In this chapter, we will first apply the term due diligence to explain the evaluation and analysis processes followed by an investor or plan sponsor to evaluate a manager.
Afterward, we will look at the due diligence process, which is organized into four main sections:
- The process of investment;
- The management of risk;
- The operational environment; and
- The assessment of the business model.
A manager should be properly prepared during the process of evaluating an opportunity worth investing in. This implies that one should have adequate knowledge of the specific investment strategy they consider applying. Once we have full information on the strategy beta and how the strategy will react under different market conditions, we can focus more time and attention on the manager’s skills of generating alpha relative to peers in the same style of investment.
Learn from the Past – Both from Success and Failures
We can easily get caught up in a hedge fund investing’s past success. As investors, we got to remember the reasons as to why funds fail. As part of the due diligence process, answers to the failures of the previous fund should be integral when considering a strategy. Some of the reasons as to why funds can fail are:
- Bad investment decisions
- Frauds; accounting frauds, valuation frauds, misappropriation of funds, and many more
- Excessive leverage, events that are unexpected, unlikely probabilities, and tail risk
- If there are too many unanticipated withdrawals at the least opportune moment
- When supervision or compliance controls associated with insider trading are lacking
- Failure of funds can also be due to their own actions or acts of others; a perfect example is the bankruptcy of Lehman, a prime broker, which went down with other funds.
- Drying up of liquidity, making the fund unable to meet redemptions and as result, at the least opportune moment, they sell into a non-existent market.
If It Looks Too Good to Be True, It Probably Is
Specific employees tasked with the duty of performing an investment due diligence are supposed to trust their own judgment before others’. They say if it looks too good to be true, it probably is. In most cases, allocation decisions of firms are made by a committee. However, the decisions of the team can sometimes be directed by only one individual. It is possible for other individuals in the committee to feel intimidated making them not communicate negative information about a manager due to the manager’s influence within the organization.
However, it is advisable for stakeholders with relevant information to voice their concerns. Usually, everyone sees what might have been obvious only in retrospect. Therefore, we should always communicate all relevant information for the good of the company.
Remember, It’s Still About Returns
It is possible for some investors to put too much emphasis on some aspect of the due diligence process, due to the amount of media and regulatory focus concerning the necessity for hedge funds to adhere to best practices. Another aspect that might as well be overemphasized by investors can be operational due diligence. This may lead them to select managers with great controls that would not add anything to the overall portfolio returns.
In this regard, a balance should be established between the fund’s risk profile and the available opportunities to invest. If the balance is not to excessively shift in one direction, then there has to be a set of minimum standards or bright lines. The organization should not compromise on the necessity for audits, top-tier service providers, and independent administrations. We should always invest with an aim of maximizing returns and reducing risks.
Common Elements of the Due Diligence Process
As compared to past decades, the process of due diligence is now much different. For example, investors in the past relied heavily on the reputation of a manager or his/her performance rather than the how and why of the performance, or even better, the measures used to protect capital. This behavior was partly attributed to the fact that there was less of a use of leverage.
In the past, the exposure to hedge funds by institutions was very low. Their only goal was to achieve a high return on the investment to matter what. Also, there was a tendency by managers to be selective in addressing concerns and too many questions were not raised.
However, the due diligence process had to expand because the industry matured with time and more institutions were venturing into the market. The expansion of the process was also fueled by some very high profile frauds that took place. Nowadays, a lot of time and effort is spent on trying to learn the source of a manager’s edge by both the investors and the managers who are always concerned about safeguarding their capital and the proper valuation of their investment.
There are two evaluations in the due diligence process, that are separate but with close relations, namely:
- The evaluation of the process of investment and related risk controls; and
- The evaluation of the operations and business model of the company.
We need to find out what exactly takes place in the fund. In this section, we summarize the common themes and concerns applied by investors as they perform due diligence on the investment process of a company.
What Is Your Strategy, and How Does It Work?
Investors examining a manager frequently begin with high-level concerns for them to have some context regarding the firm, its style of investment, and how it operates. The following are some of the concerns that need to be addressed:
- The self-described style of the manager, and its position within a certain classification scheme.
- The current themes included in the portfolio and the highest convictions of the fund or positions that are most concentrated.
- The evolution of the portfolio over the past several quarters, the outlook for any changes, provided the working environment in place.
