Hedge funds are investment strategies that aim to achieve a positive return on investment regardless of whether markets are rising or falling. Hedge fund managers invest their money into the fund that they manage, which serves to align their interests with those of the investors in the fund.
A hedge fund pays its investment manager an annual management fee, which is a percentage of the assets of the fund, and a performance fee if the fund’s net asset value increases during the year. Although hedge funds usually get negative media focus, many hedge funds are very good investments and can be an integral part of a well-diversified portfolio.
Due Diligence Process
The hedge fund due diligence process begins with understanding the characteristics being considered for each portfolio. Understanding the objectives of the portfolio is the key to defining criteria for the proper hedge fund investment.
Define Measurement Criteria
Criteria should be defined in both a quantitative and a qualitative manner. The criteria that one can use to measure hedge funds (or any other investment) should include returns, volatility, liquidity terms, fund size, longevity, investment style, investment strategy, fees and asset class. The main objective to consider is whether a hedge fund meets most, if not all, the criteria set in the search. An attractive hedge fund that does not meet the needs of a portfolio may be detrimental to the objectives of the overall portfolio.
Once the criteria are clearly defined, there are a variety of databases that contain thousands of hedge fund names and performance data. Such databases include HFR, Hedgefund.net, Morningstar, CS/Tremont.
There are a number of hedge fund marketers that can help find suitable candidates, or they can be found within the platforms of the larger institutional brokerage firms or other industry contacts.
The next step in the due diligence process is to contact the hedge fund manager and request information. The most common package of information sent by hedge fund managers includes a one-page summary of performance, a PowerPoint type presentation that describes the firm, its strategy, principals, performance and terms of the investment, offering memorandum, subscription documents, and a due diligence questionnaire. The hedge fund may send all of these at once or on request. Initially, an analyst should make sure they receive the PowerPoint presentation, offering memorandum, and due diligence questionnaire. These three documents should serve as a good starting point to better understand the hedge fund manager and generate additional questions that can be addressed.
The preliminary analysis involves confirmation of the fund’s performance to ensure it is consistent with the expectations. The PowerPoint presentation can be reviewed to understand the underlying strategy that generated those returns and to help identify hedge fund peers with similar strategies.
The first level of analysis is to compare the investor’s hedge fund to those within the same category. The PowerPoint presentation will then help further refine the strategy so the investor can selectively pick a more concentrated group of funds for comparison to determine how our fund performed versus other funds with similar strategies. Each hedge fund has unique attributes but for the sake of comparison, the investor must use his judgment to define a suitable list of comparable funds.
Once the fund’s performance has been evaluated and it has been determined that it has performed well relative to the set criteria and relative to other similar funds, interaction with the manager can be conducted in order to ask additional questions that have arisen during the preliminary analysis. This interaction should be with the portfolio manager and other persons making investment decisions.
These are the intangible issues related to hedge fund investing which include, at a minimum: contagion risk, the risk that unrelated factors could impact the fund, geopolitical risk, particularly for funds with global mandates, manager’s education and previous experience, operations staff skills and background, staff levels and capacity for growth, and office space and working environment.
In most cases, the qualitative factors cannot be accurately estimated until an office visit is conducted which should be mandatory before making an investment in any hedge fund. Even hedge funds on the platforms of the large institutional brokerages should go through the due diligence process. Although the institutional brokerage has conducted their due diligence, it must be remembered that they receive a fee for selling the fund to interested investors.
Finally, an investor should perform a thorough background check on all of the firm’s principals to ensure they do not have any outstanding liens or issues that would affect our decision to invest money with them. A thorough background check can also provide information that allows the investor to assess a fund manager’s character and style of living. There are third-party service providers that can conduct thorough background checks on individuals. This is the best option if the investor does not have the resources to conduct public record searches personally.
Third-Party Service Providers
There is another aspect of due diligence that often gets little attention, and that is to make sure the third-party service providers are of a high standard. It is not as crucial that third-party service providers be evaluated thoroughly like the investor would the hedge fund firm. However, while there are some high-quality service providers to the hedge fund world, there are others that do not provide the level of service required to manage a portfolio of hedge funds properly.
Third-party service providers can include auditors, accountants, fund administrators, hedge fund marketers, attorneys, custodians, and prime brokers. The implications of a prime broker being affected by counterparty risk and affecting a hedge fund’s investments are crucial.
When performing hedge fund due diligence, it is important to know everything that’s going on with the hedge fund and with the hedge fund management. Due diligence is about both quantitative and qualitative aspects of the hedge fund.
Thorough due diligence should be performed before an investor gets involved with any investment, especially hedge funds. The investor must also make sure that the hedge fund and the manager selected also comply with the legislation and the regulations set out by the financial services regulations board of the country in which the fund is based.