilities using different programs allows the
SIV to take advantage of the pricing dynamics of each of these markets, with the objective of managing down the cost
of funds. SIVs exhibit characteristics of operating companies as well as structured finance transactions with very active
and dynamic treasury functions for the issuance of senior liabilities.
SIVs share some common characteristics with fixed income hedge funds in terms of use of leverage, active management of funding, and restrictions on the ability of Capital Note investors to redeem their investment in the SIV.
However, SIVs are distinct from hedge funds in that they lack the full discretionary control that a typical hedge fund
manager exercises: SIVs must follow very restrictive investment guidelines and they may be forced to de-lever or
unwind under certain conditions. These arise when a SIVs ability to repay its senior creditors becomes uncertain, as
measured by rating agency criteria, or through breach of financial covenants.

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.

Moodys Rating Methodology

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.

Collateralized Borrowing and Need for Liquidity


Hedge funds use leverage to increase and/or manage their risk exposure by borrowing, typically on a secured basis,
directly from prime brokers, or by executing repurchase agreements with or by lending securities to financial institutions. Hedge funds may also add leverage to their portfolios by entering into derivative transactions such as futures or
swaps, which are typically subject to margin/collateral posting requirements. Thus, a hedge fund through various
forms of leveraging activities may create a significant amount of counterparty obligations. Virtually all of these transactions are normally executed on a secured basis, and in many cases the level of margin/collateral may be subject to
change on a unilateral basis by the counterparty. Moreover, in many instances there are also NAV triggers5 that enable
the counterparty to terminate the transaction if a hedge fund suffers substantial investment losses and/or incurs significant investor redemptions. Therefore, these secured counterparties would rarely expect to suffer a loss6.
Hedge funds normally hold a target level of liquidity (in the form of unencumbered cash and/or highly liquid
securities) in order to fund margin calls, provide additional required collateral for transactions, and to settle at market
terminated derivative transactions, etc., which may occur under a stressful market environment when investor redemptions would be expected to accelerate and also would require funding. Secured creditors, as described previously,
would normally fare reasonably well even under a stress scenario, but what about unsecured creditors?

Risk to Unsecured Creditors of Equity Puts


In the absence of covenants, the unsecured creditor, during stress scenarios, may only be able to rely on the hedge fund
managers willingness to fully enforce redemption restrictions until the portfolio stabilizes. Although senior unsecured
debt ranks ahead of equity in terms of priority of claims in liquidation, unsecured creditors are effectively structurally
subordinated to equity holders in the presence of equity redemption rights, unless there are measures to counteract the
ability of equity investors to redeem. Another critical lever that the manager has discretion over is the investment
strategy. While a rational response to a loss of capital and capital market instability would be to reduce leverage and
moderate the risk exposure of the portfolio, which would also protect noteholders, theres nothing that compels the
manager to do so. Offsetting these considerations, to a limited extent, are factors that cause the managers interests to
be aligned with unsecured creditors - e.g., the manager is interested in maintaining the equity capital in order to maximize manager compensation; however, this incentive may not be sufficient to compel a manager to suspend redemptions or take other actions in favor of noteholders under a stress scenario.
One final important observation on this point: In the event of a stress scenario, theres the moral hazard that the
hedge fund manager may attempt to double down on the bet in an attempt to recover fund losses. If that were to
occur, and lead to greater portfolio losses, while equity investors were able to redeem out of the fund, unsecured creditors would be expected to suffer even greater losses, given the smaller residual value of the fund available to creditors.
In the absence of any covenants requiring a de-risking of the portfolio under such a scenario (such as NAV triggers
linked to automatic de-leveraging of the portfolio), unsecured creditors would be exposed to a potentially larger loss
given default (LGD) than would be typical of an investor in a senior unsecured bond issued by a financial institution.

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.

Moodys Rating Methodology

Why Do Hedge Funds Fail?


