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Knowledge, Veracity, Fellowship

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About the Greenwich Roundtable

Greenwich RoundtableResearch Council

Introduction:Letter from the Executive Director

Table of Contents

The Greenwich Roundtable

Presents

Best Practices in Hedge Fund Investing: Due Diligence for Equity Strategies

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The Education Committee of

About the Greenwich Roundtable

The Greenwich Roundtable is a not-for-profitresearch and educational organization locatedin Greenwich, Connecticut, for investors whoallocate capital to alternative investments. It isoperated in the spirit of an intellectual cooper-ative for the alternative investment community.Mostly, its 120 members are institutional andprivate investors.

The purpose of the Greenwich Roundtable isto discuss and provide current, cutting-edgeinformation on alternative investing. Our mis-sion is to reveal the essence of both trustedand new investing styles, and to create a codeof best practices for the alternative investmentindustry.

The Greenwich Roundtable hosts monthly,mediated symposiums at the Bruce Museum inGreenwich, Connecticut. Attendance in theseforums is limited to members and their invitedguests. Selected invited speakers define complexissues, analyze risks, reveal opportunities, andshare their outlook on the future. For the past10 years, the Greenwich Roundtable has hostedsome of the leading managers, scientists, andpolicy makers of our day.

Stephen McMenamin, of Indian Harbor LLC,formed the Greenwich Roundtable in 1995 andis its Executive Director. Its Board of Trustees,whose membership reflects a cross section ofthe alternative investment community, sets thedirection of the Greenwich Roundtable.

“The purpose of the

Greenwich Roundtable sympo-

siums is to discuss and provide

current, cutting-edge education

on alternative investing. Our

mission is to reveal the essence

of both trusted and new investing

styles, and to create a code of

best practices for the alternative

investment industry. ”

GR

SPRING 2005 BEST PRACTICES IN HEDGE FUND INVESTING: DUE DILIGENCE2 GR

© Greenwich Roundtable 2005

Research Council

Best Practices in Hedge Fund Investing: DueDiligence for Equity Strategies is the first collaboration of its kind...between investorsand managers. The managers are members ofour Research Council who have generously pro-vided the resources to produce this publication.Each manager was nominated and appointedfor his support of best practices or, quite simply,his interest in demystifying the hedge fundinvestment process. Their business activities canbe held out as a standard for all to follow.

The investors are members of our EducationCommittee. Their backgrounds are broad anddiverse. They hail from the family office, bankproprietary capital, or fund of funds communi-ties. They are all seasoned investors in a broadrange of strategies that include equitylong/short, arbitrage, managed futures, relativevalue, distressed debt, credit, asset backed, andglobal macro. All are limited partners, sophisti-cated investors, and the quality of our discoveryprocess was exceptional. We have essentiallyunlocked wisdom that has never before beenmade public.

Indeed, the goal of this publication is to helpdemystify a topic that has been shrouded inmyth and, by doing so, help improve the level ofeducation among those who wish to betterunderstand the community of active hedge fund

investors. Our hope is that Best Practices inHedge Fund Investing may become an effectiveeducational tool for the broader community ofqualified private and institutional investors,especially those currently evaluating an activehedge fund investment program. We hope thatit might also be a practical reference for aca-demics and policymakers with an interest inunderstanding the hedge fund industry from aninvestor’s perspective. Perhaps even experiencedallocators will find this document to be a help-ful review to reexamine long-standing practicesand habits of mind.

Best Practices in Hedge Fund Investing: DueDiligence for Equity Strategies is a work madepossible through the generosity of a few hedgefund managers. The members of the ResearchCouncil of the Greenwich Roundtable haveprovided the critical financial resources thatwere necessary to bring this valuable knowledgeto the investor community. The members of theResearch Council were selected for their priorgood deeds in raising professional standardswithin their industry. Now they wish to help thebuy-side raise their standards. They also shareour belief that education is one of the greatestneeds in the marketplace.

Charles WinklerAmaranth Advisors

Clifford S. AsnessAQR Capital

Ray DalioBridgewater Associates, Inc.

Charles GruyeCRG Partners

Cliff VinerIII Offshore Investors

Tom McAuleyNorth Sound Capital

Steven BloomSagamore Hill Capital Management

Paul R. AaronsonStandard & Poor’s

SPRING 2005BEST PRACTICES IN HEDGE FUND INVESTING: DUE DILIGENCE 3GR

Greenwich Roundtable Research Council

Inside this first issue of the planned series ofBest Practices in Hedge Fund Investing you willbe treated to an informed examination into theart of due diligence. The scope of this issue willbe confined to examining equity-orientedstrategies. Early in the process of gatheringideas on due diligence, it was clear that weneeded to focus on one strategy at a time. Theuniverse of hedge fund strategies is enormouslybroad and diverse. Any single method ofinquiry applied to all due diligence wouldbecome generic. Future issues will approachstrategies in other asset classes such as managedfutures, fixed income, and asset-backed markets.

Performing due diligence on hedge fund man-agers is difficult because it is necessarily adynamic process. The investor must exhibit theskills of an accountant, a trader, an investmentanalyst, a psychotherapist, a business manager,a human resources manager, and a headhunter.By definition, hedge funds are organized toexploit inefficient pricing and anomalies, whichmakes the art of asking questions one of thegreatest challenges for investors. The bestinvestors are those who have developed notonly a good bedside manner, but also a wide

understanding of the mechanics of many differ-ent capital markets. They approach the due dili-gence process with an open mind and an atti-tude of respect for the hedge fund manager’sskill — but also with a healthy dose of skepti-cism. The due diligence process is vital to estab-lishing rapport in the relationship betweeninvestor and hedge fund manager.

It is difficult to articulate a process so depend-ent on judgment and experience. Most experi-enced investors agree on a few common areasof inquiry. These include a review of marketingmaterial, investor correspondence, legal docu-ments, interviews with key professionals, areview of regulatory and professional records,background checks, and an evaluation ofinvestment performance. Beyond this, individ-ual opinions override consensus on the issue.Despite the differences of opinion, we approachthe practice of due diligence with the assump-tion that the degree of agreement may be some-what disguised. There are practical reasons whythis is so. First, experience and judgment figureso decisively in the process. Few investorsapproach this process in exactly the same way.Second, the sequence of an allocator’s process

GR


Introduction:Letter from the Executive Director

and the emphasis applied to any area willalways reflect his sophistication regarding thattopic. Third, due diligence is an iterative processwith the prospective investor rarely taking a lin-ear approach but, more practically, shiftingfrom topic to topic to uncover important detailsas experience directs. We have attempted tohighlight the key areas of inquiry in a sensibleorder of importance.

As the broad flow of investment and human cap-ital from traditional strategies into non-tradi-tional approaches continues, the need forresearch into this crucial aspect of investing hasnever been greater. The Securities and ExchangeCommission (SEC) has imposed a registrationrule on the hedge fund industry. The SEC stafffelt compelled to create a “culture of compli-ance” to “legitimize” the industry. But a cultureof compliance already exists. Investors perform-ing due diligence create a market-based compli-ance culture. It is not the “specter of an investi-gation” but the needs of sophisticated investorsand the possibility of investor redemptions thatkeeps everyone honest.

We believe Best Practices in Hedge FundInvesting: Due Diligence for Equity Strategiesmay be the first qualitative treatment of thepractice. For two years, our purpose has been touncover “soft” aspects of performing hedgefund due diligence. Our emphasis is on devel-oping an interpretative discussion whenever aflag is raised. There have been many genericinvestor questionnaires circulated. Most werefocused on collecting quantitative data.Quantitative analysis is backward looking.

Qualitative analysis is more useful as a forwardlooking tool. In his initial review of the litera-ture, Mark Pearl discovered that no one trans-lated the answers into conclusions. We doinclude most of the quantitative questions in anattempt to provide the investor with a compre-hensive manual. But the aim of this series is tohelp investors identify exceptions and interpretwhat they are hearing.

