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Due Diligence -The Hard Edge of a Soft Science
Peter Douglas*, Principal, GFIA Pte Ltd, Singapore

June 2004

Summary

Due diligence is a reality check with an in-built veto, and commences after the manager selection process but before the portfolio construction.

It is not part of the manager selection process, although it may be part of a manager elimination decision.

It is most effective prior to investment and the work is usually heavily front-loaded, but a certain element is ongoing. Much of due diligence is qualitative, operational, and mechanical - it is only peripherally an investment function.

Due diligence is essentially a discipline which enables allocators to check what they thought they knew, and realize what they don't know

What is Due Diligence?

Do we talk about "due diligence" in our daily lives? No. We talk about checking something, making sure, drilling down to details… "Due diligence" is a phrase invented by lawyers, and therein lies a clue as to its purpose. A great deal of the point of due diligence is to be able to demonstrate and document that you took proper care to check, verify, and cross-reference, all the various aspects of an investment - bluntly, to cover your back. Like detective work, there are glamorous moments when you'll uncover surprises, successfully avoid hidden dangers, discover lurking secrets that a manager would rather you didn't know, and save the world's capital markets from unspeakable systemic risk singlehandedly just before the credits roll! But most of the time, it's a dull process of checking, verifying, and filing all the information away.

Why?

Information asymmetry ("secrecy" in layman's terms) is a part of the industry. Managers have a legitimate need to maintain some information proprietary, and often gain no commercial advantage from transparency when they are not seeking new investors. However this information asymmetry also has a negative side, allowing managers to hide what would be embarrassing. Allocators need to understand this fine line, and, manager by manager, understand it well.

Managers choose unregulated investment structures because that's what investors want. Not only are most alternative asset funds tax neutral, but they are unregulated, allowing freedom of investment action. But as with real life, the greater the freedom, the greater the responsibility; the degree of control and self-discipline is decided by the manager. Many alternative investment vehicles offer better processes, alignment of interests, and risk management than typical regulated investment funds, but inevitably not all do comprehensively. We need to check what controls actually are in place, because no regulator will do that for us.


Furthermore, human nature tends to embellish the truth. The fisherman's catch grows longer with each retelling. By the end of the roadshow the pitch is significantly more plausible than in the first few days. We need to check the hard facts behind the story.

Finally (and thankfully infrequently) there is open fraud, where a manager has an intention to mislead investors. Deliberate fraud is, unsurprisingly, usually well-disguised, but not to look for the obvious clues would be negligent given most allocators' fiduciary duties.

Bodies like AIMA www.aima.org are trying to create standards for common levels and standards of disclosure. Institutional investors often have a fiduciary need to have clear and comprehensive information flows. Generally, the trend to more transparency is established, but it's not necessarily a natural destination for the industry.

What Are You Trying to Achieve?

We make investment decisions because we think we have understood the proposition and the environment within which that proposition will play out. Our process may be qualitative, quantitative, rational, or intuitive, but unless you're conducting some experiment involving monkeys or dart boards, then you're basing your investment on a collection of information provided to you or deduced by you.

Due diligence is the process of checking that information.

Most due diligence exercises start with a questionnaire that lists the various areas of information that need to be covered. This is a useful aide-memoire to an allocator that she has examined all the relevant aspects of the proposed investment. A due diligence questionnaire is usually completed directly by the manager, unless the balance of power is in the manager's favour (for example, if the allocators is proposing to make an investment that is small in the context of the manager's overall assets), in which case the allocators may assign a researcher to go through the manager's documentation and source the information.

A typical section of a due diligence questionnaire might look like this1:

FEES
Management fee:
Administration fee:
Incentive fee:
Hurdle rate / High water mark:
Sales fee:
Redemption fee:
Any other fees:
What costs, if any, are recharged to the fund?
Are your fees calculated and charged in terms of equalisation structure by:
  • issuing a different series of shares every time shareholders subscribe?
  • the Equalisation Share method?
  • the Equalisation and Depreciation Deposit method?
  • the Equalisation-Adjustment method?
  • Others:
Do you ever share fees with a third party?
Have any investors been granted rebates?
Disclose any soft dollar agreement.