Table 2: Notable Hedge Fund Failures and their Causes*
Name of Hedge Fund

Year of
Failure or
Wind-up

Primary Causes of Failure

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

FRAUD AND LACK OF OPERATIONAL DISCIPLINE


Archeus Capital was a multi-strategy fund that focused on exploiting arbitrage opportunities in convertible bonds.
The firm had about $3 billion in assets at one point, which subsequently dropped to $700 million. It announced that it
would close by the end of 2006 because its administrator failed to maintain accurate records - and provided inaccurate
information to investors. In this case, the hedge fund supposedly neglected to independently verify the administrators
information. Investors may have become skittish over errors in reporting as well as some performance issues, causing
them to flee the fund.
In the case of Bayou Hedge Funds, the fund manager allegedly defrauded investors of $450 million by lying about
the funds' returns and issuing phony accounting statements to investors.
The above incidents, together with examples in the next section, illustrate the two most important reasons why
hedge funds may fail: (1) fraud or a major operational failure, and (2) a sudden loss of liquidity following a market
event. In some cases investors were able to redeem their investment with modest losses, and the fund simply closed.
In other cases, investors lost their entire investment.
In a 2003 white paper proprietary study7 of over 100 failed (defined as those funds that were forced to cease investment operations for reasons outside managements control) hedge funds dating back to 1982, Capital Markets Company Ltd. revealed that 54% of the fund failures could be attributed to fraud or operational issues, the most common
of which were: misrepresentation of fund investments, misappropriation of investor funds, unauthorized trading and
style breaches, and inadequate resources to execute the funds strategy(s). The authors observed that These problems
have contributed to substantial investor losses in hedge funds that could possibly have been prevented or avoided with
a more comprehensive due diligence and monitoring approach.
Given the lessons of past hedge fund failures and the expectation that these issues will continue to be relevant
going forward, a key pillar of Moodys approach to rating hedge fund obligations is the assessment of operational quality, which includes background checks on the principals of the hedge fund manager, a review of the funds valuation
approach and its independence from the manager, the quality of the administrator, etc., in addition to the risk management practices and investment strategies deployed in the hedge fund. These key factors, in addition to others, will be
discussed in subsequent sections.

LIQUIDITY, LIQUIDITY, LIQUIDITY


Some hedge funds have been making headlines in the financial press over the past several months. One notable event
was the rapid implosion of Amaranth Advisors' fund, which lost in excess of 65% of its value in a single month (September 2006) on a concentrated energy bet. As the bet's losses accelerated, the fund had difficulty liquidating its posi7.

Understanding and Mitigating Operational Risk in Hedge Fund Investments, A Capco White Paper, March 2003

Moodys Rating Methodology

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

Moodys Rating Methodology

Moodys Approach to Rating Hedge Fund Obligations


OVERVIEW OF RATING FRAMEWORK
There are three pillars to Moodys framework for rating hedge fund debtt. They are: Risk Management & Governance,
Financial Profile of the fund, and Business Profile of the fund. Because of the unique construct of a fund of funds (FOF)
portfolio, Moodys makes several adjustments in its approach to rating these types of funds (see Appendix 3).
In addition, there are various additional rating considerations that fall outside these three pillars. Some examples
include the structural subordination of unsecured debt and the impact of covenants, as well as legal entity and regulatory considerations. These factors can be extremely important, and could move a rating up or down from what the
three pillars would support. For highly structured debt, the approach would be very dependent on a quantitative analysis of the binding covenants.
In practice, we use a combination of metrics and qualitative assessments to evaluate the risk of loss to the creditors
of a hedge fund. Recognizing the great diversity of practice across hedge funds, theres a considerable amount of analyst judgment that must be overlaid on top of the metrics in order to properly interpret the results.
In our analytic framework for rating hedge fund debt, the anchor rating from which other ratings are derived is
the issuer rating, which is an opinion of the ability of an entity to honor senior unsecured financial obligations and
contracts. In practice, however, long-term senior unsecured debt will be effectively subordinated to collateralized
counterparty transactions.
There is a close linkage between the rating of hedge fund debt and the rating of its management company. The
creditworthiness of the management company is derived from the cash flows generated from the underlying funds it
manages as well as the credit profile of any other businesses that it operates. The financial profile of a management
company is primarily dependent upon the level and stability of the management fees generated by the underlying
funds relative to the management companys balance sheet and use of leverage. Therefore, higher rated hedge fund
managers will tend to be associated with higher rated hedge funds. A default at the fund level, assuming there were no
other businesses under the management company, would most likely result in a default at the management company,
since the fund would be expected to close down and management fees would cease. Therefore, in the simple case of a
single fund under a management company with no other business, the rating of debt at the hedge fund itself would
tend to act as a ceiling on the issuer rating of the management company.
For the rest of this special comment, when we refer to hedge fund debt ratings, we mean the issuer rating, unless
otherwise specified.

