Due Diligence Tips
Fund Expenses - ALL of them!
One question that we routinely ask is, in addition to the management fee, what other expenses does the fund pay? We also ask for the vendors that the fund uses. A common practice among managers is to charge airline tickets, hotels, computers, office rent, and even newspaper subscriptions to the fund. We have even seen salaries and bonuses charged to the fund, on top of management and performance fees.
We constantly challenge these practices. They create a “heads, the manager wins, tails, the LP loses” game, which we obviously are not a fan of. Unfortunately, until the investor community bands together, hedge fund managers will have free rein to continue to charge a number of items on top of management fees. At the end of the day, net risk-adjusted returns to the investor are the most important, but we encourage all investors to shine a light on these potential expense abuses.
Dear Manager.... What does your personal K-1 look like?
Many managers will say, “I manage my fund like it’s my own money,” almost as if it is a “required” statement that potential LP’s need to hear. A good way to find out if that is indeed the case is to ask what a manager’s personal K-1 looks like. As we like to say, it is not how much you make that counts, but how much you keep in your pocket after taxes.
Many managers – despite claiming that they invest the fund just like it is their own money - do not have any clue what their personal after-tax returns have been. The tremendous influx of large institutional money into hedge funds, mostly coming from tax exempt pension plans and sovereign wealth funds, have made it more profitable to generate fees from the management fees than from the return on their own capital. While many non-taxable investors say they do not need to worry about after tax returns since they are tax-exempt, they should still ask the manager the question. If a manager claims to manage the fund like it is his or her own money – and they do not know what their historic K-1s look like – think twice. The manager may be telling you just what they think you want to hear.
Trust but verify
- Contacting service providers and verifying counterparty relationships.
- Regularly calling up references on managers to benefit from the insights of others.
- Watching assets under management, tracking asset growth against a manager’s statements about capacity.
- Running comparisons of legal docs and marketing presentations to see material changes or “style drift.”
- Checking 13F filings every quarter and comparing them against the manager’s portfolio reports.
- Keeping an eye on the number of names in the fund, average market cap, and sector/geographical exposures.
- Monitoring the overall portfolio liquidity and exposure to less liquid investments.