Institutional Investors: Sniff Testing a Hedge Fund Manager’s Operations

Due diligence.

It’s the homework institutional investors do when selecting fund managers as part of their asset allocation process.

The selection process often resembles a courtship, with one exception. The investors– typically pension plans, endowments, non-profits and insurance companies — have the upper hand. If they aren’t satisfied with what they hear– and feel — the relationship will be over even before it even begins. If the fund manager can’t pass muster, it won’t win those additional dollars it needs to grow its assets under management.

Once focused almost entirely on investment returns in their due diligence on fund managers, institutional investors are now digging deeper into operational issues. They want to know if the middle and back-office pipes are strong enough to withstand potentially higher trading volumes and if the relationships with external service providers are built on the correct checks and balances.

Such operational questions might have once accounted for less than ten percent of the decision-making process, but now typically constitute at least thirty percent of the investigation, if not more. Institutional investors have learned the hard way not to rely solely on impressive numbers on a spreadsheet. With alternative single manager hedge funds and funds of funds taking up a growing proportion percentage of allocations — frequently ten percent or more of an institutional investor’s holdings — there is reason to be a lot more careful.

“The Madoff scandal and similar smaller scams have taught investors they have to delve more closely into the veracity of any figures shown. To do that they have to be comforted that independent third-parties are involved with processing legitimate transactions with the appropriate sets of controls,” said Timothy Ng, chief investment officer for Clearbrook Global Advisors, a New York-based investment advisory firm which conducts due diligence on asset managers for its institutional clients.

Bernie Madoff got away with cooking the books reporting non-existent trades with inflated returns, if for no other reason than he did all of his firm’s post-trade processing functions. There were no third-party service provider confirming his numbers.

Firms, such as Clearbrook, are hired by institutional investors to match them up with just the right asset manager. No institutional investor wants to get committed, only to discover it needs a fast exit strategy. Even if willing to accept the potential financial loss, a quick divorce may not be an option. Hedge funds have minimum lockdown periods during which investors cannot take out their monies.

In speaking with Ng and other attendees of the recent gathering of investment fund consultants co-hosted by the Investment Management Institute (IMI) and Hedge Fund Association (HFA) in Old Greenwich, Connecticut, FinOps Report gleaned the following four tips for institutional members evaluating fund managers beyond investment performance results. They may not be foolproof, but these steps highlight the questions that need to be asked, regardlesss of the fund manager’s investment strategy or type of institutional investor.

1. Verify with Service Providers

A recognizable brand name in a fund administrator, custodian and prime broker may offer some credibility — and perhaps get it through the earliest elimination round of potential candidates — but brand credibility needs to be backed up by facts and answers about processes and relationships. Fraud can take place when an institutional investors doesn’t understand the underlying operational process.

“We will ask to see how the entire trade lifecycle process works, look at all of the reports and verify all of the reports with each service provider,” says Ng, a panelist at the joint IMI-HFA event. “We will then want to know what system of checks and balances has been established to ensure that there are multiple signatories to any movement of cash and collateral, and those are verified by the service provider.”

A big no-no: allowing unauthorized staff to sign off on the transfer of cash or collateral. “We were forced to fire a fund manager when a staffer signed off on a wire transfer when his boss was on vacation and the transfer went through,” says Ng.

Yet another faux pas: allowing a fund manager to cross-collateralize a customer’s account with its own family account. It’s is a breach of fiduciary responsibility and could easily lead to a financial loss if the fund manager’s personal holdings go south. “Unless an institutional investor understands that such a scenario could take place and specifically asks about it, it won’t catch the potential risk,” says Ng.

Investors shouldn’t depend only on paper reports and documentation in their due diligence. Face-to-face visits with staff at both the fund management shop and its service providers can provide operational insight and also confirmation everyone is on the same page. “We expect potential investors to ask our service providers the same questions they ask us and get the same answers,” says George Schultze, managing partner of Schultze Asset Management, a Purchase, New York based fund manager specializing in distressed securities.

Al Morrison, principal and senior consultant with Baltimore-based consultancy Asset Strategy Consultants, compares his firm’s operational due diligence on behalf of institutional investors to the process of triangulation. “We’re looking for discrepancies between what officials at service providers disclose about their relationship with a particular fund of funds manager and what the manager itself says,” he says. A difference in explanations as to why a fund manager switched providers is a clear warning that something may be amiss.

