Reasons For Failures Of Hedge Funds

• Bad Investment Decisions
  • Funds can fail as a result of bad investment decisions. Funds can make several compounded bad decisions or just a few concentrated calls on the markets or individual securities that perform very poorly. This is an area where the true skill and experience of traders come into question. Bad decisions are often just big moves that bet a lot without a lot pf downside protection – though there might be a possibility of a big pay-day, the risks associated is usually way out of the risk appetite of the firm. It is important to note that it is not necessary that every trade that makes a loss was a bad decision – sometimes it is important to follow a pre- determined trading plan that is no doubt going to have adverse movements. Another very important point to note here is that trades that might have made money for the firm can still be bad decisions if the probability of loss was out of proportion to that of the upside. Sometimes lousy trades can make money but in the long run they would net a loss and every manager must be impartial in their reviews of the investments – both the ones making a loss and the ones not.
• Fraud
  • Funds can also fail due to all sorts of frauds, including accounting frauds, valuation frauds, or misappropriation of funds. There are many movies about flashy traders finding their edge in the grey, and often even in the black, areas. The truth is that fraud can not work in the long  run, the odds and the law would eventually catch unto the offenders. One can look at the major frauds by traders in the cases of Nick Leeson of Barings Bank and Jérôme Kerviel of Société Générale wherein large-scale window dressing and massive one-sided bets brought major financial institutions to its knees. Such frauds are avoidable not just by a ruthless implementation of the risk management systems at hedge funds but also by a intolerant attitude towards unnecessary risks and illegal activities on the part of the top management of the firm.
• Excessive Leverage
  • Funds can fail due to excessive leverage, improbable probabilities, unexpected events, and tail risk. “Leverage is a dangerous game” a quote that many legends and titans on wall street have, in some form or the other, repeated during their bankruptcy proceedings. Leverage is a mechanism that can magnify one’s returns. More importantly, it makes many trades with extremely low margins viable through rigorous exploitation of opportunities by betting way more than one’s capital. Entire businesses are able to run due to this mechanism and the financial world today seems addicted to it. However, as highlighted many times in this course, leverage can lead to catastrophe the likes of which can sometimes seem unbelievable. After all, how can a fund with a equity capital of $200 million lose twice that amount in one trade?

Leverage makes it possible. A large number of funds use leverage as a substitute for

• Unanticipated Withdrawals
  • Funds can fail due to a flood of unanticipated withdrawals of capital at the least opportune time. Funds can get caught in squeezes by the street or by other hedge funds.
• Lack of supervisor
  • Funds can fail as a result of a lack of supervision or compliance controls related to insider trading. Funds can fail because of their own actions or the acts of others.
• Failure of Third Party
  • A prime broker like Lehman or MF Global can go bankrupt and take a fund with it.
• Liquidity Risk
  • Funds can fail when liquidity dries up, and they can’t meet redemptions and must sell into a market that no longer exists, at least at that moment.

Common Elements Of Due Diligence Process

• The due diligence process today is very different than it was in the past. In the past, manager’s reputation and performance were the most important factors. Investors did little digging into the how and the why of performance and the safeguards in place to protect assets. This was due in part to the lack of leverage that individual investors had with the managers. Individual investors were often considered “lucky” just to have gotten into a well-known fund with limited capacity.
• Today, both managers and investors spend a great deal of time trying to learn where a manager’s “edge” is coming from. The due diligence process involves two separate but closely related evaluations –
• Evaluation of the firm’s investment process and related risk controls
  • It is important to understand, at least in part, the decision flow process involved in the investments made by the firm. A lot of funds have different methods of gaining an edge in their analysis of the various markets. These can involve things ranging from satellite imagery to big data analysis, from analysis of correlated areas to depending on scientific experts.
  • Another area on which substantial amount of information must be collected is the risk management of the firm. There is a saying in the markets – “Markets can remain irrational longer than most investors can remain solvent”. This points towards the need for having in place a strong risk management system which would prevent the firm from keeping too many eggs in one basket. Risk management also involves ensuring that there is enough liquidity in the fund to withstand sharp movements in value of the investors.
  • Evaluation of the fund’s operations and business model
  • While a fund’s main income (and thus, success) would come from the investment management team, operations team plays an important role in ensuring that every idea that comes from the investment team can be exploited to its fullest. This would involve things ranging from setting up and running of the technological infrastructure of the fund to ensuring that the fund’s operations are running at optimal capacity.
  • A fund’s business model is very important as the profitability and sustenance of the fund depends on it. It establishes the basic relationship, both in financial and service terms, between the fund and the various external stakeholders and ensures there is a guiding structure in all its future dealings.

