Tips on Understanding Hedge Fund Investors

July 25, 2007 |

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

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