The Shifting Hedge Fund Landscape: Operations and Due Diligence

SEI, together with Greenwich Associates, has published the results of its fifth annual global survey of institutional hedge fund investors.

Part I focused on current trends in the hedge fund industry. The newly available Part II, “The New Dynamics of Hedge Fund Competitiveness,” looks at the evolution of institutional standards.

One crucial takeaway from Part II is that “the quality of operations is a major consideration in institutions’ screening and evaluation of hedge funds.” Eighty percent of respondents agreed with the observation that “operational strength is a hallmark of an institutional-quality hedge fund.” One quarter of those say they agree “strongly.” Only three percent disagree.

Institutions, in accordance with this operational perspective, now insist on factors they might once have treated as optional, such as a separation of investment and operational roles. This separation is now regarded as “very important” by 14.1 percent of survey respondents, and as “important” by another 38 percent. Another operational factor, the quality of reporting and communications is now “very important” to 15.5 percent, “important” to 39.4. Both are more pressing considerations than past performance or fees.

Another important take-away is that managers regard the selection of fund managers as a more challenging endeavor than they used to. For five years now, SEI has had respondents list their “top challenges.” This is the first year that “due diligence” has shown up on the list at all. It went unmentioned in 2010, yet was listed by 7.4 percent of respondents as an important challenge in 2011. Meanwhile, the broader phrase “manager selection” was invoked as a key challenge by only 5.9 percent in 2010, but was listed by 16.7 percent last year.

More Scrutiny

In terms of the ranking of challenges, “meeting performance expectations” is number one. The issue of transparency, a former number one, has lost some urgency from 2010 to 2011, but is still oft cited. SEI suggests this means “that hedge fund managers have increased their openness to the point where investors have become more comfortable with the depth and breadth of information provided.” Manager selection is, as disc jockeys on top 40 radio stations used to say, “Number 3 with a bullet.”

Consistent with the greater level of concern about manager selection, nearly a third of the respondents said they have changed their due diligence process over the last two years.

The changes are in the direction of more intensive scrutiny such as more frequent onsite meetings. Also, institutions that invest in funds of funds sometimes carry their due diligence downward another level, visiting the managers of the underlying funds in the FoF’s portfolio.

Institutions surveyed were split on the significance of fund managerial branding. The study refers to Son Steinbrugge, the chairman of consultant Agecroft Partners, as one of those who believes that branding has acquired a good deal of importance in recent years as a director of asset flows. On the other hand, it refers to other (unnamed) observers for the contrarian view: recognizable brands are best avoided. In general, “our survey suggests that institutions may place as much store in systematic, objective methods of evaluating funds as they do in the vaguer, more subjective criteria described as ‘brand.’”

Recommendations

The paper concludes with some recommendations for hedge fund managers. Notably, managers should make of due diligence a two-sided coin. They should conduct their own inquiry into their investors, in order to understand their “expectations, sensitivities, and preferences … Some areas of disconnect are evident.”

Also, managers must work on the areas where investors have expressed concern, including risk management, liquidity, and transparency as well as operations.

As to investment strategy: investors say that the strategy pitches of various funds tend to sound too much alike. Managers should swim against that tide, emphasizing “distinctive insights and methodologies.”

Communication with investors itself has to develop. Investors don’t want just a set of numbers. They want “more direct access to investment teams and other key personnel” as well as “insights concerning the dynamics of performance.”

Amidst all the work that managers have to do, there is some reason to be hopeful about the near future. Institutions “have continued to deepen their commitment to hedge funds and grow their allocations.”

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