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Pruning the Thicket
John Ferry
12/01/2004
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These challenges place due diligence beyond the expertise of most
people. “If the high-net-worth individual comes from a background in the
financial markets and has an interest in doing due diligence and devoting the
time, that’s fine, but in general I think they are better served by delegating
to someone else,” says Leslie Rahl, president of Capital Market Risk Advisors, a
New York-based consulting firm. “Due diligence is not rocket science, but it
does require market expertise.”
| The search for problems of this nature takes time, and investors
gushing over an exclusive opportunity to invest in a hot manager’s
latest fund may be loath to risk their access by asking scores
of detailed questions. |
Base Inquiries
Even so, those investors who plan to conduct their own due
diligence, or those who wish to work hand-in-glove with their advisors on the
project, may find that the most rudimentary questions yield useful data. For
example, we should run a background check on the managers to ensure they have
the credentials and experience they claim, and to ferret out those who have
shortchanged investors in the past. We should also ensure the fund is
professionally audited once a year. If possible, we should discuss the fund’s
performance and operations with one of its counterparties or existing
investors—a fund of fund or prime broker (the bank that lends to the fund and
handles most of its trades), for example—to corroborate the manager’s
claims.
Another crucial step, as Lipper’s investors learned, is to ascertain
how the fund values its positions. “Ideally you’re looking for the positions to
be independently marked,” says Ed Hawthorne, managing principal at Capco, a New
York-based financial services consulting company. “You should watch out for a
situation where a significant proportion of the portfolio is being marked by the
managers themselves. You want to know how frequently the positions are marked
and how consistently.” (Click image to enlarge)
“Different funds value their positions differently,”
Rahl adds. Some funds engage in such exotic strategies that the positions in
which they trade—certain types of derivatives or illiquid assets such as real
estate, for example—may have no observable market price. In these cases, the
funds “mark to model,” meaning that they use their own financial equations to
value the position. How the manager structures the model and manipulates the
data on which it relies will determine the values it assigns to positions. In
these cases, the credibility of the fund manager is paramount. (However, as the
Long-Term Capital Management crisis demonstrated, a pile of sterling resumes can
also provide false comfort.)
DEVIL'S DETAILS
Consulting firm Capco studied 100 hedge funds that have
failed in the last 20 years and determined that operational risks
contributed to the demise of more than half. In most of those cases,
the fund manager had lied about his investment positions. |
Even funds that trade in liquid securities can
choose from a variety of valuation techniques. Some funds mark their positions
at the midmarket level, somewhere between the bid (the lower price at which we
may sell a security) and the offer (the price to buy the security). Other funds
may mark the positions they own at the bid, and those they have shorted at the
offer. “Those are accepted methodologies; however, if you are dealing with
less-liquid instruments with fairly wide bid-offer spreads, you’re not only
going to get different numbers, you’re also going to get a different pattern of
volatility,” or history of the behavior of the positions, Rahl notes. Therefore,
two funds with similar portfolios might report significantly different results
and histories, depending on which of these methods they choose.
Another
crucial point to investigate is the manager’s flow of funds, Hawthorne notes.
“You have to understand how the investor’s money moves into and out of the hedge
fund, and what safeguards are in place to prevent the misappropriation of
funds.” In some cases, a fund administrator or accountant might control the flow
of funds in order to provide a level of independence.
Once we have reviewed
all the operational issues, we should scrutinize performance and strategy.
“There’s a quantitative component to due diligence that means either looking at
the fund’s historical track record or, more frequently if it is a newer fund,
the manager’s track record prior to the formation of the fund,” Adler’s Chapman
says. “I would run the numbers and look at all the usual analytics—at Sharpe
ratios, volatility, leverage and at how they performed in comparison to their
benchmarks, if there are benchmarks.”
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