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Portfolio > Alternative Investments > Hedge Funds

Due Diligence and Over-the-Counter instruments

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The rising popularity of increasingly complicated over-the-counter instruments is making the performance of due diligence a tougher proposition given OTC securities’ ability to add unexpected risk and create pricing problems.

Indeed, according to the Bank of International Settlements, Basel, the total estimated notional value of such contracts stood at US$169.7 trillion in mid 2003.

Prospective hedge fund investors concerned about the valuation/liquidity issues raised by such instruments might focus only on hedge funds that invest in securities traded on exchanges, whether for stock or derivatives. Those prices, after all, are in the newspaper in the morning and on Bloomberg screens minute by minute. But there is a trade-off for that simplicity. Certain fruits (even low-lying ones) will go unplucked; certain risks will go unhedged.

A broader approach would be to research and invest in funds that can use over-the-counter instruments and the arbitrage strategies that they often involve but only if the instruments they use are liquid, i.e. subject to transactions by multiple counterparties. That way, the investor or investigator can value assets by seeking bids and estimating value as the average of the bids indicated.

And of course, a hedge fund investor, could make the leap of faith that entails investing in hedge funds that do just about whatever they want. Checking up on funds that use OTC derivativses, liquid or not, takes more work than looking up a price in the newspaper, of course–which is precisely why there is a market for firms that contract to do it. The Hedge Fund dataBank LLC, Atlanta, is one such firm.

Founded by C. Scott Akers Jr., the dataBank allows investors that can’t afford to do due diligence properly in-house to outsource that work. The dataBank focuses on the early stages of a fund’s life cycle. They seek out established and viable firms with managers who don’t yet have too many assets under management and too much of a known track record. This is the “high-growth and wealth-creation stage of the hedge fund managers life,” Mr. Akers said, past certain thresholds, they’ll be “absolutely flooded with capital, very little time before they’re closed.”

Mr. Akers wears two hats, so to speak. He helps manage hedge funds himself as a principal of Register & Akers Investments, Inc., Atlanta. And he offers evaluations for third parties via the dataBank. “If we find that they’ve got securities that are difficult to evaluate, we don’t take a position with those firms at all,” in the funds he manages. As to the research he provides third parties, “If somebody paid us to go evaluate it, and we saw some of those issues, we’d point that out as part of our due diligence.”

Another due dilegence pro said that a famous hedge fund blow up, that of Askin Capital Management, could have been prevented with adequate due diligence on pricing. Robert Krause, one of the founding partners of Event Capital Markets LLC, Gillette, N.J., said he is confident that adequate due diligence would have steered investors away from the Granite debacle of 1994. Mr. Krause said, “We do analyze the funds fairly thoroughly and especially when you get to pricing. That’s a big flag when you can’t price the portfolio. Where are they getting their marks from? Bid? Ask? A midpoint?”

Auditors should concern themselves with valuation, but in the words of a report posted on the web site of CRA Rogers Casey in the spring of 2003: “We are aware of one audit of a billion dollar hedge fund that is done by the portfolio manager’s uncle.” Preferably, the CRA Rogers Casey report continued, a non-kin auditor will verify securities pricing by calling the prime broker and having them back check. Usually, three historical bids make a reasonable base for valuing illiquid securities, but even that can be a bit tricky, since such “indicative bids” may not describe real buying intentions.

Robust Integrity

The author of that report, Alan Dorsey, expanding upon it in an interview, said that “there are far more hedge fund managers with robust integrity than there are crooks,” and in CRA RogersCasey’s due diligence work, the managers are generally cooperative. Of course, the diligent have to ask the right questions. “There are different levels of integrity and different assurances that they require, like non-disclosure agreements” with regard to proprietary information.

In terms of the internal controls of a hedge fund, the fund managers must ensure the separation of the back office from their front office. In the front office of a fund, where trading is done, of course there will be strongly-held views about how the fundamental value of an instrument differs from what others are bidding on it. Such differences are the source of trading profits. But in the back office, the reigning premise must be that the market is right.

Mr. Dorsey also discussed hedge fund managers’ use of indicative bids to value their own portfolio. An indicative bid means simply that a manager would call up a prime broker or market maker and ask how much the latter would pay for a certain illiquid security. Typically, one would call three different prime brokers and use either the average bid or (to be conservative) the lowest.

If the manager and the prime broker do business together as a regular matter, might not the prime broker in such a situation be tempted to tell the manager what he wants to hear, rendering the “indicative bid” not only unindicative but hazardous? Mr. Dorsey, queried on this point, said, “this is an area that people are aware of, and I don’t think that anybody wants to do the wrong thing.”

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Contact Robert F. Keane with questions or comments at:

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