A reader alerts me that Walter Noel’s Fairfield Greenwich Group has taken down its website – or at least its wonderful due diligence page in which it promised to investigate anyone they entrusted money to. Sadly, when I wrote on December 14, 2008 about FGG’s complete failure to conduct due diligence on Bernie Madoff I linked to their site, rather than make a copy of the page and post that. So the link’s now defunct. Oh well, I’m sure it will show up in court pretty soon.
UPDATE: Here it is, thanks to Google’s cache system. Just to make it doesn’t get lost again, Walt, ‘m posting it on my site – fewer accidental erasures, don’t you know.
FGG’s due diligence process is deeper and broader than a typical Fund of Funds, resembling that of an asset management company acquiring another asset manager, rather than a passive investor entering a disposable investment.
A number of areas of inquiry are examined by a team of FGG professionals who specialize in evaluating respective areas of risk. Typically, a manager has been investigated and monitored for six to 12 months before that firm can be accepted onto the FGG platform. Long negotiating periods enable FGG to be more confident of its decisions before proceeding with a manager. Areas of examination are centered around the following:
1. Portfolio Evaluation, Investment Performance, and Financial Risks:
A core area for further analysis is to attempt to dissect and further understand investment performance, how a manager generates alpha, and what risks are taken in doing so. As portfolio management and risk management incorporate elements of both art and science, FGG applies both qualitative and quantitative measures. FGG:
- Examines independent prime broker trading records
- Conducts detailed interviews to better understand the manager’s methodology for forming a market view, and for selecting and exiting core positions
- Analyses trading records
- Conducts a number of qualitative and quantitative tests to determine adherence to risk limits over time
- Confirms portfolio loss risk controls, diversification and other risk-related control policies, as well as any experience regarding unexpected or extreme market events
- Reviews the risk and return factors inherent in the strategy
- Evaluates capacity issues, which may affect alpha, as well as expected opportunities going forward within each candidate’s strategy
- Analyses the various drivers underlying a particular portfolio’s risk
- Evaluates credit risk and market risk both at the instrument and portfolio level
- Assesses the extent to which leverage is used by a manager, as well as how it is used, the funding sources, and the impact on the risk profile of the fund
- Investigate whether or not private or special registration securities are held, and determine how the daily trading volume and inventory held compares to the float and/or daily trading volume for a given security
FGG also conducts many quantitative reviews of investment performance in light of:
- Fees and fee structure
- Historical draw-downs
- Return volatility
- Commissions earned
- Performance return in calm versus volatile markets
- Current/historical correlation of the fund under consideration with standard industry benchmarks, peer groups, and other FGG or competitor funds used as benchmarks
FGG attempts to understand the return attribution for individual securities in the portfolio, and conducts a full suite of VaR analyses and stress tests to model the loss distribution function under extreme market scenarios. Leverage, concentration limits, and long/short exposures are examined over time to assess whether they have remained within operating guidelines.
Style fidelity is another key area of inquiry; the manager’s trading pattern over time and through various market environments, FGG determines whether the manager is prone to trade outside of their area of expertise.
2. Personal Background Investigation:
FGG examines the abilities and personalities of the individuals involved in managing the fund through extensive interviews, as well as background investigations.
Personal credit standing
Litigation and regulatory background
FGG explores the manager’s experience and qualifications relative to the strategy being managed. Prior professional associations of a manager’s key personnel can be crucial in understanding a person’s experience and character and how they run their investment management business.
3. Structural and Operational Risk:
“Operational risk” refers to the risk of loss resulting from inadequate or failed internal processes, human resources, or systems, or from external events.Operational failures, including misrepresentation of valuations and outright fraud, constitute the vast majority of instances where massive investor losses occur. Other operational risks include staff processing errors, technology failure, and poor data.
Pricing models, as well as the adequacy, independence, and transparency of valuation procedures, contingency plans, and other trading and settlement procedures are all matters for close scrutiny by FGG professionals.
FGG seeks a sound understanding of whether a hedge fund possesses key controls in the areas of portfolio management, conflicts of interest, segregation of duties, and compliance. FGG carefully assesses the controls and procedures that managers have in place and seek to determine actual compliance with those procedures, often suggesting modifications, separations of responsibilities, and remedial staff additions.
4. Legal, Compliance, and Regulatory Risk:
FGG’s legal, compliance, and accounting teams specialize in investment management regulation, securities compliance, corporate operations, and tax issues. Hedge fund managers function within an ever more complex legal and regulatory landscape, and the role of this part of the diligence exam is to determine the seriousness of any deficiencies in this area which may cause risk of sanction, loss, or reputational embarrassment.
Both in-house and retained legal professionals interview the management and staff of the manager, research regulatory filings, and review corporate organizational documents, as well as fund memoranda and related material contracts.