There are several objectives to hedge fund DD (and it’s not all about making sure the manager isn’t a Madoff.) It helps to recognize from the outset that each hedge fund is first and foremost a business, and for businesses to be successful, they need to have a differentiated product, and a repeatable process for creating that product. In other words, what is the manager’s differentiating ‘edge’, what is their process for exploiting that edge, (and how does it fit into your portfolio)?
To answer these questions investors must gain a deeper understanding of all of the following: (a) the strategy, (b) the investment process, (c) the people involved in the fund, (d) the ‘business’ operations of the fund, and (e) the performance track-record.
Typically, the DD process starts with an initial review to glean the basics and see if its worth spending additional time. Many investors start with the ClaritySpring Snapshot to learn the basics. Every investor has their own limiting criteria, but depending on the investor, some will pass right away due to factors such as:
- Size of the fund. Some investors want the sense of ‘safety’ from a large fund, while others prefer smaller funds due to their higher return potential.
- Undifferentiated strategy or an unfavorable strategy for the market environment.
- Lack of a track record. Many institutions and investors require 3 years of track-record or a ‘portable’ track record from a manager’s previous firm in order to get comfortable with their historical ability to perform. Other investors recognize that the best gains are often achieved by getting to the party early.
- Poor relative or absolute historical performance.
- High volatility or large drawdowns.
- Poor quality of investor communication. The only thing that differentiates a ‘black-box’ from a transparent fund is communication. If the communication from managers is sparse or uninformative it is tough to get comfortable with a strategy. We generally like to see monthly performance updates with quarterly commentary. Anything more frequent may mean the manager is spending too much time writing, and anything less means investors are in the dark for a long time.
- Lack of credible third-party service providers (auditor, independent fund administrator, prime broker, legal counsel.) Third-party service providers are the checks and balances on a manager’s operations. Investors do not get compensated for taking on unnecessary operational risks, so you don’t see credible auditors, administrators, and prime brokers (where applicable) in place you should pass immediately. ClaritySpring does not work with funds without these service providers in place, and works to verify all of these relationships directly.
Meeting or Call
If the manager passes your initial review the next step is usually a call or meeting. The first meeting(s) are usually the standard pitch, a walk-through of the presentation, and a high-level Q&A. Though you should have an idea going in on what you want answered and what you’d like to discuss, most investors let managers start with their pitch and end up free-forming after a while. The idea is to get a sense of the manager, personality, and to probe on different areas of interest or concern and get a sense of whether the story holds up.
If the strategy, performance, fund structure, and people all pass the initial smell test and merit further interest, due-diligence begins in earnest. To the extent available, ClaritySpring incorporates all of the following into our platform:
- Investor letters since inception. These give a sense of the quality of communication, investment ideas, research, and insight into the manager’s personality and approach.
- Relevant PR such as interviews, press releases, and published articles.
- Due-diligence questionnaire aka the ‘DDQ’. This is a common document that asks 100+ detailed questions about the fund. The AIMA (Alternative Investment Management Association) version is the most common DDQ. We generally recommend reviewing the DDQ provided by the manager and comparing it with the 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.
- Research samples. Again these give a sense of the depth and focus of the investment process.
- Private Placement Memorandum. This is the legal doc outlining key terms of the fund. This is generally where all the nuances on fees and fund structure are found.
- Subscription documents. These are reviewed with an eye to making sure everything is consistent with the PPM.
- Partnership agreements. These detail terms of the business structure and can also detail nuances of the fund structure.
- State certificate of organization/LP certificate/state registration doc, IRS W-9 tax ID form. These are mostly confirmatory documents.
- Audits. The independent auditor’s report is of critical importance, as it will reconcile assets, portfolio balances, performance, and often provide insights on portfolio construction, liquidity of underlying assets, and back-office protocols.
- Independent prime brokerage report as of last completed audit. This allows investors to see even more detail on the portfolio from the time of last audit and allows you to reconcile the audit with the actual portfolio. If anything doesn’t line up with the audit, it means either you or the auditor are missing something.