The manager's responses are then cross-checked against the documentation on file, including the allocator's meeting notes.

Managers do not exist in a vacuum - they form part of their own ecosystem, and this is helpful to allocators in evaluating reputation, consistency, and provenance. A good due diligence process will include verification of these external points of contact, including, for example, sight of agreements with service providers, and uptake of references for the individuals in the firm. The objective is to document that verifiable facts have been verified, and to highlight for further study any discrepancies.

Part of the process is to establish the basis for the ongoing relationship. The allocator should check what level of information is given to clients, on what schedule, with what inbuilt delay, and whether any clients receive preferential levels of information. Furthermore the allocator needs to develop a reasonable degree of comfort (tho' this may fit more naturally in the manager selection process) that she has ongoing informal access to the manager as needed.

Manager Selection

Manager selection is not due diligence.

Good allocators will have a process to decide on managers. It may be a highly experienced professional investor with a deep address book, using his qualitative skill to 'smell' a good manager; it may be a quantitative house with sophisticated analytic tools; it may be a combination. There may be a conscious optimization process to allocate among managers.

But this is not due diligence. Full due diligence is time-consuming for both the manager and the allocator, and to use due diligence as a manager selection tool would be an inefficient use of resource.

The due diligence process comes after manager selection and before (and then during) investment. Of course, if the due diligence exercise throws up too many negatives, then there may be an iterative process of vetoing one or more of the selected managers and going back to select more, which then go through the due diligence process again.

Some allocators will use a two-tier process where in order to establish a foothold with a manager they will allocate some capital on a slimmed-down due diligence process, and then a more substantial allocation following a deeper due diligence process. There is considerable merit to this. It allows allocators to follow their instinct, does not waste research resource at a point where there is less information anyway, and when the manager is still in a development phase and the pattern of operational risk will change rapidly in the ensuing months, but does not risk too much capital. The better allocators will then mandate that after a specified period (perhaps one year), they will either scale up their investment with a full due diligence exercise, or redeem fully. This prevents their portfolio being cluttered with a number of smaller holdings unsubstantiated by full process.

Due diligence is a Front-loaded Process

The bulk of the due diligence process happens before investment. Investing in alternative assets carries significant liquidity risks. Hedge funds typically have 15-90 day notice periods to redeem, monthly or quarterly dealing windows, and then 5-30 day payout delays (sometimes with partial withholding of some of the proceeds pending final accounting). So a decision to withdraw assets is by nature a medium term strategic decision.

Let's say that a manager that you invested for their edge in event driven strategies in public markets begins to trade in, say, OTC instruments, and you are concerned that this is beyond the manager's skill set. You'd like to switch to another manager you now feel more comfortable with. The following table shows that, if you're lucky, you may be able to adjust your asset allocation in three months, while nine months is a more typical turnround:

Best Case   Moderate Case
manager puts on new trades Jan 1st   manager puts on new trades Jan 1st
your risk aggregation system is capable of collecting data on all assets in the portfolio daily - you discover the trades yourself Jan 1st   your risk aggregation system cannot collect data on all assets, or the manager has mandated a time lag - you discover the new trades in the manager's monthly note Feb 5th
your manager offers 30-day or better notice and has no queue of redemptions - you place the order Jan 1st   your manager offers 45 day notice - you place the order for April Feb 5th
your manager offers monthly liquidity Jan 31st   your manager offers quarterly redemptions July 1st
the manager's administrator pays in full, promptly Feb 5th   the manager's administrator pays over two months Aug 5th
you reinvest in a new manager Mar 1st   you reinvest in a new manager Sept 1st
best reallocation turnaround 3 months   typical reallocation turnaround 9 months

Inevitably, therefore, your decision to invest must be as sound as it possible can be, as your flexibility to shape your allocations disappears once you make the investment. Your due diligence process must be complete before you make the investment.

