Hedge Fund Due Diligence – 5 Steps to Reduce Your Risk
KEY POINTS
Due diligence is essential to the investment process and mitigating investment risk
Investors can perform background checks on funds and their key employees via websites hosted by governments, regulatory bodies, and professional bodies
Independence of the manager and third-party service providers takes time to assess, but it is a critical step in the process
Integrated Approach
Due diligence of a hedge fund manager integrates quantitative analysis, qualitative assessments, and interpersonal interactions.
It is essential that due diligence is performed before making any investment. Investors must understand all the risks associated with any investment, whether it be a hedge fund, mutual fund, exchange traded fund, single security, or money market fund.
A well-designed due diligence process should provide a comprehensive assessment of a fund’s strategies, performance, risk management, legal and compliance framework, key personnel, and operational infrastructure.
Risk Management
Hedge funds are often classified as high risk as they typically design aggressive investment strategies that require complex modelling and involve derivatives (sometimes exotic derivatives), short selling, leverage, foreign exchange, concentrated positions, illiquid positions, and more.
They are less regulated than most investments and, therefore, are typically only accessible by institutional investors and accredited investors.
Such investors usually have their own due diligence process or will hire a third-party company that specializes in providing such services. The process will often include a due diligence questionnaire (“DDQ”), on-site visits, employee meetings, obtaining key documents (e.g., articles of incorporation, audited financial statements, annual report, policies and procedures manual, employee manual, disaster recovery plan), and more.
This post will focus on due diligence procedures you can do on your own. It may have limitations, but it can be very effective.
Do Your Due Diligence
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Do Your Due Diligence 〰️
For example, you can learn about a fund’s investment strategy by reviewing its offering documents. Such is critical to understanding how a fund will impact your portfolio’s risk profile.
Whereas a due diligence firm will likely perform a more in-depth assessment. Such may include meeting with the investment manager and discussing the investment philosophy, idea generation process, risk tolerances, restrictions, limitations, opportunity assessment, trade initiation, execution, and allocation.
Top 5 Due Diligence Steps
The following steps are designed to identify and assess key risks associated with hedge funds.
1. Governance
The fund’s organizational structure, ownership, and management team will have a direct impact on the fund’s risk profile and ultimate performance.
The fund’s offering documents will typically provide bio-sketches of key individuals including the directors, investment manager, chief compliance officer, and chief financial officer. The disclosures will provide a brief overview of their qualifications, experience, and background.
Ideally, the team has a low turnover rate combined with a long and successful track record of working together. The turnover of key employees is a risk to hedge funds and their investors. This risk typically has an inverse relationship with the size of the fund.
Funds will employ various strategies to mitigate this risk, including attractive compensation packages, succession planning, fostering a strong corporate culture, talent diversification, and sharing the knowledge base. The fund’s offering documents will not disclose this information, but they will disclose the existence of key committees.
The existence of various committees may mitigate turnover risk as larger funds may have multiple individuals supporting key risk areas. Such committees may include investment, risk, compliance, audit, valuation, operations, compensation, and due diligence,
Investors can use the following links that will provide a history of a firm or individual’s regulatory compliance, professional standing, and pending or settled legal actions.
United States
The Financial Industry Regulatory Authority ("FINRA") Broker Check
The Securities and Exchange Commission ("SEC") Action Look Up
The Investment Adviser Public Disclosure Website
Canada
The Canadian Securities Administrators' National Registration Search
Canadian Investment Regulatory Organization
The Mutual Fund Dealers Association of Canada
2. Investment Strategy
Evaluate the fund’s investment strategy and determine if it aligns with your short-term and long-term investment goals. Such investment approach includes the fund’s objectives, philosophy, asset classes, leverage, and risk management.
The fund offering documents will describe the fund’s investment strategy. The fund manager may also publish letters to investors that describe how the investment strategy has been applied to real world events.
To the extent possible, review the fund’s current portfolio composition. Assess whether the holdings align with the investment strategy. Determine the degree of concentration risk and liquidity risk associated with such positions.
Consider the size of the fund as extremely large funds may find it difficult to efficiently deploy their capital while adhering to the fund’s defined investment strategy.