Hedge Fund Rating Framework Outline


Pillar 1: Risk Management & Governance
Operations Quality
Risk Appetite
Portfolio Risk
Performance Volatility

Pillar 2: Business Profile


Investor Profile
Investment Performance
Diversification
Size

Pillar 3: Financial Profile


Liquidity Risk Analysis
Overall Quality and Risk of the Fund Portfolio
Portfolio Leverage and Capital Adequacy
Interest Coverage

Other Considerations
Legal Structure and Debt Covenants
Market Considerations
Manager Equity Participation in Fund
Manager-Related Considerations Beyond Operations Quality

Moodys Rating Methodology

11

RISK MANAGEMENT & GOVERNANCE


Moodys assessment of a hedge funds risk profile relies on our global framework for risk management assessments of
financial institutions along the four dimensions of risk: governance, risk mitigation, risk measurement, and risk intelligence and infrastructure8. In the case of hedge funds, we focus more specifically on the following areas of investigation:
Operational environment
Fund risk appetite (portfolio risks, leverage and capital adequacy)
Performance volatility

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

OQ2: Very Good

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.

Risk Management Assessments, July 2004


Moodys Approach to Evaluating and Assigning Operations Quality Ratings to Hedge Funds, July 2006

Moodys Rating Methodology

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.

Moodys Rating Methodology

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

Moodys Rating Methodology

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

Liquidity Risk Analysis


Moodys uses several techniques to assess the liquidity risk of hedge funds. Typically we begin by examining the assetside liquidity of the fund. We try to get a sense for the size of the positions, the liquidity of each relevant market, and
the potential for market impact upon liquidation.
Then we consider the diversity and stability of the firms funding sources. This is a multi-faceted exercise that considers:
Diversity, quality and terms of prime brokerage relationships
Diversity, quality and terms of repurchase, stock loan relationships
Diversity, quality and terms of ISDA agreements
Exchange margin requirements and regulatory bottlenecks
Diversity, quality and terms of bank lending relationships
One tool we use is the cash capital framework. Cash capital compares a hedge funds sources of long-term capital to
its uses of long-term capital. Sources include permanent equity (excluding redemptions due within one year) and longterm debt. Uses of long-term capital include illiquid assets, initial margin requirements at exchanges or in ISDA contracts, and haircuts on liquid securities. A comfortable cash capital surplus is expected for an investment grade rating.
Our most important tool is the liquidity stress test, which amounts to a detailed cash flow analysis of the firm, with
a particular emphasis on the key time buckets (today, overnight, one week, two weeks, one month, etc.) through the
first ninety days of a crisis, and then at the remaining relevant time buckets out to one year. Therefore the liquidity
stress test is a complement to the cash capital test. There will be some tailoring of the cash flow line items depending
on the fund, but a typical test would be constructed as follows:
Assume a market/credit loss as postulated in current stress tests
Identify and quantify all contractual outflows for variation margins, NAV thresholds or other triggers as a
result of the loss
Identify and quantify any behavioral changes in counterparty terms such as reduced line availability, higher
asset haircuts, demands for better collateral etc.
Identify and quantify settling trades and fails
Identify and quantify expected investor redemptions
Estimate of potential funding requirements for undrawn commitments
Operating expenses for next twelve months
Identify liquidity trapped for regulatory reasons
Cash sources would include the following:
Identify and quantify borrowing power of unpledged highly-liquid collateral
Identify and quantify borrowing power of unpledged liquid collateral
Access to committed, secured credit facilities
Any other viable sources of liquidity
13. In this report we borrow several concepts from a 1999 report titled Improving Counterparty Risk Management Practices issued by the Counterparty Risk Management Policy Group. The CRMPG issued an updated report in 2006.

Moodys Rating Methodology

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.

Overall Quality and Risk of the Fund Portfolio


We make an assessment of the overall credit and market risks of the fund portfolio. The individual investments of a
hedge fund can run the spectrum from stable, highly-rated short-term fixed income instruments to volatile emerging
market equities, exotic derivatives or structured notes. This assessment is similar to, but more comprehensive than,
the traditional balance sheet analysis that Moodys employs on financial institutions.
Since it can turn over quickly, it is not feasible to monitor the portfolio constantly. Therefore, we make assumptions about the maximum risk tolerance the fund is likely to operate within, or its risk appetite (as described in the section on Risk Management & Governance), as well as the history of the hedge funds stress-tests and scenario analyses.

