31.2.1 Investment Objective

The investment objective of a fund specifies the goals, nature, and strategies of the fund's investment program. The first question regarding a fund manager's investment objective can in turn be broken down into three questions:

1. In which markets and assets does the fund manager invest?
2. What is the fund manager's general investment strategy?
3. What is the fund manager's benchmark, if any?

Although these questions may seem straightforward, they are often surprisingly difficult to answer, and documentation may not provide the information needed. Consider the following language from a fund disclosure document, in which the manager desires to maintain a flexible investment mandate:

The principal objective of the Fund is capital appreciation, primarily through the purchase and sale of securities, commodities, and other financial instruments, including without limitation, stocks, bonds, notes, debentures, and bills issued by corporations, municipalities, sovereign nations, or other entities; options, rights, warrants, convertible securities, exchangeable securities, synthetic and/or structured convertible or exchangeable products, participation interests, investment contracts, mortgages, mortgage- and asset-backed securities, real estate, and interests therein; currencies, other futures, commodity options, forward contracts, money market instruments, bank notes, bank guarantees, letters of credit, and other forms of bank obligations; other swaps and other derivative instruments; limited partnership interests and other limited partnership securities or instruments; and contracts relating to the foregoing; in each case whether now existing or created in the future.

Let's analyze this statement in light of our three investment objective questions. The first question is not answered appropriately, as the manager has not disclosed a narrow set of markets for investment consideration. The manager's investment strategy, capital appreciation, is a goal for nearly all investment funds, so this manager needs to be more specific. Finally, the manager does not provide a benchmark in the documentation.

By contrast, consider the following language from a second fund disclosure document:

The Fund's investment objective is to make investments in public securities that generate a long-term return in excess of that generated by the overall U.S. public equity market using a long/short equity strategy.

This one sentence helps answer all three investment objective questions. First, the manager identifies that the fund invests in public securities. Second, the manager discloses that the fund uses a long/short investment strategy. Last, since the manager states that the fund's objective is to outperform the overall U.S. public equity market, the investor can conclude that a suitable benchmark might be based on an index such as the S&P 500. An initial meeting with a manager is an opportunity to obtain sufficiently detailed responses to these questions regarding the investment objective, such that the investor may make an informed decision as to the appropriateness of the strategy in relation to the investor's own objectives.

31.2.2 Investment Process

Most investors prefer a well-defined investment process, as it can offer insights into the repeatability of a strategy's investment results. The investment process of a fund comprises the methods the fund uses to formulate, execute, and monitor investment decisions. The articulation and documentation of the process can be just as important as the investment results generated by the process. Consider the following language from another fund disclosure document:

The manager makes extensive use of computerized technology in both the formulation and execution of many investment decisions. Transaction decisions will generally be made and executed algorithmically according to trading strategies embodied in software running in computers used to support the Fund's trading activities.

This is a so-called black-box trading system, based on computer algorithms developed to quantify the manager's investment insight, and is itself the core of the investment process. Many participants in the fund industry consider themselves to be skill based, so many fund investment processes are less computerized than this example and reflect the procedures by which the manager's skill and discretion are translated into implementable trading decisions. The investment process should provide an understanding of which decisions are made by investment committees and which are made by individuals. Beyond that should come an understanding of who the key people are in those committees and individual decisions, how the decisions are made (i.e., majority, consensus, sole decision maker), and how the portfolios are monitored.

Investment process risk is the potential loss from failure to properly execute the stated investment strategy. Although investment process risk cannot be quantified, it may be related to measurable events, such as the loss of key personnel in key functions or breakdowns in communication and trading systems when algorithmic strategies are followed. In many cases, this can be reduced through the use of a key personnel clause. A key personnel clause is a provision that allows investors to withdraw their assets from the fund, immediately and without penalty, when the identified key personnel are no longer making investment decisions for the fund. Other sources of investment process risk can be addressed by having robust communication and algorithmic systems that have been stress tested.

31.2.3 Nature and Source of Value Added by the Fund Manager

The final fundamental question related to developing an initial understanding of an investment program regards an explanation of how and why the manager is able to generate attractive returns. There are several ways that hedge funds can add value, such as offering attractive risk premiums for bearing risks like illiquidity and exploiting tax advantages to offer attractive after-tax returns. This section focuses on the most common argument for the source of superior returns: using available information to identify mispriced assets.

Investors seek consistently superior risk-adjusted returns. In this endeavor, a prospective investor must ask two questions: (1) What enables a manager to identify alpha? (2) What reasons are there to believe that the alpha will persist? Simply put, what makes the manager smarter than other managers? There are two primary information-based explanations for superior investment performance in competitive markets based on information: information gathering and information filtering.

1. INFORMATION GATHERER OR SEARCHER: Information gathering indicates the ability of the manager to create access to information or to have access to better information than do other managers. Thus, the manager's competitive advantage may not be in analyzing information but in developing a superior information set. The manager may have a wider or deeper information set that allows a competitive edge, or the manager may have a differentiated strategy or unique position that enables a focus on a specific segment of the market and the ability to gather better information. The advantage is a proprietary information set accumulated over time.
2. INFORMATION FILTERER OR ANALYZER: Another way to generate attractive returns is to have superior skill in filtering and analyzing information. Information filtering is the fund manager's ability to use data available to others but to be better able to glean tradable insights from it. Generally speaking, quantitative, computer-driven equity managers access the same information set as everyone else, but the successful managers have better algorithms to extract more value. These successful managers are able to process generally available information more quickly or more effectively. Fundamental managers use a mosaic approach to data gathering, piecing together many sources of publicly available information and developing insights that others who did not do the legwork would be unlikely to discover. This could include site visits to retail stores to talk to customers and employees, scrubbing industry data such as capacity utilization, or analyzing individual business units in companies with multiple product lines.

To have and maintain a competitive investment edge based on information, a fund manager must demonstrate at least one of these competitive advantages. Some managers may claim success as both information gatherers and information filterers, and in other cases, the distinction may be blurred. Consider the following language from a fund disclosure document indicating information gathering: “The General Partner will utilize its industry expertise, contacts, and proprietary databases to identify superior investment ideas.” Another manager claims to be an information filterer: “The General Partner will analyze available investment opportunities using its proven methods of determining value.” Some managers may not fall neatly into one category or the other: “The General Partner will use its extensive experience, knowledge, databases, and contacts to locate and analyze investment opportunities.”

The underlying issue in investigating the source of attractive returns is to determine which fund managers can sustain superior performance. An investor cannot rely on historical fund performance data as a means of selecting good managers over bad managers, because even in a perfectly efficient market in which no manager can generate alpha, sheer luck causes some managers to have higher returns and some to have lower returns. In that case, analysis of past data may indicate risk, but the analysis cannot predict alpha. The more reliable method for ascertaining the potential for alpha is rigorous and thoughtful analysis.

It should be noted that competition tends to erode informational advantages over time, as other managers discover the sources of returns from successful funds. Thus, an analysis of the sources of returns should include an analysis of whether an informational advantage should be expected to persist via either proprietary data or investment in continuously sought-after new sources.