General Questions In Evaluation Of Hedge Fund Managers

1. Question – What Is Your Strategy, and How Does It Work?
   • Investors who are evaluating a manager often start with high-level questions that provide them with some context about the firm, its investment strategy, and how it works. These questions can be regarding the investment style of the manager, the gross and net exposure targets, use of stop loss by the fund for risk management, etc. Once this initial set of questions about the firm and the fund has been answered, the investor can begin to drill down into more specific questions about the firm and the process followed to manage investing.
2. Question – How Is Equity Ownership Allocated among the Portfolio Management, Trading, and Research Teams?
   • Understanding the firm’s ownership structure and how things get done is critical. The participation of the investment team in some form of ownership is a critical area of differentiation among firms. Some firms do not share equity ownership among the portfolio managers or traders in the firm. Other firms use equity ownership as a key feature of their professional talent retention program and to attract and groom new talent for future leadership positions. One model is not necessarily better than the other, and each has its pros and cons. Investors often have a view one way or another. The key thing is to understand the firm’s philosophy and how it impacts performance, talent acquisition, and retention.
3. Question – Is the Track Record Reliable?
   • After an initial set of questions about the firm, an investor will want to dig a bit deeper into the manager’s and the specific fund’s track record. According to a recent report on hedge fund due diligence performed by the not-for-profit organization – the Greenwich Roundtable, investors should inquire whether the track record –
     • Is comparable to similar strategies
     • Has been audited
     • Is long enough for statistical evaluation and inference
   • Another aspect would be regarding whether returns were impacted by fund size, and if the team that produced the historical track record is still in place today. Additional questions about the track record should include how it performed during periods of market stress and how it relates to the portfolio manager’s experience at previous firms, if applicable.
4. Question – Who Are the Principals, and Are They Trustworthy?
   • Investors need to allocate resources to both references and background checks. Evaluating newer managers is a bit trickier than evaluating the established ones. New managers need to have their references, from previous hedge funds or banks, verified. It is important to look at both those that are on the manager’s reference list and those that the investor can obtain independently.

More established managers won’t need to be interrogated about previous firms or employers from the distant past as much as start-ups or firms lacking a reliable track record. When interviewing established managers or talking to their references, one should focus the dialogue more on the manager’s motivation, behavior during crisis or stress periods, ability to communicate to investors, and experiences other investors have had, including both positive and negative, over the life of the fund. The ability to verify a new manager’s prior employment is just the beginning. Further questions would include –

• Did they do what they described?
• Were they the trigger puller or acting in a support role?
• Did they generate ideas or implement ideas?
• Did they operate individually or within a group?

Often, the best way to find out is to ask former colleagues, partners, managers, clients, or other independent parties. Investors performing reference checks can think of the process as a 360-degree review of what a person has claimed about the past or even about his or her current skill set. If enough people are saying the same thing about a person or a firm, then an investor can take some comfort. If significant differences of opinion about a person or a manager are uncovered, they should be thoroughly vetted and then discussed directly with the manager.

Criteria For Evaluating Fund’s Risk Management Process

• Evaluating the risk management process and procedures entails hybrid questions that should be answered by all levels of management of the firm. Portfolio managers and traders, as well as operations staff and risk managers, all have valuable insight for investors. Risk management-related questions should be asked as part of both the evaluation of the investment process and the operational environment of the firm. Some of the important criteria in the respect are –

