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Check-the-box due diligence is not enough - Financial Times


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On-site visits with management are essential. During such trips Jonathan Kanterman, a hedge fund consultant and co-author of FTfm’s hedge fund surveys, has discovered gaps between what he read in fund documents and what he saw involving staffing, technology and investment process, as well as management spending time running other businesses.

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Check-the-box due diligence is not enough - Financial Times

  1. 1. FINANCIAL TIMES MONDAY JUNE 30 2014 9 News analysis Check­the­box due diligence is not enough There is plenty of media coverage whenever hedge funds underperform. Mal- feasance always makes for good copy. But there is pre- cious little reporting of how investors can mitigate the chances of being on the wrong side of such news. Investors should not believe that more reporting on funds or their increasing “retailisation” through Ucits or US ’40 Act products are making such investments safer. All this ensures is that more investors are at risk. Effective analysis before committing money can help avoid the hazards of hedge fund investing. But stand- ard check-the-box due dili- gence focused more on method than outcome can fail to connect the poten- tially toxic mix of dots. Despite the mystique that surrounds many hedge fund managers and claims of absolute returns, market- beating alpha or market hedges, investors need to think of hedge funds as asset managers. Accord- ingly, they must demand the same level of transpar- ency and clarity from a fund as they do from a mutual fund or stock. Every year the FTfm hedge fund survey* offers an extensive look at the process for identifying sound funds. The mantra: if fund documents and per- formance do not square, move on. Suppose a fund’s volatil- ity rises unexpectedly. To Kent Clark, who oversees $23bn as chief investment officer of hedge fund strate- gies at Goldman Sachs Asset Management, “it may suggest the manager is tak- ing on more or different risk than we were told he would”. And when he observes lower risk than expected, that may indicate to Mr Clark and his team “inclusion of illiquidity and unmarked securities, or a manager deciding to focus on collecting management fees rather than trying to generate returns from per- formance fees”. The goal of due diligence is to find such disconnects. They are the source of unnecessary and unex- pected portfolio risk. Uncov- ering such discrepancies should be deemed as much a success as having made profitable investments. While some investors may be intrigued by emerg- ing managers, generally it is advisable to concentrate on funds that have at least five years of solid audited performance under the same manager and a mini- mum of $100m under man- agement. (They should have more assets after five years, but sometimes a good man- ager may simply be a lousy marketer.) Then affirm the use of top-tier service providers and identify a complete set of literate documents. There are generic queries that apply to all funds regarding portfolio, man- agement, risk control and transparency. Operational competence is as critical as investment acumen. It is essential to understand these two sides clearly, and the logic that is purportedly binding them together. Take an equity long/short fund, which should be com- prised predominantly of stocks and/or related futures and options. If it is a global fund, for instance, take a look at how its performance relates to the referenced benchmark. If it is deviating significantly, find out why. One might turn up a closet emerging market fund or some unexpected exposure in distressed debt, which management is hop- ing will convert into new post-bankruptcy shares. Long positions may signifi- cantly outweigh shorts. Or notional value may be many times net asset value, indi- cating the portfolio is lever- aged substantially. This kind of forensic analysis is essential in finding any gap between what a fund says it is in its documents and what it actually is. Even when investors desire such aggressiveness, the strategy must be clearly articulated, from the fund’s pitch book to its risk assess- ment. If one sees plain vanilla commentary that fails to assess the potential downside accurately, that is a red flag. Much initial due diligence can be done on a laptop. All funds have presentations, monthly performance reports, due diligence ques- tionnaires, private place- ment memoranda and audited financials. Funds that have at least $150m in assets also need to file Form ADV with the US Securities and Exchange Commission. Many important regula- tors maintain websites worth visiting. In the US, the independent adviser section** provides extensive information, including past and pending disciplinary actions against funds. Remember to do back- ground checks on signifi- cant individuals, not just the funds they are running. Google each one. Past fail- ures may inform. But search for more nuanced detail, such as risk taking in their personal lives. Can such an intrepid spirit be checked at an office door? Maybe, but it is good to know. On-site visits with man- agement are essential. Dur- ing such trips Jonathan Kanterman, a hedge fund consultant and co-author of FTfm’s hedge fund surveys, has discovered gaps between what he read in fund documents and what he saw involving staffing, technology and investment process, as well as manage- ment spending time run- ning other businesses. In a study of 22 hedge fund failures, Greenwich Roundtable, the non-profit research and educational organisation, found that the three most frequent causes (evident in half the cases) were excess leverage, liquidity problems and inad- equate risk management. About a third of the time, the main problems also con- cerned inadequate transpar- ency, unreasonable volatil- ity and service providers. Jeffrey Willardson, man- aging director at Paamco, which oversees $9.5bn in fund of hedge fund invest- ments, pushes forward the discussion of due diligence. “Most investor due dili- gence is backward looking. But that does not address performance risks ahead,” he says. The investment team at Paamco makes rea- soned projections about how a fund’s strategy, and its current positions, will be likely to respond in the macroeconomic conditions that may prevail six to 12 months out. Due diligence does not stop once the investment is made. Every year, investors should review important issues and flag potential problems. If they are not resolved within a reasona- ble period, then investors should consider exiting such positions. Goldman’s Mr Clark con- curs. He believes investors should not feel complacent. Investors and advisers can pass off due diligence by investing through insti- tutional hedge fund plat- forms or fund of funds. Both bring added fiduciary protection. However, this will increase costs and could challenge the value of hedge fund exposure in the first place. Regardless of what invest- ment pundits may say, hedge funds are not an essential part of the portfo- lios of wealthy individuals or institutions. Good man- agers are. And until you find one, do not invest. * fund-survey ** Governance Analysis before committing money can help avoid the hazards of hedge fund investing, says Eric Uhlfelder 10 red flags Source: FT research Management’s reluctance to speak to investors Unknown service providers Unaudited financials Material conflicts of interests Unclear and incomplete investor communications Lack of access to existing investors for reference Long-term high volatility Frequent turnover of key personnel Lack of manager assets in the fund Liquidity mismatch between redemption terms and assets Potential for fiduciary failure Potential for obscuring transparency and negatively impacting operational integrity and performance Uncertainty about key financial metrics Raises issues of integrity Selective response to questions may suggest operational and investment deficiencies, potentially involving portfolio holdings, and a gap between manager vision and reality Less than a compelling endorsement of the fund Suggests an inability to control risk and issues with overall investment approach Problems with the fund structure and internal relationships Failure to link manager and investor interests Investors may not be able to redeem shares as per agreement, especially during a financial crisis Jonathan Kanterman was consulted in development of this list