There is a sea-change occurring in the way investors are considering potential hedge fund investments. No longer are investors satisfying themselves with a rudimentary review of a fund prior to an investment. Now best practice dictates that detailed due diligence must occur prior to, and on-going monitoring must occur following, any investment. It is now recognised that the level of due diligence applied to hedge funds should be of a standard similar to that usually applied to private M&A transactions, particularly those undertaken by private equity firms. The reason why this 'sea-change' has occurred is down to a combination of macro as well as or hedge fund-specific factors.
In our view the investment process can be divided into four overlapping stages, they are: 1. screening potential hedge funds for investment; 2. identifying (by performance reviews and management presentations) potential investment targets; 3. conducting a full due diligence review on those targets; and 4. continually monitoring the fund once the investment has been made. This article discusses the latter two phases of the investment process, that is the due diligence review of a targeted fund as well as the need to be proactive in monitoring an investment once made.
The reasons for heightened diligence
Micro factors ~ reasons specific to the hedge-fund community
The hedge fund investment community has (hopefully) learnt some valuable lessons recently from high-profile hedge fund frauds and failures. There are a great many hedge funds now managed by a great many principals. The community is no longer a small one; instead it is hugely diverse in terms of number, geographical location and investment strategies. Now, when a hedge fund first gains the attention of an investor it is most likely that the officers and corporate structure of the fund are almost completely unknown. Accordingly there is a lot to know (or that should be known) about a fund and its manager before an investment is made.
Secondly, and as a direct result of the exponential growth in hedge funds, there are now so many funds in existence that not every manager has the necessary experience or expertise to successfully deliver returns. The recent increase in the number of liquidations in Europe and the United States of hedge funds provides anecdotal support for this conclusion. Accordingly the rapid growth in the number of hedge funds arguably means that there is now a greater proportion of inexperienced managers in the field and thus there is a greater risk of a failed investment.
Finally as a result of the rapid growth of, and competition between, funds of hedge funds, these portfolios cannot afford to get investments wrong. The reputational damage is particularly acute when the flawed investment could have been avoided with the application of basic due diligence procedures.
Macro factors ~ global trends
It is easily acknowledged that the international corporate governance culture has radically shifted (for the better) in the last 12 months. Directors and senior management, in all industries, are now obliged to take more precautions and apply more stringent diligence processes to enhance (and protect) shareholder value. This is also the case for the directors and officers of funds of hedge funds, and other fiduciary investors, who are adding alternative investments to their portfolios, as they have corporate and fiduciary responsibilities to have absolute regard for the interests of their underlying holders.
There has also very recently been a renewed emphasis internationally on the implementation and expansion of anti-money laundering procedures. New rules, particularly those emanating from the United States, will soon require many hedge fund investors to diligence potential hedge fund investments to ensure that the target: (i) is not a front for the laundering of illegal gains; and (ii) has appropriate procedures in place to ensure that it is not unwittingly being used for the purpose of laundering illegal gains (see further "USA PATRIOT Act Rules to Hit Offshore Hedge Funds"). This will mean that a due diligence exercise must now take even more account of the target's potential vulnerabilities to money laundering.
Due diligence is now more than ever recognised as an important risk-management exercise. As with any transaction the risk profile of the targeted investment must be fully assessed and addressed (to whatever extent it can be) before the investment is made. Arguably the risk profile cannot be fully and completely assessed unless and until due diligence has taken place. Usefully, thorough and effective due diligence can address a number of factors on a risk profile (i.e. a systems' risk can be addressed by a review of the adequacy of the fund's systems, financial reporting procedures, risk management controls, etc). Naturally the risk profile of an investment increases in proportion to the size of the investment. Accordingly the greater the investment the greater the need to apply more risk-management processes, accordingly the need for more detailed and thorough due diligence results.
What is the aim of hedge fund due diligence?
