Hedge Fund Due Diligence E-Book

Randy Shain

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 582

Veröffentlichungsjahr: 2010

Beschreibung

Hedge Fund Due Diligence provides a step-by-step methodology that will allow you to recognize and avoid questionable hedge funds before its too late. Based on a framework that hedge fund investigative expert Randy Shain has refined over the course of his successful career, this book offers an overview of due diligence into hedge fund management, how information on managers can be obtained, and why this information is essential to your investment endeavors.

Leseprobe

Table of Contents

Title Page

Copyright Page

Acknowledgments

Introduction

CHAPTER 1 - Hedge Fund Growth—What It Means to the Institution

DEMAND FOR HEDGE FUNDS

WHAT ABOUT REGULATION? IS REGULATION THE ANSWER?

CHAPTER 2 - What Is Due Diligence? What Are the Various Types of Due Diligence?

CHAPTER 3 - What Kinds of Hedge Fund Failures Does the Press Discuss? Why Do ...

BUSINESS FORCES

INCOMPETENCE/DEMEANOR ISSUES

CHAPTER 4 - Can the Chances of Investing in Future Failures Be ...

INTERNATIONAL MANAGEMENT ASSOCIATES: FELLING THE TOUGHEST OF THE TOUGH

TIMING ISSUES

CHAPTER 5 - Investigative Background Reports—The Beginning: Identify Your Target

WHY A MIDDLE NAME CAN MAKE OR BREAK YOU

WHAT YOU SHOULD ASK THE MANAGER

MODERN-DAY IDENTIFICATION DILEMMAS: THE LAW OF UNINTENDED CONSEQUENCES

THE HOW TO OF SUBJECT IDENTIFICATION; HOW TO WINNOW

OTHER HELPFUL SOURCES

NON-LEXIS SOURCES

TIP 1 : KEEP ACCURATE RECORDS

TIP 2 : ERRONEOUS ADDRESSES

TIP 3: RELEASES

TIP 4 : STUPID INVESTIGATOR TRICKS

CHAPTER 6 - The Courts

HOW TO ENSURE YOUR COURT SEARCHES ARE COMPLETE

COURT SEARCHES: THE BEGINNING

ONLINE SOURCES: FEDERAL COURTS

HOW TO USE PACER

OTHER TIPS

ONLINE SOURCES: STATE COURTS

MANUAL SOURCES: STATE COURTS

STATUS OF A SUIT

LIENS/JUDGMENTS

CASE STUDIES

WOOD RIVER POSTSCRIPT

METHODS OF CONDUCTING COURT SEARCHES

LOS ANGELES COUNTY COURT SEARCHES: AN INSIDE LOOK

HOW TO READ A LAWSUIT

THE DOCKET

THE COMPLAINT

INTERVIEWS OF LITIGANTS

WARNING SIGNS: YELLOW AND RED FLAGS FROM LITIGATION RESEARCH

CHAPTER 7 - News Media: Is Nexis Your Only Option?

THE SERVICES

SOME CHEAT SHEETS

ORDER OF OPERATION

THE MECHANICS

A SECOND CAUTION AGAINST A BAD IDEA

CONTEXT IS KEY

CHAPTER 8 - Regulatory Bodies

SEC, NASD, AND NFA NAMES AND NUMBERS

DETAILS

REGULATORY DISCIPLINARY ACTIONS

CHAPTER 9 - Credentials Verifications

WHAT TO ASK MANAGERS/QUESTIONNAIRES

WHAT TO VERIFY

HOW TO VERIFY SCHOOLING

HOW TO VERIFY PREVIOUS EMPLOYMENT

THE WORK NUMBER

HOW TO VERIFY MILITARY ACTIVITY

HOW TO VERIFY LICENSES

EXAMPLES FROM THE ARCHIVES

CREATING A TEMPLATE

CHAPTER 10 - Corporate Records: Not Just D&B Anymore

CORPORATE RECORDS: THE LIBRARIES

INCORP;ALLBIZ

COMPNY;COMPNY

THE SEARCH STRING

DUN & BRADSTREET

CHAPTER 11 - The Internet: What It Can Do and What It Can’t

WHAT THE INTERNET CAN DO

LIMITS/NOT SO GOOD FOR

SPECIFIC SITES

CHAPTER 12 - Public Records—Is That All There Is?

WHY DO INTERVIEWS AT ALL?

OBJECTIONS

WHO IS A SOURCE?

HOW DO YOU IDENTIFY SOURCES?

NEWS SEARCHES

CORPORATE/REGULATORY RECORDS

DIRECTORIES

GOOGLE

OTHER

HOW DO YOU FIND SOURCES’ CURRENT CONTACT INFORMATION?

HOW TO GET A SOURCE TO RETURN A MESSAGE

HOW TO ENCOURAGE A SOURCE TO SPEAK CANDIDLY

PREPARATION

EMOTIONAL CONNECTION

WHAT TO DO WHEN THE SOURCE STARTS ASKING THE QUESTIONS

CONVERSATION

STANDARD INTERVIEW QUESTIONS

OTHER TIPS

WHAT NOT TO DO

CHAPTER 13 - What You Think Is Helpful, But Isn’t

SUPER SECRET SOURCES

OFAC

SOCIAL SECURITY NUMBERS

CREDIT REPORTS

CHAPTER 14 - The Law

FAIR CREDIT REPORTING ACT (FCRA)

NCIC

TAPING INTERVIEWS

PRETEXTING

CHAPTER 15 - Credit Reports

WHO CAN ORDER THEM?

THE VALUE OF A CREDIT REPORT

DO CLIENTS TYPICALLY WANT THEM?

HOW TO READ A CREDIT REPORT AND WHAT TO LOOK FOR

CHAPTER 16 - Warning Signs: Red and Yellow Flags

RED FLAGS

YELLOW FLAGS

CHAPTER 17 - Conclusion

RECAP OF THE RECAPS

Notes

Index

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Copyright© 2008 by Randy Shain. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Shain, Randy, 1965-

Hedge fund due diligence : Professional tools to investigate hedge fund managers / by Randy Shain.

p. cm. - (Wiley finance series)

Includes bibliographical references and index.