Stephen McMenamin


Robert AaronDPM Mellon


Spencer BoggessU.S. Trust Company N.A.Chairman, Education Committee

Marilyn FreemanCapital Prospects LLC

John GriswoldCommonfund Institute

Mark JurishLarch Lane Advisors LLC

Michael KellyFrontPoint Partners

Stephen McMenaminIndian Harbor, LLCExecutive Director

Kevin R. MirabileSaw Mill Managementand Research

Mark A. Pearl, M.D.Henderson Capital Management

Laurence K. RussianABS Investment Management LLC

Jeffrey S. SilvermanTudor Investment Corporation

Lynn Weber Biase RBC Capital Markets

Joelle Aractingi WeissCBG Investment Advisors, Inc.SG Private Bank

Valerie WitoshkinThe Alkimia GroupLeader, Due Diligence WorkingGroup

Best PracticesSubcommittee Members

Introduction:Letter from the Executive Director (cont.)

I. Strategy, Investment Process, and Market Opportunity . . . . . . . . . . . . . . . . . . . . . . . . . .8A. Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8B. Portfolio Construction and Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9C. Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11D. Market Opportunity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12

II. Team and Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13A. Key Investment Professionals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13B. Founders and Principals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14C. Staff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14

III. Fee Structure and Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16

IV. Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18A. Portfolio Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18B. Operational Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19C. Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20D. Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20

V. Management Company, Fund Structure, and Asset Base . . . . . . . . . . . . . . . . . . . . . . . .22A. Management Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22B. Fund Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23C. Asset Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24

VI. Quantitative Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25

VII. Operations and Transparency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28

VIII. Third Parties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29A. Auditor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29B. Prime Broker . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29C. Administrator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .30D. Marketing Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31E. Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31

IX. Intuition, Judgment, and Experience . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .32

X. Documents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .33

Table of Contents



A critical first step in any evaluation of ahedge fund investment is the establishment of aproper context for the evaluation. The question,to borrow Joe Dimenna’s phrase, is “what ball-park are we in?” Context is everything: does theprospective evaluator have an appropriateunderstanding of the investment opportunityand the risks that attend to it? Does the portfo-lio manager understand the context in which hisstrategy and organization are being evaluated?Clarifying a set of shared assumptions betweenhedge fund manager and hedge fund investorensures that both parties possess a commonvocabulary for the successful conduct of the duediligence process. Once the context for the eval-uation is properly understood, it is possible toproceed with a more nuanced investigation ofthe investment strategy, the portfolio manager’sinvestment philosophy, the character of theorganization, the portfolio manager’s edge, andother relevant fund particulars.

A. Overview

• How is the strategy best categorized (diver-sified long/short equity, event-driven,long/short technology, etc.)?

• What is the manager’s investment philoso-phy and what are the core principles thatinform this strategy?

The core philosophy may require someelaboration, but the manager should beintellectually disciplined enough to articu-late this in a clear, concise, and easilyunderstandable way.

• What professional experiences were instru-mental for the manager in the developmentof his investment philosophy or approach?

How has the current strategy evolved overtime?

• What factors might cause the strategy to bealtered -- however subtle these changesmight be? What is the fund manager’s visionfor how the organization can continue toimprove over time?

Be careful of style drift. In particular, try toassess if the manager has fundamentallychanged his strategy to accommodate anundue increase in assets or to capitalize onopportunities in which he has little expert-ise. Is the manager making logical adjust-ments to profit in a changed environmentthat is still fundamentally consistent with hisinvestment philosophy?

• How unique is the strategy? Does it attemptto exploit persistent market inefficiencies oris it a less viable, shorter-term strategy?What is the hedge fund manager’s edge?

Try to assess how genuine a manager’s edge is.Is the edge intangible as in a sixth sense, orderived from a tangible mix of experiences, ora certain quality of experience? How is theedge different from that of other major com-petitors? How sustainable is this edge?

• What is the specific range of securities ormarkets invested in for the strategy (e.g.,listed equity, ADRs, fixed income, cash,ETFs, options, OTC derivatives, swaps, for-wards, PIPEs, private equity, commodities,FX, and others)?

Do the key investment professionals possessthe specialized knowledge and experience toinvest successfully in the identified securities?

I. Strategy, Investment Process, and Market Opportunity

“Try to assess how

genuine a manager’s edge is.

Is the edge intangible as in a

sixth sense, or derived from a

tangible mix of experiences, or

a certain quality of experience?

How is the edge different

from that of other major

competitors? How sustainable

is this edge?”


Should their experience permit them to oper-ate successfully in the range of marketsrequired by the strategy?

• Does the portfolio manager have experiencemanaging liabilities (e.g., funding, equitylockups) as opposed to simply managingassets (i.e., picking stocks)?

• Which countries or regions does the managerinvest in?

Beware of the reduced liquidity and latitudefor hedging in certain emerging markets.Also, beware of managers who are investingin higher risk, emerging markets if their expe-rience and specialization may not be anappropriate match.

• What are the criteria for long- and short-security selection? What is the process forgenerating investment ideas, or the selectionand implementation of trades?

• How does the manager approach investmentresearch? How are potential positions identi-fied or screened? Are quantitative models orsoftware used? To what degree does the man-ager use primary research or consultants, andhow rigorous does this effort appear to be?What is unique about this approach toresearch? What capacity does the managerhave to generate, consistently, a truly originalinvestment thesis?

• Which indices or group of peer investmentmanagers may be most appropriate to under-stand the market dynamics relevant to thestrategy? Are there certain indices or strate-gies that might be ideal for benchmarkingpurposes?

• What are the security valuation methodolo-gies that are important to a manager? Doesthe manager employ a bottom-up or top-down stock selection approach? Do the ana-lysts create their own financial models? Howdoes the manager develop research ideas inconcert with less experienced analysts? Or,more broadly, how does the manager lever-age the capabilities of all investment profes-sionals involved in the research process?

Carefully review current and historical invest-ment examples. Ensure that these examplesrepresent a broad mix of investment outcomes(e.g., unfavorable as well as good).

Try to make sure that you are being present-ed with more than just a select number ofhighly polished and carefully vetted invest-ment examples.

Do the examples tie in with your under-standing of the manager’s investment philos-ophy and investment edge?

What professional mistakes have beeninstructive for the portfolio manager? Areany lessons reflected in current investmentpractices?

It is important to understand these examplesin the context of any important risk-manage-ment discipline (e.g., position sizing, industryexposure limit, sell discipline) that have beenpreviously articulated.

B. Portfolio Construction and Risk

Management

• Try to understand how the manager’s overallinvestment philosophy influences his

I. Strategy, Investment Process, and Market Opportunity (cont.)

approach to smaller day-to-day rules andguidelines regarding portfolio constructionand risk management.

• Review the range of gross and net exposurethe portfolio manager has employed, or mayemploy, in the management of the fund.What are the current position and exposureranges for the fund? What have been the his-torical limitations and minimums in terms ofposition sizes and exposures?

Has the manager ever exceeded these lim-its? If so, in what context did this occur?Are limitations noted in the offering mem-orandum?

Seek to understand the way in which themanager will likely deploy capital on boththe long and short sides of the book in favor-able or unfavorable market environmentsfor the strategy.

• What is the typical number of positions inthe portfolio?

How many of the positions are really mate-rial to the portfolio? Is the number of posi-tions realistically manageable? In otherwords, can the manager and his team reallyknow the positions well?

• What is the typical minimum and maximumlong and short position size at cost and uponappreciation?

Develop a solid understanding of the wayin which the manager approaches positionconcentration for both longs and shorts.How large has the manager let a positionget (long and short) and in what context?Was this discipline always applied or was it

adjusted in practice?

Try to understand the degree of risk createdby position concentration, especially in lessliquid markets; alternately, try to understandthe weakening effect of an over-diversifiedportfolio — as well as the risk of not knowingthe portfolio. Do you sense that the numberof positions in the portfolio is a function ofthe fund’s (possibly larger) asset size and lessdriven by a risk-management discipline?

• What, if any, is the fund’s limit to sector concentration?

To what degree does the manager seem toappreciate the risks posed by excessiveindustry or market capitalization concentra-tion? Does the manager demonstrate anappreciation for the risk posed by style,beta, or market cap mismatches potentiallyembedded in a given investment portfolio?

• What kind of geographic exposure does thefund’s strategy have? What is the fund’sexposure to emerging markets?

Pay attention to liquidity risks implicit incertain approaches or strategies.

• What is the range of market cap exposure,particularly to small and micro cap securi-ties? What is the manager’s definition ofsmall cap (or, the market cap segments forinvestment)?