The aim of hedge fund due diligence is simple - it is to: 1. properly determine the risk profile of an investment by discovering in great detail as much as one can about a hedge fund, its performance, management and structure; and 2. address as many of those risks as possible. Unfortunately many due diligence exercises appear to be undertaken without these aims in mind so that the risk profile of a transaction is never properly determined (or indeed addressed) nor are an investor's future expectations as to the investment properly established. Of course it has to be recognised that due diligence is an evolving process that can both satisfy perceived risks and raise potential risks not originally foreseen.
Since the optimum investment horizon for a hedge fund stake is a medium- to long-term one, investors should not take comfort from the fact that they are able to withdraw their investment at the next redemption date (usually the following month or quarter; though more and more funds now have initial lock-ups or redemption penalties for up to 12 months) as there is a great opportunity cost in the form of the wasted time value of the failed investment. Investors also run the risk, because of these restrictions on redemptions, of not being able to withdraw from the fund until it is too late. Furthermore, investors should avoid obtaining the reputation of having 'hot money' (when a redemption quickly follows the investment) as the hedge fund community will not regard them as a quality investor and may shy away from them in the future. Accordingly the aim of due diligence is to maximise the potential for running the investment into the preferred medium- to longer-term horizon by minimising the risk of having to withdraw the investment in the short-term (or having the investment fail completely).
Relevant due diligence to hedge funds
When investing in hedge funds it is vital to properly ascertain the risk profile of a hedge fund by gathering as much information as is possible about the fund and its manager but always in the context of recognising what you are actually buying. Our view is that you are primarily buying into four factors when investing in a hedge fund: the first is the expertise and capabilities of the principal officers within the investment management firm; the second is the strategies, processes and systems of that manager; the third is the fund's performance; and finally an investor is buying into the fund's corporate, tax, regulatory and custodial structure.
In addressing these principal factors investors must be prepared to invest a great deal of time and effort into the due diligence process. Given that the availability of hedge fund liquidity is usually limited to subscription every quarter or month, the opportunity cost of the investment of time is lessened and investors should use this opportunity to embark on a detailed review.
Performance, or performance potential, is fundamental to any investment. This must be diligenced thoroughly and every available piece of data must be collected in relation to all funds currently and historically managed by the manager and its principal officers. Diligencing performance crosses over with the earlier stages of the investment process, namely the targeting of funds (a topic outside this discussion). Nevertheless, diligencing performance does not stop with the targeting process and aside from reviewing historical NAVs investors should look to investor churn (i.e. the frequency of redemptions) to assess investor satisfaction (again this should be analysed for each fund either currently or historically managed by the manager and its key investment officers). Another important exercise is actually auditing (i.e. verifying) the fund's historical performance figures to ensure their accuracy as well as the proper accounting of all the historical fees and expenses.
Diligencing the principal officers of the manager
Perhaps more than in any other investment case the expertise, capabilities and experience of a hedge fund manager is crucial to the success of the fund. Hedge funds live and die principally because of an individual's investment philosophy and their particular application of a fund's investment strategy. The due diligence standard we believe is applicable is the same standard of care that a private equity firm would undertake in diligencing the management of a target company. Accordingly it is essential to know as much as possible about the principals of the management company, their investment philosophy, their historical performance and their background. Moreover, it is important to determine the possibility of the key individuals leaving the investment management team during the term of the investment.
Of course there is no single due diligence approach that can be applied in all cases, but it is not just a case of receiving management presentations on the fund, nor is it just a matter of cursory discussions with the relevant individuals. Instead, due diligence on key individuals is an all-encompassing and evolving process and great importance should be attached to acquiring as much detail as possible about any given individual via individual background checks. There should also be emphasis on spending a great deal of time meeting with, and interviewing, the key principals of the fund and making enquiries around the industry with people who have previously dealt with the individuals involved.
Diligencing a hedge fund's strategies, processes and systems
This portion of the due diligence process will occupy a great deal of the investor's time as there are many facets to this review exercise, including diligencing the:
- Investment strategy (including understanding the manager's
philosophy or the biases behind that strategy);
- Risk management programmes (including the leverage, hedging,
diversification and external control programmes applied) and
determining whether the manager comprehensively understands
the risks associated with its strategy (including any counterparty
risk and the V.A.R - the value at risk);
- The fund's systems and trading procedures, with particular
emphasis on how cash is managed (and supervised) from investment
right through to redemption;
- The frequency & manner of investor reports; and
- Compliance and anti-money laundering programmes (including
compliance with the proposed new US anti-money-laundering
rules for offshore hedge funds).
