Hedge Funds: Effective Evaluation of Managers Pre-Allocation

“What does a successful manager look like?” There’s a question all allocators are asked. The answer is arbitrary - not as black and white as in years past, and more along the lines of “you know it when you see it.”

It has been heard thousands of times – Pedigree, Process and Performance are key traits that allocators seek in fund managers. While the ‘3 Ps’ are very relevant, however, do we focus too much on Pedigree? It seems that, while a manager’s background is still important and may be a differentiator, in a market where hedge funds have been underperforming, allocators are seeking managers who demonstrate creative, intelligent ideas with disciplined execution among all strategies –  L/S equity, event driven, quant, macro and within sectors/industries including TMT and health care.

Managers are being sourced in a number of ways – and as expected, the capital introduction (“cap intro”) teams within the prime brokers (“PB”) are on the list. A manager’s PB and their respective cap intro teams have proven to be successful according allocators. Not surprisingly, a manager’s network can be invaluable. Some of the most highly regarded manager recommendations are endorsements from respected, successful managers themselves. It’s not unusual for an allocator to consider a manager who has been recommended by someone that they trust and respect. Additionally, there has been a slight deviation in the sourcing of new managers – away from hedge funds and toward “industry” – i.e., individuals who are coming out of large, successful technology companies like Google, Amazon, etc.

However, as it relates to the capital raising process, there’s still one more important piece to the puzzle – operational due diligence (“ODD”). ODD is an extensive process, typically lasting anywhere from 8 to 12 weeks consisting of on-site/follow up meetings, background checks, evaluation of fund formation documents, financial statement review, and an extensive review of post-trade allocation process and valuations of securities. At the end of the day, ODD teams are not tasked with ‘wasting good investment talent,’ however, so many are willing to be flexible and consultative in order to work with the manager to improve on items they may be uncomfortable with. In addition, there are alternative ways to provide an allocation which isn’t a direct investment into the fund – for example, the creation of a fund of one, or a separately managed account (“SMA”). One thing that ODD teams cannot overlook – and it’s as arbitrary as the response above – is trust. Ultimately, allocators are seeking trustworthy partners to be good stewards of their capital.