ISBN 978-0-470-13977-6 (cloth/website)

1. Hedge funds. I. Title.

HG4530.S485 2008

332.64’524-dc22

2007039388

Acknowledgments

Embarking on this project was a new experience for me. (Hopefully, that won’t be too obvious upon your reading the book.) I have edited thousands and thousands of 20+-page reports, accumulating a fair amount of knowledge of syntax, language, and tone in the process. Certainly, it’s also true that I have spent nearly two decades specializing in background due diligence, so I thought, how hard could it be to write about it?

As it turns out, pretty damn hard. Writing an article here and there or expounding on the topic in a new business meeting (or, G-d forbid, to friends foolish enough to ask questions) is one thing. Writing 250 pages for an institutional audience turns out to be another. Still, I have taken to comparing the process to the feeling I get when I am watching a movie that fails to entertain me completely yet remains in my thoughts for a few weeks. The process itself might not be described as fun, but I am damn proud of the way this book has turned out and hope it helps do what John Wiley wanted it to do when the editors first approached me to write it.

One thing I relearned in penning this tome was the value I place on interacting with others who share my passion for this topic. The late management guru Peter Drucker had it right when he espoused the idea that employees are a company’s value, not its cost. The staff at BackTrack, now part of First Advantage Investigative Services, is incredibly talented and hardworking. Beyond that, they proved time and again that when I needed help, all I had to do was ask. Of course, one could argue that since I am their boss they had no choice but to listen to me, and I am sure to some extent that cannot be factored away entirely. Yet, this cannot explain everything, or even most of the reason, for their competence, enthusiasm, and concern.

Specifically, no thanks are enough for Casey Drucker (née Kahl, a far more alliterative name, apologies, sort of, to her husband Steve). Casey’s responsiveness and willingness to take on ever-increasing levels of responsibility paved the way for me to have enough time to write every day (albeit not all day, as that was well beyond my capabilities), without worrying about what would happen to the office. Casey runs our firm as if it were her own; there is no bigger compliment I can give, other than pointing out that there is no one else I’d want to run the show.

No less deserving of thanks are some long-time BackTrack researchers, two of whom, Sean Leadem and Alex Foster, contributed chapters here. My feelings about those two should be evident in the lead-ins I provided to their respective chapters (Chapters 7 and 10, respectively). To reiterate, both have demonstrated time and again why due diligence background research is not a commodity; the skills, instincts, and perseverance they demonstrate every day are a crucial difference between poor results and outstanding ones. Two other researchers, Joe Cadigan (who oddly posed as me during Casey’s wedding, but that is a different book) and Chris Stevenson, are similarly skilled, and were only too willing to answer every question I asked during the writing of this book—and believe me there were a lot of them. I have said this before and repeat it here: I’d match up our group of researchers against any in the world.

Caroline Mak, who heads our Litigation department, was invaluable in helping me to answer intricate questions about our country’s somewhat Byzantine court record-keeping system. She is absurdly professional and in some ways, irreplaceable.

Stephanie Kim is another BackTrack veteran who provided me with a terrific tutorial on identification sources (Chapter 5). The ability to distinguish between items that name a subject versus those that merely cite someone else with a similar moniker is a theme that is stressed repeatedly in this book; Stephanie and her group are adept at arming our staff with the information necessary to make these critical distinctions.

Although at one time I knew practically everything about the underlying areas of our research, as time has gone on and our firm has grown clearly, I have learned to rely on other people’s expertise. Eileen Chan, who heads our Verifications unit, is one of the people on whom I now lean, and she was especially helpful during my discussion of this area (Chapter 9).

Leah Clarkson, a BackTrack editor and a published author, was always willing to use her practiced eye on a chapter. She has an amazing ability to be complimentary without making it feel as though she is being obsequious. Her points were and are always appreciated.

Barrett McInnis is an extraordinary interviewer and provided assistance in the vital chapter discussing the nonpublic records aspect of due diligence.

Our marketing department, headed by Aaron Smith, has done an admirable job battling the imitators, firms that claim they are offering due diligence but in reality succeed more at limiting their own costs and liabilities while leaving institutions holding the bag.

All those who work for BackTrack, now FADV, you know how I feel about our team. In case you don’t, it says here in print that combined, we have managed to produce the most comprehensive hedge fund background reports of anyone, which is an achievement of which all of you should be proud.

I didn’t receive help just from my colleagues. When vexed by legal lingo, I frequently turned to lawyer friends, who with one notable exception (Port Washington basketball players all know who I am referring to here) were universally helpful and accommodating. Thanks again to Ted Keyes, Mike Stolper, and Arnie Herz, who besides translating legalese also preached the idea of establishing your end goal before proceeding with any decision, a mantra I now follow religiously.

Along those lines, I received expert tutelage from a friend’s mother, a person well-versed with the comings and goings of the IRS and who asked to be anonymous here. Her name is not here, but she’ll recognize her contributions, which I greatly appreciate.

As you’ll see in Chapter 6 on the courts, I spoke with two women who cofounded one of the most renowned litigation retrieval companies in the country. Karen Wolfe & Sheri Fister-Annable, owner-operators of Research & Retrieval (R&R), took the time to explain the Los Angeles court system, probably the most difficult of any in the United States to navigate. I have enjoyed working with them for nearly two decades and look forward to continuing to do so in the future.

Without Annette Bronkesh of Bronkesh Associates, there would have been no book. Annette has helped taken our company from an expert known mostly to institutional investors to one that receives media coverage on a monthly basis. Having previously tried and failed to garner publicity on our own, the difference in using a specialist like Annette and flailing about has proven to be astronomical.

Similarly, I must point out that not every boss would be so receptive to the idea of publicly discussing the secret sauce. Andy MacDonald merits great recognition for being such a forward thinker, and an all-around easy guy to work for.

To my friend Henry Abbott, what more can I say about someone than I already have many times? A preternaturally mature and wise person, BackTrack employee number 4, Henry consistently provides sage counsel on a multitude of topics, and was instrumental in convincing me that the opportunity to write this book was something that could not be passed up. Also, by selling his soul to ESPN, Henry freed up my time to even do the book, something for which in some ways I suppose I should be grateful.