1. How Is Risk Measured and Managed?
   • Risk management is an emerging discipline at many funds. That is not to say risk was not managed well in the past. It is more a reflection of the fact that risk measurement and reporting, and the decision to take action, is evolving towards a more independent model that segregates risk taking and investing from risk measurement and management. Today, many funds have dedicated risk managers who report to the CIO or the CEO independently from the portfolio managers and traders. Many firms also employ independent risk service providers to report risk to investors completely independently from the firm.
   • Investors must first inquire about the potential risks that a strategy will expose them to in the normal course of business and then inquire about the additional idiosyncratic risks presented by a specific manager within a strategy.
   • Investors next might want to ask if there are written policies and procedures to monitor and measure each of the applicable risks and whether there is a risk committee to which each of the measured risks gets reported on a daily, weekly, or monthly basis.
   • An evaluation of a fund’s risk and its process to measure and monitor risk inevitably morphs into a discussion of systems and technology. Modern-day hedge funds use complex processes to originate and control risk. Investors should inquire about the process used by the firm to choose a single or multiple sets of risk platforms and the consistency of risk measurement between the traders, portfolio managers, and investors.
   • Great care should be taken to understand the inputs and assumptions used in the firm’s risk models and whether the portfolio is stress-tested on a regular basis to measure the impact of changing assumptions.
   • Too often, traders use a different system with different inputs and outputs to monitor their risk than the firm is using to report risk to investors. This can result in a significant miscommunication and lead to problems when things go wrong.
   • Importantly, each style of hedge fund strategy has a unique and sometimes mutually exclusive set of risks. An equity fund has beta exposure, whereas a credit arbitrage fund may have credit spread exposure. Event funds may be exposed to very specific catalysts that can have a significant impact on performance. Global macro funds have more inflation, interest rate, and currency exposure than most single-strategy funds that trade a specific asset class.
   • The information made available to investors needs to cover both the generic risks common to many funds and the particular risk associated with a single strategy and a specific fund.
2. How Are Securities Valued?
   • A firm’s valuation policy is another critical area that investors need to examine when considering a fund. Some important questions in this regard include –
   • What percentage of the fund’s assets are exchange traded and marked to market via exchange prices versus model prices or broker quotes?
   • Does the administrator take responsibility for valuation, or does the manager retain responsibility?
   • Who can override prices, and is there a formal documented process to do so?
3. What Is the Portfolio Leverage and Liquidity?
   • An investor needs to evaluate the current and historical changes in leverage, the sources of leverage, and the liquidity of the fund’s portfolio over time. In doing so,  understand where the particular manager may deviate from peers or exhibit leverage or illiquidity that can cause performance to deviate from the expectation of the strategy.
   • Some strategies such as global macro have fairly uniform leverage terms and liquidity based on the products they trade. Others, such as fixed income and convertibles, use varying degrees of leverage and have very different liquidity profiles from firm to firm. An investor who expects to earn the mean return of an index, such as a convertible index, can get very different results depending on the manager’s leverage and liquidity or orientation.
   • Depending on the answers to questions about leverage and liquidity, investors may need to adjust their expectations for returns that were initially based on the strategy or a comparable index. Investors should inquire how the current leverage and liquidity in the existing portfolio compares to previous quarters. Liquidity will also have a direct effect on a fund’s capacity and ability to handle larger amounts of investor capital.
4. Does the Strategy Expose the Investor to Tail Risk?
   • Certain strategies may expose investors to unanticipated tail risk. Investors need to perform their own analysis of a fund’s data and determine its skewness or kurtosis. They should also inquire whether the manager believes that tail risk exists and, if so, get an  explanation of how it is hedged or whether investors need to accept or hedge it on their own.
5. How Often Do Investors Get Risk Reports, and What Do They Include?
   • Investors are always entitled to periodic reporting from the fund. The fund offering documents and materials normally state explicitly when and what is provided. Some funds report on risk using a standard package produced by a third-party risk provider or include key risk statistics in their monthly fact sheet or periodic investor letter. Investors should obtain this information, ensure they completely understand it, and compare it to peers and/or strategy-level indices for consistency and to identify unique risk taking by the fund prior to investing.
6. Do the Fund Terms Make Sense for the Strategy?
   • Investors want to assess if the terms make sense for the strategy that is being offered. A long-only manager getting a 2 and 20 fee or a liquid long and short equity strategy with a one-year lock-up can be red flags. Investors can compare any specific manager or fund to its peers to see if the terms make sense. Law firms, accountants, and many commercial databases are good sources to collect comparative data on fund terms.
   • Investors who give away terms such as lock-up to managers are not getting  compensated for the risk they are taking. Investors who pay high fees for market beta are overpaying for something that could be more cheaply replicated on its own. Investors should inquire about the fees, high-water mark, and hurdle rate related to any investment. Some of the questions that they should ask in this regard includes –
     • Is the fee appropriate and in line with peers?
     • How is the hurdle rate calculated and by whom?
     • Is the high-water mark reset annually, or is it perpetual?
     • Does the portfolio’s liquidity match the liquidity offered to investors, and if not, is the gap a reasonable one?
     • Is there a lock-up period before redemptions are allowed?
     • Can the fund gate or suspend redemptions?

