Beyond the tear sheet: War stories from the front lines of hedge fund due diligence

If searching a database and reviewing marketing material was all that was involved in finding a quality manager, no one would make a bad investment. It is a little more complicated. 

Dodging Bullets: From Subtle Clues To Glaring Problems

Investing in private partnership structures such as hedge funds, private equity and private real estate can be a fruitful and exciting endeavor, especially when venturing into asset classes that lack competition and efficiency. An important qualification to remember when beginning due diligence on a partnership is that no investment is perfect. Each one has its own risks, however esoteric or idiosyncratic, and risks change over time, as do the operations and other intricacies of investment management. 

In the case of partnerships, wherein an investor is one step removed from the investment, there is the additional risk that a manager may not always act in the best interest of the end investor. While investment risk is generally rewarded through higher returns, operational and personnel risk are not. 

A prospective investor can produce mountains of work on the attractiveness of an investment, but all that work could be jeopardized by a structure that allows for unethical, reckless or even fraudulent behavior.

This is where the science of due diligence meets the art of the practice. Despite the standardization of due diligence processes in the post-crisis era of investing in partnership structures, we believe the due diligence function should go beyond “box checking.” For every manager that has made it onto our platform, we have encountered far more whose faults ranged from the paltry to the disturbing. In many of those cases, it was a subtle clue, not a checklist item, which steered us clear of those relationships. What follows are accounts of those “dodged-bullet” cases that have stood out over the years.

Check the Directory 

During an onsite visit to a firm in Westchester, New York, we arrived at their building located in a non-descript suburban office park. The firm we were visiting took up only one suite with its 30 employees. As we entered the lobby, our diligence began. 

We have learned that related parties and conflicts of interest can be found not just in the firm’s due diligence questionnaire (DDQ) and audited financials, but in a place as simple as a building’s directory. The security guard asked if he could help us as we stood there taking a mental note of the other tenants in the building. We found two things. 

First, listed on the directory was another hedge fund-sounding name, which followed the standard hedge fund naming convention of randomly combining two of the following: a) Animal b) Nature/Rock
c) Mythical Warrior/Weapon — so something along the lines of “Chicken River” or “Diamond Hatchet.” We took down the name and continued on to our destination. 

While having two hedge funds in the same building is not a red flag, with some additional diligence and outreach to “Diamond Hatchet,” we learned that one of their primary selling points was that although they were small, they shared resources with a much larger fund. That much larger fund turned out to be the other firm in the building we were there to see, which had failed to mention any shared resources with Diamond Hatchet. 

Second, on the same directory listing was a name that sounded familiar. The CFO of the firm with whom we were scheduled to meet later that day was listed separately in the directory. Upon questioning him about this in our meeting, we learned that the CFO, in addition to working for the fund, was operating a private tax practice out of the same office space, despite this fact not being mentioned anywhere in the fund’s collateral. We also learned that his tax practice took a significant amount of the CFO’s time. 

This situation raised two concerns: We didn’t like the idea of the fund not having a fully dedicated CFO, and
we had privacy concerns given that unrelated, uninvested parties would be visiting the CFO’s office, which was full of sensitive LP and GP partner information.

Furniture and Flowers?

Despite their stellar track record, an in-depth look into the financials of a prospective fund several years ago made our team highly uncomfortable. We noticed that the fund’s balance sheet contained a line item for “furniture and other office assets” while the income statement listed “other” expenses that were noticeably large. These two vague line items made up several hundred thousand dollars, prompting us to ask about them in our meeting. The manager admitted that the “other” expenses captured things like flowers and lunches, suggesting that the firm was expensing highly extravagant gifts and perks at the cost of investors. In other words, if you calculated the daily “other” expenses of the fund, you would probably assume that a Wolf of Wall Street-esque situation was under way. 

After the onsite meeting, we realized the furniture included on the balance sheet (a problem to begin with) was straight out of the 1970s, featuring desks with faux wooden tops and beige metal bases and some equally generic lighting fixtures and seating. We figured if a fund was actually going to include office supplies on their balance sheet, they should at least invest in some overpriced Herman Miller pieces as opposed to the desks on which your 5th grade math teacher kept her pencils. Given the state of the actual furniture, we wondered where the money had really been spent. 

Uncovering Operating Partners

Funds that invest in off-the-run private markets often lack the internal bandwidth to execute the strategy themselves, so they frequently partner with third-party originators. In some cases, performing due diligence on these third-party partners can be as important as the primary diligence on the fund itself. You may think the fund is directly investing your capital, but it may actually be funneling it through a more complex set of underlying limited liability and special purpose vehicles. 

In one instance, a fund we encountered described what seemed to be an internal process for originating non-U.S. consumer credit loans. After significant research, we determined there was an intricate network of third parties used to invest capital in this strategy, which involved money changing hands between numerous non-institutional local and regional investment partners. While we had done work to confirm the institutional nature of the primary fund, we were not comfortable with the credit quality and operational controls of the operating partners. 

In another instance, a fund claimed to be operating a collateralized lending strategy. After conducting our due diligence, we uncovered a relationship with an investment partner that was previously convicted of multiple instances of market manipulation. Though the strategy seemed appealing on the surface, taking the time to research how the fund was implementing the strategy and with whom it was partnered prevented us from exposing our clients to association with some unsavory characters.

Contradicting stories 

One fund we briefly considered was run by a pair of brothers and was marketing a low volatility strategy that had performed tremendously well over a span of several years. The first brother was an adept marketer and emphasized the brothers’ disciplined approach, consistently applied since the firm’s inception.
He introduced us to numerous senior portfolio managers and associates that backed up his story, which bolstered our confidence in his narrative, but we were left a bit uneasy by the tight control he seemed to have over the messaging. 

We then scheduled a solo meeting with the second brother at his home. He was more forthcoming about the trading practices of the firm, unable to resist the audience attention, and provided examples of trades that were highly profitable but also significantly more risky than the first brother let on. Some of these trades included highly levered duration bets, speculative short-term trading on rumors, and wild unhedged currency positions, none of which aligned with the communicated investment strategy of the fund. 

With such inconsistent messages from each of the co-founders, we did not move ahead with this fund. The lesson? Speak with portfolio managers individually whenever possible.

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About the Author

Salvatore Russo serves as EMM’s Head of Research and is a member of the company’s Investment Committee. Christopher Burrows, also an Investment Committee member, is a Senior Vice President on EMM’s research team, and Filip Malaric serves as a Research Analyst.