Category Archives: Marketing Your Hedge Fund

Hedge fund institutional investor due diligence

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The goal of many hedge funds is to reach a point where they can start attracting investments from institutional investors. Many hedge funds (especially those with pedigreed managers) are able to start with backing from institutional investors while others (including many start up hedge funds) will need to develop a track record before seriously courting these types of investors. This article describes institutional investors and details some of the hedge fund due diligence procedures which institutional investors will put a fund through prior to investing.

What is an institutional investor?

Institutional hedge fund investors include state and corporate retirement and pension plans, endowments (non-profit and educational), banks, insurance companies and other types of corporations and companies. Sometimes there are very large hedge funds which will themselves invest in small and start up hedge funds – in such instances the large hedge fund will be acting as an institutional investor and will require many of the same due diligence materials. Institutional investors are important for the hedge fund community because they provide a very large potential base for investments.

What is hedge fund due diligence?

Hedge fund due diligence is the process that an investor goes through in order to vet a potnetial investment in a hedge fund. Due diligence will include the following:

  • background checks on all of the managers and employees of the management company
  • thorough review of all of the hedge fund offering documents
  • review of the management company’s risk management procedures

Due diligence document request

The timeline for an investment by an institutional investor is likely to be much longer than the time an individual investor will take to invest in your fund. Typically an investment will need to be approved by the managing director in charge of investments or alternatives; then the institutional investor’s compliance department will typically make a request for certain documents and/or other information. A sample list of the documents requested might look like the following:

Please provide the following information:

  1. Brokerage Agreement with [name of hedge fund broker]
  2. Copies of the executed partnership agreement(s)
  3. Copy of executed opinion of legal counsel relating to the legality of the interests [HFLB note: this is not a legal requirement and many funds do not receive an opinion of counsel with regard to these matters]
  4. Copy of executed opinion of legal counsel with respect to U.S. Federal Income Tax Consequences [HFLB note: this is not a legal requirement and many funds do not receive an opinion of counsel with regard to these matters]
  5. Any other legal opinions rendered in connection with the Partnership
  6. Reference name, title and telephone number for each auditor, legal counsel, clearing broker, custodian, consultant, administrator engaged by the Partnership of General Partner for the past two years
  7. A description of valuation policies and procedures [HFLB note: this may not be applicable to a fund; will depend on the investment strategy and the potential investments]

Depending on the nature of the institutional investor, you will see different levels of analysis of the actual trading style and returns of the fund. A sample reqest for information might include the following:

A detailed information on the trading program including:

  • list of investments
  • execution
  • frequency
  • diversification
  • liquidity

A detailed examination of historical returns including:

  • weekly/monthly/annual returns (best/worst/average)
  • sharpe ratio
  • sortino ratio
  • standard deviation
  • VaR
  • drawdown analysis

While I have hit upon most of the high points, any one institutional investor may have requests which are completely different from the items requested above. If you have any questions on the due diligence process or an investment into your fund from institutional investors, please don’t hesitate to contact me directly.

Hedge Fund Seeder to Go Public

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Two hedge fund groups, Tuckerbrook Alternative Investments and HARDT Group Advisors, are joining forces to create HT Capital Corporation, a hedge fund seeder/incubator which will seek to go public with a $300 million offering of it securities. The IPO will be underwritten by Jeffries and Company, will be listed on the NYSE, and go by the symbol “HTG.”

HT Capital Corporation plans to use approximately $200 million to seed/incubate an initial stable of 8 promising hedge fund managers. The company will then seed an additional 10 managers within the 12 months after the IPO with proceeds from the IPO as well as a credit facility. HT Capital Corp. will invest in emerging managers through senior loans to the management company and participating interest (equity) investments in the hedge fund management company. These two types of investments are expected to produce four different revenue streams:

1. an 8.5% quarterly cash interest payment on the senior loan

2. a share of the management company’s management fees (expected to grow as AUM grow)

3. a share of the management company’s performance allocation (with the potential for such performance allocation to increase as AUM grow)

4. a stake in any sale of the hedge fund management company

The company will invest in emerging hedge fund management companies; the below statement comes from their N-2 filing with the SEC:

We plan to diversify across the following three distinct stages of emerging management companies:

“Incubation-stage” management companies, which will generally have few or no assets under management at the time of our investment, but may have, for example, an investment manager who recently came from the trading desk of a larger firm or established an investment track record in another firm’s name. We generally expect to provide incubation-stage management companies with between $5 million and $10 million of senior loans and a participating interests investment of typically about $1 million.

