Assessing New Hedge Funds

Date: Friday, June 3, 2011
Author: Alan Swersky, Duff & Phelps

Family offices shouldn’t shy away from emerging hedge fund managers, many of whom outperform their more experienced brethren.
By Alan Swersky

In the relatively short history of hedge funds, pioneers of the industry emerged as entrepreneurs who wanted to make money, manage money for others and do so “their own way.” To achieve these goals, managers usually started out managing money for family members and friends. Due to legal restrictions limiting the management of money to accredited investors, hedge fund managers turned to affluent, high-net-worth individuals and family offices to access capital. In short, budding entrepreneurs relied on established entrepreneurs to help them access cash. These deals were done rather informally, based largely on word-of-mouth among “friends,” because hedge funds are not able to advertise.

Recently, however, the hedge fund business has made a dramatic turn toward institutionalization. For many managers and investors, being “only” a $100 million fund doesn’t cut it anymore, as most institutional investors want hedge funds to launch on day one with $100 million and the ability to raise assets quickly. It is challenging for the entrepreneurial hedge fund manager to raise capital from institutions and fund of funds, so the emerging manager continues to market to the high-net-worth investor and family office.

The startup costs of launching an institutional hedge fund business continue to increase; regulatory and compliance costs, infrastructure charges, staffing and service provider expenses deter many potential new hedge fund managers from leaving them comfortable jobs at large banks or other asset management firms. If one looks at some of the large multi-strategy hedge funds, they resemble bulge bracket banks. Many of the large banks have a minority interest in these hedge funds. Also, a hedge fund entrepreneur who has successfully built a business now wants to monetize his own investment. The only buyers in town are banks and private equity firms who only want established institutional business.

In Neuberger Berman’s 2011 Strategy
Outlook, the firm studied 288 emerging managers. The study found that performance since 2002 showed emerging managers annualized +9.49%, versus the +7.61% achieved by emerged managers during the same time. “Based on this analysis, the emerging manager’s trend of outperformance seems clear,” says the report, published by the firm’s fund of hedge funds team. Despite this study and others that show smaller funds outperform their larger counterparts, consultants, funds of funds, pensions and endowments have a bias toward larger funds to mitigate headline risk. Understandably, allocators do not want to be “Madoffed” or invest in the next Bayou. However, many high-quality and trustworthy hedge funds manage a small amount of capital and rely on high-net-worth individuals and family offices for funding. Wealthy individuals and family offices will continue to reap the financial benefits of investing with smaller managers, but today’s climate requires that investors do proper operational due diligence prior to investing. This is true regardless of whom the managers are or how much money they manage. Also, monitoring the manager’s activity must continue after the investment is made. If done properly, due diligence can be performed efficiently and effectively by an internal resource or an independent provider.

Before turning money over to a hedge fund, the prudent investor should follow these basic operational due diligence steps:

1. Check their background.
• Confirming a manager’s education, employment history and other resume data is essential. Also, investors must determine whether the manager has been involved in any legal or regulatory matters. Learning about a manager’s behavioral patterns, conflicts of interest or outside business interests helps to protect the investment. This kind of background check is an ongoing process that should continue throughout the relationship.

2. Review documents.
• Investors need to read all relevant documents, including legal documents, marketing materials, audited financial statements and the due diligence questionnaire, before allocating to any manager. These documents explain the manager’s strategy and investment philosophy and reveal important details about the organization’s structure and operations, its general partner’s powers, and its various business relationships. The documents also explain the investor’s rights. Any discrepancies among the documents should be noted and questioned.

3. Visit in person.
• Commit to an in-person meeting with the manager at his or her office—and make sure the entire investment management team is present. During this meeting, obtain a profile of the manager’s culture, clarify discrepancies and verify procedures stated by the manager. At the end of the visit, the investor should assess his or her instincts before proceeding with the relationship.

4. Reconcile and verify.
• Investors should confirm the fund’s net asset value. Obtain the fund’s asset level from the manager and then verify the number with the fund’s administrator and counterparties, who usually include prime brokers, cash custodians and OTC counterparties. Three-way reconciliations may not result in 100% asset verification, but it may exceed some predetermined threshold. Also, seek confirmation from the administrator of the manager’s investment in the fund. Investors need to confirm that the manager has “skin” in the fund.

5. Confirm relationships and functions.
• Confirm all significant service provider relationships and their specific functions to the fund/firm before investing. Also, if a hedge fund has changed service providers, determine why the change occurred. Providers that must be confirmed include auditors, administrators, prime brokers, cash custodians, valuation agents, directors, technology providers and compliance agents.

6. Check references.
• Check all references the manager provides, and go one step further by obtaining independent references from current and former investors, former employees and former colleagues of the hedge fund manager and key employees. Keep in mind that all managers only provide positive references. These conversations will provide the investor with a range of opinions that can be used to draw new conclusions.

Every hedge fund business is different, but the following structure and philosophy should be shared by all trustworthy managers:

1. Appropriate Staffing
• A manager that has hired a knowledgeable CFO, COO or controller helps to separate duties within the firm and allows him to focus his time and energy on portfolio management.

2. Reputable Service Providers
• Managers should work with a reputable auditor whose practice is well versed in the hedge fund business.
• An independent administrator keeps the official books and records, allowing the fund manager to improve controls and mitigate certain risks. The administrator should also verify the valuation of portfolio assets on a regular basis. By having the proper support to maintain the fund’s books and records, investors will grow even more confident that proper oversight is in place and that the underlying fund’s NAV is accurate.

3. Sophisticated Technology
• New managers who invest resources in information technology early on offer better internal controls. Top quality IT systems quickly pay off in the form of greater efficiency and productivity.

4. Documented Procedures
And Business Plans
• Managers should demonstrate a forward-thinking approach by developing a detailed expansion plan. The plan should include a strategy on how to add staff as assets grow and new products are offered. Also, new managers should identify their breakeven point and be able to prove to potential investors that they can handle additional costs.

5. Business Transparency
• New managers have a lot to prove and “slick talk” is no longer sufficient. Managers should proactively invite investors to view portfolio management, risk management, order management and accounting. Emerging managers can save valuable time during the due diligence process by making the compliance and operations manuals, valuation policies and disaster recovery plans available to investors, as well as the contact information for all service providers and a master list of key ISDA terms. Investors are demanding 100% transparency, and managers can stand out from the pack by demonstrating openness and accessibility.

6. Compliance Culture
• Under the Dodd-Frank financial reform act, hedge fund investment managers with over $25 million in assets under management will be required to register with either their state or the SEC by July 21. Emerging managers must comply and would be wise to establish a “culture of compliance” at their firm. They should employ a qualified chief compliance officer or outsource those duties to an experienced third party.

Study after study shows that “emerging managers” can outperform more mature, larger and established hedge funds. But as the regulatory and infrastructure costs of doing business rise, smaller hedge funds will have trouble launching and remaining open. High-net-worth individuals and family offices can capture the additional alpha from emerging managers, as long as they navigate these waters carefully. This prudent approach highlights the need for proper operational due diligence, balanced with an entrepreneurial spirit. There are many new managers who are superb at investing but don’t have much experience running a business or marketing their own enterprise. By conducting thorough due diligence, family offices can invest in these new managers and have a chance at making significant returns while also mitigating unnecessary risks.

Alan Swersky is director of the alternative asset advisory division of Duff & Phelps.