Hedge Fund Manager Due Diligence

July 20, 2010

By all accounts, hedge fund investors – always a skeptical lot – have been more circumspect about their chosen fund managers since the Madoff scandal – and the Stanford, Kerviel, Cioffi and Tannin, Greenwood and Walsh, Cosmo, Petters, Nami, Traynor, Jones, and Randolph scandals — came to light over the past couple years.

It’s no longer enough for them to ensure that hedge fund marketing is above board in its representations of investment objectives and historical alpha. They want to know who’s running the money.

This has led to some anecdotal suggestions among hedge fund managers that they’re losing business because potential investors are turning their private lives into a Robert Ludlum novel, hiring retired members of the intelligence community to stake out their private lives and professional dealings for months at a time.

It’s not paranoia if everybody really is out to get you.

When it comes to investors who are wary of shifty operators pretending to be starting a hedge fund, it’s not paranoia. For those entering the world of hedge fund marketing with a spotted past, they should expect all eyes to be on them.

You can’t spell “Ponzi perpetrator” without …

At a recent New York conference organized by West Palm Beach-based portal site HedgeCo, a panel of hedge fund attorneys, administrators and third-party marketers discussed the “New Nervous”.

Based on the discussion, it was clear that the investment community, when performing their hedge fund due diligence, is focused on what’s widely called the Three Ps: performance, process and person.

Performance is well understood: How has this fund — and this fund manager — delivered on money that has already been entrusted? Process is also becoming more important. Investors want to know how these fiduciary miracles occur, or else no sale.

“My money is just as proprietary as your model,” one panelist quipped, taking the point of view of an institutional investor.

Process goes beyond that, though. More and more, investors want to see a separation of the administration and audit functions from the operational functions.

It is not hyperbole to say that incremental money spent on a third-party administrator can be considered money spent on hedge fund marketing — because vanishingly few investors will entrust their money to a manager who lacks independent oversight.

But what concerns many hedge fund managers is the increased focus on people.

Investors have long hired experienced investigators to ferret out misfeasance on the behalf of people who are marketing or starting hedge funds. Bankruptcies, liens and civil judgments are red flags as are, certainly, high crimes and misdemeanors. Also, investigators look into any violations of Securities & Exchange Commission regulations and, not stopping there, at any professional issues a hedge fund manager might have at the state level.

“In most states you need to be licensed.  Any customer complaints, trading infractions or violations [of state law] can show up,” said HedgeCo managing partner Andrew Schneider.  The results can be a devastating star-chamber court in which the accused need not be informed of what he is accused of. “I know someone with $65 million in assets under management and can’t get a hedge fund account [through a broker-dealer]. They don’t have to tell us what [the infraction] is.”

There are many investigator firms who specialize either entirely or in part on the hedge fund industry. One of the premier firms is New York-based Kroll, which relies on data gathered from intelligence sources around the world but doesn’t, as a general rule, send spies to your cul de sac. It generates reports in a nearly instantaneous manner, according to Schneider, who said he never heard of anyone actually being staked out, which is contrary to statements made by at least one of the panelists at the recent conference.

Spies like us

Altegrity, a New York-based firm that recently agreed to buy Krol, is headed up by William Bratton, famed as the New York police chief who took all the bows for cleaning up the city during Rudy Giuliani’s administration. The investigators at Altegrity tend to be, like their boss, former law enforcement officials, not former spies.

That’s according to Randy Schein, president of First Advantage Litigation Consulting, which has nothing to do with litigation consulting. It’s an investigator firm, known as BackTrack Reports back when it was a standalone company, which spends 80 percent of its time looking over hedge fund managers on behalf of institutional investors.

“We take them through a person’s history from college through the present day,” Schein said. “Has this person said anything about themselves in their bio that is untrue – in lawsuits, to the press, in regulatory filings? Have there been disciplinary actions?”

Schein said his reports are delivered in an even-handed, factual tone and are typically just one input into an investment decision.

“We’re not out looking for dirt,” he said. “We don’t tell clients what to do with the information, and we never find out if the client invests or not.”

Because his firm already has a file on just about everybody who has ever started a hedge fund, he only has to update files, so the response is usually in days, not months. The days of hedge fund investigation projects lasting months are long gone.

Previous post:

Next post: