Hedge Fund Due Diligence

The last few weeks have witnessed a storm of financial media reports surrounding the departure of Bill Gross from Pimco. However, what was most noticeably absent in the reports was the decision of Pimco to withdraw its investments in hedge funds.  This decision to withdraw Pimco’s Investments in hedge funds is noteworthy given the level of attention that Pimco can afford in monitoring its investment in such pooled investment vehicles which underscores the importance in continued due diligence in such investments.  

Recently, the universe of hedge funds has grown remarkably. However, they have lagged the market in their underlying performance. Most investors are drawn to such instruments because of the performance nature of the advisors compensation, the investment methodology and often as a means to diversify their holdings from market correlation. Often times, they are also drawn by the personality of the advisor and recommendations from industry experts and media. This media attention has proven to be the reason why hedge fund investments tend to accumulate to the mean return and if not managed prudently, suffer from volatility that is detached from risk adjusted returns.

 

When conducting due diligence of funds, I tend to break up the process into its underlying components:

Preliminary due diligence, often prior to the initial investments, is focused on the following:

Fund structure
The official offerings are compared to the current operations.
A study is conducted in regards to style shift, underlying investments, hedges, valuation, custody, risks identified, liquidity and reporting.
The fund’s agreements with the proper personnel. (LLC agreements with its managing member and with the fund’s custodian and administrator, etc.) are carefully reviewed.
A search for any contingencies that may exist in the fund’s notes to the audited financial statements.
An audit of the fund’s cash flow statement is conducted to determine if there are any side pocket arrangements that could impact the dilution of investors.

Operations:
The fund’s administrators, third party vendors, current staff and management, regulatory compliance, systems used, business continuity plans are closely evaluated.
Regulatory filings, such as Form ADV, Focus reports, audits, customer complaints, financial stability and stress tests of the fund’s balance sheet and those of the fund’s advisor and general partner are also examined.

Performance:
An evaluation of the advisor’s performance being imported by his or her prior assignments and jobs, portfolio turnovers, methods used to quantify valuations, education and experience of management, conflicts, execution quality and any quantitative based “black box” models.
A determination of the manager’s “at risk” investment in the fund both in absolute and relative terms is also made.

Technology:
Given the new headlines being made on “hacks” on systems relied upon, I focus on such issues as:
Data integration between the portfolio accounting system, partner accounting software, tax reporting, investor reporting tools, security pricing, corporate actions, rate and sub accounting systems.
Any functions performed off-line or manually.

Continued due diligence, during the period of investment:
Valuation procedures and controls:
Details concerning NAV calculations.
Source of valuation and the method of such valuation.
Verification process, controls and deadlines.
The pricing of illiquid or complex derivatives should be reviewed to determine the data used and whether an arm’s length review was conducted.
Managers’ experience in delivering NAV within 3 days of period end is symbiotic of their experience and talent.

Compliance procedures: (I derive comfort from results of SAS 70 type or similar conducted by an independent auditor)

Regulated, unregistered and un-regulated entities.
Results of regulatory exams, reports on code of ethics review, risk, assessment, AML independent reviews, reconciliation of custodian accounts, custody reports and surprise examinations, certified audit exceptions and management reports and disaster recovery testing.                                                                                                                                                  Staff changes (operations and support) such occurrences should be examined and reviewed for their impact on investment.
Investor controls and communications:
Policy and procedures related to investor accounting and reporting, including AML compliance, subscriptions, redemptions, payment processing and capital account reporting should be closely reviewed.
Accounting and processing of investor allocations, management and incentive fee computation, hot issues and side pocket allocations, tax estimates and proxy voting are of important focus.

Due diligence upon exit or when the fund closes down: Often liquidly concerns of the investor, lack of opportunities in the market, systemic risk or regulatory risk will require investors to determine when and how to withdraw funds. To prepare for this the following factors should be monitored periodically:

Physical visits with staff and management: Any change in such visits should be researched, including location, office improvements, and changes in management lifestyle and staff morale.
Measure fund performance with indexes and alternatives, including liquid alternative instruments registered under the Investment Company Act.
Monitor media accounts, including internet blogs for customer complaints, investor review, legal incidents and labor grievances.

Hedge Funds are increasingly providing investors with the opportunity to conduct due diligence to attract funds into their portfolios. Investors should seize this as a positive sign to establish a continued communication with the advisor to such funds to protect and improve their investment in such vehicles.

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