Outsourcing Helps Hedge Funds Satisfy Investor Due Diligence Demands

Institutional demand for hedge funds has continued through 2018, taking industry AUM to an all-time high of US$3.4 trillion as investors increasingly direct money to the sector. Enhanced diversification, lower correlation to equities and bonds, and lower risk are all driving investor allocations to alternative investments, says investment management and consulting firm the FERI Group.

Credit Suisse’s mid-year investor sentiment survey also reports strong investor appetite, with hedge funds on par as allocators’ top investment strategy going into the second half of the year.

But unless you’re a well-known name with an established reputation, attracting institutional money can be tough. These investors bring stringent due diligence processes and a growing emphasis on fees and expenses. Only the most efficient, robust and operationally professional funds will pass muster.

Meeting Both Quantitative and Qualitative Due Hedge Fund Diligence Requirements

Each investor will have its own specific process. Broadly though, hedge fund due diligence takes two forms:

1. Quantitative – Concentrates mainly on the hedge fund firm’s investment strategy and how it works, and digs into its risks and performance.
2. Qualitative – Focuses on the characteristics of the hedge fund (such as the terms of participating) and the manager (i.e. how they will run the portfolio, and ensuring the infrastructure and resources are in place to do so).

These qualitative considerations have become as important as the quantitative aspects, and are getting ever more detailed and rigorous.

For instance, a new alternative investments survey by Intralinks and Global Fund Media reported that 90% of limited partners (LPs) have either increased or maintained the depth and breadth of their due diligence process. The survey suggests LPs are strengthening their operational due diligence capabilities to improve manager selection and mitigate unforeseen risks, with the quality of reporting and a robust IT infrastructure particularly important.

As the Hedge Fund Marketing Association points out, “Investors understand that fund managers can do little to control markets, but they do recognize their ability to vet the operational and regulatory integrity of a prospective fund.”

Investor Focus on Limiting Operational Risk

Minimizing operational risk, by ensuring a hedge fund manager has established and maintains effective middle- and back-office processes, is a particular institutional investor concern.

Investor confidence in a hedge fund firm's operational capabilities commonly center on the quality and reach of the IT infrastructure employed; their ability to address any cybersecurity and disaster recovery concerns; and assurance regarding any third-party service relationships the hedge fund may have in place.

According to the Hedge Fund Marketing Association, key considerations will therefore include:

• Can the manager adequately explain the strategy and risks taken?
• Do the key people in the investment process have other duties at the firm (for example, to assess the level of expertise in critical functions, the appropriate segregation of responsibilities, and key person risk)?
• Who is the fund administrator?
• Who is the prime broker?
• Who is the custodian of the assets?
• Who is the compliance person, and what is their background?
• What data sources and analytic software are used to run the product?

Such operational assessments are not necessarily a one-time exercise either, with investors being urged to shift towards ongoing due diligence post-allocation.

Outsourcing Delivers Much Greater Operational Professionalism

All of which raises the operational bar for existing and start-up hedge funds – and especially smaller and mid-sized managers that may not have the resources to:

1. Recruit a team of experienced middle- and back-office staff, and
2. Implement the sort of sophisticated IT infrastructures needed today to meet investors’ service expectations and satisfy their expanding regulatory obligations.

The good news is, nor do they have to.

Outsourcing to a proven, specialist provider gives hedge funds ready-made access to the operational professionalism they need – and investors increasingly demand – without the high cost and hassle of trying to do it in-house.

Tasks such as counterparty reconciliations, portfolio accounting, corporate actions processing and performance reporting can be laborious and technically-challenging, drawing valuable resources and focus away from the fund’s core business competencies.

Moreover, clients just expect these functions to be completed accurately and seamlessly. There is no competitive advantage in getting them right, but significant competitive disadvantages in dropping the ball. Client satisfaction and the firm’s reputation are at stake.

Better then to hand the tasks to a firm that is specifically set up to do the job – and do it well. That is, after all, their business.

And it leaves you free to get on with yours: generating returns and servicing clients. That way, you’ll be much better placed to satisfy both investors’ quantitative and qualitative due diligence expectations.

Ensure Outsourcing Partners Meet Your Own Due Diligence Standards

When outsourcing, bear in mind though that your service providers must pass investors’ due diligence reviews too. Conducting your own due diligence on potential third-party providers, to ensure they truly have the capabilities you need, and will be a stable and reliable partner, is vital.

For as the Intralinks/Global Fund Media survey notes, managers that have the right operational infrastructure and system architecture will be well-placed to meet the demands of global investors and “become tomorrow’s winners in the battle for capital inflows.”