Though we both know the way other feels, writing acknowledgements without mentioning my long-time business partner and friend, Chris Man-they, would be ludicrous. We worked together for six years before striking out on our own in late 1993, two New Jersey guys with new mortgages and the theory that specializing in due diligence would be valued by institutions that were used to either slip-shod work or useful searches but at extremely pricy rates. With complementary skills, we built a business from the two of us to one that now has more than 60 employees. Chris is brilliant; more importantly, although we have disagreed about how to handle things, we have never once had even the remotest discussion around ethical conduct, often forgoing seemingly lucrative offers made by clients asking us to do research in a way we deemed improper, ineffective, or both. Few partners can make this claim, I’d wager.

When we were looking for lenders and/or investors, my wife’s late step-father, Jay Monroe, was a natural first stop. Instead of a check, however, we received extra motivation to succeed in the form of a letter that told me, among other things, that I was not an entrepreneur and “should accept my lot in life.” Jay always told it as he saw it, and did so immediately and permanently. However, he was a good sport when he turned out to be wrong, and as people who know me know, I had no trouble reminding him of this miscalculation every chance I got.

Speaking of investors, two people who literally gave us the lifeblood we needed to get rolling were Chris’s uncle, Bill Davis, and my brother, Jay Shain. I have related this tale many times but it never fails to amaze me that my brother, then not yet 30 years old and by no means wealthy, wrote us a check for $10,000 without seeing so much as a word describing our idea. Relying solely on a phone call, he asked merely, “You’re doing what you did at the other place, right?” After I responding yes, he stated, “I’ll write you a check right now. I only wish I could give you more.”

To my parents, both now deceased, I think of you often. My father taught me many things, but two stand out as particularly relevant here. He impressed upon me from an early age the idea that you should always make a living doing something you like to do, because you spend an awful lot of time at work. I still love what I do, thanks both to my father and his brother, my Uncle Bernie, whose stories about his investigative job is what got me interested in this career as a 14-year-old. My father’s other big mantra was that you do things the right way not because you are afraid of getting caught doing otherwise, but because you will always know what you have done, even if no one else does. Anytime anyone suggests cutting research costs to increase profits, or selling a report that is a mere compilation of indices to reduce labor fees, I think of what my father would say, and I understand implicitly that this is something we’ll simply never do.

As for my mother, amongst the forest of lessons that are wildly inappropriate for this book stands one thing that is. Early on, my mother taught my brother Jay, sister Shelley (a better writer than me, by the way), and me to never accept mediocre results when excellence was within our capabilities. In Jersey terms, this translates to “don’t be half-assed.” My own kids, therefore, have their late grandmother to blame for the use of this term in our home on such a frequent basis.

My wife, Michelle, said many times during this process, “I am proud of you.” I guess kind of like Renee Zellweger in the pivotal scene with Tom Cruise in Jerry Maguire (“You had me at hello”), I don’t remember anything else she said, but nothing else mattered.

And to my kids, Jackson and Dillon, who have picked up my love of reading and might yet convince me to take a crack at a kids book next. I couldn’t love any two beings more.

Introduction

Bayou. Wood River. Aurora. Amaranth. The Manhattan Fund. Integral Investment Management. For anyone who has invested in hedge funds or who follows the industry, these names are all associated with disasters. Although these hedge funds may have blown up, knowing this isn’t particularly valuable. On the other hand, determining how to avoid the funds that are most likely to blow up is. This book provides a step-by-step methodology that gives readers an intimate knowledge of the most important variable: the hedge fund manager. A precise investigation of a hedge fund manager’s career, combined with a clear understanding of what the information really means in practical terms are the building blocks of informed investment decisions. By deconstructing these and other hedge fund blow-ups of the past few years, the book will also chronicle the warning signs and how to spot them.

Professionally, for nearly 20 years, I have specialized in business background investigations and cofounded an investigative firm that specializes in hedge funds. I have had a hand in investigating more than 2,500 separate hedge funds and close to 4,500 hedge fund managers. Through all of that, consistent trends have emerged:

Not all hedge funds blow up. In fact, the vast majority don’t.

Many hedge funds do indeed go out of business. Often, however, this is due to things reporters don’t find sexy enough to discuss, like the fund’s not amassing enough assets to allow its owners—the managers—to make money. This is no more indicative of fraud than a restaurant closing due to lack of customers.

Every nonmutual fund is not a hedge fund, even if the press describes it that way. (As I will explain, Kirk Wright, who has achieved a measure of infamy by losing a lot of money for professional football players, is no hedge fund manager.)

You don’t have to invest in something secretive or unregulated to lose money. Ask people who had their money in Janus or other technology-centric mutual funds in late 2001.

Regulation is a noble concept but is by no means bulletproof when it comes to preventing fraud. One of the most tightly regulated financial industries is broker/dealers, the same folks who continue to spawn boiler rooms that prey on the unsuspecting to this day.

Good hedge fund of funds do a tremendous job weeding out the riskier hedge funds.

Individuals considering investing in hedge funds should not confuse their own business sophistication with hedge fund analysis expertise.

Most entities purporting to provide background reports on hedge fund managers provide little more than a false sense of security, based on mindless searches that result in incomplete, incorrect, or irrelevant information.

There is a way to predict and avoid most blow-ups.

That last point may be surprising. But it’s really true. As you’ll read, an examination of the backgrounds of the various portfolio managers in those cases listed above, and several others I’ll discuss, yields data that at the very least would give informed investors pause. (The data itself, in the form of addenda, can be found at www.wiley.com/WileyCDA/WileyTitle/productCd0470139773.descCd-DOWNLOAD.html.) In fact, many investors avoided those funds just for that reason. By analyzing these examples, and by explaining how you can develop this kind of research for yourself, this book will serve as a primer on how to make the most informed hedge fund investment decisions possible. And perhaps most important, with the tools presented in this book, you will have the knowledge you need to be able to deduce how a hedge fund manager’s previous behavior is likely to predict future success.

