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Horizons: Family Office & Investor Magazine

Virtual Due Diligence: A New Paradigm, Same Hard Work

Monday, September 21, 2020

Amy B. Hirsch has 40 years’ experience in alternative investments. As CEO of Paradigm, she currently provides a range of services to institutions, investment managers, corporations, and family offices. She also provides expert witness services to a number of law firms involved in alternative investment / hedge fund related litigation.

Ms. Hirsch has extensive experience in Alternative Investments & Hedge Funds including; asset management, due diligence, marketing, and operations. She has been responsible for managing in excess of one billion dollars of hedge fund-of-fund products on behalf of pension plans and institutions, and has conducted operational and investment due diligence on hundreds of alternative investment firms. She has co-managed a litigation finance firm and is well versed in lending practices. Her primary expert witness sub-specialties include due diligence on all types of hedge funds, alternative investment operations, fund risk management, and portfolio management.

She started her career in Operations at Merrill Lynch in 1980, advancing to Vice President of Trading Services for ML Futures Investment Partners. Ms. Hirsch was then Senior Vice President, of the Managed Futures Group at Smith Barney. She then joined Link Strategic Investments as Chief Operating Officer prior to becoming one of the four partners that launched Paradigm LDC. Ms. Hirsch has been sole owner and CEO of Paradigm Consulting Services, LLC since 1996. Ms. Hirsch holds a B.S., cum laude, in Economics from Fordham University. She has been registered with the NFA as an Associated Person since 1986.

‘Trust, but verify’ is the holy grail of investment due diligence. As a due diligence expert, this has meant a lot of planes, trains, automobiles, and hotels over many years. At its core, manager due diligence takes a tremendous amount of effort during normal times, and these are certainly not normal times. Our approach must change, yet it is imperative that we maintain the quality of our due diligence. In a world where travel has become near impossible, we must adapt and change to achieve this goal.

There is sudden fear in the investment community due to the pandemic; a misguided desire to only reinvest with existing managers in their portfolio, because virtual due diligence on a new manager is too hard. This is leading to over concentration and potentially, additional manager correlation. Yes, it is more difficult, but not so difficult that you should not expand your manager bench.

Prime brokers and others have risen to the challenge and created virtual manager conferences. These can be your introduction to a new manager. So, how do we as investors adjust our approach?

Typically, due diligence involves a visit to the manager’s office; meetings with the portfolio manager, analysts, and operations personnel. It includes an on-site review of portfolios and systems, and it gives you a sense of the firm culture. You walk around a firm to get some insight into inter- personal relationships and individual personalities. After all, these people are managing your money, so we need to pay attention to them.

Investors all want to discuss the manager’s views, the portfolio, and their approach in the current market cycle. There is a desire to dive straight into the performance record and ask about certain specific periods of performance. That is the sexy part of due diligence. Now, more than ever, investors must spend more time on other aspects of the firm.

I have conducted due diligence on many hundreds of managers ranging from new launches to established, multi-billion dollar funds across all types of strategies. I have successfully avoided every fraud. Am I smarter than anyone else? No. I just do the hard work, and ask questions. I was once conducting due diligence on a ‘fund’ in Australia and I asked to see the audited financials. The manager responded that there were none, as it was not a fund structure.

The marketing material he had been sending around that said “The xxx Fund” in the header was actually a combination of a small managed account and a hypothetical track record based on a ‘similar’ strategy. Do not assume that what you are reading is real. Ask for proof.

Read the footnotes of every audit and performance record. Take nothing for granted.

The recent Coggins fraud in Miami was avoidable. The SEC complaint against David Coggins stated that “Coggins lied to investors about how well their investments were performing, the amount of assets he was managing, how he planned to invest the Fund’s assets, and his experience managing investments. He also created and sent fake audit opinions to third parties and investors and falsified brokerage records and investor account statements.”

Earlier I said that the first rule of due diligence is trust but verify. Reference checks can save your portfolio and career. Don’t just call the references you are given. Use on-line tools to find other connections. Call the brokers, call the auditors, call former employers, and call the administrator. At the very least, the auditor can confirm if they are even the auditor for the fund.

So many of these reference checks have stopped the due diligence in their tracks. Coggins should never have been able to raise money. If investors had verified his experience and found out he was lying, or had called the ‘auditor’ and found out the reports were fake, it would have ended there.

Positive reference checks are just as important to continue due diligence and lead you to find great managers starting their own firms. We have had success in allocating to new managers such as Larry Robbins at Glenview or Pat McMahon at MKP to name a few. Their references led us to finish all due diligence and invest with them early on.

So now, we have an added due diligence hurdle called the virtual world.

In the current environment, on-site visits have been replaced by Zoom meetings, conference calls, and on-line posts. In order to make the most of these communications, investors must prepare ahead of time, now more than ever. Request the following documents prior to any call:

  • Firm presentation
  • Audited financials
  • Track record
  • Organizational chart and background of staff
  • Prior letters to investors
  • FAQ and DDQ prepared by the firm
  • PPM or Offshore offering memorandum

As you review the documents, prepare your key questions to be respectful of the manager’s time and to make the meeting more productive for both of you. This is recommended for on-site meetings as well.

If you are going to have a Zoom or other video call, ask that the head of Operations and Finance join as well. Split the meeting so an analyst can join. Ask for time with a member of the operations / finance department to review security protocols and firm-wide permissions.

Request the head of Operations to show you the portfolio tracking and risk management systems via a shared screen. Ask to see the system for tracking insider trading and other compliance or regulatory requirements.

Ask about morale, changes to the organization, plans to re-enter the office, disaster recovery. Discuss what was learned as they transitioned from an office to a virtual environment, and more importantly, what did they do to implement necessary changes. Ask staff how the portfolio managers are doing; how are they coping with the additional stress, what is the level of excitement?

Another key issue is offsite employee and system risk protocols, of which a few are:

  • How many staff are working from home?
  • Are they using Firm hardware or personal hardware?
  • If they use a laptop, is it physically secured?
  • What software security protections are in place?
  • What smart phone security protocols are in place?
  • Is there additional security at each home?
  • Is the VPN secured with additional passwords?
  • Are they allowed to run on the same network as their home?

These are just some of the things we must do in the current environment.

One positive note is that due diligence has been made easier in that calls can be recorded and details that would normally be forgotten can now make it into the due diligence report. Instead of focusing on writing every word that is said, you can listen. This is where the best analysts and investors shine, they truly listen. It enables one to focus and ask material follow-up questions.

After you assimilate all your information, make time to schedule a follow-up to review any scenarios that were discussed and whether they achieved the desired result. These can be positions, operational changes, new personnel, any protocol changes, etc...

Take the time to Zoom, call, or FaceTime to find the next great manager. The players may change, the strategies evolve, but due diligence has always required hard work and common sense. If it seems too good to be true, it probably is.

To misquote Madonna, we are living in a virtual world, and I am now a virtual girl.

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