Prior to the institutionalization of hedge fund investing, investment decisions and allocations were made largely on the basis of performance and the qualitative aspects of a fund: People, process and philosophy. Over the past decade, the investor due diligence process has evolved.
What was once a short and rather perfunctory process has become lengthy and detailed, encompassing both qualitative and quantitative aspects of a fund and its performance. While there is no one-size-fits-all formula for investors, one certainty is that managers who understand the components of the due diligence process will have an easier time meeting the requests of investors. To successfully raise capital, managers must be able to articulate clearly their value proposition, the components of their performance and the risks they take to achieve it.
Based on feedback from fund of funds and direct investors in hedge funds, we found that the due diligence process has become very data driven and time intensive, requiring greater transparency and granularity than ever before.
Prior to selecting an investment target, hedge fund investors first determine the investment strategy to allocate capital. These may include (but are not limited to): Equity fundamental value, market neutral, event-driven, global macro or relative value strategies.
After generating a manager list within the strategy subset, the natural entry point for an analysis of a fund is a qualitative look at its people, process and philosophy. These elements comprise the backbone of all funds and are the source of their performance.
People: This is typically the most important and decisive element of the due diligence process. Investors want to know who the decision makers are at a fund and where they received their training. A hedge fund manager’s experience and pedigree are important in establishing his or her expertise. While not necessary, working at a recognized firm with a proven ability to generate alpha lends credibility. This may lead to a shorter due diligence process, because it makes it easier for investors to check references. Investors will speak to previous employers and colleagues to determine a manager’s exact role and specific contribution to performance.
Process: Investors want to know that a manager has a proven process in place — from idea generation, through research and portfolio construction, to risk management. Managers must be able to articulate their process in a concise manner and convey to investors that a fund’s performance is consistent and repeatable.
Philosophy: A fund’s philosophy is what differentiates it from the competition. To communicate a fund’s philosophy effectively, a manager should focus internally on the aspects critical to its investing process. Investors want to understand where managers allocate the majority of their time and where they have true expertise.
These three main qualitative factors build a framework for a fund and are the first of a multi-step due diligence process. If a manager fails to meet an investor’s standard on the qualitative front, then that manager will not have the opportunity to move forward. That being said, qualitative analysis alone is not enough to form a complete picture or to ensure an allocation. As Paul Platkin of Arden Asset Management explains, “Any manager can tell a good story; due diligence is the process to make sure the story makes sense and that the numbers support it.”
Performance is the result of a fund’s people, process and philosophy. It is a static snapshot of a fund’s returns. A fund’s net performance number, however, is only the first step of the quantitative portion of the due diligence process.
Investors also will want to understand what risks were taken and where the money was made to determine if performance was a result of the process. Risk represents the possibility that a portfolio will not achieve its desired results. This definition is critical because it frames risk from the perspective of the manager’s strategy because certain strategies have more implicit risk than others. And there are various kinds of risk that must be monitored; don’t leave out liquidity risk.
After a full review of returns and risk, an investor will take a deeper look at the numbers to understand the performance. The most common method, absolute attribution analysis, will answer questions regarding active vs. passive investing and determine whether returns fall inside a manager’s stated strategy and where managers are risking investor capital. Investors want to see that it was the manager’s decisions, as opposed to luck or leverage, that generated alpha.
An investor conducting quantitative due diligence is similar to a painter creating a picture. With each layer of paint, the image begins to take shape and become clearer. Similar to a painting, hedge fund due diligence should be thought of in terms of overlays, with each overlay providing additional clarity to an investor’s understanding of a fund and its returns. Once all of the overlays are in place, the picture is complete. We have identified three overlays that comprise the quantitative due diligence process: Performance, risk and attribution analysis.
The final step for investors will be to determine if, based upon their findings, an investment is warranted. Investors will look at the risk-adjusted returns and run a correlation between the manager and the investor’s existing portfolio. There are many good managers who will not receive allocations because they do not improve on the investor’s existing portfolio. Today, it is not enough simply to have positive performance; to successfuly raise capital, you must create a differentiated fund that consistently adds value. You also must be able to define clearly what differentiates your strategy and returns. The investment process is about trading risk for reward. The investor due diligence process, which once was simply an evaluation of a hedge fund manager’s people, process and philosophy, has matured in line with the hedge fund industry so that today, these qualitative aspects are now only the first step of the full due diligence process.
Due diligence should begin with a review of the traditional metrics used by investors but also include more advanced analytics. When looking at historical performance data, managers no longer can just review total return since inception, but also must provide data for customized date ranges so investors can see how a programs reacts vs. other investments in stressful periods. In discussing correlations, managers may need to seek out a better benchmark to analyze their results than the S&P 500 or Russell 2000. When providing a composition breakdown, reporting gross and net positions is not sufficient; full delta-adjusted exposures also are necessary. Our analysis also showed that attribution analysis does not stop at alpha from long and short positions, but also should be broken down by sector, analyst, stock selection, market capitalization and liquidity to form a true picture of returns. The due diligence process has evolved; make sure that you have the tools in place to meet the current demands of today’s sophisticated investor.
It is critical to note that not all investors allocate only after the intense quantitative process we have outlined. Fundamentally, the hedge fund industry is still a story about people. Investors are looking for active management and want to entrust their assets to someone they believe to be an expert with a unique perspective. There will never be a replacement for a good story and a firm handshake, but the due diligence process helps provide additional clarity to the investor’s decision.
Note: This story is based on a White Paper produced by Merlin Securities. Download the complete report here.
Patrick J. McCurdy, partner and head of capital development at Merlin Securities, consults with hedge fund managers on their capital raising.