How NOT to Start Your Own Hedge Fund

August 29, 2007 | Leave a Comment

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I have heard about these hedge fund “meet and greets” before, but this one sounded completely awful.  The Fourth Annual New York Hedge Fund Startup and Business Development Forum  (last year) sounds like a shopping mall for turn-key “solutions providers” hawking their wares with wanna be managers hoping to bump into a high net worth investor or two. Of course this forum was held at an upscale facility - Gotham Hall in NYC – a place meant to imbue the feeling of class and professionalism.  From the sound of it, Fortune reporter, Marcia Vickers, seemed anything but impressed. 

It also sounded like a complete waste of time and money — aside from sleazy — with some of the service providers offering up some less than honest tips on how to domicile your fund in the Caymans while hiring an auditor to reset your NAV after you’ve had a good quarter or two so others wouldn’t know you have been trading your own money instead of investors’.

Tip: If you are serious about starting a hedge fund, stay away from these one stop shopping trips to hedge fund land.  Do some research and you’ll quickly find out the worthy service providers from the scags.

Wink, Wink: High net worth types DON’T frequent these events!  They’re too busy making money.

Got any stories to share about these things?  I’d love to hear ‘em.

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Questions for Third Party Marketers: #2

July 30, 2007 | Leave a Comment

Here is the second question in our series of questions every hedge fund manager should ask a third party marketer before signing on with them.  This is a simple one and possibly one that is overlooked because it is just that …

 Question #2:

Request a list of any officers, directors, or management personnel who have left in the past two years. Furthermore, ask for a description of his/her responsibilities, reason for departure, replacement and successor employer. The answers to these questions may be very telling and give clues as to how the firm conducts itself. Be sure to contact the employees who left the firm. They will be able to provide a perspective only an employee can have and may prove enlightening.

5 Questions for Third Party Marketers, A Series

July 26, 2007 | 2 Comments

Ok.  You now have enough assets under management to begin scouting out third party marketers to raise more investment capital for your fund.  You’d like to spend more time managing your strategy than raising capital! So …

The first thing any hedge fund manager working with a sales agent/marketer should consider is with whom they are dealing.  I know it sounds pretty basic, but I’ve heard many stories in my time from managers who were either disappointed or duped.  Therefore, HFL will be posting a series of 5 questions every hedge fund manager needs to ask a marketing agent before signing with them.

So, here’s question #1:

Who are the officers, directors and key personnel are of the firm? Ask them to provide names, title, background, registrations (if any), and number of years with the firm for each member of the management team. Get descriptions of their responsibilities and how the key personnel would be involved in the management of your “account” with them. If you find that the firm is populated by 24 year olds, fresh from tearing up the playing fields of a university, you might want to reconsider working with that firm.  Also ask WHO on their team will be actively marketing YOUR fund? Meet with this person and make sure they understand your fund, your strategy and how your fund is different.  Demand and expect periodic updates from THIS person.  Don’t rely on the managers of the firm to report the updates to you.  Get the reports from the guy in the trench, the one making the calls for you.

Tips on Understanding Hedge Fund Investors

July 25, 2007 | Leave a Comment

We realize that entire volumes could probably be written about investor psycology — and maybe hedge fund investors specifically.  Yet, there are some basic observations, culled from hard won experience, that can be applied to hedge fund investors and that can make the experience of encountering them a little bit easier once you understand them.  You will note that the type of investor we chose NOT to include are the “hurry up and wait” guys.  But I’m sure there isn’t a whole lot we could tell you about them anyway!

Type one is the “follow the herd” kind of hedge fund investor and may comprise the first investors you are likely to attact: family, friends, business colleagues, etc.  These people follow the leads of others and may invest solely via word of mouth. They do not usually perform extensive due diligence nor do they understand how to. They rely solely on personal acquaintance, pedigree and the recommendations of others who may or may not be invested with you. They also make alot of assumptions. The hedge fund community is pretty closely knit and, for example, when a large institution invests in a hedge fund, smaller fund of funds or individuals follow along. A review of the Integral fraud case illustrates how a large institutional investor got duped by this hedge fund and smaller fish got gobbled up along with them. So, some smaller investors, upon hearing of an investment by an institutional investor, assume that every possible precaution has been taken to guard against fraud. It simply isn’t the case. It doesn’t matter what size the investor is, most of them simply do not review their managers appropriately. They believe a degree from Harvard or experience from a top tier investment bank makes a hedge fund manager unlikely or unable to commit fraud. Unfortunately,  they do occaisonally commit fraud, and when they do, the ramifications can be far reaching.

