Since 2008 a number of factors have caused a significant style drift in the hedge fund space as the industry underperformed.  What is style drift?  Style drift occurs when the investment style of the Fund is changed without the approval of investors, and it is a form of operational risk.  The risk of style drift is a drift to areas of non-core expertise that results in investor redemptions, additional market risk and credit risk.  However, not all drifts in portfolio characteristics fall under the definition of style drift.  The wording of the investment policy and strategies of the Fund in the Offer Document and the Prospectus must be absolutely clear when it comes to the use of illiquid investments, given that portfolio characteristics can “drift” when there is significant exposure to illiquid investments, and in the absence of correct language this might be confusing to investors and could also be confused with “style drift”.  

Because illiquid assets cannot be easily rebalanced, it is difficult to maintain a target risk-return profile.  This means that uncertainty is increased beyond the forecast volatility of the asset classes as a whole because of the inability to rebalance, higher specific risk, and inability to react to new information about investments.  Thus, the range of portfolio volatility and return will be greater than would be experienced with an all-liquid portfolio, and the Fund’s risk-return profile will drift for extended periods of time, to some extent beyond the investor’s control.  By considering these factors, the Investment Managers can suggest reasonable ranges for illiquidity based on particular circumstances, however, investors need to understand all the costs and risks associated with making investments in illiquid alternative investments.  

If illiquid assets outperform liquid assets, they become a greater proportion of the portfolio, which might increase overall portfolio risk beyond target levels.  While corrective action may be taken in the liquid portion of the portfolio to reduce overall risk (e.g., selling public equities), that may also have unfavorable consequences such as reducing diversification.  It is therefore essential that all parties involved in verification of documents, especially lawyers, weigh in on the wording of the investment mandate especially where illiquid instruments are involved.  Illiquid assets can have much more specific risk than liquid asset classes, and this must be clearly explained.  Precisely clear and correct wording is needed as to what the Manager can do and what the results can be. 

Illiquidity limits investment flexibility – the ability to rebalance the portfolio at will in response to new information about investments and new investment circumstances and preferences.  The undesirable consequence of this is that there is greater uncertainty in overall portfolio volatility and return, as compared to the Fund’s original target.  In other words, over time, a Fund’s actual risk-return profile may differ from its original target due to illiquidity constraints. 

To avoid style drift, Managers must stick to the investment program as it was laid out in the Fund’s offering documents (which includes, if applicable, PowerPoints and other marketing materials), particularly in regard to leverage.  Institutional investors, including Funds of Funds, are expected to monitor for style drift via requests for position level disclosure from the Prime Broker or the Administrator.  Such information is usually laid out via a side letter if this level of transparency is not provided through the offering documents.  If the Investment Manager strays from the investment program then an aggrieved investor will have a very good case against that Manager. 

Investment Managers or other service providers should analyze the style drift of a Fund, as the SEC is gearing up to be able to determine it.  It can be significantly affected by leverage.   Some commentators and lawyers believe that we are likely to see investor lawsuits arise as a result of losses from style drift.  Apart from departures from the investment mandate and restrictions, the issue for style drift is whether the Manager has not only the authority but also the background, skill set, infrastructure, and supporting services to implement various other strategies or substrategies.  Investment Managers should be urged to stay within their stated investment objectives, and Fund Directors should discuss a potential departure from the investment mandate and/or violation of restrictions with legal counsel.  Monitoring is important for assuring style discipline. 

Normally style drift will start small and get larger.  Directors should determine whether the Manager reports its positions as well as its monthly or quarterly profit and losses, otherwise it will be difficult for most investors to detect style drift.  Some Investment Managers will not worry about style drift if they’ve crafted a sufficiently broad investment program which allows them to invest in any instruments and without regard to any sort of position limits and leverage.  For example, an offering document can contain a disclosure that the strategies listed are not exhaustive, and the Manager may actually be acting within a discretion contained in the terms of the Fund documentation.  The Fund’s Directors or lawyers must review the Fund documentation to determine whether the perceived departure from the strategy or discretion is an actual departure.  Investors should be given an opportunity to redeem in cases of actual style drift given that investment risk will likely shift. 

In the case of style drift in Private Equity, in order to alleviate the risk of style drift the upfront design of the Limited Partnership Agreement is important, as the covenants guide the behaviour of the Investment Manager.  According to UpperMark, in general, Limited Partners want the Fund Manager to adhere to their stated Fund strategy and avoid style drift so that they can estimate their risk profile better.  However, under changing market conditions, it could be beneficial to permit General Partners to explore other investment opportunities.  For example, selling a buyout investment and entering into a venture capital investment or investing abroad.