Right now you may be thinking, “Is it possible for me to learn how to conduct background research all by myself?” The answer is that you’ll certainly have all the information you’ll need to do so. Whether you choose to roll up your shirtsleeves and do it yourself, staff a department devoted to this task, or outsource to an entity specializing in this research is your call. By pulling back the curtains on this Wizard of Oz, I hope to arm you with the ability to make this decision wisely and to ensure that either way you will have the tools you need to avoid reading about yourself in the next blow-up news frenzy.

How is any of this possible? A lot of it has to do with asking the right questions (of your staff, of the managers themselves, and of your vendors). Just as you know how to ferret out information from hedge fund managers, regarding their strategy, leverage, where they put the cash, how much of their own money is in the fund, and so forth, this book will, if I do my job correctly, serve as a guide for your manager due diligence questions.

It is hard to argue with the notion that the backgrounds and reputations of the portfolio managers, and others connected to the fund, are crucial to a fund’s success. It is equally easy to prove the idea that a hedge fund of funds, a pension fund, an endowment, or any institution seeking to invest in hedge funds is not set up to learn, say, whether a hedge fund manager has been sued for fraud in a former position. No industry I have seen has recognized this more clearly, and has taken steps to rectify this imbalance between knowledge needed and ability to obtain that knowledge, than the fund of funds world. Although they may be criticized for excessive fees and a host of other purported ills, fund of funds routinely commit to some form of a background search as part of their due diligence process. Compared to venture capitalists, who despite getting crushed by their 1999 to early 2000 rush to fund the next greatest tech idea presented to them on a napkin in a room on Menlo Park’s Sand Hill Road have seen no reason to change their diligence approach (I welcome the VC community to dispute this, and may well write a book about this travesty next), hedge fund of funds and other institutions investing in hedge funds know that due diligence does not mean do as little as you can, but instead refers to a standard of “due care” established more than 70 years ago in an effort to ensure that the stock market would function honestly and beyond reproach.

The problem, then, lies not in the desire to conduct effective background research, but in the ability to know it when you see it. Here, too, there is a wide disparity between the skills hedge fund investors typically have and the skills needed to know whether the information you are receiving is all that there is, whether it is important, and oddly, whether what you are reviewing even relates to the subject manager versus another person with that same name. Unfortunately, many investigative firms prey on this, knowing full well that they can pass off the same research they do on a potential 25-year-old secretarial-level employee as being all that is needed for a 43-year-old hedge fund manager. The industry is rife with firms who have entered the hedge fund field for the same reason that legions of investment bankers morphed themselves into hedge fund managers at the turn of this century (boy, that phrase sounds odd, huh?): low, to no, barriers to entry, combined with perceived riches to be made in a short period of time. Preying on the investment professionals’ lack of sophistication regarding their work, these investigators often are able to provide just enough information to make their work seem useful (and scarily, to provide the worst kind of false sense of security), but not enough to actually do what due diligence is intended to do: that is, ensure that the investors have enough information to help them decide whether this investment will have a chance to succeed, and more importantly, whether the manager in question will not end up on the front page of a Wall Street Journal exposé into hedge fund fraud. So for those tired of that vague feeling of discomfort they get when they pick up the latest “report” they get from investigativegeneralistjustgotintothebusinessanddon’tsearcheverythingbecauseit’stooexpensiveandhard.com, read on, and be armed with the right questions to ask, and the answers to expect in advance. And, toss that other report in the garbage, where it will do you less harm.

CHAPTER 1

Hedge Fund Growth—What It Means to the Institution

Open any business publication or daily paper with even moderately in-depth business coverage and you’ll see a story about a hedge fund. Most of these stories will describe how hedge funds are unregulated, implying that somehow this means hedge funds are The Wild West of investing, best left to only those willing to brave extraordinary frontiers and the risks associated with them. Other articles concentrate on the latest scandal to touch down on a “hedge fund,” not distinguishing between a hedge fund and essentially a crooked enterprise masked as a hedge fund to take advantage of the zeitgeist of today. Finally, stories feature breathless descriptions of the fantastic growth in hedge funds, both in terms of the money they manage collectively as well as the number of funds in total. This book will touch on these issues, but this opening chapter will focus on the last point, specifically as it relates to the effect the tremendous increase in hedge fund formations has had on institutional investors.

The 2006 PerTrac Analytical Platform neatly summarized what daily and trade press have simply termed an “explosion” in hedge funds over the past several years. According to PerTrac’sa study of various hedge fund databases1:

• Nearly 13,675 single manager hedge funds were identified, up from 8,100 single managers acknowledged in the 2005 study.

• Single manager funds totaled more than $1.41 trillion under management.

• Approximately 250 funds have surpassed the $1 billion hurdle. By contrast, more than a third of single manager funds manage less than $25 million.

• Approximately 4,150 of the single manager funds appear to be clones of another fund.

• Figure 1.1 shows a steadily increasing arc of new single manager hedge funds over the past decade and a half; note that this figure does not even take into account those funds that didn’t report to any database.

FIGURE 1.1 Number of New Single Manager Hedge Funds by Year Used by permission of Opalesque.com.

The Wall Street Journal added to this analysis by reporting, on January 3, 2007, that hedge funds managed approximately $500 billion five years ago. The Journal placed the figure at the time of the article at close to $1.44 trillion.2

What does all this growth mean to an institution? Certainly, one upside is capacity, or the ability for institutions to increase their alternative asset allocation percentage if they should wish to do so. Turning this coin over reveals, however, the inherent dangers of any industry that sees its membership increase so rapidly: dilution of talent, and consequently, increase in potential losses stemming from the selection of the wrong fund. Not too long ago most hedge funds had a similar starting point. A classic biography highlighted the manager’s graduation from Harvard, followed by a Wharton MBA, a stint at a bulge-bracket investment house and then something of an apprenticeship at a place like Julian Robertson’s Tiger Management. When the manager ultimately broke out on his own, an investor could be assured, knowing the manager had the necessary background to succeed.