Diligencing a hedge fund's structure
Many hedge funds exist with offshore incorporation and with little or no regulatory transparency (although this is changing as a result of the USA PATRIOT Act - see "USA PATRIOT Act Rules to Hit Offshore Hedge Funds"). Despite the fact that the slight regulatory veil covering offshore hedge funds is often perceived as a positive factor, there are greater risks associated with entities that exist in a non-transparent regulatory regime particularly because the basic standards (usually dictated by proactive regulators) do not necessarily apply to many of these funds. Accordingly in order to address these risks proper independent regulatory and legal checks should be carried out to ensure the due incorporation and proper licensing of both a hedge fund and its manager.
A particular jurisdictional issue at present that should form part of the investment review is the uncertainty relating to the tax treatment of funds managed by entities based in Hong Kong and Japan. Since many of these funds execute their trades in these jurisdictions there is a view that a taxation nexus exists and that the offshore funds themselves would be liable to Hong Kong or Japanese tax. Unfortunately the position has not been clarified by the relevant taxation authorities and this issue remains an important component of diligencing funds managed out of Tokyo or Hong Kong.
Also necessary is an analysis of the investment characteristics of the fund to ascertain whether those details correspond with an investor's own investment objectives and guidelines. This analysis would include a review of the following factors:
- A fund's size & its maximum size
- The level of management & performance fees as well as
hurdle rates & manner of calculation
- The liquidity characteristics & redemption frequency
- The third-party service providers (custodian, administrators,
prime (& any secondary) broker, auditors, legal advisers
Moreover, different structures have different tax implications for the end investor, and this is particularly the case for US persons. Accordingly, an investor must assess the tax effectiveness of an investment in order to avoid losing the benefit and attraction that the offshore fund may offer.
Good hedge fund due diligence practice
In summary hedge fund due diligence should be an exhaustive process. Best due diligence practice recognises that an investor's own team cannot, by itself, cover all of the bases necessary for a thorough due diligence review. Instead, the expertise of professional advisors - such as background researchers, lawyers, accountants and systems experts - are often needed. Moreover, investors must be ready to engage these trusted professionals when they embark on an investment outside their known sphere of knowledge, particularly with regard to strategy or geography. The reality is that hedge fund investors cannot be expected to know everything about every strategy and every manager in every location. Accordingly a due diligence team should be assembled containing the appropriate third-party professional advisers.
Once the team is assembled a due diligence questionnaire should be tailored to the specific structure, strategy and perceived risks of the investment. Due diligence should be treated as an evolving, and not a static, process in order to assess whether the perceived risks are real and whether other risks exist. Only once the due diligence review has been substantially undertaken can an investor properly assess the worthiness of the potential investment. It is at this due diligence stage that the investor's investment team should be prepared, and willing, to forgo an investment (despite the positive results of the identifying and targeting phases of the process) as due diligence can often turn up unforeseen risks.
Following the investment: after-the-fact diligence
The final factor to recognise is that hedge fund due diligence
should not stop with the investment. Instead it is vital that
hedge fund investors continue to actively monitor the performance
and activities of each of their investments to ensure that
the expectations formed during initial due diligence are met.
Unfortunately it is the case that some investors have been
burnt by having a bias towards almost complete reliance on
a manager's disclosure. We would suggest that best practice
is for the investor to be pro-active in monitoring and questioning
each manager. It is vital to ensure that the manager is firstly
doing what he says he would do (i.e. no style shift); and
secondly is not exposing the fund to any illiquid investments,
which is a particular trap in Asia. Better practice suggests
that after-the-fact due diligence should take the form of
at least bi-annual meetings with the manager during which
weekly performance and monthly summaries (to include a list
of top holdings) should be thoroughly reviewed. Moreover,
investors should be prepared to conduct 'event-driven' due
diligence or monitoring in response to changes in market,
economic or political factors.