To summarize, in a publicly traded market, and excluding transaction costs, every cent by which one investor outperforms the market index on a risk-adjusted basis must be offset with a cent by which another investor underperforms. Successful fund managers should know the exact nature of their competitive advantage and how to continue to exploit it. Many investors chase past performance by selecting funds with attractive performance records without paying much attention to the causes of the outperformance. But successful alternative investment professionals tend to focus on identifying managers through superior analysis of their strategies and the sources of their returns.

31.3.1 Fund Organization

The fund manager may invest the fund's assets through an offshore master trust account or fund. Consider a fund manager who has two investors: one based in the United States with $10 million to invest, and one in another country with $15 million to invest. The manager knows that some U.S. investors may be required or prefer to have their funds remain in the United States, whereas many non-U.S. investors prefer to have their money outside the United States. Where should the fund be located? If the fund is located in the United States, the non-U.S. investor may have to pay income taxes both to the United States and to a home country. The best way to resolve this problem is to set up two funds, one onshore (for U.S. investors) and one in an offshore domicile that avoids double taxation (for non-U.S. investors).

The fund manager may manage the assets of both funds in a master trust account, as illustrated in Exhibit 31.1. The master trust is the legal structure used to invest the assets of both onshore investors and offshore investors in a consistent if not identical manner, so that both funds share the benefit of the fund manager's insights. Investors access the master trust through feeder funds. A feeder fund is a legal structure through which investors have access to the investment performance of the master trust. Onshore and offshore investors use separate feeder funds to access the master trust. Investors in both of these feeder funds benefit from the separation of funds because tax consequences flow appropriately to each investor. Together, the master trust and feeder funds are referred to as a master-feeder structure.

The purpose of the master trust is tax neutrality, not evasion. In Bermuda, for example, master trust funds pay only a corporate licensing fee, not corporate income tax. This ensures that there are no tax consequences to the fund investors at the master trust level. Instead, the tax consequences for the investors occur at their country of domicile. Investors in the onshore, or U.S.-based, fund are subject to the U.S. Internal Revenue Code, whereas investors in the offshore fund are subject to the tax codes of their respective domiciles—including the United States, if a U.S. investor has chosen to invest through the offshore vehicle.

In a side pocket arrangement, illiquid investments held by a hedge fund are segregated from the rest of the portfolio. Assets may be placed in a side pocket because they are difficult to value. Valuation problems can interfere with equitable treatment of investors entering and leaving the fund. Valuation of side pocket investments is typically performed on a less frequent and less accurate basis than is computation of the net asset value (NAV) of the liquid portion of the hedge fund. Future investors in the hedge fund do not participate in the returns to investments in the side pocket. The use of side pockets can be controversial. Although side pockets are typically used to separate liquid and illiquid assets within the fund, the best practice is for the performance of all side pockets (including those initiated by the investor) to be included in the performance of the fund for all periods. Investors must inquire as to the existence and nature of the fund's side pockets, how and when they are used, and whether the performance of side pockets is included in the fund returns.

Fund structures are not always as complicated as that presented in Exhibit 31.1. For example, many fund managers in the United States operate only within the United States, have only an onshore fund, and accept only U.S. investors. Nonetheless, the popularity of fund investing has resulted in operating structures that are sometimes nearly as creative as the fund strategies themselves.

31.3.2 Fund Manager Organization and Ownership

In addition to analyzing the organization of the fund, the investor should analyze the organization of the fund's manager. Geographically, where is the fund manager located? Are there any satellite offices? Where is the nearest office to the investor? The answers to these questions can be important. For example, if the manager operates overseas, there may be substantial time differences between business hours and substantial travel costs for periodic due diligence visits.

An organizational chart of personnel is mandatory, with particular attention paid to separation of duties. All investment, operations, and management functions should not be primarily accountable to the same person. Separation of duties is a key issue that should be nonnegotiable for fund investors. It is especially dangerous when the portfolio manager prices the fund's positions or when a single person is allowed to move cash without oversight by other fund employees or external service providers.

Of special importance is the chief financial officer (CFO), who is typically the investor's most important link with the fund manager after an investment is made, because the CFO is ultimately responsible for reporting the fund manager's performance numbers. Consequently, the investor should make sure that the CFO has a strong background in accounting for investments, preferably including a major professional accounting designation. The investor must also determine which senior managers are in charge of trading, information systems, marketing, risk management, and research, and analyze this information accordingly.

To wit, the educational and professional backgrounds of all principals should be documented and verified. It should be determined whether they have graduate degrees, whether they hold any professional certifications—such as the CAIA designation—and what their prior investment experience was before joining the fund. Managerial talent should be assessed in the context of the fund's investment activities. For example, short selling of equities is very different from long-only investing; thus, before investing money with a long/short fund manager, an investor should determine the extent of the manager's background and expertise in shorting equities.

The ownership structure of the fund manager must be documented. It is imperative to know who owns the company that advises the fund, whether it is an external party, active employees, or some combination of the two. The extent to which ownership is shared among the fund manager's employees is important, as sharing the ownership of the fund management company with employees can encourage proper alignment of interests and retention of key personnel.

Finally, it is important to understand the compensation structure and incentives of each key employee. Does each employee have the potential to earn equity ownership or stock options in the firm? Are incentives awarded on individual performance, or is there also a team component to compensation? Are the people making investment decisions able to earn bonuses based on the performance of the fund? It is clearly a benefit to have employees properly motivated by performance-based compensation, but conflicts of interest must be identified.

31.3.3 Registrations

The investor should document any regulatory registrations and obtain and retain copies of documents required by and for regulatory authorities. If the fund manager is registered with the local regulatory authority, such as the U.S. Securities and Exchange Commission (SEC) or the UK Financial Conduct Authority (FCA), the investor should ascertain the date of the original registration and whether there are any civil, criminal, or administrative actions outstanding against the fund manager. Investors need to determine the regulatory requirements in each manager's local jurisdiction and ensure that the manager is current with the appropriate authorities.

31.3.4 Outside Service Providers

The investor must document and assess the qualifications, competency, objectivity, and reputation of the fund manager's outside auditor, legal counsel, independent fund administrator, and prime broker. Investors should ensure that the fund employs reputable service providers with substantial expertise and reputations in the business. Some investors visit and evaluate service providers during their due diligence process.

The investor should identify the fund manager's outside auditor, legal counsel, and prime broker, and independently verify their suitability if they are not well known with solid reputations. It is a positive signal when the fund is employing reputable service providers with substantial experience in the business. Ideally, each service provider ranks high in league tables. Common in many industries, a league table is a listing of organizations, generated by a research or media firm, that ranks organizations by size, volume, or other indicators of activity. Small or unknown service providers may not have the scale or experience to adequately serve a fund manager. Each of the service providers, including auditor, attorneys, and prime broker, has an important role in the investment process. Investors should perform due diligence on each of the service providers and use the information they provide as input to their manager due diligence process.

AUDITOR: First, the investor should obtain the fund manager's latest annual audited financial statement, as well as any more recent statements. Any questions regarding the financial statements should be directed to the CFO and the outside auditor. Auditor opinions other than “Unqualified” must be understood as explained by the external auditor. Additionally, the auditor is a good source of information regarding the fund manager's accounting system and operations.

