Hedge Fund Research

The business of intelligence

CHRIS MORGAN JONES, KROLL

Better information makes for better potential returns, that is a given. Unless you accept the absolute efficiency of markets, therefore, it follows that excess returns to the market require access to information that competitors in that market do not share. An increasing number of hedge funds believe this is true, and are turning to specialist information providers to give them an edge in unlocking alpha from the more opaque corners of the financial markets

Over the past few years, UK hedge funds have begun to reach out for better and faster business information – actionable intelligence that goes beyond the standard output of the equity analysts. Routine due diligence is not enough; investors are now looking for specific business intelligence products – especially for their hedge fund placements – that can enable them to identify investment opportunities that the herd has missed.

Probably the most fundamental shift has been in the enhanced effectiveness of business intelligence to help hedge funds to locate opportunities, to test assumptions prior to large placements, or to monitor the validity of major positions in an uncertain market. The natural affinity between hedge funds and business intelligence providers stems from the fact that fund managers need information that is deeper and broader than more traditional market players. Hedge funds are likely to be more selective, eclectic, and less index-specific than other investments, and are subject to rapid and frequent change. They appreciate that gaining first-mover advantage can be critical.

Finding the right information

True, the marketplace has long been awash with information, but in London it tends to be either commoditised analysis or ‘tailored macro’ information. What has been lacking until recently is ‘tailored micro’ information.

Tailored micro, simply put, is the painstaking build-up of a report or profile based on critical analysis of the public record supplemented by knowledgeable input from informed people around the situation. Condensing this data into a coherent whole, along with insightful interpretation, is the specialist skill set that hedge funds require. These exacting criteria cannot be met in timely fashion without productive global networks that are able to respond at a moment’s notice and are coordinated at the centre by a team to pull it all together.

Not all funds will have an interest in the intelligence products on offer, but those dealing in emerging markets, special situations, distressed debt and the like are increasingly recognising the benefits that specialist investigative firms can bring. The best way to illustrate how business intelligence can benefit hedge fund investors is to look at how such a real-world assignment operates in practice.

In one case, an investor was worried about overly upbeat public pronouncements of a firm in a market where information was not always transparent. The fund manager needed independent verification to help him decide whether to maintain his investment position. The investment was with an oil company in Europe that was promoting its prospects with very bullish pronouncements. The investor held a short position and did not believe the hype, but wondered if he was being too clever by half. Optimistic forecasts kept coming from the company’s charismatic chairman, compounding the confusion, and the investor’s growing exposure was becoming increasingly difficult to sustain. To provide reassurance, the hedge fund hired Kroll to look behind the oil company’s public statements. We came back with a report indicating that these statements were putting an absurdly optimistic construction on the facts – validating the client’s suspicions. Indeed, the company’s stock collapsed shortly thereafter and the client’s short position paid off handsomely.

Both the hedge fund and Kroll were aware of the sensitivities involved, and specifically the need to avoid obtaining information from any sources that could amount to insider trading. Thus secondary sources were used, geological and oil experts familiar with the region, suppliers, and other informed interlocutors, to build up a clear assessment of the prospects of the subject company.

The lesson here was twofold. First, that appropriate use of business intelligence allowed the investor to make a substantial profit. Second, that not all information is legal or legally usable by clients. Reputable business intelligence suppliers should know this and decline investigative methods which could get them and, more importantly, their clients into trouble.

The big picture

The commodity information providers, such as bank-based securities analysts, have a clear role to play in providing information to fund managers. This is not business intelligence, however, and it is not bespoke. Quarterly earnings, senior management comments, conference calls and regulatory filings have their place but they fail to provide the complete picture. It is also widely available and thus in itself offers no competitive advantage to fund managers. Business intelligence is collated and prepared only for the specific client and thus offers a unique investment insight which can identify potential sources of excess returns.

Further, the commodity providers often focus on only one country or a handful of neighbouring countries. By way of contrast, hedge funds tend to range worldwide and thus must mobilise global investigative teams to go beyond official sources to tease out in-depth data not found in the public record. Today the investment marketplace is expanding into less regulated territory, including China, Indonesia, Latin America, East Europe and the Middle East, and the best-managed hedge funds will seek out high-grade business intelligence to help measure the risk. Some of the opportunities involve plain vanilla instruments, but in obscure jurisdictions; others are in more arcane and specialised investment areas.

As European hedge fund requirements take shape, key differences have emerged to distinguish US from European information activity. For example, the US tends to centre on long sale opportunities. In Europe, investors seek more to exploit short opportunities. In addition, the US market suffers from a generalised information overload. But in London, the hedge funds are looking for something different and specific, often in the uncharted territories of emerging markets where business intelligence providers can provide or supplement local knowledge that fund managers based in London do not have the time or resources to develop themselves.

Cross-border merger proposals are arising more frequently as off-shoring and the globalisation of business continues to develop. In one deal, a European hedge fund with a stake in a large manufacturing group was nervous. The group had just come together with an international partner of similar size, and management promised synergies that would help provide both growth and cost savings. The fund manager wanted to know where a merger would take these two companies, whether it would succeed and how the synergies would be realised. The fund engaged Kroll to provide validation of the merger in terms of savings and timescale. Getting the data required resources in Europe, the United Sates and elsewhere to draw on a range of information sources – including trade unions, former employees, suppliers, resellers and various industry experts. The final report advised the hedge fund that problems were real but surmountable, and that the promised synergies were likely to be genuine in the medium and long term. In this case, it even went the extra mile and included guidelines on how best to track future developments in the merged companies.

