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.

1. FINANCIAL TIMES MONDAY JUNE 30 2014 9
News analysis
Check­the­box 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