Hedge Fund Due Diligence

Professional Tools to Investigate Hedge Fund Managers

Randy Shain

• Publisher: Wiley
• Year: 2010
• Print ISBN:
  9780470139776
• Edition: 1
• eBook ISBN:
  9781118039243
• Topic: Business
• Subtopic: Finance
• Index: Business

Hedge Fund Due Diligence provides a step-by-step methodology that will allow you to recognize and avoid questionable hedge funds before its too late. Based on a framework that hedge fund investigative expert Randy Shain has refined over the course of his successful career, this book offers an overview of due diligence into hedge fund management, how information on managers can be obtained, and why this information is essential to your investment endeavors.

CHAPTER 1

Hedge Fund Growth—What It Means to the Institution

Open any business publication or daily paper with even moderately in-depth business coverage and you’ll see a story about a hedge fund. Most of these stories will describe how hedge funds are unregulated, implying that somehow this means hedge funds are The Wild West of investing, best left to only those willing to brave extraordinary frontiers and the risks associated with them. Other articles concentrate on the latest scandal to touch down on a “hedge fund,” not distinguishing between a hedge fund and essentially a crooked enterprise masked as a hedge fund to take advantage of the zeitgeist of today. Finally, stories feature breathless descriptions of the fantastic growth in hedge funds, both in terms of the money they manage collectively as well as the number of funds in total. This book will touch on these issues, but this opening chapter will focus on the last point, specifically as it relates to the effect the tremendous increase in hedge fund formations has had on institutional investors.

The 2006 PerTrac Analytical Platform neatly summarized what daily and trade press have simply termed an “explosion” in hedge funds over the past several years. According to PerTrac’s^a study of various hedge fund databases¹:

• Nearly 13,675 single manager hedge funds were identified, up from 8,100 single managers acknowledged in the 2005 study.

• Single manager funds totaled more than $1.41 trillion under management.

• Approximately 250 funds have surpassed the $1 billion hurdle. By contrast, more than a third of single manager funds manage less than $25 million.

• Approximately 4,150 of the single manager funds appear to be clones of another fund.

• Figure 1.1 shows a steadily increasing arc of new single manager hedge funds over the past decade and a half; note that this figure does not even take into account those funds that didn’t report to any database.

FIGURE 1.1 Number of New Single Manager Hedge Funds by Year Used by permission of Opalesque.com.

The Wall Street Journal added to this analysis by reporting, on January 3, 2007, that hedge funds managed approximately $500 billion five years ago. The Journal placed the figure at the time of the article at close to $1.44 trillion.²

What does all this growth mean to an institution? Certainly, one upside is capacity, or the ability for institutions to increase their alternative asset allocation percentage if they should wish to do so. Turning this coin over reveals, however, the inherent dangers of any industry that sees its membership increase so rapidly: dilution of talent, and consequently, increase in potential losses stemming from the selection of the wrong fund. Not too long ago most hedge funds had a similar starting point. A classic biography highlighted the manager’s graduation from Harvard, followed by a Wharton MBA, a stint at a bulge-bracket investment house and then something of an apprenticeship at a place like Julian Robertson’s Tiger Management. When the manager ultimately broke out on his own, an investor could be assured, knowing the manager had the necessary background to succeed.

Now, this is no longer the case. As hedge funds became more and more popular, and as other opportunities in the financial world became less attractive, if not, at one point, downright less available, the type of person seeking to become a hedge fund manager changed dramatically. From investment bankers to stock analysts, from physicians to pharmacists, from amusement park operators to real estate developers, all of a sudden everyone you know is a hedge fund manager. A few years ago, I attended a basketball camp and at dinner, the 18-some-odd group included an eclectic mix of careers, united only by a love of hoops. Going around the table, the spotlight turned to the only person there who then worked for an investment bank and the only person who by that time had managed to be somewhat universally irritating in his manner. Asked to elaborate on his career, he said he was leaving to start a hedge fund. I am quite certain he had little desire to be a hedge fund manager. His focus was prestige and money, not some innate love of esoteric trading strategies.