Due Diligence On Operational Environment Of The Fund

• An operational due diligence program includes review of several important aspects of how a hedge fund is managed and how its interaction with the fund itself is controlled. The primary purpose of operational due diligence is to ensure that no significant additional risk of loss is being created for investors related to the –
  • Settlement of securities
  • Process of corporate actions
  • Misappropriation or theft by employees or agents, or any other breakdown in the manager’s confirmation
  • Verification, valuation, and reconciliation process.

• An investor performing operational due diligence generally focuses on assessing the adequacy of a manager’s internal controls, consistency of fund documents and legal representations, and the risks of loss due to counterparty or service provider failure.

Due Diligence On Operational Environment – Internal Control Assessment

• A review of a manager’s control environment includes many items. Some of the more important items that investors can review include –
  • The qualifications of people at the fund
  • The quality of the written procedures
  • The ability of the team to execute them each day
  • The ability of the team to clear any breaks of exceptions that may occur
  • The fund’s exposure to derivative counterparties
  • The protections provided by the fund’s governance structure.
• It is not enough to have a good plan. The message from the top-down needs to be one of safeguarding assets, where following a process is supported and, more than anything, investors are valued and treated with respect.
• An assessment must be made regarding whether the operations, accounting, treasury, technology, compliance, and other personnel are truly qualified for the positions they hold and the products the fund is trading. Investors must ask whether the managers have experience managing and whether they themselves are qualified to get the job done correctly.
• It is not unusual for background checks to be done on the firm’s COO , CFO, accounting  managers, or other key back and middle office personnel, in addition to the checks normally done on the investment and research team members.
• A review of the fund’s written procedures related to trading, derivatives, cash and securities processing, and position servicing can be performed during a site visit to the firm. It is now routine for investors to inspect documents outlining firm procedures and evaluate those procedures to see evidence of how the written policies are being followed.
• Unfortunately, these sorts of documents and process reviews are not really comprehensive or efficient. In reality, it only gives investors a sense of whether the management of the hedge fund takes the whole control process seriously. Some hedge fund managers have made real progress in this area and have gone as far as to get an outside audit firm to evaluate their procedures and controls on a periodic basis and issue an opinion of whether the controls are sufficiently well designed and have been tested and are operating effectively.
• Compliance is another critical area of investigation. Most firms today have either their own in-house compliance function or an outsourced relationship with a compliance service provider. All but the smallest of firms have some resources dedicated to compliance.
• Compliance practices that can be verified include –
  • The existence of a code of ethics
  • Prohibition of related-party transactions
  • Restrictions related to employee trading.
• Counterparty risk related to the use of OTC derivatives and other trade counterparties is now a topic routinely covered in the operational due diligence function. Funds have varying exposure to the firms they trade with. Firms holding up-front margin have failed and closed out fund positions without any return of the margin payment held in the account. The Lehman and MF Global failures resulted in hedge funds losing money that belonged to the funds they managed. When a fund has cash being held with a dealer and the dealer goes bust, it may not get the money back. At a minimum, there may be a lengthy court battle, and then recovery may only be 30 or 40 percent of the amount they thought was safe and secure as cash on the balance sheet or a receivable from a dealer.
• Hedge funds have to diversify this risk among several firms, take action to move any excess cash out of firms that may be at risk, and have a process in place to monitor the risks of these counterparties every day.