Portfolio Leverage and Capital Adequacy


A critical analytic task is to define and identify portfolio leverage, based on the strategy and instruments employed.
Leverage exists when a given price change on an underlying position has a magnified effect on the NAV of the fund.
It's also important to recognize that leverage is one dimension within the context of a fund's risk appetite, risk management and liquidity management, which interact and largely determine how the fund would be expected to perform
under various stress scenarios.
Traditional balance sheet measures, such as assets/equity, often have serious shortcomings when assessing the
credit risk to an unsecured bondholder in a hedge fund. A simple gross leverage measure (such as a time series of long
market value plus short market value/net asset value) may give some insight into a classic cash equities hedge fund and
may be helpful in sometimes identifying trends or indicating an outlier that bears further investigation. However,
exclusive reliance on such a ratio to compare funds that trade different asset classes - or that use derivatives - is overly
simplistic at best and misleading at worst.
To improve on simple balance sheet measures, Moodys uses risk-weighted approaches such as Tangible Common
Equity/Risk-Weighted Managed Assets in bank analysis or illiquid risk positions/Tangible Common Equity in securities firm analysis as these measures can have applicability to hedge funds.
With funds that use derivatives, or with funds that hedge portions of their portfolio, we prefer economic leverage
measures such as VaR/NAV in place of balance sheet ratios. Obviously, the VaR/NAV ratio must be supplemented
with other measures such as stress tests or expected shortfall/NAV in order to provide a more complete picture of tail
risks and capital adequacy.
A unique feature of hedge funds is the redemption privileges held by fund investors. This means that the equity
base of the fund is not permanent. The equity capital cushion will depend on the funds absolute performance (and to
a lesser degree on its relative performance compared to investment alternatives).
In our analysis of capital adequacy, we exclude all equity eligible for redemption within the next twelve months
from the NAV denominator. Stress tests should also incorporate specific assumptions about heightened redemptions
consistent with the scenario.

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

Moodys Rating Methodology

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.

Legal Structure and Debt Covenants


The hedge fund rating will be assigned to the legal entity or entities identified as the obligor and will consider any
other entities that can manage, guaranty, feed or withdraw capital from the fund. Most hedge funds have several shell
companies or limited partnerships that serve as sources of equity capital (the feeder funds). The feeders commonly
include offshore vehicles, such as a Cayman domiciled entity. These so-called master-feeder fund structures are commonly used for tax efficiency purposes to enable US taxable investors to access funds separately from non-US investors
and US tax-exempt investors (e.g., pensions and endowment funds). The impact of the feeder funds and the legal and
regulatory framework of the hedge funds on noteholders' ability to be repaid is considered, similar to Moody's
approach in other sectors.
Subordination issues revolve around the relationship between the equity investors and the funds creditors, as previously discussed. Commonly, equity investors (through feeder funds) will have their capital rolled into master funds
with which the hedge fund manager executes the firms strategies. Debt financing will be supplied from other legal
entities, which may or may not be pari passu to the other sources of debt financing. Such other sources may include
repos, total return swaps, and bank loans many of which may be collateralized or subject to margin calls, which can
deplete the unsecured bondholders capital cushion. Subordination may be reinforced through trusts, special purpose
entities or other means defined in the indenture.
Given the complexity of many fund structures, a key concern is what happens under stressed circumstances
including complete liquidation. If the equity investors are freely permitted to withdraw funds, assuming that they have
reached the expiry of their lockups, but without the manager having the ability and discipline of limiting redemptions
under stress conditions,or the presence of NAV or drawdown triggers, portfolio de-leveraging requirements or other
such creditor protections, the bondholders are essentially assuming economic risks greater than the equity holders, and
ratings would be adjusted lower, accordingly.

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.

Manager Equity Participation in Fund


In Moodys view, the amount of personal wealth invested by the principals of a hedge fund manager in the equity of the
hedge fund they manage can be either a credit positive or negative, depending on the situation. Having a reasonable
amount invested in the hedge fund fosters alignment of the interests of the principals with the equity investors, analogous to senior management of a financial institution owning common shares in their company. However, having a sigMoodys Rating Methodology

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.

Manager-Related Considerations Beyond OQ


This final catch-all relates to the funds governance with respect to debt. Moodys would consider factors such as the
managers intended use of the debt proceeds (will it be set aside in low risk securities to enhance fund liquidity or will it
be used to increase leverage?), the managers willingness and ability to remain sensitive to the rating on its unsecured
debt, etc.

Can a Hedge Fund be Rated Investment Grade?


