6. Check references.
Check all references the manager provides, and go one step further by obtaining independent references from current and former investors, former employees and former colleagues of the hedge fund manager and key employees. Keep in mind that all managers only provide positive references. These conversations will provide the investor with a range of opinions that can be used to draw new conclusions.
Every hedge fund business is different, but the following structure and philosophy should be shared by all trustworthy managers:
1. Appropriate Staffing
A manager that has hired a knowledgeable CFO, COO or controller helps to separate duties within the firm and allows him to focus his time and energy on portfolio management.
2. Reputable Service Providers
Managers should work with a reputable auditor whose practice is well versed in the hedge fund business.
An independent administrator keeps the official books and records, allowing the fund manager to improve controls and mitigate certain risks. The administrator should also verify the valuation of portfolio assets on a regular basis. 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.
3. Sophisticated Technology
New managers who invest resources in information technology early on offer better internal controls. Top quality IT systems quickly pay off in the form of greater efficiency and productivity.
4. Documented Procedures
And Business Plans
Managers should demonstrate a forward-thinking approach by developing a detailed expansion plan. The plan should include a strategy on how to add staff as assets grow and new products are offered. Also, new managers should identify their breakeven point and be able to prove to potential investors that they can handle additional costs.
5. Business Transparency
New managers have a lot to prove and "slick talk" is no longer sufficient. Managers should proactively invite investors to view portfolio management, risk management, order management and accounting. Emerging managers can save valuable time during the due diligence process by making the compliance and operations manuals, valuation policies and disaster recovery plans available to investors, as well as the contact information for all service providers and a master list of key ISDA terms. Investors are demanding 100% transparency, and managers can stand out from the pack by demonstrating openness and accessibility.
6. Compliance Culture
Under the Dodd-Frank financial reform act, hedge fund investment managers with over $25 million in assets under management will be required to register with either their state or the SEC by July 21. Emerging managers must comply and would be wise to establish a "culture of compliance" at their firm. They should employ a qualified chief compliance officer or outsource those duties to an experienced third party.
Study after study shows that "emerging managers" can outperform more mature, larger and established hedge funds. But as the regulatory and infrastructure costs of doing business rise, smaller hedge funds will have trouble launching and remaining open. High-net-worth individuals and family offices can capture the additional alpha from emerging managers, as long as they navigate these waters carefully. This prudent approach highlights the need for proper operational due diligence, balanced with an entrepreneurial spirit. There are many new managers who are superb at investing but don't have much experience running a business or marketing their own enterprise. By conducting thorough due diligence, family offices can invest in these new managers and have a chance at making significant returns while also mitigating unnecessary risks.
Alan Swersky is director of the alternative asset advisory division of Duff & Phelps.