Tuesday, 27 September 2016
Last updated 19 min ago
Jan 26 2009 | 11:32am ET
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):
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:
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.
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.