It is not the fact that people from so many walks of life are becoming hedge fund managers that is necessarily troubling. Rather, it is the reason they are doing so. Illustrated in the example above (though admittedly lost somewhat in the translation) is the fact that many people are approaching the hedge fund industry as if it were a fast, easy way to make a ton of money, all with a very low barrier to entry. The low barrier to entry part may very well be true (this is probably the best argument for increased regulation, though a libertarian would argue it is the worst); the easy money part is not. People’s motivation for becoming a hedge fund matters precisely because running one is not easy. One needs a combination of trading experience, ability to deal with risk, conviction, honesty, and overall business skills (any fund seeking institutional money is no longer a guy clackety-clacking away on his basement computer; no, running an actual business is required now, too). People in it for just the fast riches often will find out the hard way that this industry is not what they thought; the key for the institution, then, is not to be the one colearning this lesson.

The trick for any institution is ferreting out which funds present an acceptable risk. This has been made simultaneously easier and harder by the drastic expansion in hedge funds from which to choose. On the one hand, given the plethora of funds at their disposal institutions no longer have to fear getting shut out of all the funds in which they might like to invest. Conversely, this very abundance of choices means it is no longer so simple to judge the quality of the people running the funds, since these people may very well be unknown to the institution and those in its circle.

Pointedly illustrating this are recent statistics on the heavy concentration of hedge fund assets in a relatively small number of funds. According to a March 2007 piece in Hedge Fund Daily, gleaned from its sister publication, Absolute Return, a unit of HedgeFund Intelligence, 241 U.S. hedge fund firms have more than $1 billion in assets under management.³ Perhaps most astoundingly, the 20 largest hedge fund firms controlled approximately $386 billion, in total, or almost one third of the global hedge fund assets reported to surveyors.

A February 2007 report in Hedge Fund Daily presented slightly different figures, although not contradicting the general concentration point.⁴ “The 10 largest hedge funds according to size control 63% of industry assets, according to Milken Institute’s Capital Access Index 2006, while the top 1% control 19% of all global fund assets. Based on data from HedgeFund.net, the study found that ... hedge funds with more than $1 billion in assets under management account for only 3% of the total number of funds but 35% of the industry’s trillion in assets, while HFs with under $100 million AUM represent about 70% of the number of funds but just 12% of the assets.”

The full list was published in Absolute Return’s March issue. Unless noted otherwise, all asset figures are as of January 1, 2007, and are in the billions. See Table 1.1.

Even if you eliminate the bottom third of hedge funds that reportedly have less than $25 million apiece, what remains is a tremendous number of hedge funds to weed through, if you don’t want to, or can’t, invest in the aforementioned big boys. Speaking of which, one theory proffered in a recent HedgeWorld story is that investors are better served by getting into funds early in the fund’s “life cycle.”⁵ According to this theory, penned by Shoham Cohen, a hedge fund has four stages, similar to what you might expect: introduction, growth, maturity, and decline. As might also be expected, he does not believe that it is astute to invest during stage four; rather, he proposes that hedge fund investors often “shy away from funds with track records of less than five years, or assets under management of less than $300 million, in favour of more established funds. These vintage funds are usually past their prime.”

TABLE 1.1 Top 10 U.S. Hedge Fund Firms—January 2007

JPMorgan Asset Management	$34.00
Goldman Sachs Asset Management	$32.53
Bridgewater Associates	$30.20
D. E. Shaw Group	$26.30
Farallon Capital Management	$26.20
Renaissance Technologies Corp.	$24.00
Och-Ziff Capital Management	$21.00
Cerberus Capital Management	$19.15
Barclays Global Investors	$18.90
ESL Investments	$18.00

Mr. Cohen avers, “Emerging funds can provide better returns, better capital protection, a longer-term investment prospect, and up-to-date investment strategies,” while “historically, high-profile funds—in most cases—will add less value.”

Although getting in while a fund is young, before it is hot, sounds appealing, these types of funds demand even more stringent due diligence analysis, for by their very nature they do not have the financial track record upon which you can rely.