Now, this is no longer the case. As hedge funds became more and more popular, and as other opportunities in the financial world became less attractive, if not, at one point, downright less available, the type of person seeking to become a hedge fund manager changed dramatically. From investment bankers to stock analysts, from physicians to pharmacists, from amusement park operators to real estate developers, all of a sudden everyone you know is a hedge fund manager. A few years ago, I attended a basketball camp and at dinner, the 18-some-odd group included an eclectic mix of careers, united only by a love of hoops. Going around the table, the spotlight turned to the only person there who then worked for an investment bank and the only person who by that time had managed to be somewhat universally irritating in his manner. Asked to elaborate on his career, he said he was leaving to start a hedge fund. I am quite certain he had little desire to be a hedge fund manager. His focus was prestige and money, not some innate love of esoteric trading strategies.

It is not the fact that people from so many walks of life are becoming hedge fund managers that is necessarily troubling. Rather, it is the reason they are doing so. Illustrated in the example above (though admittedly lost somewhat in the translation) is the fact that many people are approaching the hedge fund industry as if it were a fast, easy way to make a ton of money, all with a very low barrier to entry. The low barrier to entry part may very well be true (this is probably the best argument for increased regulation, though a libertarian would argue it is the worst); the easy money part is not. People’s motivation for becoming a hedge fund matters precisely because running one is not easy. One needs a combination of trading experience, ability to deal with risk, conviction, honesty, and overall business skills (any fund seeking institutional money is no longer a guy clackety-clacking away on his basement computer; no, running an actual business is required now, too). People in it for just the fast riches often will find out the hard way that this industry is not what they thought; the key for the institution, then, is not to be the one colearning this lesson.

The trick for any institution is ferreting out which funds present an acceptable risk. This has been made simultaneously easier and harder by the drastic expansion in hedge funds from which to choose. On the one hand, given the plethora of funds at their disposal institutions no longer have to fear getting shut out of all the funds in which they might like to invest. Conversely, this very abundance of choices means it is no longer so simple to judge the quality of the people running the funds, since these people may very well be unknown to the institution and those in its circle.

Pointedly illustrating this are recent statistics on the heavy concentration of hedge fund assets in a relatively small number of funds. According to a March 2007 piece in Hedge Fund Daily, gleaned from its sister publication, Absolute Return, a unit of HedgeFund Intelligence, 241 U.S. hedge fund firms have more than $1 billion in assets under management.3 Perhaps most astoundingly, the 20 largest hedge fund firms controlled approximately $386 billion, in total, or almost one third of the global hedge fund assets reported to surveyors.

A February 2007 report in Hedge Fund Daily presented slightly different figures, although not contradicting the general concentration point.4 “The 10 largest hedge funds according to size control 63% of industry assets, according to Milken Institute’s Capital Access Index 2006, while the top 1% control 19% of all global fund assets. Based on data from HedgeFund.net, the study found that ... hedge funds with more than $1 billion in assets under management account for only 3% of the total number of funds but 35% of the industry’s trillion in assets, while HFs with under $100 million AUM represent about 70% of the number of funds but just 12% of the assets.”

The full list was published in Absolute Return’s March issue. Unless noted otherwise, all asset figures are as of January 1, 2007, and are in the billions. See Table 1.1.

Even if you eliminate the bottom third of hedge funds that reportedly have less than $25 million apiece, what remains is a tremendous number of hedge funds to weed through, if you don’t want to, or can’t, invest in the aforementioned big boys. Speaking of which, one theory proffered in a recent HedgeWorld story is that investors are better served by getting into funds early in the fund’s “life cycle.”5 According to this theory, penned by Shoham Cohen, a hedge fund has four stages, similar to what you might expect: introduction, growth, maturity, and decline. As might also be expected, he does not believe that it is astute to invest during stage four; rather, he proposes that hedge fund investors often “shy away from funds with track records of less than five years, or assets under management of less than $300 million, in favour of more established funds. These vintage funds are usually past their prime.”

TABLE 1.1 Top 10 U.S. Hedge Fund Firms—January 2007

JPMorgan Asset Management$34.00Goldman Sachs Asset Management$32.53Bridgewater Associates$30.20D. E. Shaw Group$26.30Farallon Capital Management$26.20Renaissance Technologies Corp.$24.00Och-Ziff Capital Management$21.00Cerberus Capital Management$19.15Barclays Global Investors$18.90ESL Investments$18.00

Mr. Cohen avers, “Emerging funds can provide better returns, better capital protection, a longer-term investment prospect, and up-to-date investment strategies,” while “historically, high-profile funds—in most cases—will add less value.”

Although getting in while a fund is young, before it is hot, sounds appealing, these types of funds demand even more stringent due diligence analysis, for by their very nature they do not have the financial track record upon which you can rely.

None of this is meant to suggest in any way that all, or even the majority, of hedge funds are frauds or will blow up at some point soon. However, as with global warming, it now seems that the question isn’t whether or not hedge funds are risky, but what can be done about it.

What can be done to lessen the risk of investing in a hedge fund that blows up? Specific prescriptions appear first in Chapter 4 and then throughout this book; it is enough to summarize here that the primary way to avoid the type of headline no one wants to see is due diligence. Proper, thorough research into the hedge fund manager’s track record will go a remarkably long way toward ensuring a blow-up-free portfolio; no method is foolproof, of course, but relying on an ad hoc, hodgepodge of industry contacts, guile, and intuition is not only no longer necessary, but it is also no longer effective. And this is possibly the greatest distinction for institutional investors to recognize: the old way of hedge fund investing is no longer possible; no more can you simply invest with managers you know or with whom some acquaintance of yours has direct experience. But this doesn’t mean you can’t replicate the old experiences; it just means you have to work a lot harder to do so. Still, this work is not without its reward, because at the end of the day you can always move to the next manager on your list if your due diligence review should reveal that the first option is untenable. All in all, this isn’t so bad.

DEMAND FOR HEDGE FUNDS

The discussion above focused on the increased supply in hedge funds, suggesting that this was in response, primarily, to hedge funds becoming popular and to their perception as easy money. Another critical factor, of course, and one you are likely to be at least partially aware of, is the concurrent heightened demand for hedge funds in which to invest.

