Tuesday, 28 March 2017
Last updated 17 hours ago
Aug 12 2016 | 10:02am ET
Due Diligence Beyond the Tear Sheet
By Steven Lord, FINalternatives
Tear sheets are ubiquitous in the alternative investment industry. They are the financial equivalent of a book cover, designed solely for marketing purposes and probably the one abiding constant among all hedge fund managers regardless of style, market, geography, AUM or pedigree. For investors, the tear sheet is ground zero for any further investigation of a fund; the more impressive they are, the more questions they raise.
FINalternatives receives several tear sheets each week, but it is not every day we get one with stats like those sent to us from a Brazilian receivables financing fund earlier this year. The fund, which we’ve made anonymous for the purposes of this article, promotes performance that would make any investor’s eyes widen: 100% positive months (89% of which returned more than 1%), a Sharpe ratio of 16.7, no drawdown, and weekly liquidity.
Add to it below-market management fees of 0.4% and a 10% incentive above a 14.5% hurdle rate, and you can see why this one made us sit up straight. Two other characteristics that caught our eye: The fund does direct lending, one of the hottest areas of alternative investing at the moment, and it does it in Brazil, which was recently named in a New York Hedge Fund Roundtable survey as the overseas market offering the greatest long-term opportunities.
Going by the tear sheet, this fund is as intriguing as it gets. But it also conjures up Ponzi schemes and hand grenades, because as Madoff showed, what’s too good on paper may not exist at all. To understand the type of diligence process that accompanies an investment into a unique fund like this we reached out to Eloise Yellen Clark of OmniQuest Capital to see how she investigates and evaluates new funds on behalf of her fund-of-funds.
“This is the kind of niche strategy in an inefficient market that I love,” says Clark after viewing the tear sheet. “It’s a very obscure area, but the returns are compelling enough to do the diligence work.”
“However,” she quickly adds, “the key for investors is to be neither seduced nor afraid of such attractive returns. You just have to do the work. A lot has to be done before returns can be accepted at anything close to face value.”
Looks Can be Deceiving
Clark, who has more than three decades of experience in finance and particular expertise in complex securities, derivatives and risk management, runs OmniQuest’s portfolio of 10 to15 uncorrelated hedge funds that have consistently delivered superior risk-adjusted returns. Accordingly, she is always on the look out for the performance outlier that can survive her thorough diligence process.
“Diligence sounds simple,” Clark explains. “It revolves around verifying returns and identifying risks. But it’s not simple at all, because there is no cookie-cutter way to do it — no two funds are alike, no strategy is exactly the same, and the real areas of interest are ultimately defined by the answers you get and how you get them.”
The first step, according to Clark, is to see if a fund’s returns make sense given the strategy pursued (see “Due Diligence Do's,” below). Done well, direct lending can be a tremendous source of returns, but it requires tremendous infrastructure to conduct detailed analysis of issuer and collateral risk.
“This type of strategy needs a lot of people,” Clark said after noting the fund’s tear sheet refers to more than 50 employees involved in the investment portfolio. “That makes sense, because those people have to do three things: Source borrowers, perform credit checks and collateral evaluation and handle defaults.” With stated AUM near $300 million, the fund has more than 8,000 receivables with an average maturity of 50 days. “According to the fund, approximately 1% of their receivables remain past due after 30 days,” Clark says. “This means the fund must foreclose on collateral backing 500 defaulted receivables per year. This is a labor-intensive strategy.”
A direct-lending fund presents unique challenges to an allocator like Clark. The returns appear to be exceptional: high, stable and uncorrelated. But it is not easy to verify that the fund does what it says it will do. “Private assets are always more challenging to analyze because of the mark-to-market issues,” Clark explains. “In this case, there is no mark-to-market since the asset maturities are so short, and a gain is only recognized after the receivable is paid. But private assets are still a concern. They are hard to verify.”
In an initial conversation, the fund stated that no reserve is taken against defaults, which ultimately cost it around 0.20%. In Clark’s experience, this is very low, meaning part of the diligence has to determine the average default rate for this specific industry. “Default rates are normally consistent among lenders in a particular sector,” Clark says, making a note to get all the fund’s documentation around collateral and defaults, and to contact a Brazilian lawyer friend for clarity on local laws concerning foreclosures.
