Hedge Fund Due Diligence: The 'Other' Set Of Books

Apr 24 2009 | 2:55pm ET

By Jeff Rathgeber -- Most hedge fund investors think of the general ledger when they hear the term “closing the books.”  But what about that other set of books where the investor capital accounts are kept?  Oftentimes referred to as “partner books,” nobody really ever talks about these set of books.  But, if you’re a hedge fund investor they are the most important.  Why?  Because the capital account balance in those books is what your investment is really worth, so they better be right.

Traditional due diligence skips right past the partner books.  The process that most institutional hedge fund investors usually follows entails asking a single question such as “Describe your partnership allocation system?”  That’s it, nothing more. 

The partner books are rarely examined because they have taken on a mythical “privacy status” so investors just think they’re off-limits.  Nonsense.  Anything is shareable at a hedge fund; the trick is to make it so.  Just tell the fund manager to delete the names of the other investors and show it to you and… voila, privacy problem solved. 

At most hedge funds, it may be surprising to learn that the partner books are really nothing more than glorified excel spreadsheets that someone took the time to build-in the intricacies that hedge fund structures must accommodate:

  • Share classes with different fee structures,
  • Separating offshore from onshore P&L,
  • Accruing performance fees for underwater vs. above water investors,
  • Excluding IPO income from ineligible investors, and
  • Side pockets (don’t get me started on Side pockets)

Don’t worry, it gets worse.  In most cases these spreadsheets are not even maintained by the hedge fund, but by the fund administrator.  There are a few fund administrators who do a fine job at this, and then there are the rest of them. 

Often comprised of a wild array of excel links and formulas, these spreadsheets need to be checked and checked again.  If you’ve ever worked with one of these spreadsheets then you’ll immediately know how sensitive they are to the slightest human error.  As a fund manager, the last thing you want to hear from your back office is:

  • “There was a problem in the partners spreadsheet… the auto-calc was turned off.”
  • “There was a problem in the partners spreadsheet… we rolled-forward stale ownership percentages."
  • “There was a problem in the partners spreadsheet… the onshore/offshore split was wrong.”

Your day officially ruined, wincing behind your palms covering your face and peeking through your own fingers, you ask the only question that matters at this moment:  “How far back does the problem go?” 

It is certainly not uncommon for situations like this to occur within a fund manager’s offices.   What is uncommon is for a due diligence team to verify whether it has happened at a fund that you’re invested in.  When was the last time your diligence team spent time looking into a fund’s partner books or inquired into the above?  Chances are, they never even thought to. 

This is but one of a hundred unique risks of investing in hedge funds.  Investors deserve the protection of truly independent professionals to provide conflict-free due diligence.   Just as important, investors need to be protected by diligence teams who’ve actually run hedge fund operations and who know where these unique risks hide.

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.


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