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Some thoughts on a decade of due diligence

By David Woodhouse, Operational Due Diligence

Permal Investment Management Services Limited

Q4 2013


It has been my privilege to perform due diligence on hedge funds for over a decade, first for Fauchier Partners and now for Permal. Our teams have spent many thousands of hours with managers during that time and it should be emphasised that our meetings are for the most part as reassuring as they are stimulating. However, it is also inevitable that we have seen a whole spectrum of behaviour ranging from innovative best practice (usually the product of a culture of alignment and transparency) to conduct unbecoming a fiduciary (usually accompanied by grandiloquent or self-serving rhetoric). Such experience is instructive and, as we enter a period of more intrusive - but not necessarily more effective - regulation, it may be worth reflecting on where hedge-fund due diligence has been in the past 10 years and where it might be going.


The hedge fund industry is vulnerable to caricature and the prevailing popular wisdom is that, on the one hand, most investors did not take due diligence particularly seriously before the credit crunch while, on the other hand, the attitude of many managers to treating clients equitably and fairly was cavalier at best and contemptuous at worst. Most practitioners will be able to share anecdotes which might support this view of antediluvian practice but the truth of the matter is that, well before the deluge of 2008, the dynamic between investors and managers had already developed to the extent that proper emphasis was being placed by many of them on the two central aspects of the covenant between them: the protection of investor capital and the alignment of manager interest.  


It is perhaps easy to forget that many allocators had developed dedicated due-diligence functions with real powers and technical acumen long before 2008. Some chose instead to outsource due diligence to external advisers who have also made an important contribution to keeping managers honest (particularly if not being paid by them).  The work of both in-house and outsourced teams was one of the influences encouraging enlightened managers to develop suitably robust infrastructure, meaningful involvement by independent service providers and purposeful disclosures. For example, while the three-level fair-value hierarchy introduced by FAS 157 and its successor accounting standards has been an extremely useful development, intelligent investors had long been asking managers for this information in essentially the same - or even more nuanced - classifications. Due diligence officers should always be reluctant to tempt fate or appear righteous but many of them could say without the benefit of hindsight that they would never have countenanced the lethal combination of self-custody and conflicted auditing which characterised several celebrated frauds.


Against this background, the financial crisis was significant more in the sense that it helped accelerate developments already in train. Overall, hedge funds turned out to have managed liquidity and leverage considerably better than banks.  However, a healthy repercussion of the individual cases of mismanagement was that the minority of firms who had proved more reluctant to adopt sound practice came under increased pressure to reassess their attitudes: where once there may have been a reflex to disclose the minimum possible, now a more transparent atmosphere prevailed; where once “self-administration” was sometimes tolerated, now the tension in the valuation of complex assets between expertise and independence was better managed; where once fund governance may have been an afterthought, now the voice of investors – perhaps necessarily shrill at times – was listened to more attentively.


Despite these achievements, due diligence still has a role to play in ensuring that past mistakes are not forgotten and in contributing to the debate about future evolution. That we are seeing signs in our fieldwork of a relaxing attitude to liquidity mismatch and counterparty risk perhaps bears out J.K. Galbraith’s observation about “the extreme brevity of the financial memory”. 


At the more structural level, my personal view is that there are two areas where there has been more discussion than progress in the last decade. First, it hardly seems unreasonable for investors entrusting millions of dollars of their capital to expect full portfolio transparency from an independent source on a periodic basis (with protections for the manager such as lagging and exceptional redaction where necessary). At the time of writing, full transparency can be reliably secured only through the managed-account format. Second, while it is proper that remuneration should be set by the market, most of the bargains struck between allocators and managers have been on the quantum, not the basis, of fees.  In the long term it is in the industry’s interests to attend to the asymmetric incentive structures which can encourage bad long-term outcomes.


Recent regulatory directives have touched upon some of these issues with good intentions but under the misapprehension – as is the case with Basel III – that a more complex set of peripheral rules and disclosures than the previous set will somehow stop human beings succumbing to human nature.  As well as the danger of regulatory arbitrage caused by non-uniform application across jurisdictions, there is a high possibility that a self-referential and self-perpetuating assortment of activities may evolve, under the name of risk and compliance, which adds little value and discourages its practitioners from applying common sense. In the same way, while investors should always devote the requisite effort to the forensic examination of constitutive documents and control processes, what has come to be known as operational due diligence should in fact be more about people than about operations.


One of the main features distinguishing hedge funds from more traditional investment vehicles is that the equity of the entities managing them is usually held in very few hands. In my view this is mostly for the better because the classic principal-agent problems tend to be less pronounced in boutique management companies (where the aim should be for the principals to become the largest investors in their funds). That said, it is very easy to talk about being fully aligned with one’s investors but much harder to mean it. Style drift is a phenomenon to which investment analysts must be alert; lifestyle drift by the principals should be the parallel preoccupation of due diligence. Just as the egregious pass-through of expenses can presage abuses of investment mandates, so early evidence of managers being seduced or distracted by their own success can be the harbinger of risk-management failure. This is why, however trite or naïve it sounds, the focus of ongoing due diligence – long after the initial background and reference checks - should be on knowing the manager.


Benjamin Graham noted in his memoirs that honesty and dependability are the “qualities essential for lasting success in Wall Street” and these are also the qualities that distinguish the consistently successful hedge-fund firm. The achievement of the very best managers can appear paradoxical: as investors they must be prepared to tolerate volatility and treat every cent that they manage as their own in bad times as well as good; as fiduciaries they must not be prepared to tolerate any cultural attitudes which elide the fact that most of the capital they manage belongs to other people.  Good due diligence and regulation should seek to ensure the high integrity threshold of the manager-as-fiduciary without suppressing the high pain threshold of the manager-as-investor.


The views expressed in this article are those of the author and do not necessarily represent the views of Permal or its affiliates.




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