ATTORNEYS: The investor should speak with the fund manager's compliance manager or internal or external counsel. This is important for three reasons. First, counsel is typically responsible for keeping current all regulatory registrations of the fund manager. Second, counsel can inform the investor of any civil, criminal, or administrative actions that might be pending against the fund manager; counsel is also responsible for preparing the fund manager's offering document. Finally, the investor negotiates documentation and other issues with attorneys when making an investment with the fund manager.

PRIME BROKER: The most important service provider is often a fund's prime broker. With the many services provided by the prime broker, as discussed in Chapter 2, it is essential that a potential fund investor contact the fund's prime broker to assess the strength of the relationship, any problems that may have occurred in the past, the frequency of turnover of the portfolio, the financing and leverage amounts, and the amount of exposure the fund manager has to the prime broker.

Prime brokers have a powerful tool in their ability to make margin calls. The prime broker can demand that the fund manager deposit more cash into its prime brokerage account to support its leveraged trading, and that the fund manager liquidate outstanding portfolio positions to raise cash to deposit with the prime broker. The ultimate threat is that the prime broker can seize collateral from the hedge fund manager and liquidate the collateral to raise cash.

31.4.1 Investment Markets and Securities

The investor should document the markets and securities in which the fund manager invests. For some fund managers, the answer is not so obvious. For instance, global macro managers typically have the broadest investment mandate possible, meaning they can invest in equity, bond, commodity, and currency markets across the world. When looking at global macro managers, the investor may have to accept that they can and will invest in whatever market they deem fit.

Closely related to the investment markets are the types of securities in which the fund manager invests. For some strategies, this is straightforward. For instance, the fund's documentation may indicate that the fund manager invests only in the stocks of a particular country. However, other strategies are not so clear. Often, fund disclosure documents are drafted in very broad and expansive terms to allow maximum flexibility to the portfolio manager. Although they may prefer not to put it in writing, managers may be more forthcoming verbally as to historical norms and future expectations about likely investment vehicles. The purpose of due diligence is not to legally bind the fund manager but to document the types of securities necessary to effect the investment strategy. The ability to take derivatives positions should be clear. Derivatives are a two-edged sword, not inherently good or bad. Used one way, they can hedge an investment portfolio and reduce risk. Used in other ways, they can increase the leverage of the fund and magnify the risks taken by the fund manager. It is very important that the investor determine the fund manager's strategy for using derivatives, the types of derivatives used, and in which markets positions in derivatives are traded.

The investor should also pay special attention to determine the extent to which the fund manager invests in derivative securities. The financial crisis of 2007 to 2009 underscored the dangers of entering derivative transactions with counterparties that can default, so the investor should ensure that the fund manager has a process in place to evaluate counterparties and ensure proper diversification with these entities. Further, the crisis revealed the challenges of placing even a conservative value on complex derivative deals, for which identifying and valuing underlying assets can be difficult. The investor, then, needs to understand the manager's process for valuing fund holdings.

Particular concerns include short selling and the extent to which the fund manager may short volatility. Shorting volatility is a strategy whereby a fund manager sells call or put options, especially out-of-the-money options, without an offsetting position. If the options expire unexercised, the fund manager receives the option premiums, and the return for the fund is enhanced. Short volatility positions can generate consistently high historical returns over periods of relatively calm financial markets, but if the market moves sharply, the short option positions rapidly increase in value, causing substantial losses for investors.

31.4.2 Benchmarking a Fund Manager

Establishing a benchmark for fund managers is one of the most challenging issues facing an analyst. One reason is the skill-based nature of many investment strategies. Manager skill cannot be adequately captured by a passive securities benchmark, such as the S&P 500 index. Returns from skill, in fact, are often uncorrelated with returns from passive investing or may even be negatively correlated when better opportunities to implement skill-based strategies occur in stressed markets.

Most fund managers have risk exposures that cannot be explained well by the returns of a passive securities index. For instance, it can be argued that a long-only passive equity index is not an appropriate benchmark for an active equity long/short fund, particularly when the manager dynamically alters the fund's systematic risk exposure. In addition, fund managers often use derivative instruments, such as options, that have nonlinear payout functions, and most passive securities indices do not reflect nonlinear payouts. Another case against passive securities indices as an evaluation tool for hedge funds is that fund managers tend to maintain concentrated portfolios. The nature of this concentration makes the investment strategy of the fund manager distinct from that of a broad-based securities index. Chapter 7 provides additional information about benchmarking.

Nonetheless, some measure to evaluate performance should be established for the fund manager. A fund style index is a collection of fund managers operating with a similar strategy to the fund manager in question that can be used as a benchmark. For example, a macro manager can be benchmarked against a macro index. Red flags should arise for an investor when the risk or return of the fund differs wildly from that of the style benchmark. It may be obvious that substantial underperformance and excessive volatility are warning signs, but even large gains and abnormally low volatility can be troubling, since outperformance relative to a benchmark can be evidence of large idiosyncratic risk exposures and/or weak risk management, and abnormally low volatility can be an indication of wrongdoing, as in the case of Bernard L. Madoff Investment Securities, discussed in Chapter 29.

If the fund manager does not believe that any index is appropriate as a benchmark, then a hurdle rate should be established. Hurdle rates are most appropriate for absolute return fund managers whose rate of return should not depend on the general economic performance of a sector or a broad-based market index.

31.4.3 Competitive Advantage

Restating one of the three fundamental questions at the beginning of this chapter, a key question that must be thoroughly analyzed during the due diligence process is the nature of the fund manager's competitive advantage. Another perspective: What makes the fund manager's processes more attractive than those of other managers? For instance, there are many merger arbitrage managers. Some invest only in announced deals, some speculate on potential deals, some invest in cross-border deals, some participate in deals of only a particular market capitalization range, and some use options and convertible securities rather than the underlying equity. But specialization alone does not represent a competitive advantage. An example of a potential competitive advantage may be that some merger arbitrage experts develop large in-house legal staffs to review the regulatory or antitrust implications of the announced deals. These managers rely on expert legal analysis to determine whether the existing merger premium is rich or cheap. Using skill to better forecast merger outcomes is a possible source of attractive returns.

31.4.4 Current Portfolio Position

Due diligence includes obtaining a current snapshot of the positions of the fund. The investor should ascertain the fund's current long and short exposures, determine the amount of cash held by the fund, and decide whether it is appropriate. Too much cash indicates an investment strategy that may be stuck in neutral or waiting for attractive investment opportunities; too little cash may indicate potential liquidity issues. The investor should analyze the number of positions the fund manager holds and the nature of those holdings to indicate the extent to which the fund is exposed to systematic and idiosyncratic risks. The sources of risk exposure should correspond to the stated investment strategies.