- Reference list. They will all obviously be glowing references, but the choice of references can be very important. Who they leave out of the reference list is often more instructive than who is included. That being said, good information can still be found through the list of provided references.
- Service provider contact information. We aim to verify the relationship with each service provider, and perform due-diligence on the service providers to get an understanding of the terms and length of the relationship with the fund.
- Any external or internal risk reports. When available, these give a sense of how the fund measures risk, what risks they control for, and how they fall within those parameters.
- Regulatory registration documents such as form ADV for advisers. This is more confirmatory information but can also show critical pieces of information such as assets under management as particular dates, key principals, number and type of clients, and compliance with the law.
Once the review is completed, you’ll likely have a better understanding (and many new questions) about key issues surrounding the 3 P’s: people, process & performance. The next step is to dig on areas of interest or concern to learn more on each of these three areas.
One of my favorite stories on manager due-diligence came from a well-known investor who passed on a hedge fund because of a raincoat:
The investor wanted to get to know the manager better, so they agreed to go on a hike. Halfway up the mountain it began to downpour. Unfortunately, the manager hadn’t checked the forecast and spent the latter part of the hike completely drenched. The (dry) investor realized at that point that the manager was a little too focused on the adventure ahead of him and not at all focused on managing the predictable risks along the way. The investor passed due to concerns over risk management.
We haven’t passed on any managers over rain gear, but the point is relevant. In poker, you must observe everything about a player; betting patterns, style of play, tolerance for risk, and personality. You piece together an understanding of the person from the data in order to get a sense of their tendencies. The same applies to due-diligence on people. Fortunately we have a lot more data to work with than at a poker table:
- Background checks. Often a service provider is used that looks for criminal, regulatory, and civil infractions, including Anti-Money-Laundering checks on all principals and key employees of a prospective firm.
- Regulatory checks. The Financial Industry Regulatory Authority (FINRA) has a very comprehensive database of brokers and investment adviser firms that shows whether individuals or firms have had any regulatory infractions, their registration status, whether they’ve had any arbitration awards issued against them, and the full employment record of registered individuals (among other things). It also ties into the SEC database which is often relevant for larger firms. All of this is obviously extremely valuable background information. One little trick to use is to match up the employment record of the principal with the bio in their marketing materials. Often they 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: BrokerCheck: Research Brokers & Investment Advisers
- Back-channel reference checks. This is probably one of the hardest things to do effectively, particularly for industry outsiders, but this can be a source of absolutely critical information. This is the scuttlebutt; the “I’ll talk to my guy who worked in this manager’s Deutsche Bank division when he was a portfolio manager…” This approach is often how you get stories behind a manager and their personality and career path.
- Regular ol’ reference checks. You have to cut through the glowing praise and ask the right questions to really get a sense of the truth, but these can be helpful.
- Direct interviews with the manager. This doesn’t have to be a cross examination but during the meetings there should be a component of confirmatory questions along with getting a sense of the manager’s personality, background, and approach.
- Google. (Never underestimate!) as a researcher I was asked by a family office to diligence a manager and I googled the manager before anything. Past investors had posted on a forum that the manager lost 90%+ of their money by making risky bets then doubling down when the original bets didn’t work out.
Skin in the Game
Also worth noting is that it’s often important to know that the manager has invested in their own fund, and that they are risking their assets alongside yours. Most investors want to know what percentage of the manager’s liquid net worth is in the fund, and may request documents to prove it.
Operational and Investment Process
Now that you understand more about the people you’re working with, you want to understand the structure and processes that constrain them.
A hedge fund, like any other business, creates a product (a portfolio). In order to generate consistent portfolio performance you need to understand the sausage factory, including both the investment process AND the operational processes in place.
