By Sidney Wigfall -- Hedge funds are complex investment funds that often lack the transparency associated with more traditional investment funds. There is no customarily accessible information on a hedge manager’s process of producing returns, and regarding some hedge strategies, disclosure of investment holdings would not reveal adequately the types and magnitudes of risks a hedge fund manager undertakes. Accordingly, the unique and complex nature of hedge funds requires a level of robust, proactive due diligence above and beyond what is required for more transparent investments that are strictly regulated.
Introduction & Due Diligence Summary Primer
Due diligence is the process and set of procedures used to gather, analyze, and evaluate information about a particular investment and/or investment manager for purposes of deciding whether such investment opportunity is appropriate and prudent. The same information collected is also necessary for the ongoing monitoring and oversight of an investment and its investment manager. Generally, best practice objectives for due diligence are applicable across all investments. However, particular care should be exercised in due diligence of hedge managers and their funds, because of: their more complex investment strategies; the possibilities of concentrated exposure to market and counterparty risks; their use of leverage and the associated risks; and the generally more lightly regulated nature of these firms. In understanding how a hedge manager/fund may perform in a variety of future scenarios, fiduciaries (e.g., institutional/pension funds, funds-of-funds/FoF’s, multi-family wealth offices/MFO’s, institutional/pension consultants, and other investment advisers) should review the history of the hedge management firm and its professionals, the firm’s past and current portfolios, its investment philosophy and decision processes for implementing the investment strategy, and its organizational culture, internal economic incentives and conflicts-of-interests (“COI’s”). At this broader level, due diligence should also include an evaluation of the business and operational infrastructure, investment operations, and risk-compliance management controls in place to support and oversee the execution of the hedge fund’s investment strategy.
Robust and appropriate due diligence needs to be tailored to the circumstances and objectives of the investor-allocator and to the circumstances of the hedge manager/fund, and no universal handbook can serve adequately as a guide for due diligence in every circumstance. As a matter of investor-side best practice, a well-tailored due diligence questionnaire (“DDQ”) may serve as a useful “starting-point tool” or “baseline aid” to assist investors in understanding a hedge fund manager’s opportunities and risks and to provide a comprehensive and systematic structure to the overall due diligence and monitoring process. Such DDQ should ask probing questions and request information and materials regarding all material aspects of a hedge manager/fund, and may include the following (without limitation):
- Investment strategy, process and related performance track-record
- Investment staff and firm personnel
- Investment performance and related performance presentation materials
- Risk Management
- Regulatory & Compliance
- Legal/Regulatory Matters & Fund-Account Structure & Domicile
- Third-Party Service Providers to hedge manager/fund
No matter how well-structured, a DDQ is never solely sufficient to enable a hedge investor-allocator to make a fully informed investment decision. Investors, supported by their multi-disciplinary or interdisciplinary consulting team, must also pursue appropriate lines of further inquiry, and assess and evaluate the information obtained in response to such further inquiries and requests.
On the flipside of the “due diligence coin,” monitoring a hedge manager/fund is a continuation of the initial, fiduciary-grounded due diligence process. While the initial due diligence serves to qualify a hedge fund as a desirable investment, the ongoing monitoring process continually and periodically reconfirms that the conclusions and assumptions used in the initial evaluation and selection remain valid. Fiduciaries and institutional investment staff and consultants should take reasonable steps to identify any events or circumstances that may result in the hedge manager/fund failing to meet the standards and expectations that were originally required in the selection process. (For general background and information, see Investors’ Committee, U.S. President’s Working Group on Financial Markets/PWG, Principles & Best Practices for Hedge Fund Investors (Apr. 2008); IOSCO, Proposed International Regulatory Standards on FoHF’s & Related Best Market Practices (Oct. 2008), citing its earlier Final Report on FoHF’s-June 2008; A. Ineichen & K. Silberstein, AIMA’s Roadmap to Hedge Funds (Nov. 2008); Institutional Alternative Investment, Debates on Operational Risk: Key Issue for Hedge Investors-2008)
Other key pointers to follow and pitfalls to avoid include:
- “Drill-down Due Diligence” & “Surface Due Diligence”. “Drilldown due diligence” involving further inquiry/requests, independent source checking, and in-depth multi-disciplinary analysis (i.e., asset management operations, compliance, and regulatory-legal) is the more robust and rigorous approach versus “surface” or “check-the-box” due diligence where there is more reliance placed on information furnished by the hedge manager firm. However, it should be noted that robust, drilldown due diligence is generally more expensive and time-consuming given the requisite multi-disciplinary or inter-disciplinary skill-sets that need to be brought to bear to fully and properly review & evaluate a hedge manager (see Prof. S. Brown (NYU Stern School of Business) & et al., Presentation: Hedge Fund Operational Risk and Conflicts of Interest (2007); NYU Prof. S. Brown & et al., Hedge Fund Due Diligence: A Source of Alpha in a Hedge Fund Portfolio Strategy (Jan.2008).