Many managers are reluctant to reveal current positions in order to prevent others from transacting based on the information. Further, some managers may even be reluctant to reveal older positions to prevent others from ascertaining and potentially copying their strategy. Yet it is vital that investors understand the size, leverage, and concentration of positions, so if managers will not provide transparency down to specific holdings, investors can request that the holdings be confidentially reported to a third-party risk system that can use position-level data to measure risks. The position-level data should be reported solely by the fund's custodian or administrator, as this third-party verification makes it difficult for the manager to understate the risk of the fund. The direct position link from the custodian verifies the true positions of the fund. The risk monitoring system used to analyze the positions should aggregate the positions and provide statistics on leverage, concentration, and security types. The system may even enable scenario analysis and value at risk calculations without disclosing the manager's individual positions or the details of trading positions to the prospective investor.

A final question the investor should ask the fund manager is how the current portfolio has been positioned in light of current market conditions. This should not only provide insight into how the fund manager views the current financial markets but also shed some light on the anticipated investment strategy going forward.

31.4.5 Source of Investment Ideas

Idea generation is the source of the manager's skill. The fund manager's competitive advantage could be a research department generating investment ideas better or faster than other fund managers can generate them. Conversely, some fund managers, such as merger arbitrage managers, wait for deals to be announced in the market. The risk related to the fund's ability to generate consistent and persistent alpha is directly linked to the risk of the fund's ability to source investment ideas.

The investor should determine under which market conditions the fund manager's ideas work best and opportunities for the manager's strategy are most available. Do they work best in bear markets, bull markets, flat markets, volatile markets, or no one type of market more than others? For instance, an absolute return fund manager (a manager with a hurdle rate for a benchmark) should be agnostic with respect to the direction of the market, and the historical returns should confirm this belief. Otherwise, an argument could be made that the fund manager's performance should be compared to a market index.

31.4.6 Capacity

A frequent issue with fund managers is the capacity of their investment strategy, as discussed in Chapter 16. The ability to provide alpha is tightly linked to the issue of capacity. For example, if a fund manager targets small sectors of the economy or financial markets, the manager must not have too many assets under management, or the ability to maneuver nimbly through opportunities will be muted. For instance, the convertible bond market is much smaller than the U.S. equity market, so a convertible bond fund manager may have less capacity than an equity long/short manager and may limit the amount of money accepted from investors. Global macro fund managers, with their global investment mandate, have the largest capacity, derived from their virtually unlimited ability to invest across financial instruments, currencies, borders, and commodities.

Capacity is an important question to be asked as part of the due diligence process, because fund managers might dilute their skill by allowing a greater amount of capital into the fund than is optimal from the perspective of the existing investors. Too much money chasing a limited-capacity investment idea moves the price of the security away from the investor, cutting into the alpha that might have otherwise come from the idea. Initial evidence that a fund is nearing capacity is rising trading costs and increasing market impact as the fund attempts to execute larger transactions. Ultimately, the evidence that capacity has been exceeded is when returns decline because the manager cannot deploy all of the assets effectively. Investors respect fund managers who understand the capacity of the fund, which may result in the fund being closed to new investors.

31.5.1 Civil, Criminal, and Regulatory Actions

The fund manager should authorize investors to perform an independent background check that fully discloses all civil, criminal, and regulatory actions against the fund manager or any of its principals over their entire careers. Although five years is common, any red flag in the history of the fund manager is of concern. It is important to inquire about not only civil or criminal actions but also any other professional misconduct complaints, even if outside the financial industry (such as medical licenses). It is, in fact, rare that fund managers would have active current or previous legal activity directly related to their fund management. The fund manager may hesitate to list civil actions as well as criminal actions previously or currently pending against its principals. However, in addition to the direct red flags that legal actions raise, this is necessary information for two indirect reasons.

First, a history of civil or criminal actions filed against one of the fund manager's principals provides a valuable insight into that principal's character. Given the litigious nature of current society, it would not be unusual for a principal to be involved in a civil lawsuit outside the operating business of the fund. However, a pattern of such lawsuits might indicate practices that are skirting, if not outright crossing, ethical or legal lines. Second, lawsuits are distracting. Commonly found proceedings involving fund managers include current involvement in a drunken driving case or a divorce negotiation, each of which can take a toll on the manager in terms of time, money, and emotion. Such problems can distract a principal from the fund.

31.5.2 Employee Turnover

Given the skill-based nature of the hedge fund industry, personnel are the most valuable resource of a fund management company. Skill resides in key personnel. A complete list of employees who have been hired or who have departed is important for three reasons. First, as previously discussed, good fund managers know their competitive advantage and how to exploit it; this is often the people employed by the fund manager. A stable workforce may be one of the keys to maintaining an advantage, both from the perspective of continuing to find exploitable investment ideas and in keeping current ideas from disseminating to competitors via former employees. Second, like lawsuits, turnover is distracting. It takes time, money, and even emotional effort to replace talent. In addition, new employees need time to comprehend all of the nuances of a fund manager's investment strategy. Third, high employee turnover may indicate volatile leadership. If the employees do not have faith enough in the CEO (chief executive officer) to remain with the fund manager, why should the investor?

31.5.3 Investor Relations

Ideally, the fund manager should designate a primary contact person. This representative handles issues regarding performance reporting, subscriptions and redemptions, increased investment, and meetings. Ideally, these duties should be delegated to the investor relations team, which frees the CEO to keep the fund manager on course rather than having to take client phone calls.

31.5.4 Business Continuity Management

Business continuity management has become commonplace. Many fund managers employ sophisticated trading models that require considerable computing power. The loss of trading and computing functionality can severely hurt a fund manager's performance if investment insights cannot be implemented. Further, inability to manage existing positions exposes a fund to increased risk, especially substantial during the market turbulence that may coincide with a disaster.

The fund manager should have a disaster recovery plan if a natural or other disaster shuts down trading and investment operations. The plan could involve leased space at a disaster recovery site owned by a computer service provider, a backup trading desk in a remote location, or shared facilities with other trading desks. Questions that must be answered regarding a disaster plan are these: In the event of a disaster, how would the fund manager monitor and manage its investment positions and its risk exposures? How would the fund trade without its current data sources, hardware, and software? How would the fund manager maintain connectivity with its employees if they cannot get to the recovery site? Due diligence can ascertain whether an adequate disaster plan is in place at the fund management company, as well as at the external service providers.

31.6.1 List of Funds and Assets under Management

Due diligence should generate a comprehensive listing of all assets under management directed by the fund manager. The investor should verify how many unique strategies, funds, and separate accounts the fund manager advises as well as the assets under management for each fund. This is important not only for the collection of performance data but also to give the investor some sense of the fund manager's investment capacity and how thin the investment manager may be spread across multiple products, all relying on continually refreshed investment insights. It is essential to learn about any funds or accounts that have been terminated to avoid selection bias in analyzing performance. Selection bias is discussed in a more general context in Chapters 8 and 16.

Verifying the assets of the fund manager may not be as easy as it sounds. First, the fund manager may have onshore and offshore accounts or funds. Second, the fund manager may use multiple prime brokers and custodians to keep and trade its assets. The investor should find out how many custodians and prime brokers the fund manager uses and get all monthly statements for each. Only then can the investor piece together the total size of the fund manager's assets.

There are three important questions to ask:

1. How long has the fund manager been actively managing each current and previous fund?
2. Have the manager's performance results been consistent over time and across funds?
3. How do the investment strategies of the funds compare and contrast?