While you are invested, you stick to your due diligence process (i) if any material facts change and (ii) as a monitoring discipline periodically (every 6-12 months, depending on your investment process). A material change might include the opening of a new office, hiring new professional staff, a change of service provider, etc, and would involve a diligence process applied just to that event. The ongoing due diligence is a reality check that nothing has deteriorate or changed since the initial piece of work. Ongoing due diligence is usually less onerous, as much static information will not have changed (if the principal said he studied at a certain university and you verified that first time round, it would waste everyone's time and effort to recheck, for example).

It is good practice also to run through a due diligence checklist on addition of new capital. Neither funds nor fund managers remain static as they grow (or shrink!) and the strategy you allocate incremental capital to may not have the same drivers, constraints, and risks as the strategy you initially researched.

Operational Due Diligence

Operational due diligence focuses on the company, its administration, the investment administration, and the service providers and their interfaces with the manager.

In many ways this is the critical focus of the due diligence process: while the manager and the strategy must have impressed the allocator enough to want to make the allocation, the operational structure is less visible, but provides the architecture within which that investment process will flourish or wither. The investment risk is inevitably what attracts the investor, and is the element of overall risk that an experienced manager is primarily being paid for, and is presumably considered an expert in. That risk is what the investor, by the time they conduct due diligence, is usually cogniscent of and comfortable with. The operational risk is often less well understood, even at a relatively late stage in the process.

While investment strategies can and do go wrong, they rarely fail completely. When they do, of course (LTCM, Eifuku, etc) they tend to be spectacular and hit the headlines. But more hedge funds are killed by business and operational failures.

Most hedge funds are run by small companies or small business units, often by the investment principals. A successful bank trader may well have 10-15 years' experience in trading large pools of capital, but as she starts her new hedge fund, she has no experience of running or building a company. The organizational risk is very high. Part of the manager selection process is of course a judgement call as to whether that risk is insuperable or not, but allocators must still verify and check their facts. Have you had sight of the agreement with the IT provider? Have you confirmation that there is sufficient working capital in the firm? Have you interviewed the business manager/COO as well as the investment team?

Most funds outsource some or all of their back office and systems. The due diligence process may need to look at the credentials of the outsourcing providers (this may not be a major issue if the prime broker is a major investment bank, for example, but if the administrator is a small offshore firm you're not familiar with, then you need to check their capabilities). Allocators should also understand and have verified the money flows at all points, noting who has authority to transfer what, who needs to sign off on transactions, and who does the reconciliation (and how often, for whose eyes… etc). "Follow the money" is a key element here - from the point at which a dollar is subscribed to the fund, investors should be able to identify where it can flow to, and who can direct that flow.

Even with external administration, the manager will have an internal portfolio management system, at very least shadowing the administrator's own system, and in many cases superceding it operationally. Allocators need to be aware of the system, check that it's appropriate for the strategy, and understand how it interfaces and reinforces any external systems. Allocators also need to understand how the portfolio is reconciled, which is the definitive portfolio, and how its positions and prices are arrived at. In particular, portfolios containing non-market priced assets (OTC contracts, distressed securities, swaps, etc) or infrequently traded or illiquid assets, will cause the allocator to check the source of prices and their verification.

Risk management systems are integral to most hedged strategies, whether a simple stop-loss programme, or a more complex risk aggregation model. While it can be difficult for anyone but the writer of the programme to understand exactly the inbuilt algorithms in the models, allocators need to verify (i) that the system exists (ii) what it is trying to achieve (iii) that there is a real feedback loop so that the system's output genuinely does form an integral part of the process.

The motivation of the individuals involved is also important, and often critical. Allocators must understand who "owns" the revenue flows (through equity ownership or compensation); what the history of the partners' relationship is, and what if any other interests they have.

