Thursday, April 16, 2009

No one-size-fits-all in HF due diligence

Here is another in a series by guest blogger Cox Owen on hedge fund operational due diligence. Even though hedge fund returns appear to have stabilized and appear to be flat to slightly up on a YTD basis, OPDD remains a part critical part of the investment process for hedge fund investors.

You can also see his past posts here: part 1 (OPDD) and part 2 (the visit) and part 3 (a framework for OPDD). Please direct any comments to him directly at coxowen1 at


Connecting the Dots (operational to investment )
OPDD is titanic. As in my previous post I will only be able to discuss a brief portion of this material due to its enormity. OPDD requires an eye for detail. More importantly it requires, at a minimal, a general understanding of the investment philosophies. You must be able to understand the investment concepts in order to understand the operational flows. How can anyone claim to verify that the operational flows are correct if they do not understand the investment concept? There are institutional investors who have little faith in quantitative models (that rely on the market to move) and are convinced that active fundamental managers add more value to their investment philosophy. On the other side of the coin, there are other institutional investors who have a significant portion of AUM allocated to quantitative models. To truly understand the operational flows and complexities of these strategies and other highbred strategies we must have an acumen for the investment concept.

Let’s take a closer look for the sake of clarity. Please understand that this is only a small percentage of OPDD used to illustrate specific examples.

First, take a look at some event driven strategies. (Event driven strategies are generally designed to take advantage of inefficiencies caused by corporate actions, also known as “special situations investing”)

Event Driven Strategies
Distressed Debt Example:
There are many ways to invest in distressed organizations. From an OPDD perspective we must be able to understand the general investment concepts. Under Chapter 7 (liquidation procedures) the doors are closing and the assets are being sold. Under Chapter 11 (reorganization) bankruptcy courts restructure the financial obligations of the firm. So now we know that the manager being considered must have at least a bankruptcy lawyer with an in-depth knowledge of the U.S. bankruptcy code , specifically within restructuring or liquidation . This is certainly someone we want to do a background check on . There is clearly much more to the OPDD of a distressed shop than just the lawyer, but it is a good example of where to start when you are differentiating between strategies. ( It is also worth noting that all European bankruptcies are liquidations). We must also understand all of the debt and equity securities of the firm, that lead to “Absolute Priority “– the order in which securities are paid.

As I mentioned earlier, there are many ways to invest in distressed organizations, purchasing senior debt in a liquidation at $0.10 on the $1.00 hoping to receive $0.30 on the $1.00 when the trustee sells the company’s assets is sensible, as does purchasing subordinated debt or equity at a discount during a restructuring hoping to profit from the turnaround of the reorganization. I use this as an example because it could certainly be a red flag if while you were reviewing held securities as part of the OPDD process you noticed the purchase of subordinated debt (during a liquidation) as part of the funds holdings.

The bottom line – the more you know about the investment philosophy the better you can connect the dots between the operational side and the investment side.

Merger Arbitrage Example:
Also known as risk arbitrage, this strategy has a fairly straight forward concept that can become very complex when third parties and government agencies become involved. The primary concerns for managers are whether or not the deal is approved and how long it takes to close. For the sake of this conversation we will discuss the two types of companies. Typically they are referred to as the target firm and the acquiring firm. The usual concept here is to short the acquiring firm and purchase the target firm.

So how does this influence us from an operational aspect? If while we are conducting OPDD we notice shares of companies in the fund that are not part of a merger arbitrage transaction we should absolutely question those shares. Generally we will only see equities in these types of strategies, so if we find options in the fund this should also raise some questions. Options can be used in collared mergers, this is exactly why it is important for operational staff to have a general understanding of the investment concepts.

As an aside: We are making the assumption that we get to view trades in the portfolio. Many large institutional investors require 100% transparency, and in the current environment we could possibly see complete transparency as an industry standard. That is why we sign the Non-Disclosure Agreements.

I was speaking with a friend who is lawyer for a public pension fund and we were discussing the “Public Records Act “ that many states must follow, (any information given to public pension funds must be made available to the general public )and the Hedge Fund Transparency Act of 2009 (which could be passed as early as September 2009 with examination beginning in March 2010) to see how disclosure and transparency will evolve. We concluded that we need to see how the final draft of the HFTA reads. In the mean time some hedge funds may wish to redact brokerage statements to conceal positions from leaking to competitors.