For funds, five years is generally sufficient to qualify as a long-term track record. The consistency of performance through time and across all funds provides insight regarding risk. Performance should be linked to the investment strategies and styles. If multiple funds pursue similar investment opportunities, then the issue of trade allocation must be resolved. Trade allocation, in this context, refers to the process by which—and priorities with which—an attractive investment opportunity is distributed among the manager's various funds and accounts.

31.6.2 Drawdowns

Past drawdowns, discussed in Chapter 5, provide indications of past risk that should be carefully considered in the due diligence process. Drawdowns should be analyzed in the context of the fund's strategy, the fund's leverage, and the performance of market indices. The analysis should indicate the fund's response to periods of market stress, as well as the fund's relative sensitivities to both market and idiosyncratic risk. For example, large drawdowns in a market-neutral fund may indicate a lapse of fund manager skill. Drawdowns in directional fund strategies may simply indicate market risk.

In addition to examining the size of drawdowns, the investor should examine how long it took for the fund manager to recoup the losses. The fund manager should explain the causes of past drawdowns and, ideally, how those losses might be mitigated in the future.

31.6.3 Statistical Return Data

The statistical data section of a performance review covers the basic summary information that is expected of all active managers, including returns over a variety of time periods, volatilities of returns, and performance measures such as the Sharpe ratio and the information ratio (IR). There are numerous issues to be considered once the data are assembled. Five classic issues are related to virtually any use of past data to predict the future:

1. ACCURACY: Are the measures accurate? Performance may be intentionally misrepresented, as in the case of fraud, or inadvertently wrong due to data errors or computation errors. Expectation bias is synonymous with confirmation bias and is a tendency to overweight those findings that most agree with one's prior beliefs. Thus, a confident manager is more likely to unknowingly accept and report erroneous data if those data portray the fund's performance favorably.
2. REPRESENTATIVENESS: Are the measures representative of the fund's total experience, or is there cherry-picking or other selection bias? Marketing pressures may lead managers to report or emphasize more favorable time periods, higher-performing accounts or funds, and those performance measures that are most favorable.
3. STATIONARITY: Are past results likely to predict future results? In markets, competition should be expected to eliminate substantial market inefficiencies. Thus, high past performance should be expected to attract competition and eventually dilute profit opportunities rather than persist through a stationary return-generating process.
4. GAMING: Are the performance numbers gamed? In the context of investment management, gaming is investment activity driven by a desire to generate favorable statistical measures of performance rather than a desire to benefit investors. A survey in the spring 2010 issue of the Journal of Alternative Investments found that 27% of respondents believed that hedge funds engage in deliberate cheating by subjectively valuing securities to smooth returns and reduce volatility.⁴ Even without such misconduct, performance measures such as the Sharpe ratio are imperfect and should be interpreted with caution due to the ability of managers to boost the measures using market tactics and valuation techniques. For example, if an investment manager can shift profits from highly profitable time periods to time periods with heavy losses, the estimated volatility can be substantially reduced. A reduction in reported volatility increases the Sharpe ratio even though true performance has not changed.
5. APPROPRIATENESS: Are the performance measures used appropriate for the underlying investments and strategies? Sharpe ratios and other performance measures can be misleading statistics because of non-normal returns, nonlinear strategies, smoothed prices, and other phenomena common to alternative investments.

Analysts should also be concerned with past correlation and/or autocorrelation being unrepresentative of future correlation or autocorrelation. Most correlations increase in stressed markets. Performance numbers that do not include periods of high market stress will underrepresent future risk.

31.6.4 Statistical Return Analysis Horizon

Risk management analysis and systems based on short-term annualized volatilities (e.g., daily data) may substantially understate risk over longer time periods. For example, in the late 1990s, a well-known publisher of financial information on mutual funds assigned low-risk ratings to growth funds, especially high-tech growth funds, even though common sense indicated that these equity funds were riskier than most funds. The volatilities and drawdowns of these funds were very low when based on daily, weekly, or monthly returns because performance was so consistently positive during the tremendous bull market in that sector; however, a longer-term analysis of returns, such as quarterly returns over five years or longer, would have indicated the tremendous risk inherent in these funds, which had exploded in price to unprecedented valuation levels. In March 2000, the prices of these growth funds began a precipitous decline, and investors relying on these supposedly safe funds, rather than on common sense, experienced massive losses.

The possibility of large directional movements over months or even years may have been underweighted because of a focus on volatility computations based on short time intervals. Risk management may fail when numbers are not interpreted in context and with substantial investment experience. For example, even if daily price volatility does not change, monthly price volatility can explode or collapse, based on whether returns experience positive or negative autocorrelation. Note that a string of alternating daily returns (+1%, –1%, +1%, –1% . . .) has substantial daily volatility but generates little monthly volatility. However, a string of correlated daily returns (–0.5%, –1.0%, –1.5% . . .) has less daily volatility but generates huge directional moves. Thus, the relationship between short-term and long-term volatility relates to autocorrelation.

Chapter 4 indicates that the volatility of returns over T periods (σ_T) is equal to the single-period volatility (σ₁) times the square root of the number of time periods when returns have no autocorrelation. Thus, annual volatility is only about 16 times larger than daily volatility based on 256 trading days per year and zero autocorrelation. If daily price volatility is 1%, annual volatility is about 16%. However, when returns are perfectly autocorrelated, the same daily volatility generates much higher annualized volatility: σ_T = Tσ₁. Thus, annual volatility is about 256 times higher than daily volatility based on 256 trading days per year and perfect positive autocorrelation. A performance report, risk analysis, or risk management system that relies on annualized volatilities of short-term returns is underreporting long-term volatility to the extent that short-term returns exhibit positive autocorrelation that is ignored. Large directional moves, often during periods of market stress, can be caused by high autocorrelation.

31.6.5 Volatility in Assets under Management

Large redemptions from investment pools can have an impact on fund performance. If a fund manager is fully invested at the time of these large asset flows, fund performance typically suffers.

Rising subscriptions to a fund can also be a source of drag on fund performance. First, as it may take time to get invested in the less liquid ideas, cash may be a drag on the portfolio return. Second, unless new investors are charged for trading costs, subscriptions result in transaction costs that are typically borne by all investors as the new money is invested. As more capital flows into a fund, the trades get larger, and inferior ideas are implemented as the manager's best ideas reach their investment capacity.

For redemptions, the fund manager must sell securities to fund the withdrawals. This means that transaction costs are incurred and typically borne by all investors unless specifically charged to the investor requiring the redemption. Additionally, to the extent that a fund manager liquidates particular positions in a portfolio based on current liquidity, the resulting portfolio weights may be suboptimal. In anticipation of potential withdrawal requests, portfolios may be tilted away from less liquid positions toward securities with greater liquidity but less alpha potential. Macro and managed futures funds usually have the lowest cost associated with a withdrawal because the futures markets are typically the most liquid markets. More arcane investment strategies and securities, such as mortgage-backed arbitrage, can have substantial costs associated with a withdrawal, especially when these positions are sold into an illiquid market.

