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What Are the Specifics of Due Diligence Questionnaires When Applied to Alternative Investment Funds?
Due diligence for the alternative asset manager requires a higher level of attention. Include these questions in your alternative investment manager DDQ.
How specific should due diligence questionnaires be when assessing a Hedge Fund or a Private Equity Fund?
Alternative Investments continue to increase in popularity, and year-on-year institutional investors have been increasing their allocations to those asset classes. Diversification might be the principal reason but also a search for: higher yields, improved risk-adjusted returns, and lower market sensitivity.
As per a recent Preqin survey, 80% of institutional investors are allocating to at least one alternative asset class, with Real Estate, Private Equity and Hedge Funds as the most common.
Alternative investments are not based on fixed rules and practices as traditional ones.
Since managers have relatively free hands to be adaptive and creative with the investment strategy, this is how risks come into the picture.
Due diligence for selecting an appropriate manager for your alternative investment strategy is not a 100% guarantee of successful investment. However, identifying the right, the skillful manager is the first step in reducing the risk.
Each due diligence process needs to be done thoroughly, but because of the specific nature of alternative investments (higher risk, data limitation, complexity, etc.) due diligence for alternative asset manager requires an even higher level of attention and effort.
This should be reflected in the three main steps of the due diligence process: manager sourcing, qualitative and quantitative assessment, and manager monitoring.
Due diligence questionnaire is, without a doubt, one of the most, if not the most important bit of documentation within the managers’ research process. Nevertheless, it should not be considered as the only source of information, and it should be complemented by collecting and investigating all available information.
Every investment project is different, so you’ll want to tailor your questionnaire to the strategy type and ensure you’re asking the right questions.
On top of the common operational questions asked when selecting external managers, we will highlight some of the specific questions asset owners need to focus on when creating a due diligence questionnaire to select a Hedge Fund or Private Equity Fund.
In this article, you will find sample Hedge Funds due diligence asset class specific questions and also some questions applicable to particular types of HF strategies. In the next article, we will focus on Private Equity Funds due diligence questionnaires.
Sample questions to Hedge Fund managers
Do you categorize the fund as either directional or market-neutral? Is the manager’s style more top-down or bottom-up? What range of securities is typically included in the portfolio? Are trades directly based on quantitative output, or is each computer-indicated trade up to the portfolio manager’s discretion?
The track record
How does the fund’s track record compare with that of other hedge funds that are reputed to have the same investment style? What were the fund’s largest drawdowns as a percentage of NAV? Were there times when the manager had particularly strong or weak relative returns? Why?
Terms of the fund
Does the incentive fee have: a hurdle, a high-water mark (if it has a high-water mark, is it perpetual, or does it reset?), and is there a provision for a clawback? Is there a lockup period before redemptions are permitted, and if they are permitted, how frequently? Are there gate provisions, and if they exist, how do they work?
Management of risk
Does the manager have written policies and procedures that communicate an approach to risk management? Is there an independent risk committee responsible for monitoring risk and altering risk limits? Is there a risk manager? Does the manager use a third-party risk system for its internal risk measurement? If so, how much control does the manager have over the methodologies and how the risks are reported? What are the manager’s policies and procedures to mitigate the risk of unauthorized trading by members of his staff?
What systems are used to measure risk? Does the risk manager monitor position, sector, credit rating, and geographic or thematic concentrations as well as correlations among trades and the various parts of the portfolio? How do the risk measures deal with asymmetric risks, such as those in options or event arbitrage? Are risk measures calculated internally or by an external vendor? Is risk assessed both quantitatively and qualitatively? If so, how is it assessed qualitatively?
Is the portfolio stress tested? What types of stress tests are performed? Can the manager change allocations to securities to see what would happen to the fund’s risk levels before making a trade or a set of trades?
Does the manager have an affiliated broker, and if so, what percentage of the fund’s trades is done through the broker? Why is it advantageous for the fund to trade through the affiliated broker? Does the manager have any soft-dollar or other fee-sharing arrangements in place? What is the average commission rate paid by the manager?
What proportion of the average portfolio could be liquidated in different specified terms, for example, 1-2 days, 2-5 days, 5-10 days, etc.? Is there an active effort made to avoid crowded trades and if there is, how? What is the maximum long and short position size as a percentage of average daily trading volume or issue size? Will a significant redemption alter the portfolio by leaving the most illiquid instruments with remaining investors? Has the manager installed gate provisions to prevent a run on the fund?
How many brokers or banks extend leverage to the fund? How are liabilities dealt with operationally?
Which information is available to investors on a monthly, quarterly, and annual basis? How do reports and correspondence sent to investors look like (examples)? Is the notional value of derivatives disclosed? What risk reports does the fund provide to investors? When periodic risk transparency reports are made available to investors, are they independently available from the risk provider? How frequently are performance estimates available to investors?
