Tag Archives: due diligence

Hedge Fund of Funds

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One hedge fund strategy is a hedge fund of funds or fund of funds for short. Fund of funds managers invest in other hedge funds rather than trade directly in the financial markets, and thus offer investors broader exposure to different hedge fund managers and strategies. Like hedge funds, funds of funds may be exempt from various aspects of federal securities and investment law and regulation.

Structure and Offering documents

As noted above the FOF structure is generally the same as a regular hedge fund. The FOF manager will need to consider whether he will need to be registered as an investment advisr with the SEC or state securities commission. The FOF also may be a 3(c)(1) fund or a 3(c)(7) fund and of course, the FOF may also be an offshore fund. The fund of funds offering documents are going to look exactly the same as the hedge fund.

Fund of Funds Fees

FOFs regularly face a lot of criticism for the fee structure. FOFs will generally charge annual management fees of 0.5% to 1.5% and annual performance fees of 5% to 15%. These fees are on top of the management and performance fees which are paid out at the fund level. Because of the two layers of fees FOFs can be very expensive.

Reason for FOFs – Diversification

Although FOFs face criticism because of their high fees, they do offer investors a greater degree of diversification than individual hedge funds. Because FOFs invest in many hedge funds the performance of any single hedge fund will not, in theory, affect the whole portfolio. In extremely volatile times like we are currently experiencing, the FOF is trying to dampen volatility by being diversified. Many FOFs can weather these volatile times, but many FOFs are suffering along with their underlying funds.

Reason for FOFs – Access to managers

One of the main selling points to accredited and high net worth investors is access to hedge funds and managers which the individual investor may not have access to. Many of the very large premier hedge funds are no longer open to any investors. These premier hedge funds may, every so often, open their funds for new investments by existing investors. FOFs which have an investment with these managers will be able to get investor money into these funds.

Many individual hedge funds have very high minimum investment requirements which certain individual investors would not be able to meet. An accredited investor with $250,000 to invest will not be able to invest in a fund with a $1 million minimum, but that same investor will be able to get exposure to that fund through a FOFs. By pooling money from many investors the FOF is able to meet the minimums to these hedge funds with high minimum investments.

Reasons for FOFs – Due Diligence

Fund of fund managers are expected to perform in depth due diligence on the underlying hedge fund investments. This includes both operational due diligence as well hedge fund manager background checks. Many times a FOF manager will actually make in-person visits to the hedge fund’s offices to make sure that the hedge fund is not acting fraudulently.

Entry point for Institutional Investors

Fund of funds serve as a common entry point for institutional investors who want to get into the alternative investment arena. While there is a very large amount of assets in hedge funds through institutional investors, investments by these groups is growing at a great rate. Because these investors are typically conservative by nature, the more diverse FOFs serve as a great way for the investor to test the alternatives market. It is expected that institutional investors will become even bigger players in the alternatives area and therefore it is expected that FOFs will continue to serve as a good entry point to the industry.

For more information on this topic, please see our earlier post (GAO hedge fund report) which details what institutional investors look for when they invest in hedge fund of funds.

Non-active management – Sponsor

The FOF managers main job is to monitor investments in underlying hedge funds. While most fund of hedge funds managers were once active stock pickers, brokers or other industry professional, we are seeing the advent of the FOF manager who is really a sponsor of the fund of funds. A great example of this is Ron Insana, the CNBC analyst who became a FOF manager.

These types of FOF managers have great connections and are able to raise assets for investments in hedge funds but will not spend as much time determining the investments which will be made in the fund. In fact these managers may hire a sub advisor (paid out of the management fee) who will determine the investments the FOF will make. Other parts of the FOF back office can be outsourced – for instance there are firms which will do much of the initial hedge fund manager screening (through databases and other sources) and hedge fund due diligence. If you would like more information on these groups, please contact us.

SEC files complaint against forex fraud

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Summary:

Last Wednesday the SEC filed a complaint against a forex hedge fund manager who was supposedly using a “trading robot” to generate huge returns. It turns out the forex hedge fund manager and the trading robot did not generate the outsized returns, but instead lost investor money. There are two very important items to note here:

1. It is scams like this that has the SEC and CFTC on the offensive to regulate the spot forex market.

2. Again, it is so important for all investors to do proper due diligence on managers and to make sure they know what they are investing in. These fraudsters give a bad name to all hedge fund managers and, sometimes, they can be stopped if the right questions are asked in the beginning.

SEC Release:

U.S. SECURITIES AND EXCHANGE COMMISSION
Litigation Release No. 20688 / August 22, 2008

Securities and Exchange Commission v. Royal Forex Management, LLC and Patrick H. Haxton, (U.S.D.C., Northern District of Texas, Dallas Division, Civil Action No. 3:08-CV-1467-L)

SEC Accuses Carrolton, Texas, Man of Selling Fraudulent Securities Involving Foreign Currency Trading

On August 20, 2008, the Securities and Exchange Commission filed an action in Dallas federal court to halt an alleged unregistered and fraudulent offering of securities by Patrick H. Haxton of Carrollton, Texas, and his company Royal Forex Management, LLC (“Royal”). The securities were investment contracts involving the trading of foreign currencies on the Forex market. On August 21, 2008, United States District Judge Sam A. Lindsay entered a temporary restraining order suspending the offering and orders freezing the defendants’ assets, requiring sworn accountings, prohibiting any alteration or destruction of documents and expediting discovery. The court set a hearing for September 4, 2008 to consider the Commission’s application for preliminary injunctive relief.

The defendants named in the Commission’s Complaint are: Patrick H. Haxton, age 51, of Carrollton, Texas, the owner and sole manager of Royal; and Royal Forex Management, LLC, a Texas limited liability corporation operated out of Haxton’s Carrollton home.

The Commission’s Complaint alleges that from at least June 2007 to the present Haxton, personally and through Royal, raised at least $305,000 from 8 investors in three states. Haxton offers the Forex investments through the Royal web site (www.royalforexmanagement.com), advertising on his work truck and personal contacts. Royal’s promotional materials and Haxton’s oral statements are replete with representations of phenomenal past trading returns, including claims of 400% to 500% annual returns, generated by a complex software program named “The Currency Trading Robot” (“Trading Robot”), purportedly created by Haxton. On the web site, Haxton claims to have a great history and to have been a very successful trader since 2000. Haxton and the web site also represent that there is very little risk of loss.

The Commission alleges, however, that these representations are materially false and misleading. For instance, the Commission contends that Haxton and Royal never generated the claimed phenomenal returns by trading currency. Indeed, according to the Complaint, Haxton lost a significant portion of investor funds trading foreign currencies and misappropriated the remaining funds for his own personal use. In some instances, investor funds were never traded, but were used to pay business and personal expenses.

The defendants are charged with securities fraud under Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and with conducting an unregistered offering under Section 5 of the Securities Act. The Complaint also seeks permanent injunctions, civil penalties and disgorgement of ill-gotten gains, among other relief, against each defendant.

The Commission would like to thank and acknowledge the assistance of the Texas State Securities Board in this matter.