From the October 2007 issue of Investment Advisor • Subscribe!

Behind the Numbers

Conducting due diligence on managed futures, private equity, and hedge funds

Next time you're thinking about investing in a hedge fund or managed futures account, you may want to check with your grandmother. Explain what you're about to do, and if she understands what you're talking about, you may be on to something.

Altegris Investments, a brokerage firm in La Jolla, California, that specializes in sourcing alternative investments for its high-net-worth and institutional clientele, uses "the grandmother test" when conducting due diligence on hedge fund and managed futures products it is considering recommending to clients as investments. "We like to have managers describe their strategy to us as they would describe it to their grandmother--no offense to grandmothers," says Executive VP Matthew Osborne, the firm's CIO. "If you can't describe to me in layman's terms what edge you have and what anomaly, or market inefficiencies, you are trying to exploit, how would you expect me to describe that to my clients?"

RIAs and investors in alternative investments apply various tests to evaluate prospective managers; this article will touch on some of these. A previous article in this series explored the reasons RIAs use alternative investments (April 2007, "Plotting Your Course"), while a second article focused on some of the ways advisors gain exposure to private equity, managed futures, and hedge funds for their clients (September 2007, "Getting In").

For Altegris, there is a great deal of commonality between hedge fund and managed futures due diligence. The firm's grandmother test is part of the three Ps that encapsulate its approach to investing: pedigree, process, and performance.

Pedigree refers to the professionals involved at a hedge fund or managed futures trading advisory firm, their backgrounds, their expertise, and the kinds of people they are. "When you invest in either a managed futures program or a hedge fund, you should look at that in the same way you think about investing in a business," says Osborne. "It's not just track record that you're buying because past performance is not indicative of future results. You really want to invest in the business."

Is the business a going concern? Would you want to be in business with the principals in five years' time? Also very important, do the people involved want to be in business with each other in five years' time?

Osborne says questions about process are similar for managed futures and hedge funds: Is the manager's approach to the markets repeatable and robust going forward? This is where the grandmother test comes in. "It's important that the strategy can be articulated in a clean and concise manner, and then that that articulation can be demonstrated. Oftentimes, that means sitting in the office alongside the managers as they execute on their strategy." He adds that investors should speak with references, and with other people who might be invested in the product, to get a feel for whether the managers execute their strategy as they say they do.

The analysis of historical performance data is useful to the extent that it provides a quantitative framework for comparing managers to their peers or to suitable benchmarks, says Osborne. That comparison will consist of not only the absolute returns, but also the pathway the manager took to getting there; i.e., the volatility of returns. The comparison of these historic risk-adjusted returns can be relevant for peer-to-peer analysis.

Analysis of correlations (ideally, the lack of it) between managers and against benchmarks can assist with portfolio construction when combining multiple managers into a single portfolio.

"However, we believe that isolated quantitative analysis of historic return streams is flawed, if it is not combined with qualitative analysis of market conditions and the attribution of returns," says Osborne. He says the ultimate goal of analyzing historic performance is to determine whether luck or skill was the predominant factor in producing those returns. Does the manager's investment process create a likelihood of repeatable returns?

Managed Futures Due Diligence

Today, many managed futures trading advisors engage in quantitative trading, also known as algorithmic-based trading. A number of these are considered "black box" strategies, which means the advisor is reluctant to reveal what he considers proprietary information about his trading model. Through its research, Altegris has learned much about the construction and what's required for a robust managed futures quantitative strategy, says Osborne.

Specifically, many managed futures strategies are trend following in nature. Altegris wants to know what timeframe the trend following is trying to exploit. What are the data inputs to the algorithmic systems? Is it just price and time? If so, how far is the look-back period the manager is using to apply to the algorithm? Derivatives of price and time, such as moving averages, are very common.

Asking about how a quantitative system was backtested can generate interesting information about the model, says Osborne. An off-the-shelf program to conduct backtesting may not be as robust as an internally designed C++ program, for example. Then it's a matter of looking at the system, at the platform, and seeing the inputs/outputs. That still leaves a lot of proprietary algorithm in the hands of the manager, he says, and many times that is all right.

Not all trading advisors are quantitative and black box. Many are discretionary traders, who base their trading decisions principally on supply and demand. (It's important to note that discretionary traders often rely on computer tools to determine the timing of their trades.)

With discretionary traders, the people factor is perhaps more important than the process factor, says Osborne, because the investor is betting on the advisor's ability to trade. Also important, says Osborne, is assessing the discretionary trader's ability to manage an increasing level of assets if he's successful. Moreover, even if he was successful managing large sums at a bank, for instance, did he understand the monthly rate-of-return objective that many managed futures and hedge fund investors have, or was he managing to a dollar-profitability objective?

Hedge Fund Due Diligence

With assets flooding into hedge funds from a wide variety of investors in recent years, a manager's business operations, in addition to his strategy and performance, have become a major focus of due diligence. Operational concerns have grown in importance as hedge funds have proliferated worldwide (best-guess estimates put the number at upward of 8,000 funds).

Specialists agree on several points. Scrutinizing the service professionals employed by the fund is critical. Do the accountant, the lawyer, the administrator, the prime broker come from top-ranked firms or second-rate ones? Skimping on these services is probably a disservice to the fund and its investors.