The corporate strategy is as important as the investment strategy. An essential part of the due diligence process is to document the principals' intentions for the commercial model. Hedge funds (and hedge fund businesses) are not linearly scalable. They change characteristics over time and with increasing assets. A fund of US$50m cannot behave the same way as a fund of US$500m, and will require and be able to support a different shape of organisation - you need to understand how it will be different. The fund will have a capacity constraint - will this support the aspirations of the principals or is this an organisation that will need to diversify? Finally, this lack of scalability is one reason to maintain an ongoing due diligence regime. As a manager changes in size, it also changes qualitatively, and the allocators, through regular scheduled "reality checks" must understand how the organizational risk is changing.

Background Checks

In some ways the easiest element of a due diligence process (and often outsourced to specialist firms) is the regulatory and personal investigation. For each principal, allocators should check (i) the details of their resume (ii) regulatory history in the jurisdictions where they have worked and (iii) personal financial history including bankruptcy checks. Different jurisdictions have different rules on what an investigator may or may not access, but generally, at a very minimum, regulatory and bankruptcy checks should be possible.

Allocators would not only be looking for undisclosed black marks, but also discrepancies with principals' resumes. While some allocators may not mind that a manager who says he received an MBA from the London Business School in 1990, but in fact only studied for a short executive programme, others may see small inconsistencies as indicative of a potential pattern. Whichever the conclusion, allocators need to have the information.

Qualitative Due Diligence

Due diligence is a qualitative exercise, for several good reasons.

First, by definition, if you can measure a parameter and attach a number to it, it must reflect something that's happened already. As investors we are interested in what is likely to happen, not what has happened in the past. While there is some evidence of risk and returns persisting over short periods, generally, quantitative research does little to help us understand the risk of our investment going forward.

Secondly, the majority of the parameters we want to cover in our due diligence are qualitative, procedural, or structural in nature. It's more likely that we have run detailed quantitative analysis as part of the manager selection process initially, and, subsequently, as part of our ongoing risk measurement and management. Generally speaking, due diligence is best documented in a paper, not on a spreadsheet.

Doing the Obvious Checks

Sometimes you just don't have time to do a full due diligence exercise. A purist might argue that any investment conducted without proper due diligence becomes mere speculation, but sometimes pragmatism demands otherwise. Perhaps the manager is closing and you are under pressure to allocate capital rapidly. Perhaps you want to make an initial small investment to establish a relationship with the manager, without tying up your research team unduly.

We have done a number of these "kick the tyres" pieces of work, and while they would be a weak legal defence for a client if an investment were to go wrong, we believe that they catch most of the practically important issues:

The must-do shortlist would cover:

  • Risk: what could go wrong with the investment strategy and the organisation, and where are the key weaknesses? What are the controls or early-warning signals?
  • Service providers: are they substantial and known to you?
  • Term sheet and key offering document paragraphs - are the legal, fee, compensation, and dealing schedule and procedures broadly standard?
  • Informal personnel reference checks - are the results of 2-3 phone calls to contacts of each of the principals unanimously positive?
  • Organisation - is there working capital, people, and IT appropriate to the strategy and asset size managed?
  • Information flows - do clients receive sufficient and regular information, and do you have reasonable informal access to the manager?

This last item is probably the most important. In a world of imperfect information and huge complexity, you will never own all the information, and what you own will be confusing and time sensitive. What is important is that when you want a piece of information, you can get it readily. We will not allocate clients' capital to a manager where we do not have reasonable access to the principals, and we see a reluctance to divulge information to a professional allocator or investor as a major red flag.

For a list of the typical areas of due diligence focus, click here

* Peter Douglas is council member for Singapore, Alternative Investment Management Association and member of the Advisory Board of the Chartered Alternative Investment Analyst Association.


If you have any comments about or contributions to make to this newsletter, please email advisor@eurekahedge.com

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