Mastering Due Diligence Brings New Investments

Doing so is particularly important for new managers

ALAN SWERSKY, DIRECTOR, DUFF & PHELPS

As the economic recovery begins to draw new money into the hedge fund space, the number of new fund managers is on the rise. Studies have shown that these rookie managers tend to outperform their more experienced counterparts – but the newcomers have their work cut out for them in the current environment, as the financial crisis has resulted in a more guarded investment community.

To launch an institutional money management firm in this environment with limited staff and resources, new managers should focus on making investors feel confident that the firm’s business operations are solid. Fundamental operational issues play a key role during the operational due diligence visit. The following tips will help ensure success on all fronts.

Bring in experience
Hire an experienced employee to manage the business. This knowledgeable employee – who usually has a title of CFO, COO or controller – must be empowered by the hedge fund manager to implement industry best practices. Accordingly, the hedge fund manager should carefully consider the credentials, level of experience and skill set that an ideal business manager would bring to the table. First and foremost, the business manager must possess a technical understanding of a wide range of financial instruments, appreciate the roles of the various service providers and have the ability to interface with clients and manage client requests. The bottom line is that this key non-investment hire should give investors the confidence and peace of mind that a capable person is running the business. In addition, hiring a CFO, COO or controller helps to separate duties within the firm and allows the hedge fund manager to focus his time and energy on portfolio management.

Establish redundancy and growth plans

Investors in smaller, newer firms are especially interested to know what redundancy plans are in place for the key operational employees. All employees will be out of the office from time to time and for various reasons. By creating an organised system for covering an absent employee’s duties and responsibilities, the hedge fund manager can demonstrate to investors that the business will run smoothly and continuously, even when “life events” change the ordinary course of business. Fund managers should also demonstrate this forward-thinking approach by developing an expansion plan. The plan should set forth a strategy to bring on additional hires as assets grow and new products are offered.

Get qualified help
Carefully select qualified third-party service providers, including an administrator. An independent administrator is a business partner who allows the fund manager to improve controls and mitigate certain risks that are inherent in the management of a hedge fund. If your hedge fund deals with complex securities or if operations may become labour intensive, consider using an administrator who offers middle office functions (activities that occur after the trade but before the settlement). Designate your administrator as the party who releases cash during the redemption process and makes all payments for third-party expenses – no matter how complex they may be. In addition, have the administrator perform trade, position, and cash reconciliations each day. The administrator should also verify the valuation of portfolio assets on a regular basis. Further, when funds hold illiquid assets, a third-party valuation specialist should be engaged to provide independent verification of valuation conclusions. By having the proper support to maintain the fund’s books and records, investors will grow even more confident that proper oversight is in place and that the underlying fund’s NAV is accurate.

Make use of technology
Leverage technology in day-to-day business operations. There are numerous order management systems, portfolio accounting systems, and client relationship management systems to choose from – and many prime brokers have hedge fund consulting groups designed specifically to assist new managers with the selection of the appropriate systems. Over time, the costs of these systems have decreased dramatically, making sophisticated technology available to a larger number of fund managers. Investing in information technology will not only help institutionalise a manager, but will aid in creating better internal controls. Managers should capitalise in using systems early-on in their business because technology will pay off in the form of greater efficiency and productivity very quickly.

Get registered
It is important to register early. Managers in the US can compete with their UK counterparts by registering withthe SEC as a registered investment advisor. Though this is not yet a legal requirement, a form of registration is expected to be coming out of Washington soon. Registering early-on positions your firm as one that is thinking ahead of the curve and proves to investors that you are serious about compliance. Registering with the SEC will also force you to appoint a chief compliance officer and create your own compliance manual. A law firm or outsourced compliance company can assist in customising a compliance manual that is tailored to your business. As your firm continues to grow, have your outside compliance experts train employees and keep the firm up-to-date on the latest legal standards and regulatory developments. Also charge your compliance experts with performing a mock SEC audit on an annual basis. At the end of the day, this annual compliance exercise will save time and money, as well as prevent headaches. Plus, you will be fully prepared when the SEC performs an actual audit. Establishing a proactive “culture of compliance” at your firm by undertaking these measures will help to win over even the most sceptical investors.

Get ready
Prepare thoroughly in advance of the due diligence visit. All managers must maintain a complete due diligence questionnaire and be able to articulate the basics: Life of the Trade, Month-End NAV Calculation, Cash Management and Valuation. A good example of a questionnaire for managers to complete is the Alternative Investment Management Association (AIMA) questionnaire for hedge fund managers; managers should join AIMA and gain full access to this model questionnaire and the numerous other resources available at www.aima.org. But managers looking to get ahead in the current environment need to go even further. Proactively invite the investor to the trading desk and allow him or her to watch the trade execution and confirmation process first-hand. Provide the investor with the entire month-end NAV package and walk them through the process. Finally, new managers can save valuable time and impress investors during the operational due diligence process by having the following documents readily available (and for the taking): compliance manual, operations manual, valuation policies, contact information of all service providers and a master list of key ISDA terms. Investors are demanding 100% transparency, and a well-prepared and forthcoming manager can set his or her business apart from others by demonstrating openness and accessibility.

As the economic recovery continues, opportunities for new managers will grow more abundant. Following these tips will help even the most opportunistic new managers set up a strong operational foundation from which their start-up funds can grow into a successful, sustainable business.

Alan Swersky is a director in the Portfolio Valuation service line for independent financial advisory and investment banking firm Duff & Phelps. He is also head of the firm’s Operational Risk Due Diligence (ORDD) group and based in the New York office. Duff & Phelps’ ORDD practice provides investors with an independent, third-party assessment of their hedge fund managers’ operating policies and procedures.