Divestiture (spin-off) Example:
Companies can sell divisions for almost any reason. Hedge funds often follow these transactions (sometimes not completely at arm’s length) because the divisions that were sold will commonly have managers within these divisions having an ownership stake and are intensely driven to advance performance.

How does this have an impact on operational due diligence? If the investment philosophy of the fund is to invest only in large capitalization companies the newly formed spin-off should not be held in the portfolio. Let’s say the portfolio manager decides to hold the spin-off because he or she believes it to be profitable. This type of style drift can be uncovered by proper OPDD and a general understanding of the investment philosophy.

Quantitative Strategies
Trend Following CTA/CPO Example:
There are many ways to invest in trend following CTA’s/ CPO’s. First we must understand the difference between a commodity trading advisor and a commodity pool operator. The CTA is setup to trade managed accounts and CPO’s are setup to trade fund accounts. We should know this from an operational perspective because as an investor we might not want to me a member of the fund and wish to avoid the expenses that funds incur (auditing fees, fund administration fees, legal fees, etc). In general, technical trading recommendations may be based on computer-generated signals, chart interpretation, mathematical measurements or a combination of such items.

So when you are conducting your OPDD you want to ask questions about their data and much more. If you notice a long trade that was made during a downward trend this is almost always a red flag and should be questioned, it could be a trading error, it could be a reversal or something else.

If the offering documentation says that the fund will trade liquid futures yet they require 6 months notice for redemptions due to liquidity this is clearly a contradiction and should be investigated. Once again, these are just 2 examples of many for trend followers and how an understanding of the investment concept can prevent operational disaster and also detect fraud.

Market Neutral Example:
Market neutral strategies(also referred to as pairs trading), like many other strategies ,can come in a plethora of flavors using a variety of statistical methods. Some market neutral strategies will use technical analysis (price & volume data) others market neutral strategies can use fundamental analysis (financial statement data & other economic related data) . Some market neutral strategies are dollar neutral others are not , some are sector neutral others are not. Generally speaking, market neutral strategies usually have long and short equity positions (this is not always the case because of the numerous variations within the strategy and many hedging possibilities).

The market neutral strategies prove the point of understanding the investment concept and its relationship to OPDD very well. If your due diligence personnel are simply verifying that there are equity trades in the fund, this could be essentially any type of equity strategy. You could have thought your participation was with a market neutral fund, your investment personnel could have done thorough investment analysis, but if your operational staff does not know how to tie out the trades to the investment strategy you could be participating in something other than what you agreed to. You could find options, equities, futures and indices in the fund, however if you don’t understand the strategy how do you know if these securities belong to this fund or not? This could be the sign of a rogue trader, style drift, fraud or any number deviations from the agreed investment concept. On the reverse side these options, equities, futures and indices could be part of the strategy.

Where do we go from here?
It seems like every other day another fraudulent fund or Ponzi scheme is uncovered. Now more than ever we need the SEC to drastically improve its investigative knowledge and manpower. We have all heard the stories about Madoff being handed to the SEC on a silver platter and some have commented that the investigators were either conflicted (in hopes of landing a job with Bernie) and others have argued that they were incompetent. In any scenario, we need to insure that this never happens again. Maybe it would help to have the states attorney general offices also develop investigative teams that would provide another layer of protection. Here is another example of an alleged fraudster that got off the hook after being exposed 4 years ago.
In 2005, two Venezuelans alleged in U.S. District Court in Florida that Stanford International Bank "knowingly aided and abetted ... a classic Ponzi scheme" targeting current and former residents of Venezuela. In 2006, former Stanford employee Lawrence J. DeMaria filed suit against Stanford in Florida state court. He alleged that the firm "was operating a 'Ponzi' or pyramid scheme, taking new money to its offshore bank, laundering the money and using the money to finance its growing brokerage business, which did not have any profits of its own."
Well I hope you enjoyed the read and I want to thank all of you for e-mails and your replies to these posts. If I can help in any way certainly feel free to drop me a line or two.

Thanks again for reading.

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