FINANCIAL TIMES MONDAY JUNE 30 2014 9

News analysis

Check­the­box due diligence is not enough

There is plenty of mediacoverage whenever hedgefunds underperform. Mal-feasance always makes forgood copy. But there is pre-cious little reporting of howinvestors can mitigate thechances of being on thewrong side of such news.

Investors should notbelieve that more reportingon funds or their increasing“retailisation” through Ucitsor US ’40 Act products aremaking such investmentssafer. All this ensures is thatmore investors are at risk.

Effective analysis beforecommitting money can helpavoid the hazards of hedgefund investing. But stand-ard check-the-box due dili-gence focused more onmethod than outcome canfail to connect the poten-tially toxic mix of dots.

Despite the mystique thatsurrounds many hedge fundmanagers and claims ofabsolute returns, market-beating alpha or markethedges, investors need tothink of hedge funds asasset managers. Accord-ingly, they must demandthe same level of transpar-ency and clarity from afund as they do from amutual fund or stock.

Every year the FTfmhedge fund survey* offersan extensive look at theprocess for identifyingsound funds. The mantra: if

fund documents and per-formance do not square,move on.

Suppose a fund’s volatil-ity rises unexpectedly. ToKent Clark, who oversees$23bn as chief investmentofficer of hedge fund strate-gies at Goldman SachsAsset Management, “it maysuggest the manager is tak-ing on more or differentrisk than we were told hewould”. And when heobserves lower risk thanexpected, that may indicateto Mr Clark and his team“inclusion of illiquidity andunmarked securities, or amanager deciding to focuson collecting managementfees rather than trying togenerate returns from per-formance fees”.

The goal of due diligenceis to find such disconnects.They are the source ofunnecessary and unex-pected portfolio risk. Uncov-ering such discrepanciesshould be deemed as mucha success as having madeprofitable investments.

While some investorsmay be intrigued by emerg-ing managers, generally itis advisable to concentrateon funds that have at leastfive years of solid auditedperformance under thesame manager and a mini-mum of $100m under man-agement. (They should havemore assets after five years,but sometimes a good man-ager may simply be a lousymarketer.)

Then affirm the use oftop-tier service providersand identify a complete setof literate documents.

There are generic queriesthat apply to all fundsregarding portfolio, man-agement, risk control andtransparency. Operationalcompetence is as critical as

investment acumen. It isessential to understandthese two sides clearly, andthe logic that is purportedlybinding them together.

Take an equity long/shortfund, which should be com-prised predominantly ofstocks and/or related futuresand options. If it is a globalfund, for instance, take alook at how its performancerelates to the referencedbenchmark. If it is deviatingsignificantly, find out why.

One might turn up acloset emerging marketfund or some unexpectedexposure in distressed debt,which management is hop-ing will convert into newpost-bankruptcy shares.Long positions may signifi-cantly outweigh shorts. Ornotional value may be manytimes net asset value, indi-cating the portfolio is lever-aged substantially. Thiskind of forensic analysis isessential in finding any gapbetween what a fund says itis in its documents andwhat it actually is.

Even when investors

desire such aggressiveness,the strategy must be clearlyarticulated, from the fund’spitch book to its risk assess-ment. If one sees plainvanilla commentary thatfails to assess the potentialdownside accurately, that isa red flag.

Much initial due diligencecan be done on a laptop. Allfunds have presentations,monthly performancereports, due diligence ques-tionnaires, private place-ment memoranda andaudited financials. Fundsthat have at least $150m inassets also need to file FormADV with the US Securitiesand Exchange Commission.

Many important regula-tors maintain websitesworth visiting. In the US,the independent advisersection** provides extensiveinformation, including pastand pending disciplinaryactions against funds.

Remember to do back-ground checks on signifi-cant individuals, not justthe funds they are running.Google each one. Past fail-

ures may inform. But searchfor more nuanced detail,such as risk taking in theirpersonal lives. Can such anintrepid spirit be checked atan office door? Maybe, but itis good to know.

On-site visits with man-agement are essential. Dur-ing such trips JonathanKanterman, a hedge fundconsultant and co-author ofFTfm’s hedge fund surveys,has discovered gapsbetween what he read infund documents and whathe saw involving staffing,technology and investmentprocess, as well as manage-ment spending time run-ning other businesses.

In a study of 22 hedgefund failures, GreenwichRoundtable, the non-profitresearch and educationalorganisation, found that thethree 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 infund of hedge fund invest-ments, pushes forward thediscussion of due diligence.

“Most investor due dili-gence is backward looking.But that does not addressperformance risks ahead,”he says. The investmentteam at Paamco makes rea-soned projections abouthow a fund’s strategy, andits current positions, will belikely to respond in themacroeconomic conditionsthat may prevail six to 12months out.

Due diligence does notstop once the investment ismade. Every year, investorsshould review importantissues and flag potentialproblems. If they are notresolved within a reasona-ble period, then investorsshould consider exitingsuch positions.

Goldman’s Mr Clark con-curs. He believes investorsshould not feel complacent.

Investors and adviserscan pass off due diligenceby investing through insti-tutional hedge fund plat-forms or fund of funds.Both bring added fiduciaryprotection. However, thiswill increase costs andcould challenge the value ofhedge fund exposure in thefirst place.

Regardless of what invest-ment pundits may say,hedge funds are not anessential part of the portfo-lios of wealthy individualsor institutions. Good man-agers are. And until youfind one, do not invest.

*www.ft.com/ftfm/hedge-fund-survey**SEC.gov/answers/iapd.htm

GovernanceAnalysis beforecommitting moneycan help avoid thehazards of hedgefund investing, saysEric 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 impactingoperational integrity and performance

Uncertainty about key financial metrics

Raises issues of integrity

Selective response to questions may suggest operational andinvestment 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 investmentapproach

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