Assessing the operational risks of hedge fund investments

Past blow-ups and scandals have significantly harmed numerous shareholders and tarnished the hedge fund industry’s reputation. 

It is, however, also fair to say these events have brought their share of positive changes (at least from an allocator’s perspective) to an industry that is still considered secretive. Since the end of 2008, hedge funds allocators and consultants have raised the bar when it comes to their operational due diligence efforts. This in turn has pushed investment management firms to implement procedures and processes that let them operate and manage their funds in a more efficient manner, while trying to provide reassurance to investors who are not only worried about return on capital but increasingly about return of capital.

As an additional side effect of past turbulences, some firms have been expressing their willingness to distinguish themselves from the industry’s “black sheep” by gradually opening up to current and prospective investors. This holds especially true for managers actively engaged in the capital raising phase.

While these recent developments are positive, an investor contemplating allocating to hedge funds would still need to understand the specifics of the fund being considered and assess the operational framework of the firm managing this fund. A savvy portfolio manager who has delivered stellar returns may not necessarily possess adequate skills to act as an astute business manager.

Hedge funds are investment vehicles which usually provide a portfolio manager with a flexible investment programme. The way an investor can allocate generally tends to be straightforward. It is however usually on the way out that things can get complex. Hence, it is paramount for an investor to understand where he puts his feet before allocating. Indeed, there is risk of having capital blocked for an extended period of time and potentially being unwillingly exposed to certain instruments.

The review of the fund’s governing documents is the natural start of the operational due diligence process and will provide an initial assessment from a legal and an accounting perspective. At this stage, three essential documents should be read: the articles of association, the offering document and past annual audited financial statements.

Unfortunately, there is no cutting corners here because of the risk of being oblivious to legally binding provisions such as liquidity constraints or to the full extent of expenses that can be charged to a fund. Law firms involved in drafting a fund’s governing documents are appointed by investment managers and are more likely to include provisions that can be interpreted in favour of the investment manager rather than investors.

The next step of the process entails meeting the people involved in running the investment firm that is in turn responsible for managing the fund. The onsite meeting is crucial and sets the tone for how the investment management firm operates. Each aspect matters, from the experience and expertise the staff bring to the systems and service providers in place, as well as how communication is dealt with. Such meetings represent an opportunity to meet with people in oversight roles as well as those in operating positions and are a perfect forum to ask questions about the firm’s procedures and clarify any aspects that seemed outside best practice during the document review.

Additionally, during an onsite visit one can review documents that are only available at the premises, such as some regulatory filings, corporate governance documents or risk reports.

Some start-up firms can be likened to SMEs run with limited resources and sometimes with little segregation of duties. Allocators and investors can potentially end up entrusting substantial amounts of capital to a handful of people. Adequate operational due diligence has therefore become an essential piece of hedge fund investing and it is to be conducted independently from the research and selection teams and, most importantly, before any allocation is made. It is also preferable to allow operational due diligence teams to have a veto right in the investment decision process in order to avoid any conflict of interests or biases linked to a fund’s past returns.

Once an allocation has been made, proper ongoing monitoring should ensure that if anything alters the team’s initial assessment, then it is backed with factual evidence.   

Farouk Saidji, CIIA, Risk Officer, Mirabaud Asset Management (Suisse) SA