Performing due diligence on funds and managers

Question 1

Reasons why a fund might have failed in the past

Answer 1

1. Poor investment decisions
2. Fraud
3. Extreme events
4. Excess leverage
5. Lack of liquidity
6. Poor controls
7. Insufficient questioning
8. Insufficient attention to returns

Question 2

How can lack of liquidity lead to fund failure

Answer 2

Too many capital withdraws and redemptions to honor at once, thereby creating a squeeze on the cash flow and an inability to meet all capital withdrawals and redemptions.

Question 3

How can insufficient questioning lead to fund failure

Answer 3

In a committee style decision making process, a dominant member may sway the board. (over members who may be afraid to voice any valid concerns)

Team members should be encouraged to play the role of the “Devil’s Advocate”

Question 4

How can insufficient attention to returns lead to fund failure

Answer 4

Towards reducing operational risk, excessive internal controls are kept which may end up bearing too many expenses and not too much returns.

Question 5

What elements of due diligence should be put into consideration?

Answer 5

1. Assessing the manager
2. The fund
3. The investment strategy
4. The investment process
5. Risk controls
6. Funds operations and business model
7. Process and frequency of asset valuations

Question 6

Aspects of manager evaluation

Answer 6

1. Strategy
2. Ownership
3. Track Record
4. Investment management

Question 7

How ownerships of a manager helps ?

Answer 7

Ownership interests often help align the interests of the investment team and the investors.

Higher the ownership, lower the risk.

Question 8

Aspects of risk management evaluation

Answer 8

1. Risk
2. Security valuation
3. Portfolio leverage and liquidity
4. Exposure to tail risk
5. Risk reports
6. Consistency of the fund terms with investment strategy

Question 9

Aspects of operational due diligence

Answer 9

1. Internal control assessment
2. Documents and disclosure
3. Service provider evaluation

Question 10

How to assess business model risk?

Answer 10

1. Nature and quality of revenues
2. Significance of gap between management fees and opex
3. NWC levels
4. Fund breakeven points
5. Adequacy of personnel
6. Existence of key person insurance on relevant persons

Question 11

How can fraud risk be assessed?

Answer 11

Check if following factors exist:
1. Frequent related party transactions
2. Illiquidity
3. Frequent litigation for fraud
4. Frequent personal trading by manager of the same securities held by the fund
5. Frequent shorting of transactions

Question 12

How can fraud risk be mitigated?

Answer 12

1. Check SEC website for prior infractions.
2. Court records for prior litigations.
3. Inquire with service providers.
4. Extensive background checks