In our last post, we focused on the upheaval to the hedge fund industry from the GFC. The downside risk caused surviving hedge funds to innovate through forming management structures that attempt to gain scale and scope. Size and diversification as a form of hedging downside risk.
In this post, we focus on the second major upheaval to the hedge fund industry - the Bernie Madoff scandal. While hedge funds realized that they needed to gain scale and scope to save their businesses. Investors demanded more professional management and a broader scope of functions, as seen in other industries, in response to the uncertainty within the hedge funds in which they invested. Call it the rise of super due diligence. Of course, the government increased regulation, but investor due diligence also rose in response to fraud. The costs, especially for running a small hedge fund, increased because investors were not going to pare back due diligence because the manager was smaller. In fact, the risk of failure or fraud was likely higher for smaller funds.
The Madoff change led to stronger internal controls, legal, and compliance departments. There was also a greater demand for transparency and contact with the manager, which increased the need for investor relations and marketing. The demand for risk management and exposure reporting led to the creation of separate departments from the investment business.
Once the demand for transparency and more formal due diligence took hold, hedge funds had to provide many of the same investor services as long-only managers. The market shifted assets to larger firms, which in turn led hedge funds to focus on scale and scope, adopting more formal organizational structures.
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