- The management of the fund to some given gross and net exposure targets. Has the fund achieved the said targets today?
- The turnover of the portfolio, the liquidation period, and the triggers leading to a reversal and a long or short to cover or exit decision.
- The application of stop losses in risk management.
- How quantitative the process of investment is, and the level of reliability upon the proprietary models used
- The application of short sales as alpha generators, hedges, or both.
- The application of listed OTC derivatives in the portfolio.
- The organization of trading. Is there a central trading desk for all external order flow?
- If the trading is capacity constrained.
- Scenarios where private investments were held by the firm if any. Reasons for supporting the core investment strategy.
- If the orientation of the company leans toward returns, asset growth, or both.
- Management of the conflict between existing clients’ returns generation versus growth of assets under management.
- If there are instances when the fund was soft or hard closed, or have had capital refunded to investors.
After addressing these concerns about the firm and the fund, the investor can then start investigating more specifically about the company and the process it follows in its investment management process.
How is Equity Ownership Allocated Among the Portfolio Management, Trading, and Research Teams?
It is important that we understand the ownership structure of the company and its operations. Therefore, the investment team should be involved in some form of ownership to differentiate among firms. The equity ownership practices vary from firm to firm. In some, the equity ownership is not shared among the portfolio managers or the traders, while in others, the equity ownership is strongly featured in their professional talent retention programs and in attracting and grooming new skills for leadership positions in the future. It is crucial that we understand the philosophy of the company and its effects on performance, acquisition of talent, and retention.
Reliability of the Track Record
As an investor, you should do an in-depth investigation on the track record of both the manager and the fund in question, immediately once your basic set of concerns about the company are addressed. Some of the concerns about the track record that the investor should investigate are:
- If the track record can be compared to similar strategies
- Whether the track record has been audited
- If the track record is sufficiently long to draw statistical inferences and evaluations
- If the size of the fund affects the returns
- Is the team that produced the best or worst track record present in the company currently?
- The performance of the track record when the market was stressed
- The relationship between the track record and the experience of the portfolio manager at previous companies.
Who Are the Principals, and Are They Trustworthy?
As an investor, if you are interested in a particular manager, then you should do background checks on him/her and look for references. For new managers, they should have references from hedge funds or banks they have previously worked for. For established managers, the focus should be more on their motivations, how they react in times of crises and stressed periods, how they interact with individual investors and what the experiences of other investors who have interacted with them are. This information is important and can be obtained by interviewing them or their references.
The perception of investors towards individuals entrusted with their assets has greatly been influenced by the scandals and blowouts of the hedge funds over the past decade or so. To obtain reliable background information, especially on a manager, a comprehensive report is necessary and can be purchased for as low as USD 750. However, due to lack of proper due diligence in the hedge fund culture, frauds are likely to go undetected.
Another important source of information might be former employees, credit and audit reports, prime brokers and administrators. Other important considerations are the manager’s form ADV (the uniform form used by investment advisers to register with both the Securities and Exchange Commission (SEC) and state securities authorities), past bankruptcies, and federal and court records.
Lastly, it is crucial that top management of the company is accessible to the investors, and that the investors interact directly with the decision makers and the actual risk takers, rather than only interacting with the public relations (PR) department, the salespersons, or other junior staff without critical information.
The Risk Management Process
Critical queries should be addressed when examining the processes and procedures of managing risks by all management levels of the company. Investors can look for information from portfolio managers, risk managers, operation staff, and traders.
How Is Risk Measured and Managed?
Many funds are beginning to see the importance of risk management, and there has been a significant evolution in the process of risk management and reporting over the past few years. This evolution has been geared towards models being increasingly independent and risk-taking and investing segregation. In this day and age, most funds have hired dedicated risk managers who are independent from portfolio managers and whose superior is directly the CEO or CIO. For other funds, risk management is in the hands of the accountants of the funds and administrators.
Firstly, investors must be concerned with the potential risk they are likely to be exposed to by a strategy in their venture. They are then supposed to inquire about any further idiosyncratic risk that a certain manager may expose them to within a particular strategy.
Investors should then inquire about any laid down policies and procedures to evaluate and monitor all risks that might be present. They should also be concerned about the presence of a risk committee where monitored risks can be reported to and addressed within certain timeframes.