Who are the manager’s counterparties, and what are their credit ratings? What are the key terms of the manager’s ISDA (International Swaps and Derivatives Association) agreements, and in connection to this, what are the trigger and termination terms within the agreement?
Prime broker/Futures Clearing Merchant(FCM)/Custodian
Does the fund use multiple prime brokers/FCMs, and who are they? Has the fund manager ever changed a prime broker/FCM and if it has, why? Are all assets held in the name of the fund? If not, why not? Is the cash invested in high-grade, low-risk, AAA-type securities? Are long and short accounts that are held with the prime broker netted against each other? What insurance does the prime broker carry? How often does the manager perform on-going diligence on his prime broker and custodian?
Does the administrator send the NAVs directly to investors? How often does the manager perform on-going diligence on the administrator? How often is net asset value calculated? Does the administrator perform ERISA calculations for the manager?
How much of the portfolio is considered Level II and III according to FAS 157? What types of its investments are in Levels II and III? How does the manager obtain valuations for swaps, over-the-counter derivatives, private placements, and illiquid and other securities for which prices are not publicly available? What are the security or market valuation methodologies that are important to the manager? How are pricing disagreements with the prime broker and administrator resolved? How often is the NAV prepared and reconciled?
Sample questions specific to the Hedge Fund strategy
If you are looking for a specific kind of Hedge Fund, in addition to questions tackling the asset class itself, it is advisable to include in your due diligence questionnaire also questions particular to the strategy type. Below we will be listing some Hedge Funds strategies types and sample questions applicable to each one of them:
How is the fund’s gross and net exposure determined? Is the performance impacted more by gross and net exposure, or by the security selection? What is the maximum percentage of a company’s shares (or float) that you will hold in the fund? To what extent does the fund invest in specific stocks as opposed to blocks of stocks through derivatives or exchange-traded funds? How well hedged the fund’s long/short portfolio typically is regarding sector and industry, market cap, geography, style and beta, liquidity, and net long or short?
Event-driven strategies and special situations
Do you invest in events (such as a merger, acquisition, spin-off, divestiture, or asset sale) after they’ve been announced or in advance of expected specific events? What are the team’s skills that give it an advantage over other event-driven managers? Are you specialized in one class of securities, or will you invest across the capital structure? How do you hedge risk – at the position and/or at the portfolio level? How important is the credit cycle or activity in the new-issue market to the manager’s event-driven strategy?
Interest rate and credit arbitrage
How well do the portfolio’s shorts hedge its long positions? Are your arbitrage securities within the same asset class, against LIBOR or U.S. Treasuries, or other classes? Are you experienced in trading specific credit instruments? How sensitive is the fund typically to the direction and magnitude of interest rates? How often does the fund make duration bets? What percentage of the fund’s gross exposure is in non-standard trades? How experienced is the manager in valuing collateral and, if need be, collecting it and converting it to cash?
Are control positions in the senior-most or the pivotal securities an important ingredient in your strategy? Do you buy equity, bonds, or both in distressed companies? When, and why? Do you buy only when a company’s net asset value of cash and saleable assets is greater than the purchase price?
What is your approach to analyzing credit, equity, and volatility? What are the drivers of convertible valuations? Do you have proprietary valuation tools for modeling convertible valuations, or do you use off-the-shelf vendor models? Does the strategy emphasize investment-grade or below-investment-grade convertibles? How do you analyze companies with negative cash flow? How do you model takeover risk? What is your process for securing borrowed stock?
How dependent is the portfolio on your broad macroeconomic outlook? What portion of the portfolio is based on themes? Which are those themes? How have they changed over the years? What has been your hit rate in identifying and profiting from such themes? What is the composition of strategies that the fund is currently invested in? How do you decide on the percentage of the portfolio to allocate to a specific strategy? Does the fund report to investors when it has added a new strategy, modified an existing strategy, or closed one?
Is the portfolio driven by technical information (price movement) or fundamental information (research on the supply and demand of the underlying commodity)? If the portfolio includes strategies for both, what is the balance between technical and fundamental information? If the strategy is technically driven, are trades driven by computer output, or can the manager override computer generated trades? What are the cross-correlations among the manager’s strategies? Does the manager define leverage as margin to equity? If so, what is the manager’s typical leverage? Which particular futures does the strategy trade? What market behaviour or inefficiency is the model attempting to exploit? Does the strategy include a volatility filter? How frequently do you introduce new models?
Does the portfolio invest mainly in certain asset classes? Are there certain asset classes the manager tends to avoid? How many unrelated strategies do you invest in? What have been the correlations among unrelated strategies? Do you report to investors when it a new strategy is added to the fund, modified an existing strategy, or closed one? Is the fund’s approach more directional or does the manager seeks to isolate idiosyncratic opportunities in a relative value approach?
In our next article you can read about the specifics of the DDQ for Private Equity Funds.
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