31.6.6 Portfolio Pricing

One of the biggest issues with fund performance measurement, operational risk management, and fee computation is how the fund manager values the securities in the fund's portfolio. Prompt and proper portfolio pricing can help signal risks and problems before losses escalate. But an investment manager suffering a drawdown may have a strong incentive to hide the losses, as portfolio pricing affects performance-based compensation computations. Many investment managers have implied long positions in call options to the extent that they can reap generous incentive fees and other compensation from staying in business and accumulating profits, while enjoying limited downside in the case of losses. Thus, there are conflicts of interest in establishing prices. Simply put, if a manager can delay revealing a large loss, the manager retains the chance of recouping the loss and preserving that compensation. Less dramatic conflicts of interest include attempts to manage, massage, or smooth returns for the purpose of generating an appearance of lower risk. It is therefore imperative that the portfolio pricing process be designed to mitigate the inherent conflicts of interest and to generate prompt, fair, and accurate pricing.

To reduce the opportunities to manipulate prices, external pricing services are often used to value the positions held by a fund, especially funds holding illiquid assets. Portfolio pricing is particularly important for fund managers that invest in esoteric and illiquid securities, such as collateralized debt obligations (CDOs), distressed debt, private investments in public equity (PIPEs), or convertible bonds. Fund managers are believed to be able to earn consistent abnormal returns for securities with greater complexity and less liquidity. However, these sources of return premiums generate ambiguity and uncertainty in the pricing of positions.

For publicly traded markets such as equities and futures, pricing challenges are less acute but still offer the possibility of unscrupulous behavior. Publicly traded stocks have both a bid price and an offer price. For a large, frequently traded stock like IBM, for which the price is high and the spread is small (e.g., a bid price of $101.86 and an offer price of $101.87), the issue of whether to use the bid price or the offer price is trivial, as the spread is 1 cent on a large per-share price. Smaller and less liquid stocks may have a substantially wider bid-ask spread, especially when expressed as a percentage of the price.

A conservative approach to pricing positions is to consistently use whichever price generates a lower portfolio value. For example, the fund manager with a long position should mark to the bid price, whereas a fund manager that is short could mark the position to the offer. In addition to being conservative, using the less favorable price tends to more accurately describe the liquidation value of the portfolio, since orders to liquidate involve selling at bids and buying at offers. However, a common practice in the fund industry is to take the midmarket price, exactly between the bid and the offer prices, and use this for both short and long positions.

Even the prices of publicly traded securities can be manipulated, as discussed in the Lancer Group example presented in Chapter 29. For smaller stocks with lighter trading, the price manipulation can be greater. For example, a buy or sell order placed at the close of trading can paint the tape with a price that substantially increases portfolio values. A buy order can be placed to try to support the valuation of long positions, and a sell order can be placed to support the value of short positions. Last-minute orders can cause the closing bid, offer, and last trade prices to be different at the end of the day than they would have been if the trades were placed earlier in the day, giving other market participants time to react before the market closed. Any such transactions in securities for the purpose of artificially altering reported closing prices is a form of market manipulation. Anecdotally, trading volume at the end of months and quarters does typically spike, perhaps indicating that investors are attempting to make their portfolios look better at those arbitrary measurement points or to exit positions or risks that the manager would rather not disclose.

For stocks and bonds that are not publicly traded, the solution to pricing or marking the portfolio becomes especially problematic. Many fund managers mark to model; that is, they use valuation models to determine the prices of illiquid securities. This pricing may be subjective, biased, and unreliable. Even third-party models designed to be objective and unbiased can generate highly erroneous indications of prices at which transactions would take place during periods of extreme illiquidity and panic. Mark-to-model accounting has been the source of numerous investment disasters.

The Financial Accounting Standards Board in the United States defines three types, or levels, of assets in the context of determining fair asset values using generally accepted accounting standards. The levels reflect the degree of uncertainty in estimating fair asset values, with Level 1 assets being priced with the most certainty. Level 1 assets are those assets that can be valued based on an unadjusted market price quote from an actively traded market of identical assets. Level 2 assets are best valued based on nonactive market price quotes, active market price quotes for similar assets, or non-quoted values based on observable inputs that can be corroborated. Level 3 assets must be valued substantially on the basis of unobservable inputs, critical assumptions, and/or imprecise valuation techniques. The estimated fair values for Level 3 assets are subject to the greatest uncertainty. In all three cases, the uncertainty refers to the lack of consensus regarding fair valuation rather than to the volatility in the asset's true value.

For example, a traditional equity traded in a large public market would generally be considered a Level 1 asset. A distressed debt security traded infrequently and/or valued based on market prices of similar securities would generally be considered a Level 2 asset. Finally, an untraded structured product tailored to the tax rates and tax needs of a specific investor would generally be a Level 3 asset.

Regardless of the nature of the firm's valuation practices, such practices must always be documented ex ante. Firms must document their policy and procedure for valuing illiquid or hard-to-value assets, disclose any material information relative to how such values are determined (particularly in the case of subjective, unobservable inputs), and document, through the use of valuation memos or similar material, that the process was applied.⁵

Internal valuations should always be supported by the following:

• The use of a knowledgeable but disinterested party in performing the valuation
• Documentation and justification for the valuation methodology used
• Documentation of all inputs and assumptions
• Review, if not approval, of the final value by yet another knowledgeable, independent party

The bottom line is that the due diligence process must document how the fund manager prices positions and, in particular, how the manager uses models to price positions. The analysis of the pricing procedures for illiquid securities must be especially detailed. If the fund manager uses a mark-to-model methodology for less liquid securities, then the investor should analyze how the fund manager's model works under periods of market stress.

31.7.1 Risk Management

There are three important questions that must be answered to understand the risk profile and risk management of the fund:

1. What are the types and levels of risk involved in the fund manager's strategy?
2. What risks are measured, monitored, and managed?
3. How are risks measured, monitored, and managed?

First, investors need to understand the fund's investment strategy and the risks associated with that strategy. For example, the fund manager may pursue an equity long/short strategy, in which case the due diligence process should involve an analysis of the management of the risks of short selling. Next, it is important to determine what risks the fund manager measures, monitors, and/or manages. Are there risks that are not monitored? Finally, the due diligence process should determine which risk measures are reported (standard deviation, semivariance, Sortino measure, value at risk); which methods are used to estimate risk (historical statistics, scenario analysis); and how the fund manager monitors risk and uses the measures to manage the risk of the portfolio. For example, one way to control risk is by setting limits on the size of any investment position and adjusting those position limits with a system based on risk measurement. Another way to manage risk is to monitor position or portfolio volatility or tracking error relative to an upper boundary. The lessons of Amaranth in Chapter 29 should be heeded: The fund apparently focused on analysis of short-term volatility, ignoring the illiquidity of its massive positions and the need to prepare for large directional movements over extended periods of time.

Two particular risks that should be analyzed are short volatility risk and counterparty risk. Short volatility risk exposes the fund to the potential for enormous losses, especially during periods of stress. These exposures can be attractive to managers but difficult to detect. The reason that short volatility risk can be attractive to fund managers is that bearing short volatility risk can generate high probabilities of small, regular profits. Short volatility risk can be detrimental to investors, however, as it can generate very large losses, even if the probabilities are small.