3. Independence
Hedge funds engage third parties to provide non-core functions, access specialized expertise, manage risks, streamline operations, maintain compliance, and increase investor confidence.
Third-party service providers typically include the fund administrator, auditor, registrar, transfer agent, lawyer, prime brokers, custodian, consultants, technology providers, research providers, and more.
Demand Independence
Accept Nothing Less
We will briefly highlight the fund administrator, brokerage firm, and auditor.
A fund administrator provides several services including calculating the fund’s net assets and related net asset value per share (“NAVPS”). The NAVPS is critical as such is the dollar value of an investor’s individual unit holdings.
Hedge funds that calculate their own NAVPS have a conflict of interest related to achieving enhanced performance by overstating the NAVPS. Such may attract unsuspecting investors to invest in the fund while simultaneously generating excess performance fees that are payable to the investment manager.
Some hedge funds may trade through their own brokerage firm. Such creates a conflict of interest relating to trade execution and reporting. There is the potential to put firm trades ahead of a client’s, which is a regulatory breach. It is also conceivable the brokerage firm may inflate the fund’s reported holdings and related performance.
Most hedge funds appoint an auditor from one of the large international firms. Such dramatically reduces conflict of interest related risks. The appointment of a small unknown firm should raise flags and warrant further examination.
The above conflicts of interest may appear low risk. However, the 21st century witnessed the collapse of the largest ever hedge fund Ponzi scheme. The hedge fund manager fabricated returns based on fictitious statements generated from a brokerage firm owned by the manager. The auditor was small, unknown, and complicit.
Investors can review a fund’s offering documents to identify the key service providers. Investors can also perform due diligence on firms and individuals (see section 1 above).
4. Performance
A hedge fund’s historical returns can be statistically analyzed to quantify and measure investment risk. Two popular statistical measurements are standard deviation and the Sharpe ratio.
Standard deviation can be utilized to measure the volatility of any single security, portfolio, and market index. Higher volatility equates to higher risk. A low standard deviation does not necessarily equate to better returns: remember, standard deviation only measures volatility. Investors can calculate the standard deviation in Excel utilizing the STDEV formula.
The Sharpe ratio can be utilized to assess an investment manager’s skill by quantifying the relationship between risk and reward. It divides the return realized in excess of the risk-free rate of return by the security/portfolio’s standard deviation. It normalizes returns for a given level of risk. Investors can compare Sharpe ratios to determine how well they are being compensated for every unit of risk that they take.
5. Fund Terms and Fee Structure
Fund terms and fees structures can vary dramatically across hedge funds. The following information should be disclosed in the fund’s offering documents.
Subscriptions and Redemptions
Investor liquidity is directly impacted by the frequency subscriptions and redemptions can be made into and out of the fund. Such dates may be weekly, monthly, quarterly, semi-annually, annually, or longer.
Redemptions may have a lock-up period during which redemptions cannot be made. Such a period may be a few months or extend to a year or more.
An investor may also be required to provide written notice well in advance of the desired redemption date. Such a period may range from 30 days to several months.
The manager may have the power to suspend redemptions in extreme circumstances or impose a gate provision which limits the number of redemptions for a given period.
Fees
Hedge funds typically charge a management fee equal to 1-2% of assets under management.
Hedge funds also typically charge performance fees (a.k.a. incentives fees) equal to 20-30% of net profits. The theory behind performance fees is that such aligns the interests of the investment manager with those of the investors.
The performance fee should contain a high-water mark (“HWM”) provision and ideally a hurdle rate.
The high-water mark ensures an investor only pays performance fees based on positive net new performance. A hurdle rate ensures a performance fee is not earned until the manager achieves a set return threshold.
Some hedge funds will charge a redemption fee based on a percentage (fixed or sliding scale) of the value of the redemption. Theoretically, such fees are designed to protect the remaining investors and cover the cost of liquidating sufficient underlying securities to fund the redemption.
BOTTOM LINE
Hedge fund due diligence is a critical component to the investment process. It should be done before an allocation is made and continued throughout the investment holding period.
Significant due diligence procedures can be performed utilizing the fund’s offering documents, investor letters, regulatory filings, and executing background checks on the fund and key personnel.