What services do these professionals provide the fund? Here it's incumbent on the investor to speak directly with the providers to verify the manager's characterization of its relationship with them. This includes finding out precisely what services they provide. Principals in the Bayou Management hedge fund blowup two years ago not only lied about the fund's dismal performance and padded its account with cash from a subsidiary, but also fired its accountant Grant Thornton and "hired" a new one, a sham operation established by one of the principals to give the appearance that the fund's financials had been audited, according to prosecutors. The Bayou man was the firm's sole principal, and Bayou was its only client. Apparently, none of the fund's sophisticated investors or consultants who recommended the fund bothered to check out the new accounting firm.

Visiting the offices of a prospective manager is a good way to pick up cues for more pointed due diligence questions. How cohesive is the staff? Are key professionals incentivized to stay on board, or is there regular turnover?

Investors should also understand the fund's management structure. Does a management team operate separately from investment personnel? Does the firm have written policies and procedures in place on issues such as use of soft-dollar commissions, personal trading, and trade errors?

Another critical determination is whether asset growth results in style drift away from the fund's original strategy that had an edge, says Osborne. "Like any business, it's a good thing for that business to grow, provided it's well planned and executed and the quality of the management is not diluted through growth. The discernment of the metamorphosis of the hedge fund manager from a focused long/short strategy to a multistrategy because of asset growth may be a flag. You just have to get inside and ask questions to determine whether you think it's problematic."

Style drift can also occur when the original strategy sputters or stops producing positive returns in current market conditions. A shift to a different strategy, even if clearly communicated by the manager, can be a problem for an investor who allocated to the fund with a specific mandate in mind. On the other hand, a private investor might go along with style drift if he believes the manager has superior talent to run a business.

Private Equity Due Diligence

Due diligence in private equity fund investing focuses heavily on the investment team, its strategy, and its track record. "Our diligence is to try to ascertain [whether] these very successful people become very capable investors and make us returns," says Brian Murphy, managing director at Portfolio Advisors, LLC, a fund-of-funds manager and advisory firm in Greenwich, Connecticut.

"It's not hard to generate an 8% return, but it's really hard to compound your money at 20%. It really does require special investment talent to generate the target returns that most people have for private equity. That's why the top quartile [of fund managers] barely touches on accomplishing that."

Evaluating a prospective private equity fund's team is critical, but the approach is different for a first-time fund versus a firm on its third, fourth, or fifth fund, says one longtime investor and private placement agent, who declined to be named because he has just joined a new company. For an established firm raising its next fund, he says, it's important to ask whether the team has experience in the area of its strategy.

"If it's in the drug area," he suggests, "you would like to see at least one of the partners with some technological training and who has perhaps worked for one of the big pharma companies. In the tech area, you would like to see an EE degree somewhere in there." In the high-tech and drug areas, too, it's good for one or more of the partners to have had operating experience, a management role with supervisory responsibility, he says.

The criteria for a first-time fund are different because the partners do not have a track record together, he points out. "So you want to look at the track records of the individuals." An investor must decide whether he wants to put money with a team that has not had institutional investment experience.

For a firm that is raising its fourth, fifth, or sixth fund, an important consideration is whether it has retained its investment edge, says Murphy. "If a group is hitting on all cylinders and has proven it has a lot of stability in its relationship--even though they might be on fund three and they're really focused on their space and they reference out well--we might give them a shot versus someone who is on fund 10 and they've lost three of their seven founding partners and brought in a bunch of new guys. We think that fund has crested and is on a decline; we think the other group may be worthy of a place. We don't want to take that transitional risk."

Another consideration for an established group raising a later fund is whether it has the infrastructure to invest the new capital. "You don't want to see two guys going out to raise a half billion dollars," says the investor and placement agent. "You want to see three or four with the educational background, the operating background and/or the management background, ideally some of all."

In evaluating a private equity fund, it's important to look at the strategy, says this investor. What is the stated strategy? Have these people demonstrated in prior experience or in a prior fund that they can execute this strategy?

An important part of evaluating a private equity fund's strategy is trying to figure out how it makes itself stand out, says the investor. Take venture capital. "From the mid-1990s until today, there has been such a growth in the number of venture funds that it's very difficult to differentiate yourself from your competition." He cites several examples of how private equity firms try to distinguish their strategies.

One way is to focus on early-stage investing. Another is to limit industry sectors invested in, say, to early stage and only medical devices, or only devices and drugs. Some groups, especially in the buyout area, invest in a company they believe can grow on its own at attractive rates, but can also be used as the nucleus for add-on or lock-in or bolt-on acquisitions.

One strategy in the buyout area is investing in companies that are in growth businesses that have demonstrated a growth record, that are profitable, but can become more profitable as a result of assistance the fund can provide. On the other hand, some funds are not necessarily interested in companies that are growing rapidly and are profitable; they're interested in companies that are not growing rapidly and are facing challenges, whose management and perhaps outside investors are tired. These funds, turn-around specialists, go in with a plan for reviving the company and negotiate an attractive price.


Michael S. Fischer is a writer in New York who focuses on the financial services industry. He can be reached at msf7@columbia.edu.

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