Lou Sala, chief executive of the Capital Markets practice at WTP Advisors, says that in the wake of the Madoff scandal, due diligence processes that were once little more than box-ticking exercises have become a searching and in some respects painful examination for hedge fund managers.
First, my apologies to those who saw the headline and thought that this would be a scintillating discussion piece detailing my insight into the hot hedge fund strategies and the harnessing of alpha. It’s not. What I am presenting here is a view of the other side of investing – the unglamorous, roll-up-your-sleeves world of running the business and mitigating the inherent associated risks.
To provide you with a sense of where my expertise lies, one could look upon the monikers I have earned through the years: plumber, mechanic, Maytag Repairman and, for you Pulp Fiction aficionados, my personal favourite, Winston Wolf. Yet it is in precisely this type of work that hedge funds must concentrate if they are to thrive in 2012 and beyond.
Historically, the notion of institutionalising hedge funds was one of the objectives targeted by fund managers year in and year out. However, this effort always fell to the back burner from an infrastructure standpoint as resources and efforts were directed toward investing and performance.
To be fair, most portfolio managers held that they had been selected for their investment prowess and were mandated to assure investor’s assets were being actively managed. Their view of the middle office, back office and general administration was that of a necessary evil, and they concentrated upon meeting the minimum requirements and minimising costs.
Please keep in mind that managers are often sourced from large institutions where the support side of the business is anonymous and looked upon solely as an allocated cost through the accounting department. Clearly, many did not see infrastructure as adding value. In 2008, Bernard Madoff sounded the alarm bells and changed the game. Now the question became: “Who is minding the store?”
Investors’ reaction to Madoff forcibly pushed fund managers to assess their internal control environments and ensure that proper oversight was deployed upon every aspect of the business. Investors now expend considerable time, effort and resources evaluating the fund manager’s ability to manage the business aspects of the fund.
Operational due diligence performed on funds is much deeper and is heavily weighted in the asset allocation decision-making process. Many seasoned hedge fund managers say they have witnessed this shift in the due diligence process. Greater attention is placed upon the manager’s ability to explain and support their operational, accounting, risk and compliance procedures.
In addition, there is enhanced emphasis on human resources, specifically staff selection, personal backgrounds, experience, turnover and compensation. It’s apparent that the process can be onerous, if not downright painful. A vivid quote I have heard on several occasions from fund managers is that the due diligence process is “like getting a colonoscopy”.
The primary document on which hedge fund managers must focus is the due diligence questionnaire. The Alternative Investment Management Association provides a template frequently used as the starting point for managers, providing an exhaustive list of questions that can guide a fund manager through the operational due diligence process and establish the backbone of their DDQ.
It is imperative that the questionnaire accurately summarises all the vital information regarding the fund, as this document serves as the foundation for operational due diligence, and can influence initial make or break investment decisions.
Prospective investors will use the DDQ to seek comfort with the internal control environment, segregation of duties, business continuity planning, disaster recovery, compliance procedures, service provider selection, organizational structure, etc. – areas that are not inherently intuitive to a portfolio manager (says one: “It’s not in my DNA.”).
When preparing the DDQ, attention to detail is essential. Responses included in the questionnaire should be cross-referenced to all other published documents, such as marketing pitch books and offering memorandums, to ensure consistency.
Successful managers must be able to navigate the operational due diligence process. Before the Madoff scandal broke, these reviews were topical and more driven by checklists, ensuring the hedge funds passed ‘checking the box’. That is not the case today. On-site operational due diligence reviews consist of deep dives into the infrastructure and can take a full day or extend to a series of visits.
Fund managers must be able to support their processes by producing required documentation such as operations and compliance manuals. It is essential that the fund manager prove, beyond a shadow of a doubt, that the fund operates as a fully functioning business and that checks and balances are maintained throughout the investment process.
Fund performance continues to be, and will always be, the key factor in whether hedge funds can garner attention and prospective investors. However, the differentiating factor in today’s climate will be how well a fund can mind the store. In other words, the most successful hedge funds this year will be the ones who focus on the business of running a business.
Now let’s talk about MF Global…