Understanding Investor Due Diligence

January 11th, 2012
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Contributed by: Merlin Securities
The investor due diligence process has evolved with the growth of the hedge fund industry. What was once a short and rather perfunctory process has grown into one which today is highly quantitative and detailed. While there is no one-size-fits-all formula for investors, one certainty is that managers who understand the components of the due diligence process will have an easier time meeting the requests of investors.

This paper, based on numerous conversations with investors, seeks to identify and describe the components of a professional due diligence process – from simple annual return figures to detailed attribution analysis. The end goal is to provide a basic roadmap that can help fund managers understand the depth and breadth of this process and ultimately to help them achieve their fundraising goals.



Prior to the institutionalization of hedge fund investing, investment decisions and allocations were largely made on the basis of performance numbers and the qualitative aspects of a fund: people, process and philosophy. Over the past decade, the needs of professional fund investors have resulted in the evolution of the investor due diligence process. Today, this process has expanded to encompass both qualitative and quantitative aspects of a fund and its performance. In order to successfully raise capital, managers must be able to articulately convey their value proposition, the components of their performance and the risks they take to achieve that performance.

This white paper represents an effort to describe the investor due diligence process, with a specific focus on the quantitative performance metrics. We have conducted dozens of interviews with fund of funds and direct investors in hedge funds in order to articulate the process as described by the professional fund investor. We found that the process has become very data driven and time intensive, requiring greater transparency and granularity than ever before.

It is not our intention to present an introduction to hedge fund statistics and reporting, but rather to write a white paper that helps managers better position their funds in a competitive capital raising environment.

MOVING THROUGH THE DUE DILIGENCE PROCESS – FROM QUALITATIVE TO QUANTITATIVE

Prior to selecting an investment target, hedge fund investors first determine the investment strategy to which they will be allocating capital. Strategies include:
• Equity fundamental value, fundamental growth and market neutral
• Event-driven funds
• Global macro-oriented products
• Relative value strategies, including fixed income

After generating a manager list within the strategy subset, the natural entry point for an analysis of a fund is a qualitative look at its people, process and philosophy. These elements comprise the backbone of all funds and are the source of their performance.

People: This is typically the most important and decisive element of the due diligence process. Investors want to know who the decision makers are at a fund and where they received their training. A hedge fund manager’s experience and pedigree is important in establishing him or her as an expert. While not necessary, working at a recognized firm with a proven ability to generate alpha lends credibility to their training. This may lead to a shorter due diligence process as it makes it easier for investors to check references. Investors will speak to previous employers and colleagues to determine a manager’s exact role and specific contribution to performance.

Process: Investors want to know that a manager has a proven process in place from idea generation, through research and portfolio construction, to risk management. Managers must be able to articulate their process in a concise manner to convey to investors that a fund’s performance is consistent and repeatable.

Philosophy: A fund’s philosophy is what differentiates it from the competition. In order to effectively communicate a fund’s philosophy, a manager should focus internally on the aspects critical to their investing process. Investors want to understand where managers allocate the majority of their time and where they have true expertise.

These three main qualitative factors build a framework for a fund and are the first of a multi-step due diligence process. If a manager fails to meet an investor’s standard on the qualitative front, then that manager will not have the opportunity to move forward in the due diligence process. That being said, qualitative analysis alone is not enough to form a complete picture or to ensure an allocation. As our friend Paul Platkin of Arden Asset Management explained, "Any manager can tell a good story, due diligence is the process to make sure the story makes sense and that the numbers support it."

DEMYSTIFYING THE ELEMENTS OF A FUND’S PERFORMANCE

Performance is the result of a fund’s people, process and philosophy. A fund’s net performance number, however, is only the first step of the quantitative portion of the due diligence process. Investors will also want to understand what risks were taken along the way and where the money was made to determine if performance was a result of the process.

After a full review of returns and risk, an investor will take a deeper look at the numbers to understand the factors behind performance generation. The most common method, absolute attribution analysis, will answer questions regarding active versus passive investing and determine whether returns fall inside a manager’s stated strategy and where managers are risking investor capital.

An investor conducting quantitative due diligence is similar to a painter painting a picture. With each layer of paint that is added to the canvas, the image begins to take shape and become clearer. Similar to a painting, hedge fund due diligence should be thought of in terms of overlays, with each overlay providing additional clarity to an investor’s understanding of a fund and its returns. Once all of the overlays are in place, they provide the investor with a complete picture of the hedge fund manager. For the purposes of this white paper, we have identified three overlays that comprise the quantitative due diligence process:

First overlay: Performance

Second overlay: Risk

Third overlay: Attribution Analysis

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