Hedge Fund Investors: Know Thy Salesperson, Part 2

July 18, 2007 |

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This is the second installment to our piece educating investors about third party marketers:  

Next, an investor should ask the agent about his/her own professional experiences. Has he/she marketed other managers? If so, whom and when? (It is certainly appropriate to check references.) Why did he/she leave and choose to market this new manager? Investors should ask what licenses the agent may hold (even though none may be required). If the agent is registered, investors should check his/her disciplinary history with the NASD.

If investors ask no other question, they should ask whether the agent has invested any of his/her own money with the manager. If so, they should be asked to explain why.

As I said at the beginning, most third-party marketing arrangements are solid commercial relationships. And most third-party marketers are highly professional and ethical individuals who can add real value to both the investor and the manager. Yet an event several years ago in the hedge fund industry should keep investors on guard. A small hedge fund with extraordinary performance numbers was approached by a third-party marketing firm about striking such sales relationship. After reaching an agreement, the agent began to aggressive market the fund to investors. The manager’s allegedly stellar performance and the agent’s strenuous sales effort resulted in a considerable inflow of assets. The situation changed rapidly after the agent began to suspect the fund was overstating its performance. The agent learned that in spite of the fund’s claim, the fund’s performance had not been audited by a major accounting firm. In fact, it had not been audited by any external organization. The agent turned tail and notified investors (and the media) of the fund’s possibly inflated performance record.

It seems that the agent had not performed its own due diligence on the fund. It had not verified a claim in the fund’s documents that a large accounting firm was the fund’s auditor. It had not checked the veracity of the fund’s stated performance (even though it defied common sense-especially given the strategy employed by the manager). If it had, it would have likely uncovered certain “shortfalls” and, accordingly, saved investors considerable aggravation-and money.

Even if the agent were ignorant of these issues, investors could have made a more informed investment decision if they had asked the agent about the type and kind of due diligence it had performed. If they would have asked just one question, “Have you invested your own money in the fund and if so, does the amount you have invested represent a significant portion of your investable asset?” They probably would have learned that the agent had no vested interest in the manager-other than its payout.

Transparency is the watchword when investing in a hedge fund. Investors would be well served if they include the marketing representative in their manager due diligence process.

See Part 1: Investors: Know Thy Salesperson

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