Seeing is Believing
There is no substitute to sitting down face-to-face with a manager, says Clark. “I always do a site visit,” Clark says, “An alternative, for those who can’t, would be to have someone from a local law or accounting firm physically visit to verify the fund has the offices and employees that it claims to have. It sounds simple, but you’d be surprised how many investors don’t do them.” The same goes for basic background checks on the partners as well as independent references for them and the strategy. There is a big difference between a reference from a fund, and a reference sourced independently.
In this case, scheduling didn’t immediately permit going to Brazil, so Clark arranged to have an initial Skype call to tour the office virtually and interview the head of each team. “This fund says they have 70 employees, 60 in one location. I want to see them. I want to see the trading room and speak to the people who work there,” she says. The goal is to see if anything is inconsistent with what Clark has read and been told during previous calls, and gauge the domain expertise of the fund’s staff. “I am looking at what people say, how they say it, their response time, eye contact, etc.,” Clark says. “If you talk to enough people and spend enough time you get a sense of the work ethic and the environment. I ultimately want to verify everything independently and make sure there are no inconsistencies or red flags. Where there are, you need to dig deeper.”
It wasn’t very far into the Skype session when the questions began. Clark verified that the size of the fund’s portfolio – more than 600 credits and nearly 200 firms, whose receivables are being financed by an average of four clients apiece – requires a large staff to originate and administer. However, in a good illustration of the tendency for good answers to beget equally good questions, Clark immediately wondered about the firm’s fees given its high labor overhead. “This fund only realizes a profit when the receivable is paid off, and there do not appear to be origination or credit facility fees,” she observed. “So how does it get away with management fees of only 0.40%? More importantly, why is it priced so far below market?” Follow-up questions such as these are collected and put to the fund’s principals in subsequent conversations.
A major phase of Clark’s process understandably revolves around risk, or rather the mitigation of it. All third-party documentation, including audits and tax documents, are requested. Audits are an essential part to rooting out fraud, she says, although they’re not always the panacea they are made out to be. “Audits that are all cash are risky,” Clark explains. “Bayou and Madoff had all-cash audits at year-end. For me, the audit needs to show assets, and the auditor should be able to show an independent check was done on the receivables.”
In this fund’s case, returns were verified from 2011, but only audited in 2014 when the fund registered as a specialized investment fund in Luxembourg. The fund used a well-known auditor, but a little-known firm to verify the track record prior to 2014. “Why wouldn’t they use the auditor to audit the entire track record?” Clark asks. “It would be hard to consider investing without an audit for the whole period.” And even when a fund has every year audited, Clark still wants to dig a little deeper. “Making sure audits are not falsified is difficult, but has to be done. It is very easy to falsify an audit. All you need is a copy of a real audit.”
Clark requested a copy of the 2014 audit from the fund and simultaneously contacted the administrator in Luxembourg. “I want to understand what the administrator does,” she explains. “Normally, I can verify the assets in the audit with the prime broker and with the administrator. In this case, the administrator and/or custodian should be able to see a paper trail of assets being seized and sold, with accompanying bank statements.”
“It sounds simplistic,” Clark adds, “but in addition to verifying the cash flows and assets, we’re also making sure the guy we’re told is the administrator is indeed the administrator, actually works there, and can independently confirm what is done. If they can’t, it’s a show-stopper.”
Trust, But Verify
Her line of questioning could be interpreted as more of an interrogation than verification, but that’s also somewhat by design. “I wouldn’t normally worry so much about fraud, but this is a special case due to the private nature of the assets,” she adds. “By now, a fraudulent fund would probably stop talking to me, so the fact they are still answering my questions is a good sign. However, this isn’t Third Point or Elliott or a fund that has high visibility – this is an overseas fund that no one has ever heard of putting up extraordinary numbers for rock-bottom fees. It is important to be extra careful.”
Given the fund’s direct-lending focus, other key questions for Clark centered on collateral. How protected is the fund from defaults? During her conversations, she learned that receivables ranged from under two weeks to around three months, with an average of around 50 days. There are two scenarios in which the buyer does not pay: The buyer defaults, or the borrower does not deliver or delivers damaged goods. Quality of both buyer and borrower are thus paramount, as well as collateral that is both valuable and liquid enough to be utilized in case of a default. Clark was able to determine the fund has three sources of collateral: The receivable, a fixed asset and a personal guarantee of the borrower.
