The
scandals of the past few years have also made it good practice for investigators
to interview a fund’s principals. On occasion, they present their findings to
the managers and ask for their response. Their reactions can often say more
about their character than details in the dossier. “You’re trying to gauge their
reaction, and that is more important than what they’re saying,” Shain says. “How
honest are they? Do you have to be Johnnie Cochran to get the answer, or
will they just tell you?”
Do-it-Yourself Diligence
Some investors are conducting their own version
of due diligence, but unless they have some experience in this field, their
results may fall short, and can even provide a false sense of security. “For
most people out there, it would be a daunting task,” says Ed Bowman, a partner
with Newtown Square, Pa.-based Veritable, a multifamily office overseeing $8
billion in investments. “We have the advantage of 15 years of interviewing these
managers.” Firms that offer
access to hedge funds and funds of funds can
pressure funds for more information than would be available to all but the
largest individual investors.
Even so, Bowman likens the do-it-yourself due
diligence he conducts to the type of steps investors should take when acquiring
a small, privately owned company; the capital commitments and lack of
transparency are often similar in both types of transaction because of the
funds’ substantive investment minimums and often lengthy lock-up periods.
“Simple things like verifying with a university if the individual claims to have
a degree—these things are not hard to do,” he says. Bowman also follows the same
procedure that a professional investigator would take when creating a background
profile. “We talk to people we know in the industry to create a complete
picture,” he says. “Maybe they went to school with the person, or maybe they
worked for the person in the past.”
Whether or not an investor decides to
hire an investigator or go it alone, a number of issues should be top of mind.
If a fund outperforms on an unusually consistent basis, this may be a warning
sign, Bowman says. When choosing a hedge fund, financial advisors often use
quantitative screens to bring strong performers to light, but these tools may
also highlight funds with overly consistent records—such as those that have been
manipulated.
Another important aspect to investigate is the prospective
fund’s logistical professionalism. Hotshot traders decamping from investment
banks to set up funds may know how to run a front office (the trading floor) but
be clueless about middle-office operations (where risk and information
management activities take place) and what goes on in the back office (where
trades are valued and accounted for), all of which are crucial to a fund’s
success. Small funds often outsource some of these activities to third parties;
these entities should be recognized industry leaders.
Funds that manage their
own back-office operations should put them under the watch of experienced chief
financial officers or chief operating officers, according to a report by David
Aldrich, a managing director with the Bank of New York. Aldrich outlined a
series of additional recommendations in Hedge Fund Operational Risk: Meeting the
Demand for Higher Transparency and Best Practice, a paper published for the
firm’s clients in June. If a hedge fund outsources these duties to a third
party, investors should make certain that an operational staff member oversees
that work. Aldrich also recommends that investors review funds’ rules governing
trading and how trading errors are managed. Funds should also have a process for
valuing assets, especially illiquid ones, that are independent from their
trading floor. Chris Dardaman, a partner with Brightworth, a wealth management
firm in Norcross, Ga., also recommends scrutinizing a fund’s use of leverage and
the competence of its auditors and legal counsel.
While no amount of research
can completely immunize investors from the risk of losses due to a clever
manager’s determination to defraud, it can help weed out those firms poised to
collapse from simple incompetence—or indolence. “Go with your gut; go visit them
on-site,” Turecek says. “There are horror stories in which people have gone to a
fund manager’s office, and there was no activity there at all.”
Elizabeth Harris is a staff writer for Worth.
Illustrations by C.J. Burton. Additional Information 
The Bad and the Ugly
Web resources for DIY DUE diligence.
LexisNexis mines news and legal cases for information on
individuals and
companies. lexisnexis.com Pretrieve is a searchable archive of public financial and court records pretrieve.com
The National Association of Securities Dealers provides background data on
registered brokers, including employment and disciplinary histories. nasd.com/brokercheck, 800.289.9999 The Federal Judiciary’s Public Access to Court Electronic Records—
PACER—system provides information on fund managers’ legal histories.
pacer.psc.uscourts.gov, 800.676.6856
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