Everyone knows about institutions providing ever-increasing dollars to hedge funds. (Reuters.com reported in March 2007 that a survey of more than 40 funds with assets totaling $1 trillion revealed that only 4 percent have no hedge fund investments, down from 16 percent the year before.6) Less well known, perhaps, is one of the reasons why this is occurring. According to a January 3, 2007, Financialnews-US.com article, the two largest US pension funds, the $225bn California Public Employees Retirement System and the $153bn California State Teachers’ Retirement System, combined their unfunded pension liabilities of $49bn, as the state of California sought to address its funding deficits.7 Though going forward, California and the many other pension plans in this predicament will plausibly seek to change from defined benefit plans to defined contribution plans, this will not address the immediate problem of unfunded, or under-funded, pension plans. One ready solution, however, is investing in more alternatives, including hedge funds, in order to “goose” pension plan returns and hopefully abate or even eliminate the funding gaps that currently exist.

Around this time, HFN Daily Report quoted a press release issued by Russell Investment Group, which managed more than $195 billion in assets for advisory clients as of December 31, 2006.8

According to the release, Russell Investment Group “predicted a drastic change in pension investment portfolios as corporations respond to pension reform and try to maximize returns while matching liabilities.... ‘Changes in pension policy are being driven by a variety of pressures, and these pressures are going to push different plans in different directions,’ said Bob Collie, director of strategic advice at Russell and contributing author of the Russell Pension Report 2007. ‘There will be a breaking up of the herd as organizations pursue a wide range of both liability-matching and return-seeking strategies, driven by different responses to recent pension reform and by increasingly diverse corporate objectives.’”

The Russell report added, “Regardless of which strategy or combination of strategies companies ultimately choose, the ability of plans to employ both return-seeking and liability-matching strategies is now more feasible and necessary than ever before, a finding that challenges the traditional presumption that the two investment strategies are mutually exclusive.”

Eurakehedge had a related story about institutional investors driving hedge fund growth, based on an extensive surveyb conducted in 2006 “through more than 100 in-depth interviews with institutional investors, investment consultants, hedge funds, funds of hedge funds and industry experts worldwide.”9 This was a follow-up to a similar survey conducted in 2004, both carried out jointly by Bank of New York and Casey, Quirk & Associates.

Among the study’s conclusions were that institutional investors are by and large quite satisfied with their hedge fund portfolios and that this satisfaction means hedge funds are here to stay. The study also concluded that as recently as five years ago, hedge fund investors were comprised mostly of individuals, with a smattering of institutions joining in the fray. Now, more than 40 percent of hedge fund money is institutional (frankly, this still seems low to me, and in fact Institutional Investor News and HedgeFund.net released a report in mid-March 2007 in which Hedgefund.net estimated total hedge fund asset levels at $1.89 trillion, with $953 billion, or just more than 50 percent, from fund of funds10); by 2010, the authors expected this number to increase by half (to 60 percent—again, a figure I personally believe understates the case), with total institutional money in hedge funds predicted to be $1 trillion (said with a pinky in the corner of your lip, Dr. Evil-style). As for the whys, the authors believe that institutions are looking for both low correlation with the rest of their assets as well as absolute returns.

Perhaps the most important point from my perspective, albeit one that did not receive top billing in the research paper, was this one, “Factors such as scandal and regulation could slow predicted growth, though we would expect the impact to be marginal.” As the following chapters will show, the press treats “hedge fund” scandals the way bears do salmon, ripping them apart rapidly and somewhat indiscriminately. For the hedge fund community, institutions especially, this means that vigilance is the watchword of the day. You can’t rely on methods that worked when there were approximately 5 percent of the hedge funds that there are today. Today’s hedge fund growth and turnover demands a level of scrutiny that this book will hopefully demonstrate how to execute.

WHAT ABOUT REGULATION? IS REGULATION THE ANSWER?

I guess it depends on the question. Most important for any institution to recognize, however, is that regardless of how stringent regulation becomes, and how successful regulatory agencies are in prosecuting frauds once they occur, regulation is not intended or designed to predict which hedge fund might blow up next. For that, you’ll always need due diligence, both operational and manager research. To understand a manager’s tendencies and track record, you must delve into these items. No regulatory body can possibly replicate your research, not just because they don’t have the time or expertise, but also because this is inherently not their focus. Recognize, too, that regulatory bodies admittedly become involved in frauds against investors almost always after a whistleblower points out an ongoing fraud. At this point, you, the investor, can at best hope to recover only a portion of your investment, and you certainly can’t prevent the damage from the avalanche of bad press that is sure to follow. We’ll explore the role of regulators further in Chapter 8, but for now keep in mind that regulators cannot and do not obviate your need to do due diligence on the managers in which you are seeking to invest.

RECAP

1. Hedge funds are not a passing fad.

2. Institutional interest in hedge funds is likewise a long-term commitment, and is in large part a response to underfunded pension funds.

3. Today, 9,000+ hedge funds versus 500 hedge funds means more choice but also far more chance of finding a bad apple.

4. Ad hoc methods like calling on industry contacts are no longer an efficient or effective means of conducting due diligence on people.

5. Systematic management/people due diligence combined with operational due diligence allows for a great reduction in blow-up risk.

CHAPTER 2

What Is Due Diligence? What Are the Various Types of Due Diligence?

Googling “due diligence definition” produces an army of results. Among the herd, the following seem particularly relevant:

• The investigation and evaluation of a management team’s characteristics, investment philosophy, and terms and conditions prior to committing capital to the fund. www.ventureeconomics.com/vec/glossary.html

• The degree of prudence that might be properly expected from a reasonable person in the circumstances; applicable to foundation personnel who act in a fiduciary capacity. (See Fiduciary Duty.) www.yscf.org/glossary.html

• The analysis and appraisal of a business in preparation for a flotation or venture capital investment. Investors have a right to expect that these investigations are carried out thoroughly. www.financingcp.org/glossary/glossary.html

• The process of systematically evaluating information, to identify risks and issues relating to a proposed transaction (i.e., verify that information is what it is proposed to be). strategis.ic.gc.ca/epic/internet/insofsdf.nsf/en/so03149e.html

• The process of checking the accuracy of information contained in a company public statement, such as a prospectus, before recommending that company to others. Is also the act of one company investigating another company before buying its shares. https://www.shareanalysis.com/asp/glossary.asp

