Hedge fund due diligence: The last line of defence

Investors expend substantial time and
resources on due diligence. However, much of their efforts are front loaded,
focused on quantitative measures with a bias towards initial due diligence, ie
spotting the “bad apples” before they are included in a portfolio.
Interestingly, history indicates that most hedge fund failures have arisen from
investments which were initially sound and would have passed even the most
stringent reviews. Most of the financial debacles of recent years have been due
to a fund or individual getting into trouble and then trying to correct and/or
cover up the problem. Ongoing due diligence is therefore a crucial component of
any successful investment strategy.

New hedge funds are being launched on a
near daily basis, and as the hedge fund industry continues to grow, so too does
the opportunity for fraud and abuse, hot topics in the post-Madoff world. A
thorough due diligence program can help investors identify operational “red
flags”, such as whether a fund is fabricating returns, using “expert network”
firms or abusing fees to pay for services other than for generating returns.
Thorough due diligence can also help investors identify and avoid funds that are
likely to underperform or go out of business. 

Due diligence defined

Whilst most readers are familiar with
the term due diligence, what exactly does it mean and what does it involve?
Hedge fund due diligence is the process of reviewing and monitoring the operation
and management of hedge funds. The objectives of due diligence are to identify
managers with whom to invest and to monitor those managers on an ongoing basis
in order to ensure that investing with them is aligned with the interests of
the investor. 

Due diligence consists of a thorough
qualitative and quantitative examination of the investment manager, key
personnel, investment strategies, business structure, operations, alignment of
interests, conflicts of interest, valuation policies and procedures, risk
management, compliance, investment terms, criminal, civil and regulatory
actions, and competitive advantage, among other things. When performed
properly, due diligence provides a thorough analysis and understanding of the
potential operational and financial risks involved with investing with a
specific investment manager. 

The International Association of
Financial Engineers defines operational risk as “losses caused by problems with
people, processes, technology, or external events”. Operational risk is
therefore a very broad concept and includes risks associated with accounting,
operations, compliance, audit, valuation, reporting and the oversight of
personnel. Legal and regulatory problems are also indicators of operational
risk. Operational risk is distinguished from financial risk, which includes
poor investment performance and excessive investment risk. 

The implosion of Amaranth illustrates
the distinction between financial risk and operational risk. Amaranth was
widely reported in the financial press as having failed due to an energy
trading strategy that went awry (ie financial risk). However, operational
issues may well have contributed significantly to its demise. A due diligence
report completed more than a year prior to Amaranth’s failure led at least one
major investor to fully redeem its investment from the fund. This report
identified significant operational risk factors at Aaranth, including “the
lack of an independent third-party administrator verifying returns,
insufficient risk controls and the passing through of company expenses to the
fund”.

Operational risk and financial risk are
often closely linked. However, unlike financial risk, operational risk is not
easily diversifiable. A prudent investor must therefore perform ongoing operational
due diligence on every fund in which it invests. 

The cost of due diligence

Effective hedge fund due diligence is
expensive both in terms of money and in time. According to Mark Anson’s
Handbook of Alternative Investments, a thorough investor should expect to spend
75 to 100 hours reviewing a hedge fund before investing. Many institutional
investors are even more thorough and will spend at least 400 hours on initial
due diligence before investing in a hedge fund and then approximately 70 hours per
year on ongoing due diligence.

Approximately a third of US-domiciled
fund of funds have less than US$20 million in assets under management. With an
annual management fee in the range of 1.5 per cent, a fund of funds with US$20
million in assets generates around US$300,000 in management fees annually.
These funds of funds do not generate sufficient management fees to cover the
expected cost of due diligence for the underlying funds in which they invest,
let alone to cover due diligence on new managers and all the other costs of
operating a fund of funds. Consequently many fund of funds and institutional
investors argue that they simply cannot afford to perform the required levels
of due diligence despite their fiduciary responsibilities to do so.

Lack of operational transparency

While investing in hedge funds can
result in high returns, it is generally understood that the price of these high
returns is often the relative lack of transparency on operational issues. There
are a variety of reasons why this is the case. Unlike registered investment
companies, hedge funds are generally not subject to the long list of statutory
disclosure requirements of the Investment Company Act of 1940. Despite a host
of new regulatory requirements, such as the Dodd-Frank Act in the United States
(or the equivalent in other jurisdictions) many hedge fund managers are still
not required to make lengthy disclosures about operational matters.