“Early-stage” management companies, which will generally have an investment track record of between 6 months and 24 months and between $5 million and $25 million of assets under management at the time of our investment. We generally expect to provide early-stage management companies with between $10 million and $25 million of senior loans and a participating interests investment of typically between $1 million and $2 million.

Acceleration-stage” management companies, which will generally have an investment track record of between two and three years and between $25 million and $100 million of assets under management at the time of our investment. We generally expect to provide acceleration-stage management companies with between $25 million and $50 million of senior loans and a participating interests investment of typically between $1 million and $2 million.

Hedge fund incubation platforms are becoming more and more popular as reports indicate that small and emerging managers present larger investors with the greatest opportunity for the most attractive returns. By participating in an incubation program as well, the investor will have the opportunity to allocate more assets to the manager in the future – a potentially valuable future right.

Article: What happened with the Quants?

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I wrote this article last October after a presentation made at a Southeastern Hedge Fund Association meeting. The title of presentation was “A Feature Presentation with Matthew Rothman, Managing Director and U.S. Head of Quantitative Portfolio Strategies, Lehman Brothers, Inc.” The meeting was held October 23, 2007 at The Ritz Carlton (Buckhead) in Atlanta, Georgia. Attendees included manager’s from Atlanta’s hedge funds, administrators, prime brokerage representatives and, of course, hedge fund lawyers.

October 24, 2007

We know the basic story for the quant blow-up this summer: in the beginning of July a few very large multi-strategy funds started experiencing large losses (at around the same time that the sub-prime sector was experiencing a melt-down). The funds began getting margin calls and needed to raise liquidity quickly beginning a chain reaction which eventually sent stocks lower, fueling the need sell more to meet margin calls.

While this is an overly simplistic reading of what happened over the summer, this overview set the stage for a presentation by Dr. Mathew S. Rothman on Tuesday to the Southeastern Hedge Fund Association. With some of the finest members of the south east’s hedge fund community gathered to examine what exactly happened with the quants this summer, Dr. Rothman, current Managing Director and U.S. Head of Quantitative Portfolio Strategies at Lehman Brothers, discussed his views on the events.

For those in attendance, including fund managers, lawyers, accountants, administrators and CFAs, the central concern was not exactly what happened in August, but what those events would mean for quants and investors going forward.

What quant managers will need to be aware of in the future

Our law firm helps to form hedge funds for new and emerging managers, including managers who are quants. It is common for lawyers and other service providers to explain to managers, especially new and emerging managers, what potential investors will look for from a quant program. We often provide clients with input on their pitchbooks and how they should “sell” their program to potential investors. In the wake of the quant blow-up this summer, and the insights provided by Dr. Rothman, we will be highlighting the following points for our quant clients.

Increase Transparency

The most important thing for potential investors is transparency. The more transparency a manager provides, the easier it is going to be to raise money. (Obviously this is not strictly true for the large established funds with stellar track records.) Quant is not an asset class and a quant program cannot be the sales pitch – emerging quant managers will need to sell their “type” of quantitative program. Managers need to get away from the “black box” mentality open up a bit, tell investors some of the inputs that will be used and also let investors know some of the inputs that will not be used – this is what we look at, this is what we throw away.

Be prepared to talk about Risk Management

Quant managers should have a good understanding of the risks of their program and be able to discuss these risks with investors. Specifically, managers will need to be able to discuss leverage and any human intervention or overrides of the models.

Understanding a program’s sustainable leverage levels is probably the most important risk management aspect of a quant program. While leverage provides a means to achieve incredible returns, it can also cripple a quant program. Levered programs may not be able to weather a prolonged downturn, which unlevered programs will.

[The fund managed by Dr. Rothman, which used no leverage, was actually up 30bps for August. While the fund was down 7% over 9 days, he was able to stick to his model because he did not have to unwind positions in order to meet margin calls. In contrast, Marketwatch reported that Goldman’s Global Alpha fund was down 22.5% for the month and J.P. Morgan’s Highbridge Capital was down roughly 18%.]