• A reasonable investigation conducted by the parties involved in preparing a disclosure document to form a basis for believing that the statements contained therein are true and that no material facts are omitted. personal.fidelity.com/products/stocksbonds/content/ipoglossary.html

• A legal requirement that stock brokers, underwriters and spin-off sponsors must meet to ensure that the statements made by a spin-off company or public company are accurate and complete. The purpose is to ensure the public has full and accurate information about a public company or a private company about to become a public company. www.going-global.com/equity/finance-glossary.html

• In an offering of securities, certain parties who are responsible for the accuracy of the offering document, have an obligation to perform a “due diligence” examination of the issuer; issuer’s counsel, underwriter of the security, brokerage firm handling the sale of the security. Due diligence refers to the degree of prudence that might properly be expected from a reasonable man, on the basis of the significant facts which relate to a specific case. www.maverickenergy.com/lexicon2.htm

• An internal analysis by a lender, such as a bank, of existing debts owed by a borrower in order to identify or re-evaluate the risk. An independent analysis of the current financial state and future prospects of a company in anticipation of a major investment of venture capital or a stock-exchange flotation. A Venture Capitalist firm’s examination by its lawyers and auditors of the records, accounts and any legal documents of an existing business. www.promitheas.com/glossary.php

• The process whereby an investor investigates the attractiveness of an opportunity, assesses the quality of the management team, and assesses the key risks associated with an opportunity. Due diligence starts on initial inspection of an opportunity and ends when the investment is in the investee’s bank. www.tvp.com.au/resources/glossary.htm

• Investigation conducted by Underwriters and their counsel and, in some cases also by bond counsel and Issuer’s counsel to determine whether all material items in connection with the Issuer, the Issue and the security for the Issue have been accurately disclosed in the Official Statement (or if a Private Placement in the Placement Memorandum) and that no material disclosure has been omitted. www.indygov.org/eGov/City/BondBank/glossary.htm

Although none of the above relates specifically to hedge funds, certainly the idea of what due diligence comes through via the various definitions. Running through these definitions is the theme about searching management teams and assessing their quality; this book will focus its entire effort on teaching you techniques for performing this very task. The book will not attend to the various other types of due diligence that are also important to analyzing hedge funds, but that are outside the scope of our expertise. The most prominent example would be operational due diligence, which might include, among other items, analysis of a fund’s infrastructure; back office procedures; style and strategy; peer comparisons; financial statements; and risk management procedures. These are all very valuable, but they are also items that are best covered in a separate text, by someone with expertise in this arena.

Why focus on management team analysis? As each chapter will highlight, our premise is that effective, comprehensive management due diligence yields information about a manager’s background that is itself critical to accurately predicting the future behavior of that manager. No amount of due diligence can account for market conditions or dramatic market changes, of course, but almost all people will exhibit their fundamental characteristics time and time again, over decades, and especially under pressure. Determining what those characteristics are, therefore, will give you, the institution, the ability to recognize how the manager is likely to act in specific scenarios, and allow you to act before these actions turn disastrous.

It is not too early to note that a multitude of service providers have cropped up to meet the obviously growing need for background reports/due diligence on hedge fund managers. Unfortunately, the quality has come nowhere close to the quantity, leaving most investors confused as to what exactly they should expect from a background report, if they were to outsource this. The book will clarify this issue as well and arm you with the questions you need to ask to understand whether what you are getting is actually comprehensive, effective due diligence, or whether it should be thrown in the nearest garbage can. Nothing is more dangerous to the investor than the false sense of security derived from a search purporting to be due diligence, but in actuality being closer to “do as little as you can get away with.”

Comprehensive hedge fund manager due diligence is not achieved by magic (refer to Chapter 13, What People Think Is Helpful But Isn’t). Rather, “people” due diligence means not shirking the details. Handling due diligence on your own via your corporate security department, without understanding the information presented in this book, will lead to mistakes. Your internal people can’t fire themselves. Although they will never truly be perceived to be entirely independent, the lack of expertise is a far greater problem.

As mentioned in the Introduction, the other main problem in hedge fund manager due diligence is that institutions know or suspect that they are not aware of everything that they should be doing. Background search vendors prey on such worries, capitalizing on this ignorance by doing cheap, ineffective reviews designed to look like a search. Remember, like that phone one buys on the street in New York City, it looks good, seems good, has everything you need, except, well, the part that makes it work. Here too, this book will help you avoid these characters, and instead glean information you can really trust.

RECAP

1. Management Team Due Diligence is a critical piece of the entire due diligence puzzle.

2. Reviewing managers is not only wise, but might also be considered a fiduciary duty.

3. A manager’s past is an excellent predictor of his future actions (results are always another story).

4. Comprehensive due diligence means attending to details, not avoiding searches to save money and time.

CHAPTER 3

What Kinds of Hedge Fund Failures Does the Press Discuss? Why Do Most Hedge Funds that Fail, Really Fail?

Press accounts may prompt you to believe that hedge funds are failing every day, primarily because their operators are crooks. I am not really blaming the press, since it’s their job to report newsworthy items, and people often do find stories about scandal more entertaining than stories about virtue. That said, two points need to be recognized and explored so you have a better understanding of the real risks in investing in hedge funds, as opposed to those that come via extrapolation from salacious stories.

Point one: Most “hedge funds” that fail are not really hedge funds at all. Nor are they vehicles in which the typical institution would ever dream of investing. As I am writing this the following story was published by baltimoresun.com1:

An Ohio investment manager . . . pleaded guilty . . . to two counts of securities fraud. . . .

The agreement . . . calls for David A. Dadante to serve a minimum of 10 years in prison . . . and make restitution to about 100 investors.

More than $28 million was lost in what started as a Ponzi scheme and grew into a market fraud. . . .

Investigators say Dadante looted his fund to finance gambling junkets to Las Vegas and a luxury home in a Cleveland suburb.