Be careful to scrutinize the liquidity riskimplicit in smaller capitalization strategies.Try to assess the additional impact of othervariables on liquidity such as position con-centration, asset growth, investor concentra-tion, redemption terms, etc.



• Is leverage used in the portfolio? To whatdegree will leverage be employed in theportfolio and in what context? What par-ticular environments or circumstanceswould prompt a reduction in the use ofleverage? An increase?

• Does the manager manage beta exposure?Gauge whether a manager is sufficiently sensitive to potential beta mismatches instrategies where it is commonly found (i.e.,long small cap value will tend to be shorthigher beta small cap growth).

C. Trading

• Who makes trading and execution decisions?Who informs a backup vote?

• Is there a separation between portfolio man-ager and trader? Who reviews and overseestrades? Does the trader only execute trades,or does he have some portfolio managementauthority over a prescribed carve-out of cap-ital? How does the fund avoid the problemsthat can arise from having several individualswith trading authority?

• How and why are positions sold? Howimportant are catalysts?

• Are there different types of positions such ascore and trading positions?

• Are there systematic or quantitative ele-ments to the strategy? If so, what are theyand how were they developed? When is themanager’s judgment sufficient to overridesuch a systematic or quantitatively driveninvestment discipline?

• What is the average holding period? What isthe annual average turnover of the fund?

• Is there a stop-loss policy? How is it executed?

Strict stop-loss procedures are more impor-tant for some strategies than for others. Forexample, in more trading- and arbitrage-ori-ented strategies, strict stop-loss proceduresare vital due to the amount of leverage andposition concentration that is sometimesemployed. With many equity-oriented strate-gies and distressed managers, stop-loss disci-plines are typically explained with a greaterdegree of ambiguity. The sell discipline isunderstood to be more art than science.

Understand the portfolio manager’s tolerancefor losses. What is the manager willing tolose in a position before cutting it back, or inthe portfolio before reducing total leverage?Getting married to a position or a story isone of the most common reasons for incur-ring a substantial portfolio loss.

Understanding the risks a manager is willingto take if he is meaningfully profitable orunprofitable for the year is extremely useful.More trading-oriented managers and strate-gies will tend to press their bets when theyare up and invest more conservatively whenthey are down.

• What specific shorting experiences do themanager and traders have? Is shorting usedto hedge or to generate alpha? If shorting ismeant to generate alpha, has it actually doneso in practice? Will the manager employ anyother shorting or hedging strategies? Whatrange of instruments will be used to short orhedge (e.g., derivatives, ETFs)? How costlyhas the use of hedging instruments been and,more pointedly, how has the employment ofthese instruments or strategies added value?



• How is new capital deployed? Is there atrade allocation policy among differentfunds and managed accounts? What is thepolicy for hot issues and nonparticipatoryshares? Is there a process of liquidation tomeet redemptions? What is it?

D. Market Opportunity

• What is the breadth of the investment uni-verse that the manager’s strategy will target?How diverse or liquid are the public compa-nies, sectors, or regions that are targeted forthe strategy?

As a guide for the appropriate size of thefund, consider the asset size of other suc-cessful funds that employ the same strategy.What is the range of asset bases? Does themanager propose to cap the fund’s assets ata similar level?

• What conditions are favorable to the strate-gy? What are the current conditions for thestrategy?

How much money is currently flowing intothe strategy? Is the strategy congested? Isthere any reason to suspect that it is poisedto suffer from diminished returns going for-ward?

• To what degree can the strategy be under-stood to have cycles?

Where is the cycle today? Beware of con-spicuous outperformance when the strategyis concluding the most buoyant segment ofan investment cycle.

• What market factors or combinations of fac-tors may be particularly challenging for the

strategy? Are there certain points in an invest-ment or economic cycle that would pose par-ticular challenges for a successful execution ofthe strategy? Does the manager have experi-ence navigating through such environmentsin his current strategy incarnation?

• What kind of external shocks is the strategymost vulnerable to?

• Is the strategy long or short volatility?

• Does the fund accept leveraged equity (i.e.,accept capital from leveraged fund of funds orfrom individuals who are employing leveragedirectly to their personal investment)?

Be careful if a portfolio manager seemsblithe about any implied risks to the stabili-ty of his capital base.



“Greater separa-

tion of duties can enhance

the long-term vitality of a

hedge fund. It can also

help reassure investors

that multiple sets of unre-

lated eyes are watching

over the business and

the portfolio.”

Allocators will often focus on investment activi-ty to the exclusion of other aspects of a hedge fundorganization. However, the quality of a firm’shuman capital will contain, perhaps, the strongestclues about its prospects for sustainable success. Insimple terms, an investment with a hedge fundmanager is a bet on a few key individuals and theirteam. Moreover, the success of the organizationrequires both investment and business manage-ment acumen, skills that rarely reside in equal pro-portion in any single investment professional. Toproperly evaluate a hedge fund organization, it isimportant to not only review its personnel, but alsoconsider what depth of professional talent will berequired to execute the investment strategy andmake the organization succeed. The culture of ahedge fund organization reflects its founders (or afew key principals) and it is important to under-stand how those individuals view the organizationthey have started, their approach to building abusiness, and how they view their roles relative toother key professionals at the firm.

A. Key Investment Professionals

• Review the academic training and profession-al background of each of the key investmentprofessionals. Carefully assess the quality ofwork experience of those individuals.

• Is the length and depth of work experienceappropriate? What hedge fund experience dothe principals have?

Does the experience of the principals suggestthey will be successful in the execution oftheir current strategy? Be careful with man-agers who recast or re-invent their skill setbased on market demands.

• Does the manager have any prior perform-ance record that can be shared? Is the per-formance or track record relevant for thestrategy you are trying to evaluate?

• How are investment and business decisionsmade by the firm’s key principals? What isthe structure for investment decision-makingversus operational decision-making and busi-ness management? What kind of input doother investment professionals and seniorback office professionals have in their respec-tive areas of responsibility?

• What were the circumstances that causedthem to leave their previous positions? Arethere any non-compete or legal issues fromprevious positions?

If relevant, is a former employer investing intheir current fund? If not, why not? Keep inmind there are circumstances where aninvestment by a previous employer may notbe appropriate or even desirable.

• How are investment professionals compen-sated? To the degree possible, review com-pensation for all investment professionals.

Try to understand whether the proper incen-tive structure exists for both principals andemployees to pursue investment success in aproductive way that meshes with your com-mon investment objectives.

• Does one of the key principals have CFO,operational, or investor relations experience?

An experienced COO or CFO can reduce sig-nificant business distractions and allow forthe fund manager’s enhanced focus on prof-itable investments.

• Has the team worked together in the past?Do the skills of the investment team appearto complement one another? Is there a skillset or role that is obviously missing?


II. Team and Organization


II. Team and Organization (cont.)

• Assess the personality and the character ofthe team members with respect to theirintegrity, attitude, work habits, reputation,and expectations for success.

• Are the key investment professionals’ incen-tives aligned with the investors? What aretheir personal capital commitments? Of theentire staff, what percentage of their net worthresides in the management company and inthe fund? Will the portfolio manager commu-nicate a reduction in the level of personalinvestment held in the fund? If so, how?

Alternatively, for more longstanding fundmanagers with very substantial sums investedin the fund, does the current fee structure cre-ate potential disincentives for appropriate risktaking? In other words, are limited partners indanger of paying for a very expensive form ofcash management? Have former alpha gener-ators turned into mere asset gatherers?

• What is the policy for personal tradingaccounts? What is the process to review per-sonal account activity? Who reviews it andhow often?

If trading is permitted, are there any limitsplaced on the amount of time spent and thekinds of instruments traded? What instru-ments are traded separately from fundactivities? Is there a potential for any indi-vidual to front run the fund’s trading orinvestment activity?

• Have any of the fund principals ever beeninvolved in a lawsuit? Do any of the fundprincipals possess an official disciplinaryrecord (pending or past)? Have there everbeen any regulatory infractions, fines, or sus-pensions from any regulatory agency or pro-fessional organization? What are the details?

• What are the provisions for the absence ofthe key man? Who has the ability to fill inon a short-term or long-term basis?

