Apr

12

Four Levels of Hedge Fund Investors

April 12, 2004 | Leave a Comment

Operational due diligence occurs on a few levels.    

Level one is the “follow the herd” type of hedge fund investor. They follow the leads of others or invest solely via word of mouth. They do not perform extensive due diligence nor do they understand how to. They rely solely on pedigree and the recommendations of others who may or may not be invested with the hedge fund manager. They also make alot of assumptions. The hedge fund community is pretty closely knit and when a large institution invests in a hedge fund, smaller fund of funds or individuals follow the herd. If you really review Integral’s fraud case, you will see a large institutional investor getting duked by this hedge fund and smaller fish getting gobbled up with them. The smaller investors upon hearing of an investment by an institutional investor assumes that every possible precaution has been taken to guard against fraud. It simply isn’t the case. It doesn’t matter what size the investor is, most of them simply do not review their managers appropriately. They believe a degree from Harvard or experience from a top tier investment bank makes a hedge fund manager unable to commit fraud. Well, they do commit fraud, and when they do, it’s huge.   

Level two is the “send them a questionnaire” type of investor. This investor meets a number of managers and does conduct quite a bit of analytical review of the manager’s strategy as well as returns. They will request data, historical returns, perhaps some portfolio information and run analysis or benchmark the fund via some software. All the information received comes from the manager and is taken at faith. They will meet with the manager for an hour and maybe track the fund prior to an investment. At some point they will send a 30-page questionnaire to the hedge fund manager to fill out. This questionnaire addresses a number of issues regarding the asset management firm, including having strategy specific, operational and risk management type questions. The problem in level two of course is the lack of verification of any information. All the information provided by the manager or the staff is supplied by the manager. A large number of investors fall into this category.   

Level three is the “I will review you but I don’t want to pester you too much so that you tell me to buzz off because I am high maintenance” type of investor. This type of investor does in fact spend a little more time looking over the operational aspects of these hedge fund managers. They may not independently verify information being reported by the manager but they do spend time trying to understand operational aspects of the firm, such as pricing, responsibilities, control of cash, reporting, etc. They won’t just rely on some questionnaire but may go beyond interviewing only the investment manager and interview others in the firm. This is good technique to see if everyone in the firm is on the same field. They will make an effort to understand pricing, internal controls, and other operational aspects of the firm. This is where most investors limit themselves and for good cause. If you cannot allocate a large chunk of money to a manager, he or she might just tell you they aren’t interested in having you as an investor. Managers really aren’t looking for high maintenance investors.     These type of investors may also ask and even receive some access to the fund’s custodian reporting system to monitor certain aspects of the fund. Several custodians have sophisticated reporting systems that allow a manager to open up their prime brokerage reporting systems to investors and check off the information that they will allow investors to receive.    

Level four is the manager/advisor who will conduct a thorough review of the asset management firm. The beginning premise for this type of individual is to verify as much information as possible and do it independently. There are a few fund of funds and advisors who conduct this type of review and it is probably the best safeguard against being taken for a ride and avoiding investing in a fraudulent situation. One of the most common lies by hedge fund managers is how much money they are managing. You can get a pretty good idea about your manager after asking him/her how much they run and then independently checking that information if you can get access. It doesn’t matter who they are or what kind of pedigree they have, THEY WILL LIE about how much they are managing. So why not verify it. Plus there are certain rules regarding 3(c)1 funds and investors sizes so you might think you are not 10% of the fund but you actually may be.    To get access to independent data requires you to ask the manager’s permission to contact personnel at the custodian and administrator. You also should have enough “pull” to get this access, meaning your allocation is large in proportion to the manager’s asset base. This type of investor may have a dedicated person at their firm who solely conducts operational reviews, usually a former hedge fund CFO or auditor since they have the best qualifications for this type of position.    They will independently verify the assets under management, they may independently verify returns, they perform walkthroughs, they obtain sample reports, they understand the internal reporting systems to review responsibilities within the firm regarding the portfolio, etc. They may even test various internal allocation schemes between accounts. I will get into all of this later.   

This type of investor understands the firm they are investing with thoroughly. They know what they will receive in terms of transparency, they know what they will receive in terms of performance updates, they know what those updates will contain, they know who to call when they need information and they have obtained the transparency necessary to closely monitor their investment. This type of investor asked for it all in the beginning and got it because when you ask for less in the beginning it is difficult to get more later.   

Some might say level four is overkill, why are you doing a year end audit? It’s more than an audit, it’s protection and it allows you to understand how your money is being managed as well as having an eye on that money. It’s more than an audit because an audit comes too late in the game. Whether it is the SEC or a CPA firm, they just aren’t timely enough to prevent you from investing with a manager who is in the middle of a debacle and needs your investment to try and increase risk and make those losses back.   

It also allows you to understand whether your manager is flowing through more costs than another manager. It allows you to understand how many accounts the hedge fund manager is managing and whether one account generates more fee revenue than another and open up a possibility for the manager to funnel trades into the better fee generating account.   

I spend alot of time reviewing hedge fund fraud and reviewing the SEC’s web site. There are just too many items to review to ensure a safe investment.   

By Bin Bulsara


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