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The Realities of Due Diligence on Established Managers

The due diligence process is one of the most discussed topics with respect to the burgeoning investment asset class called hedge funds.

I have helped develop an underlying hedge fund manager from less than US$10 million under management to close to US$150 million in about 18 months when our performance was only 10%+.

Now I educate both buy and sell side participants regarding the alternative investment industry, regularly attend fund-of-funds conferences, moderate or direct fund-of-funds workshops, master classes and panel discussions. In my very humble career I was the CEO of a joint venture fund-of-funds company as well.

The underlying managers are the bedrock of the 'hedge fund business'; with fund-of-funds, service providers, investors and consultants all following on from the activities of these hedge fund companies.

Often when I read memos or guides outlining the procedures for hedge fund manager due diligence, I immediately think that this author/consultant has never worked in an underlying hedge fund firm. Owning, running or selling a hedge fund product, yields unsurpassed insight into the needs of the investor, and the intricacies of the information that concerns the potential investor.

I will continue with this theme more substantially in the future but note the following.

Many funds of funds and investors have stringent internal procedures for manager selection that dictate standards for the lifecycle, performance and size dynamics attributable to potential new investments. However, in my experience with that underlying manager based in Asia, we had several multi-billion dollar, international funds of funds giving us substantial capital to trade/invest. The amount of due diligence done was less than minimal. All allocated to us without ever visiting our office and only one ever visited us after allocating US$10 million initially.

The following describes my experience with three multi-billion dollar hedge funds of funds and their due diligence and allocation processes with my former hedge fund manager.

In one case, my colleague and I were visiting New York, as most managers do, to see investors. At the time we were managing about US$60 million and we had been in existence for about three years. Our gross net performance to that point was about 35% over 36 months of trading. We visited the offices of a European fund of funds that operates from mid-town Manhattan.

Our visit was cordial but short; my colleague had met very briefly the people running this fund of funds a few years back. During the meeting nothing very technical came up and we treated the conversation as preparation for more serious meetings in the future.

After we returned to our offices in Asia about one week later we discovered that this big, aggressive fund-of-funds had already contacted our mid-office staff, without informing us, asking for triplicate copies of the subscription documents and some other very basic information.

After our return, we just approved a few 'side terms' but nothing like a true 'side letter' and at month end we received a US$10 million allocation and thereafter received inflows of US$1-2 million/month from this firm.

There was virtually no due diligence as people in the hedge fund area generally understand the process. I won't even mention here those usual, basic requirements.

In another case, my colleague and I again were visiting another huge European fund of funds based in New York. It was early December and we were both tired and sick with bad colds. We were sustaining ourselves with continuous doses of cold tablets bought in the pharmacies in New York. We made our scheduled visit, sat briefly as we were coughing, wheezing and wiping our eyes because of our colds in a conference room with the people managing this big firm. They were so busy doing their work that they didn't sit with us very long. They asked a few questions and the most important person among them concluded our 20-minute session by saying, "Amazing!".

Six weeks later this firm without any side letter or side terms but just through the straightforward subscription process allocated US$20 million to our fund.

Again, almost no due diligence requests, visits to the office, monitoring only our smiling, hopeful faces!!

My last example is with a huge London-based fund of funds where one person there spent about 15 minutes with us, mostly smiling and moving paper from one side of his antique writing table to the other.

We returned to Asia, negotiated a true side letter, answered some basic informational requests not about the investment strategy but general things about how the firm was run, ex insurance policies we had, etc.

Again, no office visits, not even basic, multi-page due diligence reports, almost nothing and several weeks later we received an initial US$10 million with subsequent monthly inflows of a few million dollars. We had also been informed that the gross allocation to us over the next 12-18 months would be easily more than US$40-60 million.

If I were to say there was insufficient or absolutely no due diligence, I would not be entirely wrong. But why?

Very briefly, because most due diligence as it is described by fund of funds people, is really most relevant to start-up managers or those managers with less than nine months of audited investing track record. The due diligence part of the investment process for a more established fund will be substantially different.

For example, in contrast to the start-up manager, consider a fund that has been in existence for two years, manages US$200 million with 20 investors who may be bigger and more thorough than an incipient manager, the usual series of due diligence procedures, in my mind, become less pressing, along the lines of 'the big boys have checked them so we have less to do' approach.

Furthermore, the big funds of funds have such constant and substantial inflows each month that their need is to find valid counterparties and then put their capital to work. The fund-of-funds business, again in my humble view, is becoming more like a 'commodity' investment business where the scale is so great that protracted due diligence is not the most important order of the day. Capacity, decent manager performance, marketing the fund-of-funds product and keeping the whole thing under control are the pressing exigencies.

Finally, there are so many new hedge funds, and the allocators see so many new Power Point presentations, monthly performance reports, etc, that these individuals can discount very fast what would be of interest to their funds. Standing out from the crowd is important when marketing a fund.

In my previous case, our strategy was a little different from the tiresome multitude of long/short Asian equity strategies. So when we came along, the big funds of funds were so eager for something different that the elaborate pre-investment due diligence steps mostly 'went out the window.'

We are not advocating avoidance of such manager due diligence, but rather we are attempting to shed light on what really happens in practice during the investment process for many of the more established funds and funds of funds in contrast to emerging or start-up managers.


1 Dr John S. Wisnioski is a Principal of Gan Consulting Pte Ltd, Singapore, and is the firm's lead educator in all aspects of hedge funds and alternative investments.