To monitor and originate risks, most hedge funds nowadays apply sophisticated procedures. It is therefore important that investors seek information about the procedures applied by the company when selecting their risk platforms.
Finally, it is important that the information availed to investors cover the generic risks that are commonly reported to many other funds. The information should also address the specific risks associated with a particular style of investment or fund.
How Are Securities Valued?
When examining the valuation of a particular fund the information that should be sought after needs to include the percentage of assets of the fund that are exchange-traded and marked to market through exchange prices against model prices or broker quotes.
The aspiring investor should also be concerned about whether valuation responsibility is taken by the administrator, or responsibility is retained by the manager. The question as to who can override prices and the existence of a documented procedure that is formalized to do so needs also to be addressed.
What Is the Portfolio Leverage and Liquidity?
The current and past variations leverage, the source of the leverage and the liquidity of the portfolio should all be meticulously examined by the investors. This will enable them to know if there might be a deviation from the fund’s peer group. Investors may also need to understand if the manager exhibits leverage or liquidity leading to performance deviation from the strategy’s expectations.
Therefore, with the answers they will get, the investors can adjust their expectations for returns. The comparison between the current liquidity and leverage in the existing portfolio to the previous liquidity and leverage is a question that should be addressed as well. It is expected that the capacity and ability of the fund to handle larger amounts of investor capital will affect liquidity and may sometimes, depending on the strategy, affect returns.
Does the Strategy Expose the Investor to Tail Risk?
Some strategies can be non-protective in that they may introduce unexpected risk to investors. Investors should, therefore, investigate information about funds and decide on risk distribution. An investor must ask if the manager has a complete understanding of tail risk with regard to leverage and derivatives products.
How Often Do Investors Get Risk Reports, and What Do They Include?
Regular reporting from the company is a right of every investor. For some funds, the risk is reported using a standard package that a third party has provided. Furthermore, these reports can also include risk statistics in the fund’s monthly fact sheet or periodic investor letter.
The information should be obtained by investors, and these investors should understand it and do a comparison with peers for the sake of consistency before tying up capital.
Do the Fund Terms Make Sense for the Strategy?
Investors can collect data to compare fund terms with other similar funds. Compensation for the risks that they are exposed to might not be possible if investors give away terms, like lock-up periods, to managers. It is also advisable that the investors do not pay high fees for the market beta as it can be cheaply replicated on its own.
Fees, high-water marks, and hurdle rates linked to capital should be inquired by the investor. The inquiry should focus on whether the fees are appropriate or aligned with peers, the computation of the hurdle rate, whether the high-water mark is reset on yearly basis or is it perpetual, the comparison between the portfolio liquidity and the one given to investors, the availability of a lock-up period prior to redemptions being allowed, and finally, whether the fund can gate or suspend redemptions.
Fund Operating Environment, Documentation, Financials, and Service Providers
The fundamental role of an operational due diligence is to make sure that the downside risk should not be significant, and it should not be created for investors associated with the following:
- Securities settlement;
- Corporate actions processes;
- Theft and misappropriation by both the employees and agents;
- Any other breakdown in the confirmation of the manager;
- Valuation; and
- Reconciliation process.
Moreover, the following actions should be key components for an investor undertaking operational due diligence:
- An assessment of the internal controls of the manager.
- Are the fund’s documents and legal representations consistent?
- The risk of loss as a result of failure by a counterparty or service provider.
Internal Control Assessment
The following are some of the factors the investor needs to review when assessing the control environment of a manager:
- Are the individuals at the fund sufficiently qualified?
- Are the written procedures of adequate quality?
- Can the team adequately execute the written procedures on a daily basis while clearing any expectations likely to occur?
- What is the exposure of the fund to derivatives counterparties?
- What is the protections provided in the governance structure of the fund?
Documents and Disclosures
The documents and disclosures have to be verified by the investor. This verification should be with a by a law firm. It is possible for managers to change the content of their fund documents without the consent or knowledge of the company that created the said documents.
It is important for the investor to consult the manager and the law firm immediately for a discussion in case he/she notices changes that were effected after the “as-of” date. The listed law company, in the document, should be under the retainer agreement of the fund manager.
Moreover, the investor has to confirm that the same information is provided in the memo, subscription agreement, limited partnership agreement, Form ADV, investment management agreement, and the website, at the same point in time.
