By Jeff Rathgeber -- We've tried counting the number of times we’ve sat at the other side of the table, in our prior lives, when large hedge fund investors came to our offices to conduct due diligence reviews. If memory serves us, the figure is in the hundreds. Be they family offices, fund of funds, endowments or pensions, almost without exception we were dismayed at the lack of depth in the process. Invariably, each due diligence visit was but a single stop on a diligence team’s speed-dating tour of managers.
We’ve seen too many diligence visits let the prospective fund manager off the hook because they made at least one of the following classic mistakes:
- They requested documents either too soon or too late, given the date of their manager visit.
- They asked for information in a way that was easily felled by the “privacy” excuse.
- They asked questions answerable in two words or less:
- "Have there been any changes in prime brokers?" - "No."
- "Have there been any changes in the firm's investment strategies?" - "No."
- "Are cash and positions still reconciled daily?" - "Oh sure."
Industry groups have long published guidelines for manager visits that lend themselves to inquisitive blinders. Also, when hedge funds were putting up spectacular returns on a consistent basis, there was an element of "not wanting to upset the firm you just gave $50 million to with too many pesky questions." That's how backwards the investor/fund relationship had become. Furthermore, the due diligence model adopted by most hedge fund investors simply doesn’t allow for deep diving.
Timing is Everything
An important factor in any due diligence meeting is a request that certain documents be made available upon the diligence team’s arrival and for their examination. The timing of this schedule of requests is vital to the success of the meeting. As was our experience, whenever diligence teams showed up and then requested information, it was the same answer: "Oh sure, let me get a pen and write this down so we can get that right over to you after you leave." In this scenario, the diligence team would ultimately have no idea if the control work actually was being performed each day or if the fund manager was simply completing a homework assignment.
If the hedge fund is performing all the reconciliations that make up the checks and balances they purport to do doing each and every day, then pulling it together for a visit should be just a clerical exercise. As a rule of thumb, if a diligence team is visiting a single-strategy fund, it should send the schedule of requests only two days before arrival. If it's a large, multi-strategy fund, send the requests three days before arrival. Point being that if a fund can't pull together basic information for review on three days notice it's because:
- The work is not being done in as timely a fashion as they represented and they need to get caught up; or
- It's not being reviewed and signed-off by senior staff in a timely manner and they're scared to share it without a senior person doing a last-second review; or
- They're arrogant and either have a lack of respect for an investor's right to get comfortable or they think the investor is not a whale and they only jump for whales.
Either way, if a fund can't share all of the requested information with a diligence team on three days notice, something is amiss. In the same light, making a document request too early in advance of a diligence meeting is also a big mistake, because doing so will allow the manager sufficient time to create the documentation if it doesn’t already exist. The diligence team will not be in a position to know if the document was merely put together as a result of their request or if the fund actually performs the critical control functions outlined in the documentation.
Don’t Settle For The “Privacy” Excuse
Another mistake we watched due diligence teams make was letting managers off the hook by falling for the old privacy rebuff. Teams would ask to see something, and they would get a polite, "The document you asked for contains position level data, investor names, or confidential information and, as such, certainly you understand why we can't share it with you." Hogwash.
If you are a member of a due diligence team, you need to make it very clear in your schedule of requests that the manager is free to redact whatever information it needs to make the information shareable. If you want to see an overall capital tie-out that shows all investors balances adding up to the total NAV, then request that the manager simply black out all the other investor names and show it to you. If you want to see the month-end price testing, then request that the manager black out the names/cusips of the positions and show it to you. Tell the manager you don't need copies of anything, you will take your notes with you and vouch for what they've shared. Don’t give them a reason to say no. Make it clear that you have no interest in any investor names or any portfolio holdings. The sole purpose of your visit is to walk away knowing that the control functions that act as the safeguards over your investment are properly in place and are being performed in a timely manner.
Conducting an operational due diligence review this way should not be viewed by the fund as being confrontational; it's quite the opposite. In fact, doing so avoids a confrontational approach by asking smart requests in a direct manner.
Current market conditions have knocked enough hedge fund managers off their perch that the backwardness of the investor/fund relationship is starting to correct itself.
Remember, as an investor, you’ll always be treated well by a hedge fund manager before you wire in your money. So, if requests made in this open manner are rebuffed by a manager, then caveat emptor.
Jeffrey Rathgeber is a founding partner of Pelorus Advisors, a leading authority on Capital Risk Management. Rathgeber is an experienced hedge fund CFO and runs the firm's Hedge Fund Investor Assurance practice group. Pelorus supports leading investors in the alternatives space, including pensions, family offices, endowments, and fund of funds.