Due Diligence On Operational Environment – Documents & Disclosures

• An investor needs to verify with the listed law firm in the fund documents that they were responsible for the original content and for any updates. Investors generally rely on the quality of the law firm that has created or amended fund documents.
• On some occasions, managers have been known to make changes to their fund documents without the consent or even knowledge of the law firm that drafted the documents. An investor can actually check the document to see if any changes were made after the as of date on the face of the document.
• Changes made after that date should be discussed with the manager immediately and also with the law firm. In addition, it is important to verify that the law firm cited in the fund documents is still under a retainer agreement with the manager or fund. Most law firms will at least indicate whether they currently represent the fund.
• Next, it is very important to ensure that all the following documents are saying the same thing at the same point of time –
  • the fund offering memo
  • subscription agreement
  • limited partnership agreement
  • investment management agreement
  • Form ADV
• Other than the above documents, it is also important that the firm’s website is on the same page as other sources regarding all material facts.
• Very often, these documents can change after a fund launch, and some may no longer match the terms of the offering memo that ultimately governs an investor’s rights and obligations. Particular attention must be paid to –
  • Fees
  • Liquidity
  • Side pockets
  • Gate
  • Suspension rights
  • Creation of sub funds or SPVs
  • Change in offshore investment managers.
• Investors in hedge funds must carefully consider the conflicts of interest section of the fund’s offering memo (OM). This is where the law firm drafting the documents most clearly states any concern about nonstandard arrangements with managers, co-investors, and others. 
• Be sure to query these representations, especially if they are vaguely worded, such as “certain principals or affiliates of the manager may maintain relationships with certain fund counterparties but will always operate on an arm’s length basis”. This can mean anything from “our administrator also does some accounting for Citibank, where we hold our operating accounts” to “the manager takes a personal rebate from the prime broker”. Caution is advised when there are either insufficient or extremely broad risk disclosures.
• Insufficient risk factors are more of a red flag than too many. In addition, overly broad and irrelevant risk factors are also a red flag. In the latter case, the law firm may not have adequately looked at the manager’s program or is drafting the OM so broadly that it is looking primarily to protect itself, not the investor.
• Also be sure to check registration and compliance language with independent counsel specializing in the regulation of the strategy mix that the manager trades. Foreign advisors may not be exempt from U.S. registration, even if one is investing through a feeder fund.
• The scope of exemptions from registration is constantly changing and should be current. Document review should include a complete read of all the fund documents to ensure that the terms are reflective of the discussions the investor has had with the manager. Very often,  terms are omitted or not discussed in person, yet later are uncovered at the last minute when documents are being reviewed or, worse yet, being completed.
• Redemption right, liquidity, notice period for redemptions, hard or soft lock-ups, early redemption fees, the ability of the manager to gate or generally suspend redemptions, and the amount and timing of payouts following redemption (there may be a 5 to 10 percent holdback pending annual audit) should all be confirmed with the manager verbally and reconciled to the fund documents. The same holds true for management and incentive fees subject to a high-water mark or hurdle rate and the expenses that a fund will bear related to start-up costs, market data, or other costs.
• Finally, subscription rights (timing of subscriptions, minimum subscription amounts, limits or commitments on capacity) should be reviewed and agreed upon with the manager. Other important considerations when reviewing fund documents include the powers of the manager. Some questions that must be asked in this regard are –
  • Are they very broad or relatively narrow?
  • Are there any restrictions related to the use of leverage or concentration in the documents?
  • Can the manager amend fund documents, such as the limited partnership agreement?
  • What are the key man event rights or notice to investors?
  • Does the fund have indemnification provisions?
  • What extent does the fund itself indemnify the manager and any directors?
• Typical indemnifications should not extend to the gross negligence, bad faith, fraud, or willful misconduct of the manager. The documents should also clearly state the manager’s obligations for reporting to investors, including audited financial statements and any tax implications associated with the fund’s investments that can impact fund investors.
• Financial statements are also important documents for investors to evaluate when considering a particular fund. Analysis of the fund’s last financial statements can provide investors with valuable information about the manager and the fund.
• A review of the financial statements should start with reading the opinion and confirming that it is, in fact, “unqualified”. This basically means the independent auditor has reviewed the company’s records and issued the statements without any material caveats or concerns.
• An investor can examine the balance sheet and income statement to see if it makes sense based on the fund’s trading strategy. Equity funds should look very different than global  macro funds or fixed-income funds. An equity fund that purports to have a low level of leverage that has been declining year over year should not report a high level of interest expense that is rising year over year in its financial statements. A global macro fund most likely has interest income earned in its income statement. Investors can quickly learn to expect certain patterns in the balance sheet and income statements of funds pursuing specific strategies.
• If a particular fund doesn’t make sense, then questions need to be asked immediately. Leverage on the balance sheet can be recalculated and compared to the leverage expected by the strategy or represented by the manager. In addition, funds that have a long-term buy-and- hold strategy should not be generating large amounts of realized gains or losses each year, instead, they should have sizable unrealized gains or losses instead.
• Any unusual line items that raise a red flag should be discussed with the manager or even the auditor. Material items that are unique or different are usually explained in the footnotes. Reading the footnotes is critical, as it is often where the really important items get clarified, such as the use of derivatives or litigation.
• Investors can and should recalculate the fees paid by the fund to the manager and make sure  they make sense. Fees should be compared to the pitch book and other fund documents such as the OM. There should never be incentive fees earned in years when the fund lost money.
• Finally, one must check the equity section to see if the general partner is continuing to invest in the fund. Withdrawals or reductions in equity are a big red flag. Investors should thoroughly discuss and understand the changes in the capital accounts of the general partner and any significant key people who run the fund.