- Operational & Compliance Review. Investment strategy reviews should be sufficiently vetted first in the normal course prior to the initiation of operational and compliance due diligence. Operational and compliance due diligence generally starts with Form ADV (Parts 1 & 2/Schedule F) and/or a fund private placement or fund offering memorandum along with other DDQ materials, including performance presentation materials/disclosures, and has a primary focus on “conflicts of interests” as the overlay review framework.
- “Pedigree Traps” & Background Reviews. In conducting what should be an “objective” background review, avoid over-reliance on the prior educational, experience, and connections pedigree traps.
- Regulatory Over-Reliance. Similarly, avoid over-reliance on regulatory examinations, reviews, inspections given level of infrequency and level or areas of focus based on regulatory risk-factor matrices. There could be anywhere from a 2-4 year gap in a registered investment manager being examined depending upon myriad risk factors as noted by both the SEC and U.S. GAO (Government Accountability Office), a congressional oversight arm.
Implications For Due Diligence & Industry In A Post-Madoff Hedge World
The implication ripples from the Madoff fraud blowup are just beginning to make their way across and be felt in the “worldwide hedge fund & FoF’s sea.” Such implications will likely cause industry shifts/consolidations to accelerate and alter some long-standing hedge allocation and business practices which did not have the appropriate fiduciary focus. This is a short-list of some of the more important issues that are and will be unfolding as we move forward.
- FoF’s will face continued pressure as Madoff and hedge fraud blowups go to one of the keys of the FoF business model and value-add: robust manager due diligence and ongoing monitoring to protect against and manage the hedge manager-investment downside risk (S. Wigfall, FoHF’s: At an Evolution Crossroads, Emerging Manager Focus-Aug.2007). Also, institutional investment consulting firms are increasingly converging with FoF’s and launching their own internal FoF’s given their traditional manager research skill-set as covered in a September 2008 Pensions & Investments article and dedicated panels at the 2007 & 2008 Opal Annual Alternative-Hedge Investing Summits.
- Institutional hedge investors-allocators, both individually and collectively through groups, will force greater transparency and better hedge manager/fund practices (S. Wigfall-FundFire, MoneyVoices: Expect Hedge Fund Self-Regulation, May 2008). One such example already of post-Madoff derivative shifts is Union Bancaire Privee’s new requirement and redemption move regarding “independent fund administrators”, which represents a watershed event and reflects a key take-away of Madoff, Bayou and other similar blowups (see articles from Bloomberg, Reuters-Thomson/HedgeWorld, & DowJones’s Wall St Jrnl & Financial News.) This is an early indicator that, exercised collectively, such institutional power and pushback would likely have a material impact on hedge industry practices and related transparency in key operational areas.
- The SEC is apparently already telegraphing greater scrutiny on FoF’s/feeder funds, especially where co-marketing/distribution relationships and conflicts, as noted in Wall Street Journal articles. Note that SEC and its examinations office, OCIE, will likely use this prior guidance to FoFs in 2005 as the framework to begin ratcheting up its oversight of the FoF’s industry (BargeConsulting-SCA, Clients & Friends Update: SEC & FoF’s (Dec. 2005); S. Wigfall, Emerging Regulatory Standards: FoHF’s & SEC, FINalternatives-Mar. 17, 2006).
- Madoff-FoF lawsuits and ensuing related and derivative litigation will flesh out the contours of due diligence responsibilities of FoFs as well as other hedge investing/allocating fiduciaries. Also such litigation and any negotiated settlements will test the insurance coverage limits and exclusions of investment managers’ fidelity bond, E&O (errors & omissions) and professional liability coverages.
Sidney Wigfall (JD/Esq.) is a Managing Partner/Attorney-Consultant with BARGECONSULTING-SCA. The firm is a boutique consulting group focused on institutional asset management matters, compliance/regulatory consulting, and investment manager due diligence and monitoring services for institutional/pension investors and funds, funds-of-funds, sub-advised funds, family-wealth offices/MFO’s, and institutional advisors/consultants.