This story is as relevant to institutional investors as what Steve Cohen of SAC eats for breakfast, and perhaps less so. David Dadante, described here as an investment manager (and by a previous story in the same publication as a fund manager), was also provocatively referred to by the SEC as an unregistered investment advisor. He was also cited as a purported hedge fund manager by Hedgeworld. For the first time in my memory, in fact, a story actually describes the alleged fraudster as a “purported” hedge fund manager; that is progress at least in that the writer has seemingly recognized that calling yourself a hedge fund manager does not make you a hedge fund manager. (I can bake a mean cobbler but that doesn’t make me Julia Child.)

Another notable facet of the story of Mr. Dadante’s fund is that it had at least 110 investors. Given this number, it is almost certain these investors are individuals; if they were institutions these institutions would be named. This is reinforced by the assets under management figure ($51 million), an amount almost certainly too low to attract institutional attention.

Finally, and perhaps most tellingly, Mr. Dadante is accused of running a “Ponzi” scheme, which refers to a scam perfected by Charles Ponzi in 1920. The reason this scam works is that early investors do indeed get paid, handsomely, in fact, although with monies given by subsequent investors. This house of cards is destined to fail eventually, and in a further bit of mixed-metaphor-dom, the people who lose are those who are last to the party. But the real issue is that the first Ponzi scheme predated hedge funds by more than 40 years—and more like 80 years before the recent surge in hedge fund popularity. Ponzi schemes have nothing to do with hedge funds per se; they succeed because early investors tout their gains to their friends, who then want in on whatever the vehicle of the day happens to be. As hedge fund fever cools off, watch the next generation of crooks move on to another story that will explain how they turn your money into riches (for them).

So why do people who commit frauds call themselves hedge fund managers? For the same reason that criminals and con men have been immersing themselves in the popular financial terms of every era: because it works. Investors want to hear a story that resonates, a story that tells them that the storyteller knows something that the investor doesn’t, something the investor is willing to pay for. Calling yourself a financial analyst just won’t ring as sexy as laying out your ideas under the guise of hedge funds which are now perceived to be hotter than Beyonce.

By the way, I am not a lone wolf here. Commissioner Walt Lukken of the CFTC, according to Opalesque asserted2:

[I]ndividuals who commit fraud by marketing themselves as hedge fund managers and bucketing the profits for themselves ... are fraudsters and have little to do with the concerns surrounding the legitimate hedge fund industry. These fraudulent individuals use the term “hedge fund” as a hook to illegally solicit funds from the public. From a regulatory standpoint, this behavior is not a hedge fund problem, per se—it is essentially an issue of fraud.

Point two: Most hedge funds that fail do so not because the managers are criminals, but because of either business forces or incompetence or demeanor issues. The latter two are still critical and have recognizable signs, which comprehensive due diligence efforts can reveal. The former refers mostly to the economics of investing and marketing, that is, if the fund does not market itself well enough, and achieve above average results quickly, it can find itself managing too little money, and thus unable to support the infrastructure it has developed to run the business at hand. Let’s look at each a bit more closely.

BUSINESS FORCES

This term cuts through a wide swath of territory but can be pretty much narrowed down to some combination of performance issues and fund-raising /marketing issues. Although these issues are not to be minimized, they affect, primarily, the hedge funds themselves far more than the institutional investor community. Why? Well, hedge funds that are unable to raise enough money to sustain their business operation——are those that often have little or no institutional support, by definition; if they had institutions behind them, typically they’d be able to raise money from other institutions. And although this Catch-22 is clearly a dilemma to the small, fledgling hedge fund, it is beneath the radar screen of almost all institutions, and therefore will not receive further discussion here. (Check out http://www.crestmontresearch.com/pdfs/HF%20Myths%20Facts.pdf for a lengthier explanation.)

Regarding performance issues, even funds that have managed to attract institutional attention can fail without doing anything nefarious. Witness Scion Fund, which according to Jenny Anderson of the New York Times heavily shorted a sub-prime lender, one whose stock did ultimately crater.3 Sounds great, right? The problem was the timing, with Scion making its bet a bit too early, something that almost led to its demise. You can be sure, however, that if Scion had gone under, attention to its closure would far outweigh any subsequent stories that outlined how it had been correct in its initial prognostication.

Then there was UK-based Westferry Global Markets, which according to a February 2007 snippet in Hedge Fund Daily, closed not long after it started. Financial News reported that the firm pursued a managed-futures strategy, and “from day one was losing money for its clients.”4 According to Hedge Fund Daily, telling investors to be prepared for drawn-out losses, while keeping the strategy itself a major secret, is “no way to build a hedge fund business,” even if investors are told to expect positive returns eventually.

Other similar stories abound. Take Keel Capital Management LLC, which according to a February 27, 2007, MarketWatch.com piece shut down its $175 million fund because of “a lack of attractive short-selling opportunities and a strategy that it described as too restrictive.”5 According to the story, Keel Offshore Ltd., which concentrated on companies undergoing disruptive change, had a return below its benchmark but noncorrelated to the benchmark, something that is typically a positive trait. However, when some investors began withdrawing their money, Keel had to choose between shifting its strategy or shutting down. The article added an ominous note, “Hedge funds thrive on market volatility, because that creates mis-priced assets for them to trade. But as more hedge funds have started and others have grown into giants, trading opportunities have become scarcer and volatility has declined.”

Finally, what about the billion dollar babies? Mid-March 2007 brought several stories about a number of large hedge funds that saw 2006 as their last year. Hedge Fund Daily, via Absolute Return, reported that nine hedge funds with over $1 billion in assets each ceased to operate in 2006.6 Only Amaranth is likely to be recognizable to people looking for a sexy story; the others that called it a day were “Archeus Capital Management’s Animi Master Fund ($2.65 billion); Sagamore Hill Capital Management’s Sagamore Hill ($2.6 billion); Saranac Capital Management’s Citigroup Multistrategy Arbitrage/Saranac Arbitrage Fund ($2.2 billion); BKF Asset Management’s Levco Alternative Investment Fund ($1.9 billion); Ritchie Capital Management’s Ritchie Energy Trading ($1.2 billion); Saranac’s Citigroup Archer/Saranac Total Return Fund ($1.1 billion); MacKay Shields’ MacKay Shield Long/Short ($1 billion); Mangan & McColl Partners’ M&M Arbitrage ($1 billion); and Harbert Management’s Harbert Convertibles ($900 million).”