The human element and interaction with the quant model is also an important part of risk management. A quant model is just that – a model. While the model is designed to weather storms to a certain extent, some managers will include a “human override” component to the program. In some instances, allowing for a human override could prove to be exactly the wrong the strategy. Dr. Rothman noted that quant programs who stuck to their models during August were generally those programs which caught the snap-back. Those managers who rebalanced their portfolios (weather for reason of leverage or the human override) were those managers who missed the nice snap-back and ultimately were worse off then if they had followed their programs.

Be prepared for questions related to the August blow-ups

Fat tails and black swans are now standard terms investors use when talking about quant programs. It is very likely that you will be asked about fat tails and black swans by future prospective investors. Does this mean we will tell advisers to rewrite their risk models? No. However, you should at least be able to answer the question as to why your models do not address this phenomenon and it is a good idea to understand a model’s limitations during these times.

The Conclusion

While we may not completely understand what exactly happened in August, it is clear that prospective future investors are aware of the limitations of quant models and will generally want to see more information from managers. While it is always up to the market to decide what any one manager will need to tell prospective investors, moving forward we will let our quant clients know that it would be wise to address the above items when crafting a description of their investment program and deciding how they will market their fund.

Deciding on a strategy for your hedge fund

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One of the most critical questions that a soon-to-be hedge fund manager must ask themselves is this: what exactly is my strategy going to be and (most importantly) is this a strategy I can sell to potential investors. Of course the strategy must be sound and must be something that the manager knows – this is not the time to begin experimenting.

It is most common for a manager to continue on with a strategy which he has been running for a long time, either on the side or with a previous employer. For many different reasons (fear, greed, uncertainty) the manager may decide to implement a dual strategy hedge fund . Often the dual strategy hedge fund will have a more conservative strategy and a more aggressive strategy. The dual strategy approach is different from a principal protection hedge fund and is more than simply hedge fund risk management procedures.

Whether a manager decides to utilize a dual strategy approach is business consideration. If you are running two strategies – a major and minor strategy – then you are going to be, at least somewhat, internally conflicted when it comes to time management, especially if the minor strategy is a time intensive strategy. It might be that the higher returns from the minor strategy (instead of, say, a money market) may not be high enough to justify the time necessary to achieve those higher returns. If that time cuts into the time for the major strategy, then you are probably going to be better off focusing in on your major strategy.

Like anything, when you focus on one trading program, especially for smaller, non-institutionalized fund managers, you are generally going to be better able to perform.

Changing the name of a previous entity (track record portability)

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Hedge fund track record portability is always a big issue. A manager will want to bring his track record with him and some people believe that the track record of a “fund” is better than the track record of a managed account. In furtherance of this, some managers may be tempted to use an old management entity as a fund by changing the name of the entity (and perhaps even the structure – i.e. LLC to LP). In this way the “fund” gets to keep a certain track record and also maintain that it has “been in business” for longer than it has.

There are a couple of pitfalls to this idea. First, in these instances the original entity was often not audited which means that when the fund is eventually audited the manager is going to have to pay a larger audit bill so that the auditor can get comfortable with the previous year’s activities (unless there was an earlier audit). Second, there is the risk that the company has some outstanding liabilities (or the potential, based on the managers past action, for a liability to arise based on previous conduct). The risk of these outstanding liabilities will probably need to be disclosed in the fund’s offering documents.

Whether or not this is even is necessary is debatable. Some people view that having one track record is better than having two track records. However, it seems to me like there is no real reason to go through the hassle and disclosure items. Generally, investors are going to look at past performance. While it is better to have a track record for the fund that is being sold, if that track record comes with a very long disclaimer attached, it would seem to me like this would defeat the purpose. In essence, the manager is trying to hide what must be disclaimed – that this “fund” really doesn’t have this long track record. I think that at the beginning of the relationship with an investors, whether individual or institutional, the manager is going to want to be as forthright as possible. In this case I believe it means that the manager should not change the name, should create a new entity, and explain that the track record represents a program that was run by the manager and is the same program which will be run by the fund.