I know what you’re thinking—operations are boring. The sexy stuff is how people come up with their brilliant investment ideas. Unfortunately, the operations and business side of the fund are not trivial matters; research has shown that over half of all hedge fund blow-ups occur due to operational issues that have nothing to do with the investment process. As unappealing as it is to try to figure out the nuances of how Net Asset Value is calculated and reconciled with the fund administrator, it’s even less appealing to lose a billion dollars because one didn’t take the time.
In addition to operational processes, the investor must understand the investment processes in order to get a sense of how the fund’s portfolio is constructed. How does the manager source ideas, and what does their own research consist of? What kind of risks does the fund take? Risks such as currency, security, sector, market, interest rate, volatility, and countless other risks can be a part of the portfolio construction process. How does the manager make sure they are adequately compensated for those risks? How do these risks fit into the investor’s broader portfolio? Professional portfolio managers must account for all of these factors with the funds they invest in.
On every disclaimer on every document you will read from a hedge fund it will say: “Past performance is not indicative of future results.” I’m generally not a fan of legalese but this bit should be taken as gospel. Historical returns are in the past, and without understanding them in the context of the strategy, the risks taken, and the changing nature of the strategy in the market, then those returns are meaningless. Statistics lie. At the very least they can mislead: Did you know that the Vatican City has 5.9 Popes per square mile? True fact.
Lets go through another quick example. If a manager tells you “we returned 100% last year.” Are you:
(d) Overwhelmed by feelings of inferiority over your own lousy returns
If the answer is anything other than lots of ‘c’ with a little bit of ‘b’ then you need to learn more about what performance means. (If your answer is ‘d’…we suggest yoga.)
Performance needs to be understood in context. What risks did you take to make 100%? What is the volatility an investor can expect on those kinds of returns? (No matter how great your returns are, you only need to lose 100% once to wipe it all out.) Statistics like Sharpe ratios, maximum drawdown, correlation, and volatility can only really be helpful in the context of the market and the strategy that contributed to that performance.
We once met with a manager who returned 142% in 2009 and 55% in 2010. Those were eye-popping returns, and they had all the right service providers and statistical ratios to ‘prove’ how credible and great they were.
The manager said that their whole strategy was to analyze momentum price signals, because “when you focus on one thing all day you get pretty good at it.” They were a complete black box as far as their model and their investment process, but the manager shared one aspect of the model: “When the market goes up we are able to capture those returns, but as soon as the market starts to drop, the model shuts down in order to mitigate any losses.” Classic baloney. (Explanation: Unless you know whether the market will continue to go down or up you can’t determine when to turn the model on or off. He was basically implying that they could perfectly predict the direction of future price action in the market.)
We obviously passed on the fund, and it literally blew up the next month. (To be fair, we didn’t realize it would blow up so soon, though we did know that it would inevitably blow up with those returns coupled with no credible explanation of how they produced them or why they would persist.) The moral is that it’s hard to find an edge and generate consistent returns, and historical performance (whether good or bad) has to be understood in full context.
We believe the hedge fund industry is in desperate need of higher standards. Many institutional investors feel that their due-diligence process is their trade secret but we would rather see all investors have a deeper understanding of the process. It’s bad for the industry when charlatans run around with impunity, and quality diligence helps lift the entire profession. Most hedge fund managers are good people (honestly), but even among good people there can be a lot of average performers and undifferentiated strategies. A good due-diligence process can be both informative and collaborative– in addition to learning about the managers, ClaritySpring’s on-boarding process often leads to operational improvements among funds we work with.
This overview really just scratches the surface, but hopefully the framework and actionable tips are helpful. Take your time, and don’t be afraid to ask even seemingly stupid or awkward questions. The best questions are often a little bit awkward. Always keep in mind that the next stone you turn over could be the difference between gaining or losing. If a manager seems reticent to provide information or answer your questions, it’s generally a sign of what the relationship will look like going forward. Investments in hedge funds are ultimately partnerships and the good managers will understand and appreciate your need to learn before investing. Our process here at ClaritySpring hopes to shine light on hedge funds and help investors fully understand these partnerships. Please let us know your feedback and how we can improve!