I-Spy Hedge Fund Managers
Financial sleuth helps uncover managerial red flags for institutions and fund of funds
February 18, 2008
When mulling an investment in a hedge fund, investors rightly place emphasis on a manager's past performance and behavior. Randy Shain, vice president of First Advantage Investigative Services, investigates hedge fund managers for a living and provides information to institutions and funds of funds, among others.
Shain has examined more than 2,500 funds and 5,000 hedge fund managers in the past 15 years. He and his team of researchers, have authored thousands of reports which review vast amounts of information on managers including school, court and other records. They also contact and interview former work colleagues.
Shain spills some of his secrets in a new book: Hedge Fund Due Diligence: Professional Tools to Investigate Hedge Fund Managers. Working closely with clients for several decades, he recognizes what investors look for when performing due diligence on managers. Shain recently shared thoughts with IDD on the process of investigating hedge fund managers, and some possibly warning signs to look out for.
Randy Shain
IDD: How willing do you find former colleagues of managers to talk when you call them seeking information?
SHAIN: Most of the time, not very willing. Remember, unlike the police or prosecutors, we can't impel people to speak. And unlike reporters, we don't have much of a carrot to offer either. That said, we have been quite successful in breaking through many people's natural desire to remain on the sidelines, not commenting, by using the various techniques outlined in the book. People of course are typically more willing to speak when what they have to say is entirely positive. It's more difficult when a source has had an issue with a subject; still, most situations are not black and white. Also culture plays a role too, as people from, say, the UK are less apt to speak about a former colleague than a US interview source.
IDD: How closely is a manager's past behavior related to the future success of the hedge fund?
SHAIN: I would make the argument, and plenty of institutions have made the argument to me, that if they see a manager has acted in a way that that institution is not comfortable with in the past, then it's very unlikely that institution will be comfortable with the way that person will act going forward. Although people can change and clearly people mature, under stress, many if not most humans, tend to act the same way they have in the past; it's kind of the way we're wired.
IDD: What are some of the red flags that would alert investors something might be awry?
SHAIN: Certainly the biggest red flag in the hedge fund world is bankruptcy. If a hedge fund manager has personally gone bankrupt it's very unlikely that an institution is going to look at that and not say "this is a disaster." That's red flag No. 1. Red flag No. 2 is a hedge fund involved in a civil fraud suit that the manager lost. Those are really difficult issues for institutions to get past.
IDD: What are some yellow flags to look for?
SHAIN: In the lawsuit category alone there are so many. Any hedge fund manager that has had multiple law suits yielding large judgments, or multiple tax liens with amounts over $50,000. Also, any unusual suits in the industry, such as hedge fund Wood River, which was sued for failure to pay rent, that just doesn't happen. My point in the book is that's something that's hard for the institution to know and that's what they have to ask the investigator they are using. Is this usual? If it's usual, although they may be disturbed by it, contextually they might be alright.
IDD: What other types of information or behaviors are some investors troubled by?
SHAIN: Institutions often think how they feel about court cases. For example, if you're an investor in a public school endowment, that school is probably more likely to be upset if a person was caught drunk driving than the typical fund of funds. A typical fund of funds, who is really seeking alpha, may say "the manager has great returns, it happened five years ago, there is no pattern of behavior," and are willing to roll the dice on it. A public institution, while agreeing with the reasoning, still may feel they might get into trouble with trustees if they had an investment in someone like that. It could be as simple as that decision.
Others are concerned about patterns of behavior. For example, no one really thinks it's relevant information about a manager who divorced their spouse 15 years ago. However, that can be very different than someone who has been divorced four times. Even though one might argue it's just a personal situation, some institutions will say they are just not comfortable and want to factor that into their decision.
IDD: Can investors perform this due diligence by themselves or should they hire an investigator?
SHAIN: The book is designed to say exactly how the work gets done, so whichever way you choose to do it -- either by yourself, through an investigator or hybrid -- you know how it should get done properly. Yes, in theory an institution that is doing this on its own now or thinking about investing in hedge funds and doesn't know what to do in terms of background checks could use this book and investigate managers on their own. It's OK for me to say that given I've shared what we do step-by-step in a book.
Ultimately, institutions trying to do this entirely on their own would find it extremely difficult unless they were going to devote resources to it, meaning build out a staff. If you're going to do this on your own you need the people who've done the nitty gritty themselves before.
I'm not naive enough to think that people aren't already doing this on their own, but at least understand what it is you're doing, what you're missing and how to fill in the gaps.
IDD: What is the goal of book?
SHAIN: To explain to people how investigative work gets done in the most effective and efficient way. Whether investors decide to do this on their own or use a vendor, in either case they will know what questions to ask to make certain they receive all the materials they should when reviewing information about people running hedge funds.
IDD: How do you gather information and find past colleagues or hedge fund managers?
SHAIN: People are revealed via old-fashioned public record searches. Searches are done first, such as finding news articles, corporate, court and regulatory records, and then the records are verified. From the searches emerges a list of people who work or may have worked with the subject. The people are all business contextual relationships, not neighbors and things like that. I'm not pitching to someone that this work should be akin to the Secret Service.
Once you get names of past colleagues, you don't know necessarily what the relationship was. All you may know is that the person could have been a former boss. The next step is finding where the potential interview sources are, getting them on the phone and then having them open up.
IDD: How would one go about interviewing a potential source on a manager?
SHAIN: When approaching a source don't ever call and use the words "I'm investigating." One could say, "We're considering doing an investment transaction with said subject, and we saw that the two of you worked together based on a past article."
(c) 2008 Investment Dealers' Digest Magazine and SourceMedia, Inc. All Rights Reserved.
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