• What happens if the portfolio managerbecomes incapacitated or deceased? Is therea liquidation process for extraordinaryevents? How long would such a liquidationtake? What would the impact of this liquidation be on the portfolio and on themarkets the manager invests in? Is there keyman insurance?

B. Founders and Principals

• Are the founders or principals the keyinvestment professionals? What is their levelof involvement in the firm or fund?

• Have there been gaps in their professionalhistory? Have there been failed funds orother ventures?

Be wary of unexplained gaps in resumes. Inaddition, be wary when failed predecessorfunds are involved. Discover, specifically, whathappened and understand what the managermay have learned from the experience.Although failure can be instructive, multiplefailures or a string of brief professional stintsshould be reviewed with grave concern.

C. Staff

• How many staff members are there? What isthe ratio of back office to investment profes-sionals? Review (or sketch out) an organiza-tional chart.

• How many investment professionals are onstaff? Review their biographies. How long

II. Team and Organization (cont.)

have they been employed by the firm? In theindustry? Has there been a pattern of organi-zational turnover?

A significant number of new staff can requiretime to work effectively together and such aphenomenon can affect the effectiveness of aninvestment organization.

Beware of heavy turnover at either the senioror junior staff levels. Portfolio managers whoseem unable to preside over a stable organi-zation should be evaluated with greaterscrutiny. The ability and commitment to keeptalented professionals and employees whohave been encouraged to develop their skillsshould be evident. An inability to do so maybe a sign of a congenitally poor business orpersonnel manager. It also may reflect anunhealthy ego on the part of the principal.Broadly construed, these circumstances canbreed employee disloyalty, turnover, and pos-sibly elevate key man risk.

• Is the depth of the organization sufficient forthe assets under management? What are thegrowth plans for the fund and the organiza-tion as a whole?

It is better to grow assets into infrastructurethan vice versa.

• Are there any branch offices?

While branch offices for a large researchteam may be beneficial, long distance portfo-lio management has shown a less compellingtrack record of success. Portfolio manage-ment by principals in disparate branchoffices often suffers from poor communica-tion and isolated decision-making, and caneven create the conditions for rogue trading.

• Regardless of the size of an organization, whois responsible for the following functions?— CIO— COO— CFO1

— Research— Trading/Risk Management— IT/Systems/Programming— Operations/Back Office/Audit— Compliance/Legal— Marketing/Investor Relations

• Are these functions separated?

To the degree possible, separation among keyprofessional functions (e.g., COO, CIO,CFO, Marketing, Compliance) is better.Greater separation of duties can enhance thelong-term vitality of a hedge fund organiza-tion. This knowledge can also help reassureinvestors that multiple sets of unrelated eyesare watching over the business and the port-folio.

Try to understand where the range of profes-sional responsibilities naturally lies in what-ever size organization you are attempting toassess. Specifically, try to understand howsmaller organizations concentrate the num-ber of professional responsibilities managedby key individuals. This can represent apotentially significant (and hidden) level ofinvestment risk.

Under-qualified employees in key roles or nepo-tism in the hiring of personnel for key organi-zational roles should be viewed with caution.


1 Among larger hedge fund organizations, a higherstandard for this skill set should probably apply.For, example, do any key professionals possesstreasury or cash management skills? Do any pro-fessionals have experience actively managingasset-liability gaps?

“Beware of funds

that give unduly accom-

modating liquidity terms

to investors when the

underlying assets are not

highly liquid. ”

The evaluation of a fund’s fee structure andterms is essentially an exercise in understand-ing the value proposition of a particular hedgefund investment. Much of this will depend onthe circumstances and environment in whichyou are considering the investment opportuni-ty. Market forces will have a large say in dic-tating what these terms are likely to be, butethical considerations are important to bear inmind too. Ultimately, an investor must deter-mine whether the terms and conditions forthis investment are reasonable and fair.Unreasonable and unfair terms may suggestsomething about the market environment butthey also may convey something importantabout the motives of the fund’s principals aswell.

• What are the management and incentive feesfor the fund that is being evaluated? Howare these fees calculated and accrued?

Are the fees for this fund appropriate givenwhat other similar funds charge?

How often does the fund pay itself fees:annually or quarterly? Does the fund use arolling claw back for its fees?

How does the portfolio manager make useof his management and performance fees?Is the management fee invested in thebusiness?

• Who participates in the carry, and to whatdegree do less senior professionals have theincentive to contribute to the investmentsuccess of the fund? Is this expected tochange over time?

• How many share classes are there for eachfund? If there is more than one class, whatare the various fees and terms for each class?

Are there different fees and terms foronshore and offshore investors?

Does the class structure allow one class toinherit risk from the other? Do cross-liabili-ties exist between the classes or funds? Forexample, does the class with lower leverageassume the risk of the higher leverage class?

Try to appreciate the character of the strate-gy’s liquidity relative to the liquidity of thedifferent share classes, and how much capi-tal resides in each share class. Is the bulk ofthe capital principally invested in one shareclass? What are the implications for the sta-bility of this fund’s capital base?

• What expenses are charged to the fund, inaddition to management and performancefees?

Standard fees usually include items likeadministration, audit, and other profession-al expenses. However, a manager sometimeswill expense the firm’s overhead, includingT&E, rent, salaries, and bonuses to thefund. If this is the case, get an understandingof what the percentage charge to the fundhas been in prior years. Is it in line withindustry standards? Are you willing toaccept this?

• Is the manager incubating new or separatestrategies at the expense of current investors?

Sometimes a large fund will begin to incu-bate start-ups to access emerging talent (andto develop a promising substrategy that canhelp diversify firm capital), or have proxim-ity to a talented individual who could not bepersuaded to become a full-time employee.If this is the case, what is the fund’s arrange-ment with the newly incubated manager


III. Fee Structure and Terms

III. Fee Structure and Terms (cont.)


strategy, and has the larger fund informedinvestors as to how they are compensated?

• Is there a high water mark or hurdle rate?How are they calculated? Is the high watermark reset?

Ask what percentage of assets are under waterand how long they have been under water. Ifthe fund has experienced a drawdown, howmuch performance does the fund have toaccrue to earn performance fees? If this is anunreasonable amount, beware of the built-intemptation for a manager to swing for thefences and risk even more substantial capitallosses.

• What is the liquidity/redemption policy?Lockup? Notice period? Is the liquidity provi-sion for investors consistent with the liquidityof the underlying securities of the fund?

Beware of funds that give unduly accommo-dating liquidity terms to investors when theunderlying assets are not highly liquid. Ask ifany investors have side letters with more forgiving liquidity terms. If so, in a liquiditycrunch, these investors will have an unfairadvantage. Be careful to understand the liquidity profile of your investment relativeto other investors (especially a fund’s largestinvestors).

• If there is an early redemption fee, is it payableto the fund or the management company?

The fee should be payable to the fund, not tothe management company.

• Have there been any prior liquidity suspen-sions? Are there pending changes to theredemption policy?

Many investors begin with the assumptionthat investment risk is the most important issueto assess in considering or monitoring a hedgefund investment. However, many studies of thehedge fund industry underscore the degree towhich operational risk is the source of hedgefund failure or blowups. A firm’s risk manage-ment processes will have important quantitativeand qualitative aspects and this can span thearrangement of IT systems, written procedures,and certain intuitive aspects of the portfoliomanager’s approach to managing his business.The key is to uncover all the rocks and takegreat care in understanding the managementphilosophy that can tie this all together. Globalfinancial markets consistently undergo rapidchange and, therefore, it is important to under-stand the portfolio manager’s commitment toinvesting in risk management and, more gener-ally, to the consistent improvement of his hedgefund organization.

A. Portfolio Risk

• Invite the manager to articulate his risk-management philosophy.

Is the process meticulously thought throughor does it seem more intuitive? Be wary ofportfolio managers who do not seem to havea disciplined risk management process.

• Does the manager have written policies andprocedures that communicate an approachto risk management?

Obtain a copy of any relevant documenta-tion or procedures. Make a detailed reviewthat includes operational, liquidity, andcounterparty risk.

• How does the manager gauge risk? What riskmeasures does the hedge fund manager useinternally? Which are most important to him?

