Hedge Funds: Conducting Due Diligence

Hedge Funds:
Conducting Due Diligence
Stephen D. Philp - Director, Capital Markets Group
There are, to say the least, a number of considerations for institutional investors looking to add hedge funds to their overall asset mix: strategy, correlation, leverage, volatility, transparency, due diligence, structuring. The list goes on.

Once it has been determined that an allocation to alternative assets is justified, it is incumbent upon the investor to construct the portfolio of managers, select the right funds and conduct a due diligence process that will enhance the likelihood of success.

There seem to be stories in the popular press on a monthly basis that recount the latest hedge fund blow-up. For the most part, these stories have nothing to do with hedge funds and everything to do with frauds that have been perpetrated on people that did not, or could not, take the steps necessary to confirm that the manager had the requisite talent and integrity to properly manage money. A good due diligence process essentially audits prior returns, how they were generated and validates that the people, processes and resources are present to do the same in the future.

For example, we use a combination of interviews, questionnaires, reviews of printed materials, discussions with industry contacts and disclosures from key service providers like auditors, prime brokers, marketing firms and offshore administrators. Of all of these, the most important is the on-site interview with the principals of the fund. During this interview, we concentrate on understanding what each of the key people bring to the firm, their approach to risk management, the investment discipline and finally the business acumen of the owners. The annals of hedge fund history are replete with stories of managers that were great traders but failed miserably when it came to running an asset management firm.

In terms of constructing your own due diligence process, there are a number of resources that are accessible through various industry association web-sites. The Managed Futures Association and the Alternative Investment Management Association are two that provide sample question sets. A number of institutional managers, rather than constructing their own process, choose to outsource the evaluation to an independent consultant or fund of funds manager. The key in the outsourcing decision is to determine whether the consultant understands your risk considerations and can act as your proxy in discussions with managers. Interviews with a number of consultants, as well as institutional managers who have used consultants in the past, will provide context for choosing the consultant that can best serve your needs.

Whether you conduct your own due diligence or hire a consultant to do it for you, your interests will be served if you can more precisely outline your expectations for your alternative investment portfolio. A clear definition of the risks that are acceptable, as well as those that are not, will focus your due diligence process and ultimately help you to identify a group of managers that will meet your investment objective and, more importantly, let you sleep at night. *


Contex Group Inc.