Similarly, counterparty risk can be difficult to detect and dangerous to investors. Fund managers frequently establish positions in over-the-counter derivative instruments. The counterparty to such trades is often a large investment house or a large money center bank. When a fund manager establishes these derivatives, the fund takes on the credit risk that the counterparty might fail to fulfill its obligations under the derivative contract by declaring bankruptcy. A counterparty is most likely to fail during periods of enormous market stress and when its derivative positions have large unrealized losses. These are also the conditions under which a fund may be in distress and find that its derivatives with large unrealized profits have become worthless due to counterparty risk.

31.7.2 Leverage

Leverage is a crucial determinant of risk. The fund with a leverage factor or ratio of L (L = Assets/Equity) has short-run returns that have L times the volatility of its assets.

However, the probability of large losses increases by a factor greater than L. To illustrate, consider two funds with assets of identical risk, one without leverage and one with leverage. There may be a tendency to view a particular percentage equity loss (e.g., –20%) as being L times more likely to be reached with the leveraged fund than with the unleveraged fund. But the probability for large equity losses in the leveraged fund is far more than L times the probability that the unleveraged fund will experience such a loss.

Unusual events are often described as N-sigma events. An N-sigma event is an event that is N standard deviations from the mean. An unleveraged fund with an asset volatility of 10% experiences a two-sigma event when its value falls more than 20% or rises more than 20% (ignoring the mean return).

For normally distributed variables, a two-sigma loss should occur with a probability of about 2.3%. Thus, the unleveraged fund with assets that have a volatility of 10% should have about a 2.3% probability of experiencing a loss equal to or greater than 20%. Note that a fund leveraged 2:1 with the same asset volatility (10%) experiences a 20% loss in equity when the fund's assets drop by only 10%, a one-sigma event. The probability of the assets experiencing a 10% loss is almost 16%, more than seven times higher than the probability of a 20% loss!

This discussion has illustrated the potential role of leverage in magnifying the risk of the equity for relatively modest events (two or three sigmas) and relatively modest leverage (2:1 or 3:1). However, extremely stressed markets have been measured as having experienced double-digit sigma events. For extreme events or larger leverage, an analysis would demonstrate much more dramatic relative probabilities.

Some fund managers specifically limit the leverage they employ. This limit is typically set in the private placement memorandum, so that the fund manager is legally bound to stay within a leverage limit. Many fund managers, however, do not document a limit on the amount of leverage that they may apply. If a fund intends to use leverage, the due diligence process should document the highest amount of leverage applied by the fund manager, as well as the average leverage of the fund since inception. One of the reasons for the demise of Long-Term Capital Management was the massive amount of leverage employed in its strategy. Although leverage can be a successful tool if employed correctly, it can have a highly detrimental impact on fund performance during periods of stress and illiquidity.

31.7.3 Chief Risk Officer

The chief risk officer (CRO) oversees the fund manager's program for identifying, measuring, monitoring, and managing risk. Larger funds often establish a senior executive who oversees risk across all funds and separate accounts. Often, especially with smaller funds, the CFO serves as the risk officer. This is a good solution, as long as the CFO is not also the CIO (chief investment officer).

The CIO and the CRO should not be the same person. If so, there is a conflict in risk control because risk management should function separately from investment management. Without this independence, there can be no assurance that risk will be properly identified, promptly reported, and appropriately managed.

If the amount of leverage is not contractually specified in the limited partnership agreement, then the CRO should set a limit. The CRO must monitor the leverage in each fund and account to ensure that it is consistent with that fund's investment strategy. Finally, the CRO should establish the position limits for any one investment within a fund portfolio. Due diligence requires documentation of the CRO's responsibilities and evaluation of the quality of the programs that the CRO oversees.

31.8.1 Type of Investment

Most fund investments are structured as limited partnerships, although some managers offer separate accounts for their investors. A limited partnership can provide a liability shield for the investor. A limited liability shield or financial firewall is a legal construct that prevents creditors from pursuing restitution from investors or other participants involved in an economic activity beyond the amount of capital that they have contributed. For example, the limited liability structure limits investor losses to the amount contributed, even when a highly leveraged hedge fund experiences losses greater than the value of the assets contributed by investors.

Limited partnership laws protect limited partners so that they are typically at risk only to the extent of their committed capital. Any excess risk is borne by the fund manager as the general partner. Therefore, the limited partners' maximum downside is known, but it is subject to exceptions, of which limited partners should be aware. If limited partners act in some capacity beyond their role as passive investors, the limited liability shield may be pierced. Due diligence requires analysis of the integrity of the liability shield and the activities that could render the shield ineffective, such as becoming actively involved in the day-to-day management of the organization.

Separate accounts do not typically offer limited liability to the investor; therefore, there is more risk associated with this type of investment. Investors in separate accounts may be responsible for losses beyond their investment to cover losses from the use of margin or the use of derivatives. There are potential advantages to separate accounts, however, that may offset potential liability exposure. These potential advantages relative to a limited partnership include facilitated risk reporting, reduced risk of fraud, increased transparency, increased liquidity, and elimination of adverse effects from redemptions or subscriptions by fellow limited partners.

31.8.2 Fees

Due diligence requires a clear understanding of the structure of all potential fees, including exactly how they are computed and when they are collected. Typically, management fees are collected on a quarterly basis, but they may be structured semiannually or annually. The investor should also determine whether there is a clawback provision with respect to incentive fees.

31.8.3 Lockups and Redemptions

More and more hedge funds are requiring lockup periods for their investors. A lockup period is a provision preventing, or providing financial disincentives for, redemption or withdrawal of an investor's funds for a designated period, typically one to three years for hedge funds, and up to ten years or more for real estate and private equity funds. During this period, the investor cannot redeem the investment. Lockup periods can refer to the time period immediately following an investor's initial investment, which means that every investor in the fund may be operating under a different timeline, or can be triggered subsequently by events. Due diligence requires careful assessment of the provisions regarding redemptions as well as the potential risks and conflicts of interest that they can create.

Lockup periods provide two benefits. First, they give the fund manager time to implement the investment strategy. Imagine how difficult it might be to implement a sophisticated investment strategy, especially in less liquid securities, while worrying about funding redemption requests. Second, withdrawals of capital by one limited partner can disadvantage the remaining partners through transaction costs borne by the fund.

Funds may require either a hard lockup period or a soft lockup period. In a hard lockup period, withdrawals are contractually not allowed for the entire duration of the lockup period. In a soft lockup period, investors may be allowed to withdraw capital from the fund before the expiration of the lockup period but only after the payment of a redemption fee, which is frequently 1% to 5% of the withdrawal amount. This redemption fee serves two purposes. First, it discourages investors from causing liquidity disruptions by leaving the fund. Second, it allows the fund manager to recoup some of the costs associated with liquidating a portion of the fund portfolio to redeem shares or to make up for the drag on performance from a cash balance that the fund manager maintains to fund investor redemptions.

