The cornerstone of hedge fund investing is due-diligence. Over the years investors have missed blatant red flags that are obvious to experienced hedge fund investors. Apply these 8 tips to your due-diligence process to help sort through the weeds and avoid potentially fatal losses:
1. Audit Switching. The tricky thing that most due-diligence professionals already know about auditors is that when an auditor sees potential malfeasance they are more than likely to resign or be fired than blow the whistle. If a manager switches accountants multiple times over the years that is a glaring red flag. What many people don’t realize is switching accounting offices of the same accounting firm can be almost as bad. You see, accountants understand the concept of multiple legal entities all too well. Each office of PWC for example may have its own separate legal entity which protects the greater organization and other offices from shared liability. In other words, working with 3 different offices of the same firm can be like working with 3 completely different firms. Most investors would see that and think: “Well, the manager has used a credible auditor since inception, therefore it’s all kosher.” Wrong.
2. Rehypothecation. Rehypothe-what?? This term describes when a fund lends their securities to their prime broker. The broker can then use the securities as collateral to lend against, and will generally pay the fund a small fee in return, which helps lower the fund’s brokerage expenses. How this is relevant: When Lehman Brothers went bankrupt, this small distinction determined whether the fund or the insolvent broker ‘owned’ the assets. It was the difference between blow-up or solvency for many funds. (About $22 billion was tied up in bankruptcy court over this nuanced operational detail.) Learn this detail and always be aware of where your counterparty exposures are.
3. Exceedingly High Returns. Everyone is on the lookout for losses but high returns can also be a glaring red flag (and one that is often met with investor attaboys and congratulations). Amaranth Advisors was a well-known diversified multi-strategy fund. Their roots were originally in convertible arbitrage, a low return/low volatility strategy, but in early 2006 they started posting numbers like these:
Going into September Amaranth had a YTD return of 31.57%. Not exactly slow and steady. Some investors saw this as ‘style drift’ and pulled out, but others cheered the returns. Unfortunately, the returns were driven largely by bets on natural gas futures, the most volatile commodity in the world. Amaranth at one point owned 10% of the market in natural gas futures, a position that was impossible to unwind and destined for decimation given the volatility of the asset. In September they lost over $4b and ended up wiping out 70% of client assets. Lesson: Question the good returns just as much as the bad ones.
4. FINRA Employment Check. FINRA has a great resource called BrokerCheck which allows you to view the full employment record of any current or past broker (among other great pieces of info such as arbitration claims and regulatory infractions.) One little trick we use is to match up the FINRA employment record of the principal with the bio in their marketing materials. Often managers will leave firms out of their bio if they had a bad experience there, though they’ll include it on their regulatory filings. It may bring up points that require further digging.
5. Audit Reconciliation. Compare the audit with the prime brokerage report as of the date of the last audit. If the two reports don’t match up it will indicate that either the audit is missing something or you are.
6. Valuation Check. For firms that use difficult to value assets it’s hard to trust the numbers at their reported values. Ask for the latest position sheet then select specific positions and ask for the full valuation methodology on the individual positions. This will give you a sense of their marks and the weaknesses or rigor of their approach.
7. Outsourced Administration. It has been estimated that 90% of all frauds could have been avoided simply through verification of credible, independent third-party fund administration. This is critical for all hedge fund investments. In addition to taking care of non-core investment functions such as accounting and net asset value (NAV) calculations, administrators can play critical roles in cash management and investor account maintenance.
8. DDQ Analysis. Review the due-diligence questionnaire provided by the manager and compare it with the industry-standard AIMA DDQ to see if the manager deleted any questions from the list. Usually when a question is missing from a DDQ it’s because it was irrelevant to the strategy, but sometimes a deleted question can be HIGHLY relevant and show what questions the manager doesn’t want to answer.
Happy hunting! View our other articles for more practical tips on hedge fund research and investment.