Hedge funds typically dont present credit profiles consistent with investment grade financial institutions. It is conceivable, however, that a hedge fund could have the right balance of structures and attributes counterbalancing the
non-investment grade characteristics, and thus an investment grade rating might be achieved.
Hedge funds clearly lack many of the attributes that usually help a financial institution to attain an investment
grade rating. Investment grade financial institutions are subject to effective regulatory oversight and are governed by
minimum capital standards and standards of market conduct. They also typically have robust corporate governance
practices that include an independent board of directors and a strong independent audit function, and they publish
comprehensive and relatively transparent financial/statistical reports.
Conversely, hedge funds possess some distinct attributes not typically associated with investment grade credits.
Hedge funds frequently have an unfettered ability to quickly change investment strategy. Moreover, even if a hedge
fund has a well-articulated risk management strategy, self-governance could render risk constraints less effective in an
actual stress scenario. As a result, the future risk profile of a hedge fund may differ significantly from its historical profile, and even developing good visibility into the risk profile of hedge fund portfolios is made challenging by their limited transparency and high level of complexity. Finally, hedge funds, unlike investment grade financial institutions,
have equity capital that is subject to redemption, which may compromise the capital cushion supporting noteholders.
However, there are a number of hedge fund attributes (aside from tight debt covenants) which, taken together,
could balance out these structural weaknesses. The following are some examples of such characteristics:
Diversified, multi-strategy fund, or a fund using a strategy that is inherently well-diversified, with greater
than $500 million in equity capital, with only a minor proportion of equity capital represented by investor
types viewed by Moodys as less patient. A significant portion of equity in the fund for at least three years.
Good performance track record covering at least a 3-year period
Robust, institutional-like infrastructure, with a Moodys operational assessment of excellent
Well-laddered capital structure with long-term lockups on investor redemptions
Strong coverage of illiquid assets with long-term capital (i.e., a cash capital surplus)
Excellent, integrated liquidity management with an ability to manage twelve months under stress scenarios
without defaulting
Strong cash flow coverage of debt service from sustainable realized returns generated by the fund
Leverage consistent with the strategies employed
Consistently low concentration of fund investments
Deferred manager compensation invested in the fund represents a meaningful portion of total equity capital, subject to a long-term lockup and with some preferential treatment granted to noteholders under stress
conditions
A clearly articulated and documented operating plan for managing periods of highly tumultuous market
activity and potentially associated investor redemption requests such that noteholders would be protected.

18

Moodys Rating Methodology

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.

Moodys Rating Methodology

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.

Dedicated Short Bias


Dedicated short sellers were once a robust category of hedge funds before the long bull market rendered the strategy
difficult to implement. A new category, short biased, has emerged. The strategy is to maintain net short as opposed to
pure short exposure. Short bias managers take short positions in mostly equities and derivatives. The short bias of a
manager's portfolio must be constantly greater than zero to be classified in this category.

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.

Equity Market Neutral


This investment strategy is designed to exploit equity market inefficiencies and usually involves being simultaneously
long and short matched equity portfolios of the same size within a country. Market neutral portfolios are designed to
be either beta or currency neutral, or both. Well-designed portfolios typically control for industry, sector, market capitalization, and other exposures. Leverage is often applied to enhance returns.

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.

Fixed Income Arbitrage


The fixed income arbitrageur aims to profit from price anomalies between related interest rate securities. Most managers trade globally with a goal of generating steady returns with low volatility. This category includes interest rate
swap arbitrage, US and non-US government bond arbitrage, forward yield curve arbitrage, and mortgage-backed
securities arbitrage. The mortgage-backed market is primarily US-based, over-the-counter and particularly complex.

14. Source: Lipper HedgeWorld's Education Center, which follows Credit Suisse Tremont LLC's series of sub-indices

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Moodys Rating Methodology

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

Moodys Rating Methodology

21

Appendix 2
Securities Laws Related to Mutual Funds
FOUR PRINCIPAL SECURITIES LAWS GOVERN INVESTMENT COMPANIES
The Investment Company Act of 1940

The Securities Act of 1933

The Securities Exchange Act of 1934

The Investment Advisors Act of 1940

Source: 2006 ICI Fact Book

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Moodys Rating Methodology

Regulates the structure and operations of investment companies


by imposing restrictions on investments and requiring investment
companies to maintain detailed books and records, safeguard
their portfolio securities, and file semiannual reports with the U.S.
Securities and Exchange Commission (SEC).
Requires federal registration of all public offerings of securities,
including investment company shares or units. The 1933 Act also
requires that all investors receive a current prospectus describing
the fund.
Regulates broker-dealers, including investment company
principal underwriters and other entities and persons that sell
mutual fund shares, and requires them to register with the SEC.
Among other things, the 1934 Act requires registered brokerdealers to maintain extensive books and records, segregate
customer securities in adequate custodial accounts, and file
detailed, annual financial reports with the SEC.
Requires federal registration of all investment advisers, including
those to mutual funds and other investment companies. The
Advisers Act contains various antifraud provisions and requires
fund advisers to meet recordkeeping, custodial, reporting, and
other requirements.

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

Moodys Rating Methodology

23

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