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Table of Contents
Part 1: Due Diligence----------------------------------------------------Page 5
Part 2: Hedge Fund Careers-------------------------------------------Page 17
Part 3: Regulation & Compliance ------------------------------------Page 65
Part 4: Hedge Fund Strategies---------------------------------------Page 87
Part 5: Hedge Fund Marketing-----------------------------------------Page 120
Part 6: Starting a Hedge Fund-----------------------------------------Page 128
Appendix A: Service Provider Listings------------------------------Page 215
Appendix B: Additional Hedge Fund Resources------------------Page 218
Part 1: Due Diligence
HEDGE FUND DUE DILLIGENCE GUIDE
New hedge funds are launched daily, which is constantly increasing the importance of conducting formal hedge fund due diligence and determining which hedge funds are appropriate for you or your firm to invest in becomes increasingly important. Every person or company is going to have different investment horizons, risk tolerances, strategy preferences, etc. so it is usually more valuable to know the basics of how to evaluate a hedge fund then it is to hear someone say which hedge funds are "the best." I think giving hedge fund recommendations even to the degree of suggesting exactly how to evaluate a hedge fund is too close to finance advice to put online but official site for the SEC provides this advice in conducting a minimum level of hedge fund due diligence before investing:
1.Read a fund's prospectus or offering memorandum and related materials
2. Understand how a fund's assets are valued
3. Ask questions about fees
4. Understand any limitations on your right to redeem your shares
5. Research the backgrounds of hedge fund managers
When discussing risk management in the hedge fund industry, obtaining a clear definition of the different types of risk exposure for each kind of hedge fund is important. Considering the wide range of objectives and diverse trading instruments used by each specific type of hedge fund, it is important to note the varying risk concerns which apply to different types of hedge fund managers. A good consolidation of the results in a matrix form was developed by Jaeger and Säfvenblad , who define the different risk exposures by each type of hedge fund as follows (click to enlarge the image below):
Using the table above, but now with a investor’s perspective, it should be also clear that the risks associated to investing in a long-short hedge fund are completely different from those associated to, for instance, investing in a Fixed-Income Arbitrage hedge fund. Thereby, for both hedge fund managers and investors, uncovering the different dimensions of risk present in each hedge fund portfolio becomes the first step towards managing risk effectively. Read more articles like this within the Hedge Fund Due Diligence Guide.
*I have been collecting these hedge fund due diligence resources over the past 18 months and I'm providing them with the hope that they will help construct a relatively holistic view of what hedge fund due diligence is about along with provide a few example RFPs and tools to use while conducting due diligence on hedge fund managers. This is not an exhaustive list and the information anywhere, or within the linked sites, should not be treated as investment advice or a substitute for financial advice of any type. This is simply an aggregation of online hedge fund due diligence resources. I have only listed 21 resources here so far, I hope to make this more robust, if you have something you think should be added here please email me at Richard@RichardCWilson.com.
Hedge Fund Fraud
SEC Fraud Analysis | Case Study
Hedge fund fraud cases are important because they give some definition and life to the various investment advisor and hedge fund laws. Much of the advice that hedge fund lawyers give to their clients is based on reasonableness and best guesses on how the securities laws will be implemented in the hedge fund context. For many hedge fund issues there are not clear- cut cases which give color to the securities laws. One of my colleagues refers to this as the “square peg – round hole” dilemma by which he means it is hard to apply the archaic securities laws with the current state of the hedge fund and investment management industry.
When the SEC does bring cases, as practitioners we get to see how the SEC views the securities rules and how we should be advising clients. While many of the fraud cases represent completely unbelievable actions by unscrupulous people, there are still lessons, which well-intentioned managers can learn from.
Specifically this case gives us an opportunity to examine five separate areas which investment managers should be aware of:
1. Make sure all statements in the hedge fund offering documents and collateral marketing materials are accurate.
In this case the hedge fund offering documents contained many material misstatements including materially false and misleading statements in offering materials and newsletters about, among other things, the Funds’ holdings, performances, values and management backgrounds. For example the complaint alleges:
Specifically, both PPMs represented that most investments made by Partners and Offshore would trade on “listed exchanges.” In truth, a majority of those funds’ investments were and are on unlisted exchanges such as the OTCBB or pink sheets. Furthermore, the Partners’ PPM stated that investors would receive yearly audited financials upon request. Partners has not obtained audited financials since the year ended 2000 and repeatedly refused at least one investor’s requests for audited financials for the year ended 2001.
