Managers under security
‘Due diligence’ might now be an in-vogue term, but there is value in its meaning, writes Kristin Fox.
The first commandment of hedge fund investing is: Know thy manager as thyself. No one knows this better than the fund of funds manager, whose reputation and returns ride on the backs of his underlying managers. The reasons managers succeed are as varied and numerous as the reasons why they fail, which makes thorough due diligence a critical part of the manager selection process. Investing in a fund of funds means investing in that manager’s ability to choose underlying managers both wisely and well. But what criteria should the fund of funds manager apply? Independent third-party investigations can be one place to start. “The recent exponential growth of the hedge fund industry inevitably brings with it the increased potential for manager fraud,” says Jeff Joseph, managing director of HedgeWorld Capital Markets, Chicago. “Knowing what the manager is investing in is important, but knowing that manager’s background and capabilities is even more important. Third-party due diligence and verification of a manager’s background is an essential step towards avoiding the risk of manager misrepresentation and fraud.” Manager scrutiny, however, doesn’t stop there. “We feel there is a significant amount of ambiguity surrounding the very ‘in vogue’ term, due diligence,” says Robert Swan III, chief operating officer of Lighthouse Partners. Based in Palm Beach Gardens, Florida, this is a fund of funds running $1.1bn. “Prospective fund of fund investors must require an appropriate definition of the process and procedures used by fund of funds managers or consultants to evaluate a hedge fund manager’s investment strategy and operation. He adds: “Most often this definition will not include an adequate process for evaluating one of the most fundamental and basic risks in hedge fund investing – back-office operations.” “This is something we are dedicated to evaluating equally along with the investment strategy review, as part of our ongoing due diligence process. It has reached the point where we have segregated the evaluation of operational risks of each portfolio allocation as a primary responsibility of our chief operating officer,” Mr Swan continues. Moreover, the Lighthouse chief operating officer has ultimate veto power over any investment allocation, based on the evaluation of the overall internal financial control structure of a manager’s operation. Mr Swan explains: “If you perform even limited research of the history of significant trading losses within investment firms – from Barings to Allfirst Financial – there is a common thread among virtually all of them: there is a consistent underlying disconnection between the operation of the system of internal controls and senior management.” In the operational due diligence process, Lighthouse looks to make sure there is an adequate operational infrastructure philosophy delivered from senior management, as well as a consistent process of monitoring the system of internal controls by senior management. According to Mr Swan, Lighthouse Partners breaks the due diligence process into two distinct areas: investment management and strategy due diligence, and operational due diligence. The primary objective always is to safeguard the funds’ assets. The first step in operational due diligence involves documenting a clear understanding of the corporate and organisational structure. This includes diagramming potentially intricate domestic and offshore investment structures; understanding management and ownership control; and evaluating any outside influence on business or strategy allocations and monitoring potential for distraction from the identified edge and trading strategy. The second step involves people, process and performance. This means understanding the daily, weekly, monthly, quarterly and annual accounting processes. It also involves verifying the accuracy of performance track records, the adequacy of internal management information reporting and the reporting capabilities to the client, including transparency. The third part involves process, which translates into evaluating trading (front office) and accounting (back office) systems and their integration and segregation. Lighthouse Partners also documents its evaluation of the overall internal financial control structure, according to Mr Swan, while Gary T. Hirst, principal of $50m fund of funds Hirst Investment Management, carefully watches his managers’ returns and looks for style drift. Kristin Fox is vice-president of news & research, HedgeWorld.com
Lighthouse partners’ five-step programme 1. QUALITY AT THE TOP
Operational focus must be delivered from top management, but cannot end with the highest levels of management 2. RISK ASSESSMENT
Understanding the inherent trading and operational risks of the investment strategy vs risk tolerance 3. MANAGEMENT INFORMATION
Without complete and accurate information, it is impossible to be in control 4. CONTROL ACTIVITIES
Authorise properly; record timely; analyse timely; reconcile to independent sources; compare to expectations 5. MONITORING ACTIVITIES
Need to permeate the firm and be the eyes and ears of management looking for anything that can go wrong.
