Unfortunately, due diligence is not a one-off project. The latitude that fund managers have to invest our capital as they see fit behooves us to keep a close eye on their strategies. “One of the things I always put in the hedge fund memorandum when I represent the manager is that the manager has the discretion to modify his trading approach and invest in any instrument he deems is in the best interests of the fund,” Matteson says. This is standard practice, and it means a hedge fund manager has no legal obligation to maintain his trading style. “But best practices would say that if you modify the approach or methodology, you should disclose that to your investors and give them the opportunity to withdraw their money,” he adds.

“We are on the telephone at least once a month to the managers,” Chapman says. “I want portfolio transparency, so not only am I taking the pulse of the manager and getting that qualitative update on his sentiments and what he thinks of the markets, but I also want access to his portfolio.”

Even with this type of access (which most funds are loath to provide—after all, they are supposed to be spending their time trading), we cannot avoid making qualitative judgments, Rahl says. “To me, the most important part of due diligence is sitting down eyeball-to-eyeball in a meeting room, and asking the fund managers probing questions about how they run their business,” he explains. “You judge their personalities and the way they handle stress. Sometimes I ask, ‘Would I hire this person as a trader if I were running a trading desk?’”

Alpha’s Omega
Operational risk—the potential for loss stemming from personnel, legal, administrative, technological or regulatory issues—is the bane of hedge funds. In a recent study, Capco found that half of all hedge fund failures stem from operational risk issues; 18 percent of these were the result of misrepresentation of investments. Misappropriation of funds accounted for 7 percent of all hedge fund failures.

Capco says an effective due diligence must include a comprehensive view of the structure, quality and control of people, operations, technology and data supporting the fund. The review should also examine internal systems, processes and information flows, as well as interfaces provided by external parties, such as prime brokers, administrators and custodians. Assessments should be repeated periodically, as well as after events that may affect the fund’s performance, such as the loss of key personnel or a change in investment strategy or an institutional relationship, say, with a prime broker.

Rogues’ Gallery
Sept. 1998 - Long-term capital management, a massive hedge fund with two Nobel laureates as partners, loses hundreds of millions of dollars and almost collapses, but is bailed out by a group of banks at the instigation of the New York Federal Reserve.

Jan. 2000 - Manhattan investment fund, a well- known $500 million long/short equity fund, goes bust.

Feb. 2002 - Lipper & co. admits its convertible arbitrage fund lost 40 percent of its value the previous year.

Oct. 2002 - Beacon hill asset management’s hedge funds lose some $400 million. The SEC charges the company with overstating its returns.

Additional Information
Storming the Citadel