2. Make sure all appropriate disclosure relating to personnel is made.
Hedge fund attorneys will usually spend time with the manager discussing the employees of the management company and their backgrounds. During this time the attorney will ask the manager, among other questions, whether any person who is part of the management company has been involved in any securities related offense. In this case there were two specific items, which the manager should have disclosed in the offering documents and other collateral material:
Failed to disclose that a “consultant” to the management company was enjoined, fined and also barred from serving as an officer or director of a public company for five years for his fraudulent conduct involving, among other things, misallocating to himself securities while serving as CFO and later president of a publicly traded company.
Failed to disclose a member of the fund’s board of directors was barred from associating with any broker or dealer for 9 years.
3. Take care when going outside stated valuation policies.
Many hedge fund documents have stated valuation policies but then allow the manager to modify the valuation, in the manager’s discretion, to better reflect the true value of the securities. However, when a manager uses this discretion, the manager should have a basis for the valuation. Such valuation should not be based on an artificially inflated value of the asset. To be safe managers should probably have some internal evaluation policies that should be in line with generally accepted valuation standards for such assets. I found the following paragraph from the SEC’s complaint particularly interesting (emphasis added):
II. Bogus Valuations
34. In order to obtain at least year-end 2001 audited financials for Offshore, Lancer Management provided off shore’s auditor with appraisals valuing certain of that fund’s holdings. These appraisals mirrored or closely approximated the values assigned to Offshore’s holdings by Defendants based on the manipulated closing prices at month end. These valuation reports were, however, fatally flawed and did not reflect the true values of Offshore’s holdings under the generally accepted Uniform Standards of Professional Appraisal Practice or American Society of Appraisers Business Valuation Standards. For example, the valuations were improperly based on unreliable market prices of thinly traded securities; unjustified prices of private transactions in thinly traded securities; unfounded, baseless and unrealistic projections; hypotheticals; and/or an averaging of various factors. Indeed, under accepted standards of valuing businesses, certain of the Funds’ holdings were and/or are essentially worthless.
4. Do not engage in market manipulation.
Many of the securities in which this hedge fund invested were traded on the OTCBB. The fund engaged in trading in these securities near valuation periods in order to artificially inflate the price of these very thinly traded securities. Additionally, the complaint alleges many incidents of “marking the close.” This goes without saying but a hedge fund manager should not engage in market manipulation.
5. Always produce accurate portfolio statements. Do not overstate earnings. Always make sure that statements to investors are accurate.
While many of the examples above are so egregious they probably do not need to be listed on a “do not” list, you should make sure you do not engage in any of these activities. Additionally, if you do make some error or mistake (for example, if a valuation turns out to be incorrect or inaccurate), immediately contact your attorney to create a plan to inform investors about the incorrect or inaccurate statements. A mistake can generally be cured, all out fraud cannot.
Guest post published in partnership with the Hedge Fund Law Blog
Hedge Fund Manager Due Diligence Ongoing Hedge Fund Manager Due Diligence
I recently found a great article on hedge fund manager due diligence, it focused on ongoing hedge fund manager due diligence. When reviewing a hedge fund, process transparency is crucial to the method as risk transparency. Institutional investors must hold the prerequisite that their investments meet the prudent man standard. They need to understand; what a hedge fund manager’s abilities are; is there a process for measuring and assessing risk as well as reward; the manager’s strategy and allowable deviations from it; the safeguards in place to shun fraud; that the people operating the hedge fund are honest.
Some additional topics to consider are alpha generation, risk measures, risk mitigation strategies, basis of performance, warning signs, imploding scenarios. Some classic due diligence topics include, how risk is managed, recovery plans, max leverage, and risk transparency.
Ongoing due diligence and intelligent manager selection are the most crucial parts of the process. In depth knowledge of the specific strategy being used as well as awareness of how hedge fund managers “operate” are key qualities one must possess to perform true hedge fund due diligence and exam all inherent risks involved. Evaluation of how these risks are supervised by the manager is an essential part of the procedure as well.
Gregory Schink & Richard Wilson
High Net Worth Clients
Hedge Funds + High Net Worth Clients
Here is in article published by Advisor Perspectives which tells the story of two Boston-based wealth management firms which emphasize the importance of due diligence. The two firms, RINET and Colony, use a strategy for placing its high net worth clients in riskier investments based on their level of wealth. The policy addresses the investors personally, by requiring its investors to have at least $5 million in investable assets to qualify for investing in hedge funds. Those HNW clients who do not qualify for hedge funds are placed in sometimes less risky, more traditional investments, such as separate managed accounts or mutual funds. This simple strategy reduces risk for those clients not financially ready to invest in less liquid or secure investments.
