The Due Diligence Imperative

by Sara Grillo, CFA Jul 17, 2010

The rewards of properly-conducted due diligence are high. Sara Grillo of Diamond Oak Capital Advisors explains the benefits of due diligence in the reduction or elimination of the risk of fund fraud or asset overvaluation can significantly enhance investment returns.

Hedge funds remain an appealing investment vehicle with the capacity to improve diversification and risk-adjusted returns for their investors. Investing in them, however, must be done with thorough analysis, including investment and operational due diligence, a critical part of the hedge fund investment process. The rewards of properly-conducted due diligence are high – reducing or eliminating the risk of fund fraud or asset overvaluation can significantly enhance investment returns.

The primary lesson of the hedge fund investment cycle that ended with exposure of the Madoff fraud is that this process frequently failed, often because of advisor conflicts of interest. Independent, unbiased due diligence on behalf of the investor is crucial. The overarching question is always: From a purely investment standpoint, is this fund, compared with its peers, the best investment vehicle?

There must be a realistic chance for a fund to fail the due diligence analysis. If there is not, the process is not stringent enough. The process should also be free from bias:

  o When a fund pays to have due diligence performed, bias may influence the analysis
  o When a fund pays an evaluator based on assets brought to the fund – such as an external “feeder fund” – bias may influence the analysis
  o When an entity receives a fee for steering investors to a fund on its platform, bias may influence the analysis as the fund may have been chosen simply for its willingness to meet the criteria to be on the platform.

Thorough due diligence includes both operational and investment components. The Madoff fund failed both – from an operational standpoint, self-custody of investor assets and a substandard auditor raised serious operational red flags; from an investment standpoint, his inability or unwillingness to discuss strategy with investors is incongruous with the world-class investor and portfolio manager he purported to be. A fund such as Amaranth, with a portfolio highly concentrated in a single investment idea, also failed both; risk parameters failed and high portfolio concentration rendered the fund’s investment strategy a poor risk. Proper diligence is particularly critical when investing in “emerging” hedge fund managers, those often defined has having a track record shorter than three years and assets of less than $300 million.

Skepticism and persistence are indispensible in the process. It is imperative to know the hedge fund, its competitors, its investment strategy and be able to have peer-to-peer conversations with the managers and other senior personnel. Research has shown significant failure of funds to tell the truth during due diligence reviews.

The due diligence process must go far beyond a simple background check. There is a need to use a questionnaire to obtain information and gauge the manager’s ability to describe its investment strategy and business – which itself provides insight into investment skill. The analyst’s ability to interpret answers and derive follow-up questions is the most important part of the questionnaire process.

Quiet hedge fund managers inhibit transparency and are highly suspicious. Manager willingness and ability to talk at length about strategy should be a key component of a scoring system. Investing prudently requires patience; it is never appropriate to invest just to put money to work. Ample substitutes for uncommunicative managers exist in each hedge fund investment strategy; there is always another manager who may be found to be worthy of capital.

Key substantive subject matters of a questionnaire should include:

    o Investment Strategy and Process
    o Investment Performance
    o Transparency
    o Valuation
    o Audit Procedures
    o Portfolio Risk Management

Additionally, the analyst must be mindful of the importance of intangible factors and be able to judge them: character, talent, and dedication.

In addition to due diligence at the time of investment, continued manager monitoring is critical. The initial due diligence process should flag important issues for continuing review. The monitoring process gives investors ability to help them unwind troubled investments on their timetable, not regulators’ timetable – which is almost always too late. Key factors to review include style drift, personnel changes and strategy changes.

Past failures of fiduciaries have illuminated the need for proper prudence, independence, and intelligence applied to the hedge fund selection and monitoring process. However, when correctly performed, hedge fund investing may offer significant portfolio benefits.

* Sara Grillo, CFA is a Managing Principal of Diamond Oak Capital Advisors, LLC, a New York-based investment advisory which designs customized Fund of Funds portfolios. More information on Diamond Oak Capital can be found at www.diamondoak.com.

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Image of Sara Grillo, CFA

Principal at Diamond Oak Capital Advisors, LLC

Ms. Grillo has performed extensive quantitative research, modeling, and due diligence at three funds of hedge funds. Her 12 years of industry experience include work at Lehman Brothers and JPMorgan, and internships at Fidelity Investments and Merrill Lynch. Ms. Grillo earned a B.A. from Harvard University and an M.B.A. from NYU Stern School of Business, and is a CFA charterholder and member of the New York Society of Securities Analysts' Alternative Investment Committee.  She is an avid author on the subject of alternative investments.  In 2005, she authored a piece on the statistical aberrations in risk monitoring of hedge fund strategies, which was published in London’s Investor Services Journal.  Her writings on alternative investments have appeared in several publications devoted to the space. 

Ms. Grillo speaks Spanish and mentors younger women and minorities in finance.