Hedge Fund Due Diligence: Do Not Let Them Fool You Again

May 21 2009 | 12:43pm ET

Jeffrey Rathgeber -- Let’s admit one thing right off the bat: hedge fund managers always have been and always will be a step ahead of their own investors. If you need proof of that, just look at what’s going on right now in Hedgistan. Hedge fund investors have made a knee-jerk reaction to the Madoff affair and sprinted to their selected managers screaming bloody murder about asset verification:

“It says in the Journal that he may not have done a single trade in 13 years?!”

“There are fund of funds who invested client money with the guy, and they actually had the words ‘asset verification’ on their Web site … how is that possible?!”

The anger and confusion is understandable and these diligence claims will have to be sorted out. But what is perfectly clear is that hedge fund managers are being inundated with calls from investors who want to storm the castle and verify that their pieces of gold are still there. The managers (especially the good managers who are running clean and responsible shops) are looking for a way to short-circuit this stampede. And now they’ve found it.

The managers have figured out that if they have 50 investors, the only way to avoid having 50 meetings is to corral the herd and convince them that in light of recent ugly events in the industry, the manager will deign to provide asset verification as a single benevolent act. The herd is thrilled with the news because a drop of water from a shut faucet is a gift indeed. This is how backwards the investor/manager relationship has become. Managers are trying to capitalize on investors’ worst fears and sell them asset verification in lieu of proper and complete due diligence. The mechanics of this Jedi mind trick work like this: Mr. Manager goes out and selects a due diligence firm (first violation of independence) and then in some cases he also pays for the review (second) and informs all investors that the “independent” report will be distributed to all.

Here’s the problem: while asset verification is an extremely important procedure in a proper due diligence review, it is exactly that … it is just one procedure out of about fifty that need to be completed in order for an investor to complete the loop on his fiduciary responsibility. Need proof?  Fine … Amaranth would have done just fine during an asset verification, because the money was right where it was supposed to be, until it was lost. It’s like mowing half of your front yard, but investors have been so starved for meaningful information that it’s being mistaken for a bonanza. Remember, asset verification does not mean “portfolio review” … it means verifying that the money is there by vouching the equity at the custodial locations.

For good managers running clean shops, there is a right way to do this, where you get what you want (have 1 meeting instead of 50 while steering clear of any “most favored nation” issues by openly offering it to all investors), the investors get what they want (an independent, detailed, and signed-off due diligence report that includes asset verification and all the other goodies, and at a fraction of the cost of going it alone), and what the diligence professional should want (to be working purely for investors in a conflict-free position). 

Mr. Manager should send a letter to all investors that basically says this:

“In two weeks time, we will host a secure conference call and all investors are invited to either dial-in or to actually come to our offices and participate in the discussion. Our goal is to provide a forum where our investors can come together and discuss a collaborative due diligence effort where you will collectively select a diligence firm and you will each pay a fraction of the cost, since it is inappropriate for myself to either select or compensate the diligence firm. We run a clean business here and have no problem allowing our investors to complete their fiduciary responsibilities. But we still have a business to run and we hope you agree it’s fair for us to ask that you all work with us in that spirit by coordinating your efforts to ease the burden on our day-to-day operations. We understand that this idea will not work for everyone and we are happy to accommodate those investors separately, but we certainly think it can work for most.”
Please tell me how that would be received by investors as anything other than extreme good faith by the manager and an unexpected and refreshingly new stance in the industry.

Would any investors step forward and get on the call or attend the meeting? In this climate, can you imagine a CIO telling his Board that he had a chance to get a full and independent due diligence review on a fund in which they have placed client money, and at 1/50th of the usual cost, but decided against it?

Would any managers actually try this?  Not if they think they can sell you mere asset verification instead … so do not let them fool you again.

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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