• Which portfolio, market, factor, or security-specific risks are most relevant to consider?Are there particular risks in specific types ofinvestments or trades? How is that managedor hedged? The composition of differentrisks for a fund can vary considerably evenamong apparently similar equity-orientedstrategies. The following list is not meant tobe comprehensive but it may serve as a rudi-mentary point of reference:— Equity market risk— Interest rate risk— Credit risk— Liquidity risk— Volatility risk— Basis risk— Foreign exchange risk— Counterparty risk— Leverage

• Which sensitivity measures are employed forrisk management purposes? Such measure-ments could include, but are not limited by,the following list: — Equity and interest rate delta— Equity and interest rate gamma— Equity and interest rate vega— Theta— Rho— Duration and convexity

• A thoughtful evaluation may uncover thepossibility that particular strategies mayhave risks which are only, perhaps, hinted atin the more generic list of investment andmarket factor risks. For example, some risks


IV. Risk Management

“What condi-

tions would create the

perfect storm, where

portfolio leverage would

pose problems for the

strategy or the portfolio

manager? ”

that are conspicuous for equity long/shortmay include, but are certainly not limited by,the following list:— Position, sector, or industry concentration— Market cap or geographic mismatches

embedded in the portfolio— Style mismatch or beta mismatch

embedded in the portfolio— Directional risk posed by an unusually

aggressive posture (net short or net long)— Liquidity profile of individual holdings

• Is the portfolio stress-tested?

If so, under what conditions? What assump-tions are made? Who reviews the stress tests?How often are they performed? Have theyever been acted upon? Ask for examples.

• Does the fund have an individual who isresponsible for risk management? Whattraining has this individual had? What otherresponsibilities in the firm does this individ-ual have?

• Has the manager ever had a significant draw-down? If so, what were the circumstances?What kind of risk management failure mightthis represent? How might the fund’s invest-ment disciplines been improved under thecircumstances?

B. Operational Risks

• How are the distinct responsibilities for thefund’s front and back office arranged and,ideally, separated?

• Are the operational, back office, and adminis-trative professionals seasoned? What chal-lenges have these professionals encounteredsince the fund’s inception (or at a prior firm)?In general, how do they appear to have adapt-ed to these challenges? With what frequency

have issues or problems been surfacing? Arethere any current operational issues the firm isdealing with? To what degree do you sense thatproblems are being anticipated?

• Follow the money. How does the money flowinto and out of the fund? Where is it kept?Who signs the checks for the company andfund in which you are investing? Is there aco-signer? Is one of these individuals a thirdparty? Do you fully understand the path thatthe money takes? What is the role of inde-pendent third parties?

• Follow the trade. After an investment decisionis made, how is the idea executed? Is the tradeexecuted electronically? Is the process paper-less? What is the frequency of broken trades?

• How consistently has the fund experiencedoperational or back office errors? Is the man-ager content with the service provided by theprime broker(s) and other key back officeservice providers?

How fluent and comfortable does the man-ager seem in discussing the character of thefund’s back-office processes and operationaldiscipline(s)? Does the manager seem dis-tracted or preoccupied with trade reconcilia-tion or broken trades?

To the degree it is relevant for specific invest-ment and trading strategies, try to make sureyou have a sufficient understanding of some ofthe following risks:

— Counterparty risk— Ratings of counterparties— Degree of equity concentrations by

counterparty— Financing liquidity risks— Tenor of financing terms— Sensitivity of income to changes in

financing rates


IV. Risk Management (cont.)

• What precautions has the portfolio managertaken in light of a possible catastrophic fail-ure prompted by a computer, systems, soft-ware, telecommunications, fire, or terroristattack? Is there a disaster recovery plan?

• Are there provisions if a key service provider(e.g., prime broker, administrator) is sud-denly unavailable? Are there provisions forthe loss of the portfolio manager or otherkey investment professionals?

C. Liquidity

• What is the hedge fund manager’s definition ofliquidity? How many days would it take to liq-uidate the portfolio in an orderly fashion?What is the definition of an orderly liquidation?

• How do reduced trading volumes affect theliquidity of the relevant markets or instru-ments? What is the impact on the market ofa typical investment for this strategy?

Who is on the other side of the trades thatthe strategy typically executes? Is there adominant dealer? Is that dealer monopoliz-ing the liquidity in that instrument?

• Do the liquidation terms of the fund makesense or match the liquidity of the fund’sinstruments or marketplace?

Be very wary of funds that provide generousliquidity terms relative to the liquidity of theinstruments and securities trafficked in bythat given strategy.

• Has the manager installed appropriate termsto prevent a run on the bank? Are there “gateprovisions” installed to protect remaininginvestors? How do any “gate provisions”impact your specific interests as an investor?

• What is the percentage of average tradingvolume held in the largest positions?

Has the manager filed 13-D or 13-G formswith the SEC? Do the positions reflected inthe filings make sense for the strategy? Canrestricted or private instruments affect theportfolio’s liquidity profile?

Will a significant redemption alter the port-folio by leaving the most illiquid instrumentswith remaining investors? Be wary of thispossibility, particularly if there are side let-ters and preferred redemption terms forsome investors.

• What is the maximum position size, longand short, with respect to average daily trad-ing volume? Has the manager ever exceededthese parameters?

• To what degree can the manager be under-stood to traffic in heavily shorted securities?How sensitive is the strategy to short squeezes?

• Does a manager intend to hold any privateissues? Will private issues be side pocketed?How are they marked and what is the pro-cedure for marking them?

D. Leverage

• Invite the portfolio manager to discuss hisrationale for employing leverage in theapplication of the strategy.

• How does the hedge fund manager defineleverage? How does the manager defineexcessive leverage?

• What is the typical amount of leverage used?What is the maximum leverage that would beemployed at any time? What is the maximum




(and minimum) amount of leverage that hasbeen used at any particular time in the operat-ing history of the fund? Is the fund ever man-aged without leverage? What factors mightprompt the manager to reduce leverage?

• What conditions would create the perfectstorm, where portfolio leverage would poseproblems for the strategy or the portfoliomanager?

• How many brokers or banks extend leverageto the fund?

• How much of the borrowing terms areovernight terms?

How much are less than 90 days? How muchare greater than 90 days? How has thatchanged over the past 12 months? Do theterms of their assets match their liabilities?Can counterparties change the financinghaircut with less than 90 days notice?

• Has leverage ever been revoked? If so, obtainan explanation.


“Is the management

company more focused on

gathering assets than on

generating performance?

”


V. Management Company, Fund Structure,and Asset Base

An evaluation of the hedge fund’s manage-ment company should be focused on what kindof business it is. A number of basic questionsshould come to the fore: Who owns it and whatindividuals have the biggest interest in its long-term success? Are the principals committed tobuilding a real money management business oris it simply a one-off investment partnership?Are there any conflicts of interest? In the finalanalysis, an investor needs to understand ifthere is a true alignment of incentives betweenthe prospective investor and the portfolio man-ager in regards to their investment objectives.

A. Management Company

• What is the legal entity? What are the detailsof its state or country formation? Where isit domiciled?

Is the country of domicile a well-known oran unknown jurisdiction? Is it a well-respected jurisdiction?

• Are they registered as an InvestmentAdvisor, Commodity Trading Advisor (CTA)or Bank Holding Company? Are they regu-lated under the U.S. Securities and ExchangeCommission (SEC), National Association ofSecurities Dealers (NASD), the NationalFutures Association (NFA), the FinancialServices Authority (FSA), Bank of England,or the Federal Reserve Bank?

Do you fully understand the kind of infor-mation implied by the various mix of regis-trations that may apply to a portfolio man-ager or investment advisor? Use an in-depthreview of these information sources to deep-en your understanding of the investmentprofessionals and the organization as awhole. Anticipate your plan for consistentlyreviewing these affiliations and registrations

for your eventual monitoring regimen as youconsider a prospective investment. Caution:Registration with regulators does not alwaysprovide a seal of approval.

• What is the ownership structure?

Simple is better!

Who are the owners? Certain employee(s) oran institution(s)? Bear in mind that a culturaldifference may be reflected in the ownershipstructure. For example, institutions com-monly own U.K. funds, whereas U.S. fundstend to be employee-owned.

• Does the manager own a significant percent-age of the fund or management company?What percentage of his net worth is investedin the fund or the management company?Does the manager have an upfront policy forhighlighting any material changes to his per-sonal investment in the fund?

