Check-the-box due diligence is not enough - Financial Times
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FINANCIAL TIMES MONDAY JUNE 30 2014 9 News analysis Check-the-box 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. *www.ft.com/ftfm/hedge- fund-survey **SEC.gov/answers/iapd.htm 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
description
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.
Transcript of Check-the-box due diligence is not enough - Financial Times
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
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