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Why Due Diligence is More Valued than Reputation
John Butcher, HFMWeek February 2007
 

The hedge fund industry has always been about reputation. It began with big names, larger-than-life characters, making outsized returns with innovative and sometimes risky strategies. Top performers have been referred to as ‘star managers’, and successful management firms have taken on almost mythical status.

Employing a star still causes a stir in the industry. DKR’s recent hire of Owen Lamont, a professor of finance at the Yale School of Management, as a portfolio manager definitely attracted press attention as well as that of other management firms. Aetos Capital’s hire of William Owens as chief executive officer and chairman of AEA Holdings Asia as part of the trend toward bringing big names on to the board also raised a few eyebrows. Until November last year Owens was chief executive officer and chairman of Nortel. Owens has served on the board of 19 public companies and founded two technology firms.

Individual reputations remain highly important in the hedge fund sector, but today they are more relevant for climbing the career ladder than for attracting investors, according to industry sources. What makes a reputation is also changing, as the aims of new investors become less about high returns and more about avoiding risk.

The change all comes down to institutionalisation. It’s beginning to sound like a well-worn cliché, but ultimately hedge funds are adapting to become more attractive to institutional investors, and that is affecting the importance of reputation.

High net worth investment in hedge funds has been increasing, but not at the pace of institutional investment. According to Dan Lancellotti, managing director and global head of capital introductions for Citigroup’s prime brokerage business, “Institutions are the majority investors and the high net worth portion of the pie has decreased. Dollars invested from high net worth individuals have gone up, but they have been dwarfed by the emergence of institutional investors.”

The scramble for institutional money has altered the degree of importance placed on reputation. As another source at a US prime broker puts it, “Reputation is never going to go away, as the investment pedigree of a manager is never going to be unimportant, but what we are going to see is more emphasis on the part of investors on better due diligence.”

This is already happening and has been for some time in fact. For several years many hedge fund management firms have placed less emphasis on hiring a name and more on advertising their sound processes and solid infrastructure. Some funds play down the importance of newly-hired managers, even those with a great track record, because they know that manager could walk out in a year, and they do not want half of their assets under management to walk out with him.

Hedge funds used to be about a key figure, a public face that investors could equate with the business, like Julian Robertson, George Soros or Michael Steinhardt, according to Daniel Strachman, managing partner and founder of A&C Advisors.

“I think you still need a public face that people equate with the business, but investors have realised you cannot have just a one-person show any more. You need a collection of really smart people,” he comments.

Managers, service providers and investors have pushed the industry forward, leading to a dramatic increase in its size and a maturing of the way it works, “[That] caused it to take on a traditional money management role,” Strachman says. Now, investors, and especially institutional ones, want to put their money with firms where they do not have to worry about infrastructure, just the quality of the investment product.

“The importance of a name individual and star managers is still every bit as important today as before because returns are still the name of the game. However, other pieces of the puzzle which are present now are just as important if not a little more so,” according to Lancellotti. “So reputation is less as a percentage of the decision-making process.”

The industry’s growing maturity and size have made it more difficult to establish the kind of reputation that managers once had. The crowded marketplace means it is more difficult to make exceptional returns, and anyway, that is not necessarily what investors are looking for anymore.

For many institutional investors, risk management has taken the lead over returns. Their due diligence process still includes looking at the background of the manager, where his or her trading experience comes from, and track record. But, according to a source, an increasing emphasis is being put on risk management and areas of the hedge fund business that have nothing to do with individual reputations.

Transparency, not reputation, is becoming the big attraction, Lancelotti comments. He adds that infrastructure, liquidity, transparency and risk management − things institutional investors want to see − have begun to overshadow reputation. “It really does mimic the change in the investor base,” he says.

Barry Emen, president of US-based recruitment firm MJE Recruiters, adds, “Performance is still key but it is only half the deal. A lot of investors are becoming more critical.”

Managers with a big reputation may hold less sway over investors than they once did, but what about a figurehead on the board of directors? It could be argued that as hedge funds have grown in size, and become businesses rather than trading platforms, names on the board have become more important.

A big board name can indeed turn the heads of some investors and make them take a look at a fund, but it does little beyond that, according to Emen. “It looks good, but I think investors are asking a lot more questions and want a lot more detail,” he says.

Strachman adds, “Hiring a big name for the board is like window dressing. Does anyone think it is more than a guy collecting a fee? It can lend some credibility but it does not add any value to a hedge fund.”

For less established funds, that extra credibility might be worth the expense of a big name director, but for larger, more established hedge fund businesses there is little value in it, according to Adam Herz, founding partner of New York hedge fund recruiters Hunter Advisors.

“If you are a large established fund, there is less value because you already have the cachet. The less established you are the more value there is in it,” he comments.

Hiring big names for the board can be worth it if they come with market insight, according to Lancellotti. “I think information is power,” he says. “The right person on the board can give a fund an inside edge and the ability to forecast accurately. It is critically important in an asset-raising situation. It certainly helps credibility and overall reputation.”

Ultimately, as in all business, the customer is always right. As the growth of institutional investment continues to make them the main hedge fund customer, it is likely their needs and desires will further dwarf those of high net worth investors. “As institutional money comes in, priorities change,” says Lancellotti. The days of the star manager aren’t necessarily numbered, but the new breed of hedge fund investor wants a steadily shining one, not a shooting star.

 

This article first appeared in Issue 52 of HFMWeek.

 

 

 

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