Another lesson in reducing risk is that RINET favors placing its high net worth investors in fund of funds over single hedge funds. This diversifies the investor's portfolio and the investor is less vulnerable. When considering hedge funds, the firms look at the historic performance and the fund's level of risk. They measure this by examining standard deviation, comparing the fund with the S&P 500, and looking at the hedge fund manager'sAlpha. Also, the firms go beyond the hedge fund's strategy and process to back office operation concerns and factors that have affected historical performance. Finally, RINET and Colony see hedge fund due diligence as an ongoing process that doesn't stop at the investment. The firms practice due diligence throughout to secure steady returns to its investors and protect against fraud and other hedge funds hazards.
Investment Due Diligence Resource
Last month someone sent me this resource on due diligence. Fortis offers this guide to investment due diligence which goes beyond the initial selection process. The article focuses primarily on identifying potential problems by maintaining contact with hedge fund managers and thoroughly looking into the operations. Although much can be learned from traditional due diligence, Fortis suggests simply talking with the staff and manager. They suggest that a practical understanding of psychology helps detect the underlying factors that could affect a manager's performance. This article advocates a close relationship with the manager, adding a level of transparency for the investor and includes helpful tips for building this relationship.
Institutional Hedge Fund
Institutional Hedge Funds Trend
A recent white paper stressed that as hedge funds continue to flourish, they have started to look to the institutional market for new opportunities to expand their growth. However, hedge funds must prepare themselves for the distinct set of demands these institutions have. In order to set themselves up for success, hedge fund managers should consider five main challenges in order to attract investment from the institutional market.
1.Exhibit high quality infrastructure and operations
3.Create stable, likeable management teams consisting of people with a variety of skill sets
4.Shift away from a focus of high risk and high performance to one of stability and constancy
5.Devote resources to ensure that general business practices are followed
Essentially, institutions prefer doing business with hedge fund managers that operate as they do. This means being highly organized, transparent, and honest. The most successful hedge funds will be able to match these qualities while also performing at the same high level that originally attracted investors.
Read more articles like this within the Hedge Fund Due Diligence Guide.
Due Diligence Questions
Hedge Fund Due Diligence Questions
Last month I found this article on questions you should ask during a hedge fund due diligence process. While nothing within this blog should be taken as financial advice this article and the hedge fund due diligence guide on my website might give you a high level overview of hedge fund due diligence.
According to Douglas Dick, the best place to look for information on the hedge fund you are completing due diligence on is in the offering memorandum. This document will state all the hedge funds outside supporters, from law firms to independent contributors. The first sign of caution is when you ask a question that the hedge fund is not willing to answer. Willingness to answer all questions without it being too much of a hassle is a small but good sign and will be the foundation for a trustful relationship between you and the fund.
Here are four questions to consider during your time of due diligence. They’ll allow you to get started but it’s extremely important to do thorough research with an expert into all aspects of the fund.
1.Does the hedge fund use a third party marketing firm?
2.What technology services do they use? How are they supported?
3.What law firms are involved with the fund? What other types of hedge funds do they work with?
4.Who is the outside administration?
Looking into how the hedge fund presents itself and works from the outside is always an important thing. It’s equally important, however, to look at the hedge fund from the inside too. By asking some of these questions you’ll be able to discover valuable information that will eventually help you decide where you will invest your money.
Fund of Fund
Fund of Fund Due Diligence
I recently found this fund of fund due diligence article, which you might have seen a link to within my hedge fund due diligence guide. Within this article Jim Tomeo, Chief Operating officer and Senior Portfolio Manager of SSARIS Advisors, presents some interesting information regarding hedge funds asset allocation process. He talks a lot about building a portfolio using a bottom up / top down approach and the due diligence that requires. This approach includes taking into consideration two different investment philosophies:
Convergent Strategy – The value of an equity is based on the company’s future expected earnings, future growth rate of these earnings, and uncertainty of these predictions.
Divergent Strategy – Past patterns in security prices can forecast future price patterns.
His process calls for 50% of returns coming from the convergent strategy and 50% coming from the divergent strategy. It also emphasizes the importance of proper pricing on hedge fund success. Another point that Jim stresses within this article is the importance of constantly evaluating hedge fund managers. This means frequent hedge fund manager due diligence:
Reviewing internal structure / procedure
Review of hedge fund documentation including memorandums
Jim believes that taking cautions in terms of pricing, manager selections, in addition to sticking with a bottom up and top down approach can help hedge funds endure through tough times and succeed.
Read more articles like this within the Hedge Fund Due Diligence Guide.
Additional Resources: Book- Hedge Fund Due Diligence: Professional Tools to Investigate Hedge Fund Managers, By Randy Shain
FINRA Broker Check
Hedge Fund of Fund RFP Example - Used in Institutional Due Diligence Processes
HFN's Guide to Hedge Fund Due Diligence
Whitepaper on Hedge Fund Operational Risk & Transparency
Alpha through rigorous hedge fund due diligence
In-depth hedge fund risk & due diligence PowerPoint