Hedge Fund Due Diligence

There are some people worthy of blind trust with your money. They are the ones who: 1) seem to make money over time; 2) have well-audited books, which prove indeed they have; and 3) seem to have a cogent plan to continue making money in the future. All three must be satisfied and everything else is unimportant.

I’ve been railing against the “hedge fund industry” for as long as I’ve run hedge funds (1996). In spite of great promotion over the past ten years that the hedge fund industry is an asset class – like stocks, bonds or real estate – hedge funds (yours and mine) are still only private investment pools of money that speculate in the capital markets. The hedge fund industry should not be an industry and it seems, finally, that it is headed back to the cottage business it once was. Hedge funds are being right sized so that the ones remaining – the ones that keep offices down the hall from an accountant or dentist – are managed by individuals with a knack or a view, and who know they are speculating. Their investors are likely to know that too, and they will invest less in each fund. The scale of the “industry” will shrink. Hallelujah.

This does not imply that policymakers and regulators won’t heed wayward calls to “improve the system”. They are likely to confuse some issues though. First, private investment partnerships can’t be regulated merely because they are private investment partnerships. There is no legal difference between a partnership that invests in movies, multi-family rehabs in The Bronx, senior secured bank loans or large-cap stocks, and so there can be no law that forces a private investment partnership to register with any authority unless all such partnerships are to be regulated by that authority. So, if all “hedge funds” are to be regulated, it must be because they invest alongside the public in the capital markets and are subject to the same scrutiny as everyone else in those markets – no more, no less. Since private pools of capital investing in public markets are already regulated in the same way as every other investor in public capital markets, it seems obvious that there can be no new regulation enacted to stop “hedge funds” from being “hedge funds”.

Second, investors in unregistered hedge funds that lose their money know in advance that they have no regulatory protections. So, unless an investor accuses his hedge fund manager of fraud or of not abiding by the terms of their private agreement, there is nothing to be adjudicated. Regulators can do nothing to change this. CNBC is beating up on a straw man to produce public outrage for ratings. There is no public damage in the Bernie Madoff case, as there was with Bernie Ebbers, et al.

Barry, I know you agree that anyone should be allowed to privately syndicate a pool of investors and speculate with their money using any mix of investments or strategies upon which they and their charges agree. If investors in a private fund want a good audit every year, month or day, great. If they couldn’t care less, great. If they want to leverage their portfolios 80 times and their lenders and investors don’t mind, great. If they want to sue their hedge fund manager for not abiding by their agreement, great.

“Hedge funds” might hedge or they might be pools of capital that speculate using their best efforts (QB Partners is the latter). The only document that accurately portrays an investment program and the merits and risks involved in a fund is the official offering document. They all say (or at least they should say) that investors can lose all of their money and that the investment management company can do anything it wants with investor money.

Of course, nothing is guaranteed – corrupt managers can hide great losses or gains at any point in time and can perpetuate them over time with the help of a shoddy auditor. Investors shouldn’t think for a moment that vigilance or rigid risk controls can overcome fraud. The only thing vigilance may accomplish is spotting fraud earlier than fellow fund investors, which might allow the vigilant to get his money back before everyone else catches on.

WHEN YOU INVEST YOUR MONEY IN A PUBLIC OR PRIVATE POOL OF INVESTMENT CAPITAL – REGARDLESS OF WHETHER IT IS A LIGHTLY REGUALTED “HEDGE FUND” OR A HEAVILY REGULATED MUTUAL OR MONEY-MARKET FUND – YOU ARE SPECULATING (NOT SAVING) ON TWO LEVELS: 1. MARKETS (BETA) AND 2. THE CONDUIT (ALPHA).

If investors don’t have the acumen to judge whether a fund and its manager should be trusted, they should look at the fund’s audit and only then diversify their fund investments.

Paul Brodsky
QB Partners

QB Asset Management Co.
(917) 538 – 1908
pbrodsky -at- qbamco.com