Due Diligence On Operational Environment – Service Provider Evaluation

• Investors should expect that a hedge fund will make all of the key contacts at their service providers available to them so they can verify the scope of any services being provided.
• Investors can also obtain internal control letters and audited financial statements from the fund’s service providers to make sure there is an independent check on the service providers themselves.
• It is not uncommon for investors today to interview service providers and discuss the role they play in –
  • Executing trades
  • Providing technology
  • Performing valuations or verification
  • Safe-guarding assets.

Assessing Hedge Fund’s Business Model Risk

• Running a hedge fund is an entrepreneurial activity that is now being held to institutional level best practices as standards. It is a business that has risks that are similar to many others. There are some questions that constantly need to be answered and whose answers hold the fate of the fund –
  • Will there be adequate cash on hand, where does the working capital come from, and is it organized properly?
  • What happens if too many investors redeem at the same time?
  • Is there enough liquidity in the fund to exploit opportunities in the foreseeable future and to handle major losses in major outstanding positions?
• These and many other questions are relatively new to hedge fund managers. During the early stages of the industry’s growth, hedge fund managers rarely had to face these sorts of issues. The early stages of the hedge industry had a very rosy picture, usually characterized by –
  • Relatively low barriers to entry
  • Relatively low barriers to success
  • Plentiful Capital
  • Available leverage
  • Rising markets
  • Low interest rates
  • Narrowing spreads
• Today, there are much higher barriers to entry, and the barriers to success have gotten much higher. Not everyone succeeds. In fact, over the past several years, as many as, or in some cases more funds, have failed than have been launched. This rarely occurred in the past, if ever.
• The implication to investors can be significant. A fund that fails needs to be liquidated, often in adverse conditions. Capital may be tied up; worst case, there may be litigation and embarrassment or a loss of confidence in the investor’s decisions. No investor wants to give money to a manager who then closes suddenly, having run out of cash to run the business.
• Many hedge fund managers are simply not prepared for this brave new world. They often have never needed to develop the business building, financial planning, and strategic planning skills needed to launch a business, retain talent, and grow a business over an extended period of time. Managers who take business model risk seriously and who are actively modifying their business to adapt will be successful. Those who do not adapt will not be successful. Given the massive changes in this industry over the past five years, it is virtually impossible for a manager to simply stand still and still be successful.
• Since 2008, understanding the cost base and the revenue and expense model of any fund has become critical to predicting whether a fund will survive. Managers need to spend a great deal  of effort to design a sustainable business model that can survive under a wide range of performance scenarios and that can support the ever-increasing demands of investors. Not all funds are able to do this well. In fact, many funds have decided to simply return capital or close rather than evolve to meet the demands of the market and of their changing investor base.
• A manager’s ability to control costs and predict revenues, while not easy, is essential for a firm to survive. Firms that overly rely on variable incentive or performance fees have increased business risk unless there is a working capital facility in place. Firms with significant assets, where management fees far exceed operating costs, have less business model risk.
• Larger firms, however, may unfortunately have performance challenges, particularly if they have grown beyond the strategy’s capacity or diluted performance just to gain or gather assets. According to the Merlin study, “There is still no one-size-fits-all business model for hedge funds, but thereare several common factors and best practices that have developed to ensure the manager is engaged in asustainable business. A fund operating in the red zone is dependent on outsized performance to cover itsexpenses; a fund in the yellow zone requires minimal performance; and a green zone fund can sustain itselfwhen its performance is lower than expected, nonexistent, or even, negative. Funds that structure their business model to operate in the green zone are better positioned to navigate through down turns and therefore have higher survival rates over the long term.”
• In addition to being aware of the firm’s strategic positioning, business plan, and other issues that come up regarding its business model, an investor can and should ask questions designed to uncover any additional business model risk. Investors can ask additional questions specifically designed to evaluate a fund’s business model risk throughout the entire due diligence process, including –
  • What is the firm’s strategic vision?
  • Does the firm have a multiyear budget?
  • How many months of cash flow does the firm have in the bank?
  • What steps can the fund take or is it taking to lower its cost base?
  • When was the last time the fund renegotiated its terms with its key service providers?
  • Does the fund use any outsourced solutions? Why or why not?
  • What is the management company’s break-even AUM?
  • What is the fund performance needed to break even at the existing AUM level?
  • What is the capacity of the existing staff to handle additional assets?
  • Does the fund have key man insurance and, if so, on whom, and what is the succession plan for the firm’s founder?