None of this is meant to suggest in any way that all, or even the majority, of hedge funds are frauds or will blow up at some point soon. However, as with global warming, it now seems that the question isn’t whether or not hedge funds are risky, but what can be done about it.

What can be done to lessen the risk of investing in a hedge fund that blows up? Specific prescriptions appear first in Chapter 4 and then throughout this book; it is enough to summarize here that the primary way to avoid the type of headline no one wants to see is due diligence. Proper, thorough research into the hedge fund manager’s track record will go a remarkably long way toward ensuring a blow-up-free portfolio; no method is foolproof, of course, but relying on an ad hoc, hodgepodge of industry contacts, guile, and intuition is not only no longer necessary, but it is also no longer effective. And this is possibly the greatest distinction for institutional investors to recognize: the old way of hedge fund investing is no longer possible; no more can you simply invest with managers you know or with whom some acquaintance of yours has direct experience. But this doesn’t mean you can’t replicate the old experiences; it just means you have to work a lot harder to do so. Still, this work is not without its reward, because at the end of the day you can always move to the next manager on your list if your due diligence review should reveal that the first option is untenable. All in all, this isn’t so bad.

DEMAND FOR HEDGE FUNDS

The discussion above focused on the increased supply in hedge funds, suggesting that this was in response, primarily, to hedge funds becoming popular and to their perception as easy money. Another critical factor, of course, and one you are likely to be at least partially aware of, is the concurrent heightened demand for hedge funds in which to invest.

Everyone knows about institutions providing ever-increasing dollars to hedge funds. (Reuters.com reported in March 2007 that a survey of more than 40 funds with assets totaling $1 trillion revealed that only 4 percent have no hedge fund investments, down from 16 percent the year before.⁶) Less well known, perhaps, is one of the reasons why this is occurring. According to a January 3, 2007, Financialnews-US.com article, the two largest US pension funds, the $225bn California Public Employees Retirement System and the $153bn California State Teachers’ Retirement System, combined their unfunded pension liabilities of $49bn, as the state of California sought to address its funding deficits.⁷ Though going forward, California and the many other pension plans in this predicament will plausibly seek to change from defined benefit plans to defined contribution plans, this will not address the immediate problem of unfunded, or under-funded, pension plans. One ready solution, however, is investing in more alternatives, including hedge funds, in order to “goose” pension plan returns and hopefully abate or even eliminate the funding gaps that currently exist.

Around this time, HFN Daily Report quoted a press release issued by Russell Investment Group, which managed more than $195 billion in assets for advisory clients as of December 31, 2006.⁸

According to the release, Russell Investment Group “predicted a drastic change in pension investment portfolios as corporations respond to pension reform and try to ma...

Table of contents

• Title Page
• Copyright Page
• Acknowledgments
• Introduction
• CHAPTER 1 - Hedge Fund Growth—What It Means to the Institution
• CHAPTER 2 - What Is Due Diligence? What Are the Various Types of Due Diligence?
• CHAPTER 3 - What Kinds of Hedge Fund Failures Does the Press Discuss? Why Do ...
• CHAPTER 4 - Can the Chances of Investing in Future Failures Be ...
• CHAPTER 5 - Investigative Background Reports—The Beginning: Identify Your Target
• CHAPTER 6 - The Courts
• CHAPTER 7 - News Media: Is Nexis Your Only Option?
• CHAPTER 8 - Regulatory Bodies
• CHAPTER 9 - Credentials Verifications
• CHAPTER 10 - Corporate Records: Not Just D&B Anymore
• CHAPTER 11 - The Internet: What It Can Do and What It Can’t
• CHAPTER 12 - Public Records—Is That All There Is?
• CHAPTER 13 - What You Think Is Helpful, But Isn’t
• CHAPTER 14 - The Law
• CHAPTER 15 - Credit Reports
• CHAPTER 16 - Warning Signs: Red and Yellow Flags
• CHAPTER 17 - Conclusion
• Notes
• Index