There are a lot of things to look out for when doing manager check-ins, but here are the 15 most critical points to keep track of.
This sounds obvious, but there are several important elements to note here:
- Pre-vetting. Funds are always comfortable talking about how great their team is when they are working together, but after the employee is gone their role will usually be minimized. It is essential to establish the importance of team members while they are still employed at the firm. Ask what makes the employees indispensable, or what they do better than anyone else at the firm.
- Ownership. Ask whether there is any equity owned by departing team members. If there is, ask whether there are any plans to buy the partners out. Any buyouts could impact the fund’s budget or strain other needs. If there wasn’t, maybe it’s a sign that the fund needs to establish an incentive plan to retain talent.
- Flooding ship. If multiple team members are departing it could be a sign that there is a leadership struggle or that the organization is decaying.
14. Performance that strays from objectives.
Notice how we didn’t say bad performance. If the volatility of the returns are higher than what the strategy should be generating (regardless of whether the returns are positive or negative) it merits a close look to understand potential style drift or potential excess risk being taken. Remember, many funds experience periods of abnormally great performance before the blow-up (e.g. Amaranth Advisors, Long-Term Capital Management.)
13. Asset gathering vs. asset managing.
Two key points here:
(a) Parking a bicycle vs. parking a 747. Most strategies perform worse when they have more capital to deploy. A small cap manager playing with $1b+ will not be able to participate in the same opportunities as one with $100m.
(b) Time management. Every time a manager meets with investors he is taking time away from the portfolio. If he’s a very active marketer it is nearly a guarantee that he is spending less time generating returns for you.
12. Legal & compliance.
Regulatory investigations are always a glaring red flag. (Quick tip: You can make a Freedom of information [FOIA] request to see if your managers are being investigated by the SEC.) Also look for any new disclosures on the form ADV or in their DDQ. There are several background check providers that do a very good job scanning the local and federal court systems for updates on firms or principles. Any litigation needs to be looked into because:
- It takes time away from managing the book.
- It can threaten the solvency of an organization.
- It can threaten the reputation of the firm and lead to large-scale withdrawals (and threaten the solvency).
- It can indicate larger ethical or operational concerns.
11. Lamborghini in the parking lot.
For a fund with relatively small AUM, any extravagant office space build-outs or major expenditures could be a sign that (a) the manager is living too large to focus on the portfolio or (b) that some kind of misappropriation may be taking place. Recently, ‘pharma bro’ Martin Shkreli got pinched by the FBI for paying himself more than the stated 1% in management fees, among other things. A clear sign of misappropriation is when a manager lives above their means.
In either case you generally don’t want someone managing your money when there are questions about their own financial stewardship.
10. Change in administrator, auditor, independent valuation or independent compliance provider.
Any of the above would require a thorough and reasonable explanation, and it should be verified with the service providers or the personnel directly (when possible). Legitimate reasons for a service provider change:
- As funds increase in asset size or complexity they may upgrade to a service provider with a better brand, better capabilities to serve their strategy, or lower fees due to economies of scale.
- If a service provider is acquired or goes out of business the fund will obviously need to switch.
Claims that require more looking into:
- Sometimes a fund decides to stick with the person or team they know, even if they have switched provider firms. You can usually verify this independently by checking press releases & LinkedIn profiles of the service provider person/team in question to confirm the validity of this claim (or by asking them directly.)
- Be cautious of downgrades to less reputable providers. If the fund cites lower fees as the reason ask what the fee differential was. Downgrades obviously can occur if AUM declines due to market forces or withdrawals.
- If the auditor was switched check the last audit to make sure there wasn’t a qualified opinion. If a switch occurred after an audit delay this could be a sign that there was a disagreement between the auditor and the firm that led to either a resigning or firing of the auditor. This is a substantial red flag.
- If the administrator was switched make sure that the protocols for pricing, NAV calculation, cash movement, and fee assessment remain consistent.