• Are there any joint ventures or partnershipsthrough which business is conducted thatmay cause a conflict?

Do they offer a crossover (public and privatesecurities) fund that may either add value toresearch or may create a liquidity problem?

• Do they operate a mutual fund? Do theyhave a long-only separate account business?Take care to understand what conflicts ofinterest may be present and which ones themanager has anticipated.

• In what other partnerships and businessesdo the principals operate or maintain a sig-nificant interest?

Does the management company own a brokerdealer? Is it disclosed? Are trades recapturedby the hedge fund? Does it present any con-flicts or does it add value? Why or why not?

V. Management Company, Fund Structure,and Asset Base (cont.)


Do the principals sit on any boards or havetime-consuming obligations such as privateequity investments?

• Are there any direct relationships with otherhedge funds? For example, does another hedgefund provide seed capital? Is that seed moneyfrom the hedge fund manager’s personal capi-tal or is it provided by his investors?

Seed capital from larger hedge funds can mit-igate start-up risk when they act as a mentorto the new fund. This stands in contrast tobroker-sponsored funds whose mentoringability is limited.

• If the hedge fund has a sponsor relationship,seek to understand the agreement. Does thesponsor have capacity or other specialarrangements?

Does a sponsor dominate a new fund’s capacity?

• Does the sponsor share its infrastructurewith the hedge fund? If so, can the sponsorsee the trades?

Can the sponsor piggyback on these trades?Do they share ideas that can negativelyimpact capacity or trading nimbleness?

• Does a sponsor use its equity in the new fundto drain off profits, thus reducing the incen-tives or the motivation of the entrepreneur?Can the sponsor continue to add valuebeyond the initial investment?

Are there any special arrangements with thesponsor that can create a burden on the newmanager? Is there a sunset provision for thisrelationship? In other words, is the econom-ic relationship designed to diminish overtime? Does the portfolio manager retain theright to buy back the sponsor’s interest?

• What is the history of the hedge fund’s man-agement company and what are the company’sdevelopment plans?

Aggressive asset gathering in one or manyfunds may reveal business priorities that arenot aligned with the interests of mostinvestors. Is the management company morefocused on gathering assets than on generat-ing performance? Again, explore the detailsof the principal’s and the institution’s level ofco-investment and business ownership. Arethe more obvious incentives for obtainingmanagement or incentive fees?

Has the management company recently reor-ganized itself out of a mutual fund structure?Why? If yes, how is its investment strategydifferent?

• Who is on the Board of Directors? Whatauthority does the board have, if any?

Do not overestimate the influence of a Boardof Directors. Currently, they are hired by thehedge fund manager and have little independ-ence. Many boards are transparently estab-lished for marketing and public relations during an initial capital-raising phase.

B. Fund Structure

• What funds are offered by the managementcompany? How are they structured? Forexample, is it a master-feeder structure?

Does the offshore fund run pari passu withthe domestic fund? If not, why?

Understand the allocation process betweenfunds if they are not organized as a master-feeder structure.

• Is there more than one strategy? If so, isthere synergy in the application of the vari-ous strategies?

Ideally, you should want the key profession-als’ investment and business success to befocused on the fund in which you are invest-ed. You want them to have a substantial per-sonal investment in the same fund in whichyour capital is invested.

C. Asset Base

• What are the total assets under management ofeach fund and of the management company?What is the historical growth in assets undermanagement for each vehicle and in aggregate?

• Are the assets under management appropri-ate for the strategy? What is the anticipatedgrowth in assets and does this appear to bemeasured/disciplined? Are the strategy andinvestment processes scalable as assets undermanagement grow?

Are there capacity constraints?

Is the manager realistic in determining thecapacity? Is the manager creating a falsesense of urgency? Is the manager manufac-turing hype to raise money by setting a softclose? Will growing the assets beyond a cer-tain point result in style drift?

This may be a good time for you to under-stand the composition and stability of themanager’s investor base. It may also be anopportune time to discuss your potentialfuture capacity needs to determine if themanager will be able to meet them.

• Have there been periods of substantialredemptions? If so, is there a reasonableexplanation? Were redemptions met without

delay, a gate, or interruptions? Was perform-ance negatively affected by the redemptions?

• What has been the rate of asset inflows?

Does the fund have a disciplined policy fortaking money in? Have the principals estab-lished any limits on inflows? Does the port-folio manager have control over inflows?

• Are there separately managed accounts? Arethese accounts subject to special arrange-ments like structured notes? What percent-age of assets is managed separately from thefund? How are the separate accounts struc-tured? Are the liquidity terms of the funddifferent from the separate accounts?

Undue administrative and business compli-cations are always the enemy. Less compli-cated business and decision-making struc-tures generally allow for better professionalfocus and tighter alignment of incentivesbetween the manager and the investors’interests.

• What is the composition of the investor base?

Is it diversified or is there concentration amonga few outsized investors? Is it concentrated inone category of investor? For example, howbig is each of the three largest investors?

Try to understand the relative stability andsophistication of the marginal fund investor.Also, pay attention to the mix of offshoreand onshore investors, and the manager’s (ororganization’s) level of direct familiaritywith those investors.

• Is there a “Most Favored Nation” clause? If not, get an explanation of any differentterms offered to other investors such as betterliquidity, fees, transparency, etc.


V. Management Company, Fund Structureand Asset Base (cont.)

Allocators who are less familiar with hedgefund strategies but skilled in various aspects ofquantitative analysis often court problems whenthey emphasize quantitative analysis overimportant qualitative dimensions of the process.As Pensions & Investments noted, “Most [allo-cators] do not know how to evaluate hedge fundstrategies and, thus, tend to rely upon statisticaltools that give a totally inaccurate picture of theriskiness of a given manager.” (P&I 4/30/01).Many experienced hedge fund investors appearto view quantitative analysis as a valuable complement, rather than a substitute, for morequalitatively drawn judgments. Deployed intelli-gently, certain quantitative disciplines can helpconfirm the wisdom of more qualitativelydrawn judgments and assist in highlightingaspects of the investment strategy that warrantfurther investigation.

• Review monthly performance of the hedgefund since its inception and confirm the own-ership of the record. Consider prior trackrecords for key principals if the degree of own-ership is material and can be accounted for.

• What are the return goals for the fund? Hasthe performance objective been consistentlyachieved?

• Is performance consistent with your, theprospective investor’s, expectations?

• Compare monthly, quarterly, and annualtrack records to appropriate peer groups andmarket indices. How does performance com-pare with that of similar funds and strategies?

• What are the volatility parameters for thefund? Does the fund’s recorded standarddeviation fall in line with what the portfoliomanager has suggested in interviews and inmarketing documents, or the prospectus?

Is the fund’s volatility outside of its expectedparameters or beyond the volatility you wouldreasonably expect of other similar strategies?

• Is the track record audited?

• Is the track record pro forma?

Be wary of pro forma track record. Mostinvestors do not consider the evaluation ofpro forma track records to carry much ana-lytical value. It is important to understandthe methodologies used to construct the pro-forma track record and the limitations ofthose methodologies.

• Consider how assets under management mayhave changed over the life of the trackrecord. Gather data on the assets by fund,strategy, and for the firm in aggregate.

Has an increase in assets appeared to affectperformance?

Has the track record been achieved with a tinyamount of assets? If so, was the manager ableto use smaller capitalization instruments thatthe fund may be too large to take advantage ofnow? In general, is the process that generatedthe present track record repeatable?

Are separate accounts included in the trackrecord? If not, are they attempting to disguisethe true amount of assets under managementin the strategy? Be aware that separateaccounts can hide a fund’s true measure ofcapacity and continued growth.

• What percentage of the track record is attrib-utable to the current team managing the hedgefund? Are the individuals who created thetrack record still there and are they still asactively involved in the investment process?


VI. Quantitative Review

“Quantitative

analysis can help shed new

light on the character of a

strategy but should be

evaluated in the context

of all other research,

including qualitatively

drawn judgments. ”

• Determine who is the owner of the fund’strack record. Understand who was responsi-ble in precise terms. Understand who hadauthority for investment decision-making.

Seek to understand the nature of a newhedge fund manager’s set of responsibilitiesat his previous employer. Does the managerhave actual portfolio management experi-ence? Portfolio management requires a verydifferent skill set than that of picking stocks.

