Guest Contributor: Patrick J. McCurdy, partner and head of capital development at Merlin Securities
The investor due diligence process has evolved with the institutionalization of the hedge fund industry. Investment allocations used to be made primarily on the basis of basic performance numbers and the qualitative aspects of a fund: people, process and philosophy. It was a rather short and perfunctory process. Over the last decade, however, this process has become very data driven and time intensive, encompassing both the qualitative and quantitative aspects of a fund and its performance.
While there is no one-size-fits-all formula for investors, one certainty is that managers who understand the components of the due diligence process will have an easier time meeting the requests of investors and positioning their funds favorably in a competitive capital-raising environment.
First Step – Qualitative Due Diligence
After an investor has decided which investment strategy to allocate to, a list of funds to analyze is generated and due diligence starts with a look at the qualitative aspects of each fund – its people, process and philosophy. These three main qualitative factors build a framework for a fund and comprise the first of a multi-step due diligence process. Meeting an investor’s standard on the qualitative front is not, however, enough to ensure an allocation. A look at the quantitative aspects of a fund’s performance is next.
The Three Overlays of Quantitative Due Diligence
There are three basic overlays, or steps, that investors will take when conducting quantitative due diligence:
- First overlay: Performance
- Second overlay: Risk
- Third overlay: Attribution Analysis
The process begins with a fund’s net performance number. Investors will then want to understand what risks were taken along the way and where the money was made to determine if performance was a result of the process. Finally, using an attribution analysis, investors will take a deeper look at the numbers to understand the factors behind performance generation and to answer questions regarding active versus passive investing, whether returns fall inside a manager’s stated strategy and where managers are risking investor capital. A detailed analysis of the three overlays can be viewed here.
Finally, investors will ultimately look at the risk-adjusted return figures and run a correlation between the new manager and their existing portfolio. If the fund in question does not beat out one of the existing managers in the investor’s roster, the new fund will not receive an allocation. To be successful raising capital, funds must have positive performance, and show they have created a truly differentiated fund that consistently adds value.
It is critical to note that not all investors allocate only after the intense quantitative process outlined above. Fundamentally, the hedge fund industry is still a story about people. At its core, investors are looking for active management of their assets and want to entrust those assets to someone they believe to be an expert with a differentiated process. There will never be a replacement to a good story and a firm handshake, but the due diligence process helps provide additional clarity to the investor’s investment decision.