Assessing Hedge Fund’s Fraud Risk

• Investors in hedge funds always need to be on the lookout for fraud. Despite the due diligence done on the investment, risk management, and operational practices of a manager or fund, and even where there is a complete understanding of the business model risk, investors can still find themselves defrauded.
• The FBI lists hedge fund fraud as a type of white-collar crime on its website. It says that hedge funds are minimally regulated investments that present many risks to investors. It says that hedge funds can and do fail for many reasons, including fraud, which is a risk present when investing in hedge funds, and it goes on to elaborate on several types of frauds that might occur.
• According to the FBI website, there are several potential indicators of fraud that investors should investigate before investing in a fund. These include-
  • Lack of trading independence when a fund executes via an affiliated broker-dealer
  • Investor complaints about lack of liquidity
  • Litigation in civil court alleging fraudulent acts.
  • Unusually strong performance claims.
  • A high percentage of illiquid investments or those marked to market by the manager.
  • Related parties participating in valuation or a lack of independence (for example,  valuation agents, brokers supplying prices, or administrators where the manager is the largest customer, has a personal relationship, or has an investment).
  • Personal trading by managers in the same securities or similar securities as the fund.
  • Aggressive shorting and organized efforts to spread rumors or disseminate unfounded or materially false information about a company.
• The agency suggests that investors review the SEC website for past regulatory actions; state securities websites; and federal district, bankruptcy, and appeals courts records and check service providers’ independence and reputation, as well as use of a professional service for background checks.
• The SEC website also has a section dedicated to hedge fund due diligence. The SEC published a list of questions that investors should consider before making a hedge fund or fund of hedge funds investment. Some of the SEC recommendations include – reading a fund’s prospectus or offering memorandum and related materials, understanding how a fund’s assets are valued, asking questions about fees, being wary of extra layers of fees, understanding limitations on share redemption rights, researching the backgrounds of hedge fund managers, and not being afraid to ask questions.

Elements In Due Diligence Questionnaire

• The table of contents of a typical due diligence questionnaire created by a hedge fund for circulation to potential investors would likely include disclosure of all of the following information –
• Manager information
  • Registration
  • Ownership
  • Organization
  • References/Background checks
  • Track record
  • Risk management
  • Operations
  • Service providers
  • Contact details
• Execution and trading
• Third-party research policy
• Compliance
• In-house legal
• Anti-money-laundering policy and procedures
• Disaster recovery and business continuity
• Insurance coverage and key man provisions
• Fund information
  • Management and incentive fees
  • Lock-up
  • Subscriptions and redemptions
  • Notice periods
  • Fund directors or advisors
  • Administrator
  • Auditor
  • Legal advisor
  • Prime broker
  • Assets
  • Performance
  • Capacity
  • Gates and lock-ups
  • Historical drawdown
  • Use of managed accounts
  • Investor mix
• Investment process and portfolio construction
• Risk controls
  • Concentration and diversification
  • Liquidity
  • Leverage
  • Exposure to market risk factors
  • Reporting
  • Portfolio Greeks (duration, delta, beta, etc.)
• Financial statements
  • Year-end opinion
  • Level 1, 2, 3 assets
  • Interim statements
  • Administrator reports
• Terms and use of third-party marketers