9. Reduced transparency.
Every fund should have a level of communication and transparency that reasonably balances the needs of (a) protecting the investor and (b) protecting any proprietary information about the positions or the strategy. Find a reasonable balance, and then be vigilant about making sure that the communication level is maintained. People have a natural tendency to share less when the news is bad, so be extra-wary during times of market or strategy stress.
8. Signs of partnership dysfunction.
There are always going to be partner issues, and generally the tension is a healthy one. Be inquisitive about any points of friction among partners, and take time to understand any “co-portfolio manager” relationships. No relationship is completely balanced (think about your spouse or loved ones for example.) Again these are much easier to assess up-front, as you will never get the full story after a co-PM or partner leaves.
7. Divorce, disease, or death.
These are the sad facts of life that can affect the manager or key employees. Ensure that the manager is still emotionally and physically healthy enough to be making decisions. As one family office told us, they get deep into the specifics of relationships; they’ll ask if the spouse works and asks indirect questions to ascertain whether the spouse came into the relationship with wealth. Their view is that a divorce tends to be much more brutal when a non-working spouse with no wealth is fighting for their survival versus two people that are relative financial equals.
6. Funny numbers.
Review the annual audits and ask questions to understand both the investment & operational items. Audits are often confusing but they are one of the best ways to understand the real nuances behind a fund and whether the story checks out. If the audit is a qualified statement that’s often a sign that you should run for the hills with only the most precious personal belongings that you can carry.
5. Market dynamics.
- Distressed managers often underperform when default rates are low because there are fewer opportunities.
- Strategies like merger arbitrage, closed-end fund arbitrage, and credit (in general) have spreads that are often either attractive or not.
The best approach is to set rules in advance (similar to a price target). It can become very easy to ‘let it ride’ with a strategy that has experienced recent positive returns. Sell discipline is as important in fund allocating as it is for your underlying managers.
4. Inexplicable AUM shrinking.
Know your fellow LP’s and keep open lines of communication so that we can all help one another out. Go to the annual party or cocktail hours and meet the other investors. The most efficient way to bolster your intel at the lowest cost is to broaden your network of other smart investors.
3. Changes to the legal structure.
Legal structures don’t get modified in a vacuum. Sometimes legal changes are made to a fund to open it up to a new class or geography of investors (eg: a 3c7 fund designed for ‘qualified’ investors or a master-feeder structure designed for non-taxable entities) but sometimes structures can be used to limit transparency or compartmentalize liability. Be wary of any structural changes that make it harder to hold managers accountable. Funds with wacky legal structures and a history of litigation are a classic red flag.
2. Introducing leverage.
Sometimes a strategy is being run very conservatively, and after a time the manager gets comfort with adding modest leverage. At other times, the edge has eroded in the strategy and the only way to deliver the same returns is to add risk. Leverage can be tricky (what happens if the lending line gets pulled?), so be cognizant of any changes to leverage, be inquisitive as to the reason, and assess the new risks thoroughly.
- Restatement of NAVs or lack of controls with money movement.
NAV restatements could happen if there are complicated, hard-to-value, or illiquid instruments. It can either reflect poorly on their administrator, the fund’s internal controls, or both. If NAV restatements are a regular occurrence, inquire with the fund and the admin as to the source, and try to understand if there is any conflict relating to valuation.
While you’re at it, check with the administrator to understand the latest fund policies relating to money movement. You’ll generally want the administrator to approve wires over a certain amount, or at the very least require a dual signatory at the fund before moving money. The last thing you need is the manager to go AWOL in Morocco with your money after a messy divorce. Perform the above basic checks to make sure that won’t happen!
Critical bonus point: Gut-check.
As the head of alts at an insurance company put it, “I would also add that an off feeling alone is a reason to re-underwrite a fund…where there is smoke, there is fire worth sniffing out. That and the second you waiver on questioning the trustworthiness of someone who is managing your money, you need to stop and take a closer look. I would rather reaffirm my conviction in a manager and reestablish that they are good stewards of capital than gloss over questionable behavior (even if benign) and end up losing my investment.” Words to live by!