Replicating the returns is also important. In some instances, it is merely a matter of recreating the trades. In this fund’s case, it is a bit more complicated but not impossible, and making sure the math checks out is one of the primary places where diligence can go sideways. “I will find an independent source to check the normal level of profitability of a strategy like this, and get an understanding about the other players in the market,” Clark explains.
Overseas funds operating or investing in a different currency require additional questions. Clearly, the exposure to the Brazilian real is a major consideration when evaluating this particular fund. “This group says it lends at 3% per month in Brazilian real and hedges at the fund level in Luxembourg back to U.S. dollar, euro and Swedish krone, according to share class,” explains Clark, who was a foreign exchange trader for Citi early in her career. “With emerging markets, there is always risk of a devaluation. Exchange controls are also a risk, but this fund has weekly liquidity, and controls don’t happen overnight – it’s something we can monitor.”
She doesn’t stop there. Utilizing the broad and deep network she has developed over three decades in finance as a trader and investor, she reached out to a hedge fund in Omniquest’s portfolio that operates in emerging markets, and spoke with one of their portfolio managers with expertise investing in Latin America. “We discussed the risks of the strategy, the large number of defaults each year, the foreclosure process in Brazil and the hedging aspects of what our subject fund does. This type of call is extremely helpful in making sure we’re asking all the right questions.”
Although very interested in the strategy itself, Clark’s diligence process began flashing warning signs about this particular fund. “My biggest concern at the moment is the absence of an audit for the entire track record,” Clark confides. “I am looking for integrity and humility as much as investment skill and a profitable strategy,” she adds, “but a profitable strategy is probably the hardest one to find.”
According to Clark, Omniquest’s concentrated strategy is the byproduct of an extraordinarily granular process on every fund she considers. “One of the benefits to my investors is that I cannot afford to make a mistake,” she says. “A fund of fund with 100 investments is not going to dig as deeply as I do. Because every investment in my fund is material, there is no room for mistakes. It’s one of the reasons I believe in concentration – it forces investment discipline. It is also the only way to generate alpha and minimize beta.”
Clark chalks up her tenacity to a simple philosophy: Only invest in a fund when you feel 100% comfortable everything possible has been done to avoid a mistake or miss something crucial.
The Bottom Line
In this fund’s case, what she learned from reviewing the 2014 audit ultimately stopped her process in its tracks. Although the track record on the fund’s tear sheet dates to 2011, its inception date is actually mid-2014. This means the audit only covered several months of one year – a material fact that not clearly disclosed to Clark despite several inquires. “Having an audit for only one year of a multi-year track record is concerning all by itself,” Clark observes, “Learning that it is actually only for a stub portion of that year, especially at a late stage, only raises additional questions.” But that wasn’t the biggest issue Clark discovered after receiving the audit.
“The audit showed the only assets of the fund were a small amount of cash and an interest-bearing note issued by an entity affiliated with the fund,” Clark explains. “The fund itself did not directly own any receivables. It was not what I expected — a fund that owns a note is quite different than one that owns receivables.” In addition, the assets values did not match. “In the audit, the assets of the fund are the note and some cash totaling a mere 5% of the AUM provided by the fund for that year.” Clark says, noting that she had requested an explanation and any additional information that might explain the material differences in size and structure. However, as this article went to press, she remained unable to reconcile the fund’s assets, as disclosed, with the audit provided. “We have to put our pencils down after something like that,” she says.
“There are risks you cannot protect yourself against, like a bad stock pick,” she concludes. “The hedge fund industry’s recent experience with Valeant Pharmaceuticals is a case in point. It was a costly mistake, but an honest one. I know we will have them. I know we will have drawdowns. Some managers will not perform as well as we expect, and some will perform better. But to invest in a fraudulent fund is inexcusable, and avoiding it is within our control as an allocator. It’s our job.”
This article originally appeared in the June 2016 issue of Modern Trader.
The information and analysis provided herein is solely for educational and editorial purposes and is not an endorsement, critique or solicitation of or for any fund, its principals, management entities or affiliates.