Type two is the “send them a questionnaire” type of investor. This investor meets a number of managers and does conduct quite a bit of analytical review of the manager’s strategy and returns. They will request data, historical returns, perhaps some portfolio information and run analysis or benchmark the fund via some software. All the information received comes from the manager and is taken at faith. They will meet with the manager for an hour and maybe track the fund prior to an investment. At some point they will send a 30-page questionnaire to the hedge fund manager to fill out. This questionnaire usually addresses a number of issues regarding the asset management firm including having strategy specific, operational and risk management type questions. The problem with type two investors is the lack of verification of any information. All the information provided is supplied by the manager. A large number of investors fall into this category.

Type three is the “I will review you but I don’t want to pester you too much so that you tell me to buzz off because I am high maintenance” type of investor. In other words, this investor wants to conduct a more thorough due diligence, but he is afraid of “offending” the manager by seeming like a pest. This type of investor does in fact spend a little more time looking over the operational aspects of these hedge fund managers. Investors of this type may not independently verify information being reported by the manager but they do spend time trying to understand operational aspects of the firm, such as pricing, responsibilities, control of cash, reporting, etc. They won’t just rely on some questionnaire but may go beyond interviewing the investment manager only and may choose to interview others (staffers) in the firm. This is a good technique to see if everyone in the firm is on the proverbial same page. These investors will make an effort to understand pricing, internal controls, and other operational aspects of the firm. And this is where most investors limit themselves and for good cause. If they cannot allocate a large chunk of money to a manager, they may be told they are not welcome to invest. After all, many managers really aren’t looking for high maintenance investors.

Additionally, this type of investor may also ask and even receive some access to the fund’s custodian reporting system to monitor certain aspects of the fund. Several custodians have sophisticated reporting systems that allow a manager to open up their prime brokerage reporting systems to investors and check off the information that they will allow investors to receive.

Type four is the manager/advisor who will conduct a thorough review of the asset management firm. The beginning premise for this type of individual is to verify as much information as possible and to do it independently. There are a number of fund of funds and advisors who conduct this type of review and it is probably the best safeguard against being “taken for a ride” and avoiding investing in a fraudulent situation.

One of the most common deceptions by hedge fund managers is the amount of money they are managing. One can get a pretty good idea about a manager after asking him/her how much they run and then independently checking that information if one can get access.  So why not verify it? Plus there are certain rules regarding 3(c)1 funds and investors sizes so you might think your investment comprises 10% of the fund but you actually may be.

To get access to independent data usually requires investors to ask the manager’s permission to contact personnel at the custodian and administrator. Also, one should have enough “pull” to get this access, meaning the allocation is large in proportion to the manager’s asset base. This type of investor may have a dedicated professional at their firm who solely conducts operational reviews – usually a former hedge fund CFO or auditor since they have the best qualifications for this type of position.

These professionals will independently verify the assets under management, independently verify returns, perform walkthroughs, obtain sample reports, and they understand the internal reporting systems to review responsibilities within the firm regarding the portfolio, etc. They may even test various internal allocation schemes between accounts  (I will get into all of this later).

The type four investor understands the firm they are investing in thoroughly. They know what they will receive in terms of transparency, performance updates and what those updates will contain, who to call when they need information and they have obtained the transparency necessary to closely monitor their investment. Type four asks for it all in the beginning and gets it because if one asks for less in the beginning it is difficult to get more later (as a general rule).

You might say the type four investor does due diligence to the point of overkill.  Afer all, why conduct a year end audit? Simple.  Because it is more than an audit, it’s protection and it allows them to understand how their money is being managed. It’s more than an audit because an audit comes too late in the game. Whether it is the SEC or a CPA firm, they just aren’t timely enough to prevent one from investing with a manager who is in the middle of a debacle.

An audit also allows the investor to understand whether the manager is flowing through more costs than another manager. It allows him to understand how many accounts the hedge fund manager is managing and whether one account generates more fee revenue than another and open up a possibility for the manager to funnel trades into the better fee generating account.

So hedge fund managers — conduct your business operation professionally and with transparency in mind.  Offer those type one and type two investors more information than they know they need.  It will demonstrate that you have respect for them and their money.  Moreover, offering to educate these investors will only strengthen the trust they have in you already and develop the relationship into something more than just investors but as partners.

By Bin Bulsara

Hedge Fund Investors: Know Thy Salesperson, Part 2

July 18, 2007 | Leave a Comment

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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