• Have there been any changes to the strategyover the life of the track record that shouldcause the record to be reviewed in segments?Examples of this may include a new hedgingdiscipline or a marked increase or decreasein gross exposure.

New funds often require time to ramp upexposure.

If some key investment disciplines are beingapplied differently due to adjustments or les-sons learned, be certain to segment the per-formance history accordingly.

• Review the correlation of the hedge fund’strack record to relevant market indices and,to the degree it is appropriate, the portfoliofor which inclusion is being considered.Review correlations over different andrevealing intervals of time such as periods ofmarket dislocation. Understand the fund’scorrelations in the context of its strategy, itschosen exposures, and its performance duringnotably difficult market environments.

Use correlation analysis as a tool to enhanceyour understanding of the fund strategy butbeware of its obvious limitations. In particu-lar, correlations can be relatively unstable

and may change dramatically in differentmarket environments. Quantitative analysiscan help shed new light on the character ofa strategy but should be evaluated in thecontext of all other research, including qual-itatively drawn judgments. Correlationanalysis is most helpful as a complement torigorous qualitative assessments.

• Review all drawdowns from peak to trough.How quickly did the fund recover? Whatare the longest monthly positive streak andthe longest monthly negative streak?

What kinds of drawdowns are acceptable tothe manager? Ask the manager what kind ofdrawdown should prompt a call from theinvestor.

As an investor, what is the maximum draw-down you would expect from this manager?

• What is the biggest positive and negativemonth?

Do these outlier months make sense in thecontext of your expectations for the fund’sperformance and its supposed risk manage-ment disciplines?

• Understand drawdowns and large upswingsin the context of the market environment inwhich the fund has operated. Is the fund’sperformance too dependent on a lucky callor two? Is good performance the result of asingle outsized bet that worked and isunlikely to be repeatable? Has the basicportfolio posture (and the returns the strate-gy has generated) simply been the benefici-ary of a market environment for which it isperfectly suited?


VI. Quantitative Review (cont.)

VI. Quantitative Review (cont.)

• Gather returns data on a detailed attributionbasis by longs and shorts, sectors, differentinstruments, substrategy, or market capital-ization. Review your understanding of thefund’s return drivers and contrast this withyour study of the fund’s actual sources ofreturn in practice.

Does the attribution analysis confirm yourunderstanding of where the manager mademoney? Is there a surprisingly strong orweak performance in certain segments ofthe portfolio?

What does the attribution analysis suggestabout the manager’s true level of stock pick-ing or portfolio management skill?

Is the manager a proven talent in selling shortor in deploying portfolio hedging strategiesand how can you tell?

• Obtain, if it is permitted, a few historicalportfolios, using dates chosen by the evalua-tor for review prior to an investment.

These portfolios should be obtained directlyfrom the prime broker rather than the hedgefund manager to ensure data integrity andindependence. This test should demonstratethe manager’s consistency in the application ofthe strategy over time, as well as the portfoliomanager’s adherence to stated risk disciplines.

• Is the fund managed with a degree of tax sen-sitivity in mind? What percentage of returnsis realized and unrealized?

Bearing in mind that the offshore investor isindifferent to tax consequences, are theonshore and offshore funds being managedin a substantially different way? Are differ-ences in the application of the onshore andoffshore strategies a source of distraction?


“Is there a commit-

ment to maintaining a

dialogue of substance and

quality? ”

An earlier section emphasizes the importanceof understanding the operational sources ofhedge fund investment risk. However, the issueof information disclosure and transparency areof critical relevance in understanding and mon-itoring these types of risks. That said, there is abig difference between portfolio transparencyand translucency. The former implies a moresubstantially active role on the part of the man-ager in identifying and clarifying key risks forhis investors. The latter implies a simple com-mitment to provide a clear view of portfolioholdings and may not be very helpful in inform-ing the investor. Ultimately, the key issue is thedegree of trust and comfort you have in yourrelationship with the portfolio manager(s) andwhether you believe you have the latitude tostay on top of the risks that matter. The bestinsurance policy for this is an investor’s convic-tion about the integrity of the person withwhom he is investing.

• What are the backup procedures for the hedgefund’s operations? Is offsite trading readilyavailable? Are there frequent backups oftrade, client accounts, and research data?

• What transparency is provided to theinvestor? Does anyone have special trans-parency agreements or side letters?

• Would the manager allow the prime brokerto provide a monthly or quarterly portfoliofor the investor’s review?

This procedure can significantly reduce thepotential for manager fraud, as well as givethe investor insight as to how the managerinvests, and whether the manager adheres tohis disciplines.

• How does the manager communicate toinvestors? How often?

Does the manager’s Letter to Investorsreveal what is really going on in the portfo-lio? Is there a commitment to maintaining adialogue of substance and quality?

• Are manager’s meetings with investors dis-couraged? Why?

• Are those responsible for investor relationssufficiently experienced and informed enoughto provide an in-depth and useful dialogue?

• Has the hedge fund manager ever delayed hisestimates of the fund’s net asset value? Why?Is the delay out of the manager’s control?

• How frequently are performance estimatesavailable to investors? Are mid-month orweekly estimates available?

• What information is available to investorson a monthly, quarterly, and annual basis?The following list represents ongoing infor-mation that should be considered funda-mental for educated investors:— Size of fund and growth of assets under

management— Net and gross performance by share class— Top 10 holdings and position weightings

(Many funds will not reveal currentshort positions, but should agree tocharacterize the positions.)

— Participation by sector, market cap, geographic region, or asset class

— Net and gross exposure information— Factor and risk exposure information— Information regarding any changes in

the firm, fund strategy, and personnel

• Is there appropriate disclosure of the charac-ter of the fund’s overall balance sheet or thedegree to which certain asset/liability gapsmay be present? Is the notional value ofderivatives disclosed?


VII. Operations and Transparency

Most hedge fund managers depend on arange of third-party service providers to helpmanage their business and investment activities.Evaluating the quality of the third-party ven-dors, as well as understanding the intersectionof in-house and third-party business manage-ment, is critical to understanding how disci-plined the hedge fund business and investmentprocesses truly are. The perspective of the third-party providers can also provide important illu-mination on the hedge fund manager’s skill as amanager of a business. Generally, third-partyvendors can bring additional efficiencies to themanagement of a hedge fund business, but theengagement of these services also involves ced-ing control of certain business and investmentactivities. How a manager chooses to balancethe cost and benefits of such arrangements is animportant area of focus for a prospective hedgefund investor.

A. Auditor

Contact the auditor. Cultivate a relationshipand speak with the account leader.

• When was the last audit? How often are thebooks audited?

Has the auditor ever been changed? Why?Carefully scrutinize turnover in key vendorrelationships but especially with the primebroker and auditor. If fraud is occurring,these vendors will likely know before you do,and many firms have shown a willingness toshun business they think will eventuallybring them trouble.

• Where did the audits take place? How wasinformation collected?

• Is there also an outside accountant?

• Have there ever been any valuation issuesthat have arisen during an audit? Are thereany other issues?

Ever since the episode of fraud at ManhattanCapital where the auditor failed to identifythe fraud, auditors are reluctant to releaseany details to investors. They usually referthe investor to the annual audited financialstatements. This is why it is essential that aninvestor read through the audited financialstatements as far back as they are available.

• Ask for the financial statements to comedirectly from the auditor. Review them indetail, paying particular attention to theAuditor’s Notes, the Financial Statement, andthe Auditor’s Report or Statement. Go back tothe auditor directly to clarify anything in thesesections or for the statements in general.

Compare year-end assets, subscriptions,redemptions, (i.e. cash flows), and NAV toyour notes with the manager.

Review expenses. Do they seem in line withthose of the fund’s peers? In percentageterms, have the expenses changed materiallyfrom year to year?

B. Prime Broker

Contact the prime broker. Cultivate a relation-ship with the prime broker and speak with theaccount leader.

• Does the fund use multiple prime brokers?Who are they?

Has the fund manager ever changed primebrokers? Why?

Understand that the prime broker standsahead of the investor in the fund’s capital


VIII.Third Parties

“It is essential that

an investor read through

the audited financial state-

ments as far back as they

are available.”

structure. Understand that the prime brokercan liquidate the fund to take its capital first,leaving what is left for the investor.However, they also have an incentive toshun relationships that might create liability,and many firms have demonstrated a recordof doing so.