The conflicts of interest section of the offering memo (OM) of the fund should also be very meticulously considered by investors in hedge funds. Any queries concerning the nonstandard arrangements with managers, co-investors, or any other relevant party, should be addressed by the law firm that drafted the documents.
In the event that the risk disclosures are either insufficient or excessively broad, then the investor has to be very cautious. Furthermore, the registration and compliance guidelines have to be counter checked with an independent counsel whose specialty is regulating the strategy mix traded by the manager.
When the document is being reviewed all the fund documents should be carefully read. This will make sure that the terms are a mirror image of the discussions between the investor and the manager. The investor should also review the subscription rights before any agreement is reached with the manager.
The investor is also advised to review the manager’s powers, his/her obligations to report to investors, financial statements, balance sheets and income statements, a re-computation of the fees the fund pays to the manager (they should be relevant), and finally a confirmation from the equity section that the general partner is still venturing into the fund.
Service Provider Evaluation
It is expected that a hedge fund ensures that the crucial contacts of their service providers are made available to the investors for the purposes of verification. Furthermore, the investors should get, from the service providers of the fund, internal control letters, and audited financial statements to ensure an independent validation exists on the part of the service providers.
Business Model Risk
In this section, we consider the risks encountered when running a hedge fund. The concerns that need to be addressed include the availability of adequate cash on hand, the source of the working capital, its organization, the availability of a succession plan, the outcome of many investors redeeming at the same time, and many others.
In most cases, a failed fund gets liquidated in very adverse conditions. This process may include tying up the capital, litigations and court cases, and loss of investor confidence in their decisions.
Success can be guaranteed to managers who are serious about model risk since they will always be actively involved in modifying to adapt to the current market environment.
It is crucial for the survival of a fund to have the manager be able to control costs and predict revenues. There is no general business model that is applicable to all hedge funds. However, there exists some common factors and best practices developed to ensure that the manager undertakes a business that is sustainable.
It has been noted that the impact of performance fee makes the model of a hedge fund to be superior. The following are some of the issues that should be addressed by the investor regarding any present business or model risk:
- The strategic of vision of the company;
- Availability of a multilayer budget;
- The number of months of cash flow available in their bank;
- The steps taken by the fund to lower its cost base;
- The last time the fund renegotiated its terms with its key service providers;
- If the fund applies any solutions that are outsourced;
- The break-even AUM of the fund;
- The necessary fund performance to break even at the existing level of AUM;
- Is the existing team sufficient to handle additional assets?
- Availability of key man insurance.
Cases of fraud risk should always be a priority to investors in hedge funds. According to the FBI, hedge fund fraud is a white-collar fraud. Many investors are still vulnerable to hedge funds that are minimally regulated. The following are some of the potential fraud indicators that investors have to be cautious about:
- Lack of independence in trading when a fund executes through an affiliated broker-dealer;
- Lack of liquidity concerns raised by investors;
- Litigations due to fraudulent activities;
- Performance claims that are unusually strong;
- Illiquid investments of very high percentages, including those marked to market by the manager;
- When there is no independence during risk valuation, or even related parties doing the risk valuation;
- If the managers undertake personal trading in the same securities or similar securities as the fund; and
- Hostile selling of stocks and systematic attempts to escalate gossip or circulate lies regarding an organization.
Which of the following is NOT a potential indicator of fraud that should be investigated by investors prior to investing in a particular fund?
- The fund represents over 35% of the Brasilian interest rate futures exchange.
- The activist fund makes systematic attempts to escalate gossip regarding an organization.
- The fund has posted positive returns between 5% and 10% for the past 10 years.
- The fund is engaged in the buying and selling of stocks which have trading volumes of fewer than 5,000 shares per day.
The correct answer is C.
According to the FBI website, there are numerous potential indicators of fraud that should not escape the eye of a potential investor and should, therefore, be investigated when considering investing in a given fund.
These indicators include, but not limited to, the following:
- A large proportion of a market with few individuals participating and a low volume of activity (which removes options A and D);
- Hostile selling of stocks and systematic attempts to escalate gossip or circulate lies regarding an organization (which removes option B);
- Interconnected partners engaging in evaluation or not being individualistic; and
- Abnormal performance. Option C, returns between 5% and 10% over the past decade, does not constitute abnormal performance. In fact, we could find hundreds of funds that post these kinds of returns consistently.