Hedge fund
managers are also concerned about compromising their investment, business and organisational
strategies and processes. Thus, although hedge funds often pursue investment
strategies with high degrees of complexity, illiquidity and operational risk,
investment managers are generally reluctant to be fully transparent about these
operational issues due to the burdens and costs related to the added resources
needed to provide such transparency.

A lack of operational transparency poses
a variety of risks for investors and potential investors. Without sufficient
operational transparency, it is much more difficult, expensive and
time-consuming for investors to perform adequate due diligence with respect to
operational risk. However, operational risk is a significant cause of hedge
fund attrition and underperformance. Given that operational risk can have a
material negative impact on hedge fund performance, operational risk deserves
considerable attention in the due diligence process.

Hedge fund failure and underperformance

Empirical evidence indicates that hedge
funds go out of business at a highly predictable rate. While the number of
hedge funds that “blow up” and capture the headlines is relatively small, the
number of hedge funds that go out of business on an annual basis is
significant. A study by Brown, Goetzmann and Ibbotson found that the attrition
rate for hedge funds is about 15 per cent per year and that the “half-life” for
hedge funds is just 2.5 years. 

Operational failure is a significant
cause of hedge fund liquidations. In a study of more than 100 hedge fund
liquidations over 20 years, Feffer and Kundro (2003) found that “54 per cent of
failed funds had identifiable operational issues and half of all fund failures
could be attributed to operational risk alone”. Of the funds in their study
that were liquidated due to operational failures, 41 per cent of liquidations
involved misrepresentation of investments and performance, 30 per cent involved
misappropriation of funds and general fraud, 14 per cent involved unauthorised
trading and style breaches, 6 per cent involved inadequate resources and 9 per
cent involved other operational failures. 

In addition to being a major cause of
hedge fund attrition, operational risk is also a cause of hedge fund
underperformance. In a 2007 study Brown concluded that operational risk is
negatively related to fund returns, particularly when there are conflicts of
interest between the investment manager and investors. 

Enhancing performance through due
diligence

Given that operational risk is a major
cause of hedge fund attrition and underperformance, it follows that the
performance of a diversified hedge fund portfolio can be enhanced by excluding
those funds likely to do poorly, or fail, due to operational risk concerns.
Obviously, funds that underperform for operational risk reasons will lower the
overall return of a diversified portfolio. Thus, excluding them through
rigorous operational due diligence will enhance the returns of the overall
portfolio. Additionally, excluding funds likely to go out of business for
operational risk reasons enhances the overall return of a diversified portfolio
in several different ways. 

Fund attrition is linked to excess risk
and poor relative performance. Funds that go out of business are a drag on the
risk-adjusted returns of a portfolio and are also a drag on the expenses of a
fund of funds. Additional money and time must be spent on due diligence to
identify a new hedge fund to replace the one that has gone out of business.
Transition costs are involved with redeeming an investment in a closed fund and
investing in a new fund. A period of time may also be involved when the fund of
funds is not fully invested in its optimal portfolio.

Conclusions

There are several important implications
for potential users of a due diligence service line such as managers of funds
of funds and other investors who invest in portfolios of hedge funds. Firstly,
while performing due diligence is a necessary part of the role of a fiduciary,
the greater value lies in the fact that it can play an active role in
generating alpha. Hiring a third party consultancy company to assist can be
shown to add positive net present value. Secondly, the value of due diligence
lies more in avoiding hedge funds that underperform or go out of business than
it does in selecting top performing hedge funds. Thirdly, many of the worst
losses experienced by investors during the global financial crisis of 2008
would very likely not have happened if they had actually undertaken the kind of
thorough due diligence required of them before entrusting money to a hedge fund
manager. An investor’s only line of defence against such events is a rigorous
and ongoing due diligence programme. 

 

Endnotes: 

  1. Hosking, Patrick, “Investor paid out extra penalties to quit Amaranth,” The Times (of London), 13 October, 2006, p. 50.
     
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Rob Aspinall
Rob specialises in forensic investigations, due diligence investigations, consulting, insolvency and restructuring for hedge funds. Rob graduated with a degree in economics from Durham University and subsequently qualified as a chartered accountant via the ICAEW. He is also a Certified Fraud Examiner. Rob has over seven years experience in the alternative investment industry, including two years working in a senior role at a top-tier hedge fund administrator.

Rob Aspinall
Senior Manager
Hedge Fund Services
Deloitte & Touche
Citrus Grove
PO Box 1787
Grand Cayman KY1-1109
Cayman Islands

T: +1 (345) 814 3334
E: raspinall@deloitte.com
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