Beyond the tear sheet: War stories from the front lines of hedge fund due diligence

The Over-Controlling Manager 

While some message massaging happens behind closed doors, in other cases it is much more overt. A manager we ended up firing shortly after a very nervous and controlling performance during an investment meeting offers a classic example of a manager trying to spin a situation to his own benefit and prevent colleagues from undermining his highly controlled message. 

We were invested in a discretionary macro fund for several years that initially enjoyed strong returns but started to struggle as its success in trading U.S. rates and developed market currencies began to deteriorate. The fund was beginning to look at more esoteric and illiquid opportunities, while their book became increasingly convoluted with derivative plays that were difficult to quantify and understand.

The manager was an extremely intelligent and well-spoken individual, but his demeanor quickly worsened as returns continued to drag and investors became more impatient. Update calls started to drag as well as the manager tried to justify performance and insist on attractive future opportunities. And what once appeared to be a collegial team quickly dissolved into a dictatorial dynamic where the team was minimized. 

We decided that a meeting was necessary to assess what was causing the underperformance. During the meeting, the manager was highly verbose and continually talked over senior portfolio managers in an attempt to control the conversation and force a positive atmosphere. One of the senior portfolio managers was significantly more open and did admit to certain mistakes and missed details by the team, while his boss sat glaring. A transcript of the meeting may have read as cohesive, however, the manner of delivery did little to ease our concerns. We fired the manager shortly thereafter. 

The Value of Values

In some cases, a partnership may have all the operational pieces in place as well as a strong investment platform but may still be disqualified due to questionable ethics or controversial investment practices. A due diligence team must consider its firm’s (or its clients’) ethical standards and their sensitivity to negative headlines. Some strategies or investments may not align with an investor’s value systems, and may even pose reputational risks for a firm. 

Some of the investments our team has encountered can only be characterized as reprehensible. One manager we encountered employed a strategy that took advantage of the families of victims of a terrorist event who were awarded significant settlements for injuries or life-changing tragedies. These settlements often pay out over several years and the manager’s firm would offer money up front at significant discounts due to victims’ immediate needs for liquidity, often at levels approaching loan shark rates. 

Needless to say, we passed due to ethical concerns. In fact, one of our investment professionals was so enraged that he confronted the manager during an introductory meeting and had a few choice words about him “ripping off” victims and their families. This episode is clearly one of the more extreme examples of unethical behavior by general partners, but it serves as a reminder that the way in which a client’s capital is being utilized demands consideration.

The Alignment Paradox

The manager of a Los Angeles-based small-cap long/short equity fund with a long, impressive track record painted the picture of a portfolio comprised of underfollowed, misunderstood stocks. The marketing collateral matched the story, and the Ivy League-trained investor relations team kept the portfolio manager (PM) on message. 

While reviewing the audited financials back at the office, we noticed gross exposure that was significantly higher than reported anywhere else in the firm’s materials. Upon further questioning, we determined that the fund manager, due to his significant personal investment in the fund, was “boxing positions” in an effort to avoid realizing capital gains. Boxing is the somewhat rare practice of offsetting long positions with an identical short in an effort to avoid realizing gains on your long positions. The PM justified this practice by saying, “Not only does it prevent me from realizing gains on my personal investment, it has also significantly improved the historical tax profile for investors in the fund.”

On the surface, a simple answer. Looking deeper, however, we discovered that to avoid triggering the Internal Revenue Service’s constructive sale rule, the short side of the “box” had to be removed for 60 days every 12 months. During these times, the fund would need to substantially adjust the portfolio to accommodate the unboxed positions. This had the effect of exposing investors to a vastly different set of risks than those present during the other 10 months of the year – and a move inconsistent with the fund’s exposure profile. 

When we addressed this with the PM, he did not sufficiently appreciate that new investors in the fund would be walking into a portfolio of very large unrealized gains with the potential to create significant taxable gains without commensurate financial return. Additionally, he disregarded that fund investors were paying additional expenses (through trading and leverage-related costs) to maintain the box position. We passed.

Another note on the “alignment paradox.” We often worry that PMs with too much of their liquid net worth in their own funds may become paralyzed during drawdowns instead of taking advantage of opportunity during the some of the best times. In our experience, asking PMs about the size of their personal investment in a fund, and how that exposure might impact their decision-making ability during tough times, can be an enlightening conversation.

Google Is Your Friend

Though background checks provide a nonpublic source of reference, public sources are equally important, and they are often underutilized and underappreciated. Simple search engine queries aimed at uncovering regulatory filings or news articles are one of the easiest ways to disqualify a manager. 

Our team has done extensive online research on less prominent firm employees, past affiliations, and on specific partnership and corporate structures hidden and owned by the general partner. In the course of such research we have found a surprisingly wide variety of questionable information, including potential SEC violations, unsavory news articles, inconsistencies regarding the ownership of assets and the deployment of capital, past connections to Ponzi schemes and broad indications of unethical behavior.

In one case, we met with a manager that constructed and operated U.S.-based renewable energy assets. Because the manager did not have a third-party administrator or valuation provider, few experienced staff and vague firm policies and procedures, we were uncomfortable with in-house operational controls. Accordingly, we made it a priority to verify that the assets were actually in the ground and operating, and that they could actually be tied back to the manager. 

Google Earth and Google Images allowed us to confirm the projects existed and, in some cases, also confirmed the parties responsible for operations. Using images of previous renewable energy projects provided to us by the manager, we spent significant time researching the genesis of the financing and construction as well as ownership and operating details. News articles, regional and local government meeting transcripts and renewable energy developer websites provided information on such details as land ownership, financing sources and amounts, the total expected wattage the project was to produce, local concerns over construction and when the assets became operational. 

For some projects, Google Earth provided signs on the premises of the companies involved in operations. In one specific case, we saw a picture of a truck owned by an operations crew driving through a project. Following up with image and news searches, we connected the projects to limited liability holding companies and were able to query state dockets and general business search engines. It quickly became apparent there were no connections we could find between the manager and the projects he provided. The research we performed was essential in convincing us to reject the partnership.

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