Terms regarding withdrawals and redemptions are specified in the subscription agreement. Some funds provide monthly liquidity (i.e., transfers are made at or immediately after the end of each month), but the norm is quarterly or semiannual redemption rights. This allows for controlled cash flows to and from the fund, especially for the purpose of matching redemptions and subscriptions to minimize the impact of investor flows on the fund. Also, limited partners must usually give notice to the fund manager that they intend to redeem. This notice period typically ranges from 30 to 90 days in advance of the redemption. The purpose of the notice is to give the fund manager the ability to position the fund's portfolio and liquidity to meet the redemption request.

A last risk to consider is whether the redemption provisions provided by the fund manager match the liquidity of the underlying securities in which the fund manager invests. For example, the distressed debt market is one of the least liquid securities markets. Liquidity can be virtually nonexistent and is typically available only by private negotiation between two parties. Even in this scenario, it can take several months to find a willing seller and buyer. If a distressed debt fund manager has liberal redemption provisions, a liquidity mismatch could cause a run on the fund's assets when there is no ready market into which the assets of the fund can be liquidated.

Investors also need to evaluate the fund documents to understand whether gates are allowed. A gate is a provision describing the terms under which investors may withdraw funds. In times of market volatility or substantial investor withdrawals, some funds retain the right to limit investor withdrawals, even when the investor has satisfied the lockup period. Although investors may desire to exit the fund, the hedge fund manager may lock the gates, preventing investor capital from leaving. Gating typically occurs during times of market turbulence and constrained liquidity, as the hedge fund manager may perceive that liquidating enough assets to fund investor withdrawals will have a substantially negative impact on the value of the fund.

31.8.4 Subscription Amount

Virtually all funds have a minimum subscription amount, specifying the smallest initial investment that the fund manager will allow. Generally, this amount is quite high for two reasons. First, the fund may be using a safe harbor provision that limits the number of investors. The manager will not want to expend these limited slots on investors with small subscriptions but with the same level of reporting requirements as the largest investors. Second, higher capital commitments help ensure that only sophisticated investors with a large net worth subscribe in the fund. Hedge funds are designed for sophisticated investors who not only understand the risks but are in a financial position to bear those risks.

Some funds also have a maximum subscription amount. This is done so that no single investor becomes too large relative to other investors in the fund. Redemptions from one very large investor can intensify or create acute liquidity problems. Also, the fund manager may have capacity issues that limit the size of the fund or the effective and prompt deployment of a very large initial capital contribution.

31.8.5 Advisory Committee

Advisory committees serve as a source of objective input for fund managers. An advisory committee is composed of representatives from the fund and investors in the fund. The advisory committee may provide advice on the valuation of particular investments, especially illiquid investments. The advisory committee may also advise the fund manager as to whether the fund should be opened up to new investors and how much more capacity the fund manager should take. Although advisory committees serve as useful devices for control by limited partners, they are more common in the private equity world than in hedge funds. Also, the exercise of control by limited partners increases the risk that they will be deemed to be participating in the management of the fund and therefore will no longer be afforded the protection of limited liability.

31.9.1 Service Providers

The structural review section of this chapter included discussion of the importance of speaking with a fund manager's primary service providers. For instance, with respect to outside auditors, the investor should ask an auditor directly to receive information regarding the last audit, including whether the auditor issued an unqualified opinion. Due diligence requires full investigation of any issues that auditors have raised with the fund manager over the course of their engagement.

With respect to the prime broker, the investor should inquire directly with regard to financing arrangements, the size and frequency of margin calls, and whether any calls have not been met. The prime broker is also in the best position to evaluate the market value of the fund manager's investments. A discussion with the prime broker should be part of the due diligence process to provide confirmation that the manager is accurately reporting the proper value of the fund's portfolio, as well as other issues relating to the prime broker.

Outside service providers are relatively easy to identify. A problem can be extracting frank information from a service provider that reflects unfavorably on a client. Outside service providers receive fees from the funds and may be concerned about lost revenues, damaged reputations, or even litigation that could result from providing a reference containing negative information about a client.

31.9.2 Other Investors

Ownership information of funds is generally private. Fund managers often provide a list of selected existing investors who have agreed to serve as references. Talking to these existing clients is a necessary step to check the veracity of the fund manager's statements and to receive an indication of existing client satisfaction. The best questions for these existing investors include the following:

• Have the financial reports been timely?
• Have the reports been easy to understand?
• Has the fund manager responded effectively to questions about such topics as financial performance?
• Has the fund manager done what was promised, such as maintaining the investment strategy?
• What concerns does the current investor have regarding the fund manager or the fund's performance?
• Would the current client invest more money with the fund manager?

However, a sample of reference checks derived from a list of current investors the manager provides is a biased sample of investors. An unbiased sample of investors would be derived from a list of all current investors and former investors. The problem with obtaining a representative sample of all investors past and present is identifying former investors and current investors not selected by the fund manager as references. Further, if these other investors can be identified, it may be difficult to obtain their open and honest opinions with regard to any problems with the fund manager. The best way to receive good information from these investors is by establishing an extensive network of industry professionals committed to openness and honesty. Informal reference checks with these contacts, as well as with the listed references and the outside service providers, should include an open-ended summary question, such as: Is there anything else about this fund and its manager that I should know that would help me make a better decision with regard to this potential investment?

31.10.1 Conclusions Based on Operational Defaults

Christory, Daul, and Giraud analyzed operational default for hedge funds and reached the following three conclusions:

First, a diversified portfolio of at least 40 funds provides reasonable diversification against operational risk.

Second, investors should conduct an informed operational due diligence examination that takes into consideration the relative importance of the main risk factors affecting funds in general.

Third, when investors assess the operational risk of funds properly, the information can be valuable in developing a more accurate return and risk profile for the fund.⁶

31.10.2 The Omega-Score and Bankruptcy Prediction

Following the general approach of corporate bankruptcy models and credit scoring models, Brown, Goetzmann, Liang, and Schwarz propose a quantitative approach to measure failure risk for funds known as the omega-score. The omega-score is a measure of future risk that is computed as a function of a fund's age, size, past performance, volatility, and fee structure. The information for their study was obtained from SEC filing information (Form ADV) in February 2006, when funds were briefly required by the SEC to register as investment advisers, and variables from the Lipper TASS database. Brown and colleagues found that the omega score explained the disappearance of funds from the sample. They conclude:

Operational risk is of course not the only factor explaining fund failure. We find that there is a significant positive interaction with financial risk, which suggests that funds with high degrees of operational risk are more subject to failure from excessive financial risk. This is consistent with rogue trading anecdotes that suggest that fund failure associated with excessive risk taking occurs when operational controls and oversight are weak.⁷

31.10.3 Costs and Benefits of Due Diligence

Fund due diligence is expensive, in terms of both money and time spent. Anson mentions that effective due diligence requires 75 to 100 hours of work reviewing a fund manager.⁸ According to Brown, Fraser, and Liang, the cost of due diligence depends on a series of factors, including time spent; level of thoroughness; and whether accounting firms, law firms, third-party service providers, and consulting firms are used. These authors assume “a conservative cost of due diligence of $50,000 to $100,000 per fund.”⁹ However, they contend that effective due diligence of funds in the selection of fund managers can generate alpha for the investor's portfolio.