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Research reveals transformation in investor evaluation of hedge funds

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A study by Deutsche Bank has revealed a fundamental shift in the depth and nature of due diligence carried out by hedge fund investors.

The poll of senior professionals at leading fund of funds and consultants in Europe, representing over USD411bn in hedge funds assets under management, shows operational due diligence teams are now viewed as a partner and peer to the investment team and actively vetoing investments.

The level of sophistication institutional investors apply to operational due diligence has increased significantly as they demand greater transparency from managers. The research reveals a robust infrastructure, established service providers and a culture of compliance and governance are now vital considerations in the investment process.

The role of operational due diligence teams has grown since the onset of the financial crisis, with 73 per cent of fund of funds and 80 per cent of consultants having operational due diligence teams that operate separately from the investment due diligence process.

The survey reveals how the financial crisis and subsequent hedge fund losses have driven wide-ranging changes in the way investors evaluate hedge funds, and the emphasis now placed on rigorous controls across the front to back office.

Reasons operational due diligence teams have vetoed investments in the past 18 to 24 months include:

– Lack of independent oversight – such as self-administered and self-custodied funds, using an unknown audit firm or a board with no independent directors.
– Unwillingness to provide transparency – investors will assess strategy, disclosures made to other investors and track record, and expect access to sample portfolios to perform detailed risk analysis and identify style drift.
– Valuation issues – including weak or unclear valuation policies, lack of administrator pricing expertise, or absence of CFO sign-off on a portfolio manager’s pricing of illiquid instruments.
– Insufficient investment of personal wealth – investors understand compensation structures and expect a significant proportion of a founder’s liquid capital to be invested in the fund to align interests to their own.

Daniel Caplan, European head of global prime finance at Deutsche Bank, says: “Institutions have embraced hedge funds as a source of positive risk adjusted returns, and this runs hand-in-hand with a greater focus on control and compliance. Investors have a rigorous toolkit of evaluation techniques and hedge funds have responded by vastly increasing transparency and access.”

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