From the May 01, 2012 issue of Futures Magazine • Subscribe!

Due diligence is getting more complex

Managed Money

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.”

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