• Who are the counterparties? Who is the cus-todian?

For many strategies, it is very importantthat there be a prudently diversified groupof counterparties to the fund. This helpsto insulate the fund’s operations frommarket dislocations that could affect acounterparty’s ability to serve its contrac-tual responsibilities.

• What are the credit ratings of any counter-parties to the fund?

Ideally, the disposition of the fund’s assetsshould reflect proportionally the differentratings of its counterparties.

• Does the fund get contractual settlementsfrom their prime brokers?

• Has the fund been assessed fees by theirprime brokers for operational errors?

• Obtain permission from the portfolio man-ager so that you are able to contact theprime broker directly to confirm the fund’sassets under management before formallyinvesting in the fund.

C. Administrator

Contact the administrator. Establish a relation-ship and speak with the account leader.

• Are they a respected, well-known adminis-trator?

• Do they have a full-service agreement or justa record-keeping agreement?

• How often is NAV calculated? When caninvestors expect to receive estimates andfinal NAVs?

• By what means and how often does theadministrator receive the trades? Do they gettrades from the manager or from a directfeed provided by the prime broker?

Position and trading information must comefrom an independent source, and not themanager.

• How do they receive pricing? Do theyreceive it directly from a market data ven-dor, from a third-party pricing agency, orfrom the manager?

The administrator should price a portfolioindependently from the manager.

Some illiquid securities may be difficult toindependently price. In those situations, theadministrator should have written policieson valuation.

If the manager does not price the entireportfolio, what percentage does he price?Be very diligent in understanding a manager’sinfluence on the portfolio valuation.

• In the case of less liquid securities, do theyset the price with quotes from more than onesource?

• Has there been any restatement of month-


VIII.Third Parties (cont.)

VIII.Third Parties (cont.)

end NAV? When? How often has thisoccurred?

• Through the administrator, develop anunderstanding of the pattern of recentredemptions and subscriptions. Compare thisinformation to what has been discussed withthe hedge fund manager.

• Ask the administrator for NAVs since incep-tion. Compare this to performance numbersgiven by the hedge fund manager.

D. Marketing Relationships

• Is there an external or outsourced marketingrelationship?

What kind of an agreement exists betweenthe fund and the marketing agent? Is it anexclusive agreement? Are there multiple mar-keting agents?

• Where do the fees payable to the marketercome from?

Investors who come in to a fund through amarketer or placement agent should not bedisadvantaged in any way, and should notpay higher fees or expenses.

• Does the agent add value or communicatewith the investor after the initial introduc-tion? Is there a sunset provision for itsinvolvement?

• What is the reputation of the marketingagent?

Good agents are concerned with fund due dili-gence, determining investor suitability, andmanaging appropriate expectations. Someagents are more focused on rapid asset gather-

ing rather than creating a stable base of long-term investors. Agents can often have a crudeincentive to encourage a manager to raise morecapital and raise it more abruptly than mightbe prudent.

Does the agent clear trades for the fund? Thismay create a conflict of interest.

Remember that introductions by reputablebrokers do not constitute an endorsement.Moreover, prospective investors mustunderstand that prime broker-sponsoredmarketing introductions, for example, donot include due diligence.

• Is the agent registered with the National Association of Securities Dealers(NASD) (http://www.nasd.com), or theFinancial Services Authority (FSA)(http://www.fsa.gov.uk/) in London?

E. Other

Try to understand the marginal benefit of addi-tional third-party providers versus the addedcomplication of additional vendor relationships.Also, attempt to understand what services maybe better handled in-house.

• What other functions are outsourced by themanagement company? — Trading— Front/Back office— Accounting— Research consultants— Risk management— Operational consultants


“Finally, and most

importantly, would you

invest your own money or

your family’s money with

this manager? ”

No amount of due diligence can completelyreplace the importance of experience and intu-ition when investing with a hedge fund manager.Some of the following questions are suggestedas a simple means of checking your gut beforeformulating a final investment decision.

• Do you feel comfortable with your level ofunderstanding of the strategy and risks thatattend to the investment? Can you explain itwell to others? Investors and allocatorsshould stick to the rule that they only investin what they understand and where they canproperly assess the risks.

• Can you trust this manager? Does he have anypersonal or emotional issues? Are there hintsof issues with integrity, ego, arrogance, pride,“affluenza,” complacency, carelessness, exces-sive optimism, or any personal difficulties?

• Do you feel pressured to make an invest-ment? Is this a “hot” manager? Is the fundclosing quickly? Have you been given

enough time to properly perform your duediligence? Does the manager appreciate yourfiduciary obligation to do complete andproper due diligence? Were you expecting tofill in the blanks later?

• Do you believe the manager is truly commit-ted to the fund and the interests of the limitedpartners?

• Fundamentally, is the manager staying trueto his core investment philosophy and doingwhat he said he would be doing?

• Finally, and most importantly, would youinvest your own money or your family’smoney with this manager? If you cannotconfidently answer yes, you should notinvest with this manager personally, or onbehalf of your client.


IX. Intuition, Judgment, and Experience

X. Documents

A critical first step before undertaking time-intensive due diligence is to obtain and evaluatethe full range of available marketing materials,legal documentation, and audit information.

• Offering Memorandum and SubscriptionAgreement

Take note of the quality of the prospectus.Does it include the appropriate biographiesof the management team? Is it written inclear understandable language? Is there aclear statement of the fund’s strategy andinvestment process? Are the risks disclosedand clearly explained?

• Audited Financial Statements

If possible, try to evaluate statements goingback three years. Audited financial state-ments should be closely investigated in thecontext of manager interviews regardingexpenses, transparency, and legitimateadministrative expenses.

Pay particularly close attention to a changein auditor because here such changes mayvery well entail a vendor seeking to avoid lia-bility associated with fraudulent practices.

• Marketing Materials

Qualitative review of the marketing materialsand the manager’s own correspondenceshould help delineate particular nuances ofthe strategy that is being executed, as well asthe philosophy that animates the approach.— Marketing materials— Annual Reports to investors (three years)— Monthly/Quarterly Reports to investors

• Due Diligence Questionnaire

RFPs — might be seen as akin to Wall Streetresearch. A due diligence questionnaire canbe a nice way to fill in any gaps in the storybut it is not a substitute for doing your ownhomework on the fund, strategy, principals,and the organization as a whole.

• Investment and key personnel biographies

• Organizational chart of the hedge fund’smanagement company and the hedge fund’sinvestment team

Review the biographies of each of the keyinvestment and back office professionals tounderstand the strengths and weaknesses ofthe organization. Try to conceptually link theprecise skill sets the key professionals possessand the ideal requirements for an organiza-tion trying to execute that strategy.

• List of references that should be contacted bythe evaluator

To the degree possible, the evaluator shouldseek to complement formally offered refer-ences with supplemental industry referencesgenerated through their own network ofinvestment industry contacts.

Careful interviewing of current (and especiallypast) vendors, and third-party service providersshould also help.

A background check on the manager, keyemployees, and the firm is desirable. This canbe outsourced to an investigative firm. Theadded expense of a full background checkcan help add a level of fiduciary comfort but isunlikely to convey much color on key intangi-ble areas such as motivation, work habits, andmanagerial/operational expertise.


“Take note of the

quality of the prospectus.

Does it include the appro-

priate biographies of the

management team? Is it

written in clear understand-

able language? Is there a

clear statement of the

fund’s strategy and invest-

ment process? Are the risks

disclosed and clearly

explained?”

• Historical portfolios: the dates chosen by theevaluator

Try to understand if past portfolio holdingsmesh with your understanding of the invest-ment strategy and risk management disci-plines you have read about in the prospectusand have come to understand in the inter-view process.

• Prime brokerage agreements and otherfinancing agreements

Independent confirmation of the fund orfirm’s assets via the prime broker is oftenconsidered an important final step before aformal investment is made.


X. Documents (cont.)

Robert M. AaronDPM Mellon


Mark DaltonTudor Investment Group

Dennis KeeganAuspex Group

Kevin R. MirabileSaw Mill Management andResearch

Donald H. PutnamGrail Partners LLC

Robert W. StoneNew York Life Investment Management LLC

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