Hedge Fund Investors: Know Thy Salesperson, Part 1

July 16, 2007 |

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Hedge funds, unlike traditional asset managers, are likely to use independent parties to sell their products to investors. These parties-often called third party marketers in spite of the fact they sell rather than market a product -typically strike a deal with hedge fund manager whereby they will receive a portion of the management and incentive fees generated on the assets they raise for the fund. Seems like a pretty straightforward commercial arrangement and in most cases it is. Such an arrangement should benefit the hedge fund manager (it increase its distribution), the marketer (it generates a revenue stream) and prospective investors (it provides them with information to which they might not have access).

Yet prospective investors need to be aware of such relationships when they are performing due diligence on hedge fund managers. In fact, they should expand their due diligence to include the third-party marketer so they can properly evaluate the information the agent is presenting.

Investors first need to discern whether the individual presenting the hedge fund to them is an independent contractor or an employee of the firm. This makes a difference because an employee has a vested interest in the product and firm. They have made a bet (by taking a job with the manager) that the hedge fund is worthy of an investment. Moreover, they may have part of their compensation tied to the performance of the fund itself. A third-party marketer makes no such bet. These agents are independent contractors and they have no vested interest in either the strategy or the firm. Their interest is to raise assets for the manager. Certainly this is a big incentive, but it in no way indicates that they have performed any due diligence on the manager themselves. If the individual marketing the fund/manager is an independent contractor, an investor should evaluate the agent just as they would the manager.

An investor should begin by determining what type of due diligence the agent has performed on the manager. Did they speak with the fund’s auditors? Did they meet with key personnel to ascertain the level of compliance within the firm? Have they reviewed the daily trading activity of the manager? Have they spoken with the fund’s prime broker regarding it creditworthiness and performance? Have they checked with the NASD (if appropriate) regarding disciplinary actions? Do they know the complete employment history of the manager and key staff members?

An investor should also inquire about the specific nature of the relationship between the manager and the agent. What is its genesis? How long has it been in place? Is it exclusive (i.e., do other agents represent this manager and does this agent represent other managers)? Is there a fixed terminus for the arrangement? What is the agent’s compensation program and payout structure?

Part 2

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