Setting Your Firm Up for Success with Investor Due Diligence

“You had me at hello.” Twenty-plus years in the hedge fund marketing business and hundreds upon hundreds of investor due diligence meetings later, I’ve never heard an institutional investor utter those words. On the other hand, a hedge fund manager articulating some semblance of, “SHOW ME THE MONEY!” has been heard more times than most marketers care to count. Aside from the current buzz of the NFL playoffs, I’m not sure why Jerry Maguire, a movie that came out 25 years ago, is coming to mind as I pen this, but maybe it’s Jerry’s line, “We live in a cynical, cynical world. Filled with tough competitors…” Now THAT rings true!

There are many hedge fund managers whose passion and sales skills make for compelling first meetings and without that, second, third and fourth meetings might never occur. But marketing success in this business is not measured by a single meeting. Rather it’s marked by a series of meetings that take place over weeks, months (and sometimes years), all in the name of Due Diligence. Only then, will your fund be considered for a potential investment.

So, what does it take to set your firm up for success with investor due diligence? First and foremost, it means understanding that the due diligence process is two-fold: (1) Portfolio due diligence to be followed by (2) Operational due diligence (and you never get to Operational due diligence if you don’t get through Portfolio diligence). A very practical first step is filling out a standardized Due Diligence Questionnaire. The AIMSE DDQ is a great example of what a thorough DDQ document should include and serves as a general guide as to what to expect from the institutional investment community.

Let’s begin with Portfolio Due Diligence

Starting Day 1 – Keep good records. Extraordinary fund performance can pique interest but never guarantees an investment. Institutional investors undertake a methodical due diligence process that will make them ask how, when and where fund performance was derived. This data should be readily available upon request. Information not received promptly can take you out of an institutional investor’s due diligence queue. It also sends the message that you, the fund manager, may not be analyzing key components in portfolio construction and risk management. It is unusual for investors to take the statistics provided in a fund’s marketing materials at face value. Investors typically recalculate all statistics in their own models to confirm accuracy. Portfolio managers need to calculate their fund statistics based on industry standards and be able to thoroughly explain these calculations in the due diligence process.

• Data should be saved in an Excel format so investors can easily slice/dice
• Performance attribution, long/short by asset class and by instrument
• Performance attribution, top 10 longs and shorts, as well as largest de-tractors
• Fund exposure, gross and net
• Sector exposure, gross and net
• Long and Short exposure, gross and net
• Exposure by instrument, long and short, as well as gross and net
• Exposure by credit quality
• How much alpha are you generating? And where?
• How much beta are you generating? And where?
• Upside and Downside Correlation
• Portfolio turnover on a name basis? On a dollar basis?

Precision around Portfolio Construction. So many managers like to describe their portfolio as “idiosyncratic”. Imagine yourself an investor, meeting new managers every hour, multiple days a week and in each of these meetings the new manager you are sitting across from describes his/her fund strategy as “idiosyncratic”. Bottom-line, back up your bold statement with data!

• Accurately articulate your fund’s return profile
  • Event Driven, tends to be episodic. Is your attribution from a few names or is it more evenly distributed? What is the time frame for holding a name?
  • Long/Short Equity, are you long biased? Do you trade around your names? if so, when and how?
  • Shorting – if you short, how do you short? Alpha shorts? Baskets? Put strategies? Do your shorts generate alpha or is this more of a hedging strategy?

Consistency of Portfolio Construction and Risk Management Process. Investors want to “get inside the head” of fund managers before they invest so they can anticipate how managers will perform in various market scenarios. Investors will ask iterations of the same question to determine consistency of process. They will also ask the same series of questions to the portfolio manager, the chief risk officer and analysts in one-on-one meetings, again looking for consistency of process.

• Portfolio Construction
  • How does the Portfolio Manager work with analysts?
  • Does the PM push ideas down to analysts to work on?
  • Do analysts work independently and push ideas up to PM?
  • How does a name get into the portfolio? How does a name come out?
  • How do analysts get compensated for their work?
  • Are analysts sector specialists or generalists?
  • How are positions sized?
  • How are positions hedged?
• Risk Management – How does the fund manage risk?
  • Does fund have a Chief Risk Officer? If so, how does CRO work with the Portfolio Manager?
  • Who has trading authority?

Moving the Ball Down the Field
Okay, let’s assume you’ve made it through the Portfolio Due Diligence process. Congrats! You’re one step closer to a potential investment, but there’s still more work to do before that potential new investment becomes a reality. The institutional investor now taps others within their organization to perform Operational Due Diligence (“ODD”) or they’ll outsource this task to a consultant, OCIO team or an ODD specialist group.

Endgame
Be patient and continue to follow your playbook. Building a strong track record is key to garnering institutional investor interest, but to overcome the built-in, and well-justified, cynicism of the most thorough institutional investors, appreciate the due diligence process for what it is: a time for an investor to get to know you AND for YOU to get to know your next potential investor. That’s certainly what your competitors are doing.