Entering uncharted territory

But it is the new markets that present the most potent mix of risk and opportunity; the challenge is balancing the two. On the risk side, regulated disclosure rules are less developed than in more mature financial systems. On the opportunity side, getting it right can mean rapid and substantial gains.

Effective data underpinning depends on quick access to a network of financial investigators and forensic accountants, among others. Eastern Europe is a prime example of a region where public information in a new free-market arena can be subject to manipulation or misinterpretation in the local media.

In one case, an international consumer products company was reported to be facing a revolt by its Hungarian workforce. One investor held a long position on the firm’s parent, in effect betting on a share price rise. He needed a ‘tailored micro’ report. Disturbed by stories he was hearing about abuse of employee rights, he needed facts. An employee lawsuit was mooted and speculation arose that other East European subsidiaries of the parent company might follow suit. To clarify the situation, agents and investigators were able to tap discreetly and quickly into local sources and determine that militant employees were privately working out a settlement with management. The threatened troubles were essentially over. The client decided to maintain his holdings and did well as the company continued its East European expansion.

In the highly regulated London environment, conditions differ fundamentally. Financial institutions routinely face questions from regulatory authorities, raising alarm in the media and requiring quick clarification. The result can be a sort of investigation into an investigation. A leading global investment bank recently feared repercussions of an expanding probe by regulatory authorities. The probe focused on a brokerage house and funds that were among its clients. The investment bank also provided services to one of the funds, a discreet hedge fund. The bank needed to know more about the fund – who the investors were, the amounts they had invested, and whether they were pulling their holdings out as a result of media attention.

Getting a clear picture required sensitivity and expertise. But within a tight timeframe the bank got its assessment. The report provided the perspective on issues of reputation, as well as an assessment of the risks of continuing to do business with the hedge fund.

Investigators must have a rare skill set, a blend of resourcefulness, discretion, persistence and mastery of privacy and securities legislation in a variety of jurisdictions. There is no right background for an investigator; it is more a matter of attitude and aptitude. Kroll’s staff in London is a mixture of journalists, accountants, bankers, businessmen, lawyers, diplomats and other government employees. The applications for their research capability cover a wide spectrum of topical business issues, including fraud investigations, enhanced due diligence, asset searches, reputation management, dispute support and competitor intelligence.

And for hedge funds?

In the hedge fund context, due diligence and competitor intelligence are the key areas of interest, although there is also demand for such services from the other side of the desk – from fund managers or funds of funds wanting to know more about the people behind hedge funds in which they are looking to invest. Such research calls for investigation into the personalities and past performance of the principals behind the funds, as well as their fund managers.

The volatile and varied nature of hedge funds makes getting the quantification of risk that much more crucial. Good information properly packaged can enable the fund manager or other clients to make that assessment, and forecast share price movements with greater confidence.

Not all of what the business intelligence specialists can do for clients is rocket science. Some of it may be a matter of outsourcing. It is not worth most hedge funds subscribing to the range of databases that Kroll does, and they probably lack the same expertise in tracking through these databases for the key information links.

Similarly, most funds wanting to verify the status of a physical asset in, say, mainland China are unlikely to have the time or hands spare to send someone out on the ground. Kroll can deploy staff there from one of our four China offices on behalf of clients both quickly and cheaply. Fund managers may also be reluctant to be seen asking questions themselves about particular investment opportunities. Hire an investigator to ask the questions for you, and your confidentiality can be maintained.

Beyond this outsourcing function, however, the business intelligence providers do offer a level of expertise in unearthing, collating and analysing complex information, information inthe non-public domain or with regional or sectoral angles, on specific topics which hedge funds may not be able to replicate in-house.

The chances are that we will have faced a request for similar information before, that our network of expert sources will include people well-placed to assist and that we can swiftly come up with a plan on how to respond to a client request. Where we believe information cannot be obtained, we say so, but we may also have the experience to suggest other ways of approaching the problem to deliver the same result.

For instance, one client was alarmed by press reports that the principal of one company they were looking at had a brother closely linked to a Middle Eastern intelligence service. Could we find out if this was true? To prove such a linkage conclusively would be very difficult, if not impossible. What Kroll did do, however, was prove that the principal did not have a brother, and that the press reports which had threatened to scupper the deal could not therefore be accurate. The deal went ahead.

As the above cases indicate, hedge funds and their investors are demanding real-time business intelligence to help them anticipate events that impact their investments. Gathering the intelligence that may be hidden requires a combination of overt and covert methods and reliance on the most well-placed human sources.

Good intelligence-gathering and well-honed techniques of analysis are beginning to give hedge fund managers real-time agility – the essence of competitive edge.

About Kroll

Kroll is headquartered in New York and has approximately 3,900 employees and a worldwide network of consultants with specialised expertise across more than 65 cities.
Kroll Inc is a subsidiary of Marsh & McLennan Companies, Inc, the global professional services firm.

Biographies

CHRIS MORGAN JONES

Chris Morgan Jones is Regional Managing Director of Kroll’s EMEA Consulting Services Group, based in London. Chris joined Kroll in 1997 to work on business intelligence and investigations cases across Eastern Europe. Chris’s expertise lies in pre-transaction intelligence-gathering, reputational audit, competitor intelligence, political risk assessment and dispute strategy consulting, primarily for Western clients operating in the CIS and for Russian clients expanding their operations internationally. He has a degree in English Language and Literature from Oxford University.