It goes without saying that fund managers should be using external third-party providers. Madoff’s scam depended on creating master-feeder funds housed under his umbrella which he could self-custody and self-clear without any oversight. Make certain the third-party provider is truly independent and not a unit or affiliate of the fund manager. “Institutional investors should have been alerted something was amiss when visiting Bernie Madoff when they couldn’t speak with any custodian, administrator, or prime broker,” says Schultze. “They just relied on the big numbers.”

2. Verify Valuation Process

The calculation of the value of an investor’s holdings is only as good as the numbers backing it — meaning the specific valuations of the underlying assets of the fund. When the assets are exchange-traded securities, it’s is a breeze because market data is publicly available. Not so when it comes to some asset-backed, mortgage-backed or private equity assets. These complex valuations are based on a combination of science and art — hard pricing model and inputs plus interpretation of market trends. “The fund administrator needs to be able to handle such esoteric instruments and the fund manager should also rely on an independent third-party pricing specialist,” says Ng.

In the case of an institutional investor wanting to invest in a fund of funds, it’s critical to ensure that the fund of funds manager has the appropriate infrastructure, software and processes in place to aggregate underlying hedge fund data such as valuations and cash flows. The fund of funds manager must be able to reconcile its books and records with those of each hedge fund manager and service provider, explains Morrison. Such reconciliation is needed to confirm the composite figures, and with so many moving parts, it’s easy to make a mistake.

The fund manager must also demonstrate it has a valuation committee with specific guidelines as to how each asset category should be priced, under what conditions valuations must be changed, and who at C-level should be notified when errors are identified. Schultze says that his firm’s valuation committee meets once a month and consists of representatives from fund administrator UBS Fund Services, his chief compliance officer, chief financial officer, and himself.

One clear red flag, says Ng: a fund manager who says it will override an external valuation. He cites instances of fund managers who intentionally grossly overvalued portfolios of holdings in non-publicly traded assets. Naturally, by doing so, they could charge investors excessive performance fees. Regulators eventually uncovered that the true valuations were only a fraction of the managers’ stated values.

3. Look into Relationships

It’s a given that independent board of directors are supposed to be just that — independent or unbiased. “We pay close attention to not only their qualifications, but the number of companies they service,” says Ng. “A board member who sits on several dozen hedge fund boards of directors might not be all that objective and could easily be overworked and look the other way at potential problems.”

When it comes to a fund manager’s employees, common sense also applies. “If I get a call from the chief marketing officer asking if I know of any other jobs, it’s time to worry,” says Ng. Mismanagement or even potential fraud comes to mind.

When it comes to matching an institutional investors with a fund manager, “we won’t present any manager we wouldn’t want to work for,” said Andy Wethern, a consultant in the West Palm Beach, Florida office of Asset Strategy Consultants, which helps institutional investors track down suitable fund of fund managers. Case in point; a fund manager who says it doesn’t need to add any operations staff could be suspect if it plans to scale up the business. It simply isn’t sound to overload current employees. Yet another red flag: high turnover, says Wethern, also a panelist at the IMI-HFA event.

4. Consider Liquidity

It’s not enough for a fund manager to say that investors can redeem their holdings on a quarterly or even semi-quarterly basis. Institutions investors need to be concerned about the liquidity of the underlying assets, when considering the terms of a lockdown agreement. “There were fund managers who during the financial crisis of 2008 did allow their investors to redeem their holdings, but investors found out they couldn’t,” recalls Ng. The reason: the underlying assets–often exotic mortgage-backed and asset-backed securities —  weren’t liquid enough or had rapidly become illiquid.

While addressing these four basics should help investors pry open the Pandora’s box to uncovering critical operational information, there is debate about whether institutions investors are sufficiently concerned or worrying too much. Ng thinks they are belatedly addressing the critical issue of operational risk, but Schulze wonders if they aren’t overcompensating for past mistakes. “The pendulum may have tipped too far in favor of paying too much attention [to operational issues] and not enough to investment results,” he says. “There are some institutional investors, who are happy with low returns as long as they are comfortable the operational risk is low.”

As institutional investors are now asking more questions of prospective asset managers, it appears to their decision-making increasingly logical and fact-based. Not always, says Schultze who recalls the most bizarre request he ever received: a handwriting sample. That investor apparently made the same request of Bernie Madoff. Madoff won the investment. “It became clear that he was putting hundreds of millions of dollars with a fund manager by relying on a rather unscientific approach,” says Schultze.

Needless to say the potential investor lost plenty, as did others. Operational due diligence shouldn’t be taken lightly. It may not be as quantifiable as understanding performance results but it’s just as important, if not more so, say experts. No one wants to be stuck with headline risk.