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10 Questions to Ask Your Fund-of-Funds Manager

Date: Wednesday, February 4, 2009
Author: Portfolio.com

If you were a client of Access International Advisors, which lost a lot of money with Bernie Madoff, then you would have been told that they "conducted thorough due diligence when selecting outsider fund managers". Which might have been reassuring, until you found out what that "thorough due diligence" comprised:

Candidates had to undergo a handwriting test with a graphologist and Access would often hire private investigators to check the background of executives.

Clearly, some firms' ideas of "thorough due diligence" leave something to be desired. And so Jason Scharfman, of Corgentum, has put together a list of 10 questions every investor should ask about the due diligence being performed on their behalf.

Seriously: ask these questions. Doing so isn't rude; in fact, it barely scratches the surface of the questions your advisor should be asking of the people managing your money. But if all of the questions are answered to your satisfaction, you'll sleep much better at night.

Most of the questions have obvious "right" answers: yes, you want a separate due-diligence process to be performed on operational risk, rather than that being lumped in to the investment-risk process. Yes, you want a hedge fund's service providers -- it's auditors, etc -- investigated as well. That sort of thing. But question #8, about whether the due-diligence process was done in-house or whether it was outsourced, didn't have such an obvious "right" answer, so I asked Jason what to look for. He replied:

In a perfect world my preferred answer to number 8 would be to see an advisor who does everything in-house. That being said, most advisors (i.e. fund of funds) do not have the internal capabilities to really do a detailed job on such things as background investigations which certain firm's specialize in.
In such a case working in conjunction with an external ("outsourced") vendor would not necessarily be bad in and of itself. The key to me is to see an advisor which takes the work of an outsourced organization and further analyzes it/digests it as part of their entire hedge fund due diligence rather than simply relying whole-heartedly on the outsourced work and moving on.

But the most important question, I think, is #10:

Previous Examples - Can your advisor cite recent examples of hedge fund managers they have ever not hired (or fired) because of items uncovered during the due diligence process?

Due diligence should never be a rubber stamp, or a marketing tool: it should be an important part of choosing hedge-fund managers. You want the possibility of missing out on a great fund because it failed the due-diligence process. And you certainly don't want to see any fund managers getting a free pass, as Bernie Madoff did with Access's Patrick Littaye:

The relationship with Mr. Madoff, which for Mr. Littaye dated to the mid-1980s, wasn't subject to the same rigor, in part because of Mr. Madoff's reputation on Wall Street. "Of course we made an exception with Mr. Madoff," says Mr. Littaye. "I can't imagine asking him to pass a handwriting test."

Maybe there should be a question #11 on the list: have any of your fund mangers not had full due diligence performed on them?

From Corgentum.com:

Many hedge fund investors including high-net-worth individuals, pension funds, family offices, endowments and foundations, often do not have the requisite expertise or resources necessary to perform their own due diligence. This is one of the reasons they rely on financial advisors, hedge fund consultants and professional hedge fund allocators, such as funds of hedge funds. With the recent flurry of hedge fund Ponzi schemes allegedly perpetrated by money managers such as Bernard Madoff and Arthur Nadel, it is now more important than ever for investors to be able to evaluate the quality of the due diligence being performed by their advisors. How is an investor supposed to objectively and independently evaluate the quality and effectiveness of the due diligence performed on their behalf?

The Top 10 Questions Every Investor Should Ask

  1. Appropriate Resources – Are sufficient resources (i.e., staffing levels, budget, etc.) committed to due diligence as compared to other functions such as client service or investment management?
  2. Intensity – What exactly does your advisor’s due diligence process entail (i.e., documentation collection, on-site visits, etc.)?
  3. Documentation – How does your advisor document the due diligence process?
  4. Scope – Is separate operational due diligence performed on operational risk, or is all due diligence – investment and operational – lumped together?
  5. Qualifications – What makes the individuals performing due diligence particularly suited to vet a hedge fund’s investment and/or operational risks?
  6. Diverse Skill Sets – Is there diversity of skill sets among due diligence analysts to ensure a variety of risks are vetted, or do they all have the same general background (i.e., all former hedge fund accountants)?
  7. On-Going Monitoring – After the initial due diligence process is complete, does your advisor perform any on-going due diligence?
  8. In-house or Outsourced – Does your advisor outsource any part of the due diligence process, such as background investigations, to other firms or is all due diligence performed in-house?
  9. Service Providers – Is due diligence performed on a hedge fund’s service providers (i.e., auditors, administrators, etc.)?
  10. Previous Examples – Can your advisor cite recent examples of hedge fund managers they have ever not hired (or fired) because of items uncovered during the due diligence process?