Operational due diligence has become a key consideration for European institutions investing in hedge funds, Deutsche Bank latest research reveals.
Since the financial crisis, the proportion of institutional investors in hedge funds has increased. Now 57% of total assets under management in hedge funds comes from institutions, according to a recent AIMA/KPMG global survey.
Deutsche Bank says this ‘institutionalisation' of the industry is has led to increased focus on due diligency, as the investment objectives of institutions place an important emphasis on risk-adjusted returns and capital protection.
This mandate to minimise risk brings a hedge fund manager's people, operations and technology into focus for investors, Deutsche Bank says.
Daniel Caplan, European head of global prime finance at Deutsche Bank, said: "Institutions have embraced hedge funds as a source of positive risk adjusted returns, and this runs hand-in-hand with a greater focus on control and compliance."
The survey polled senior professionals at leading fund-of-funds and consultants in Europe, representing over $411bn in total hedge fund assets under management.
The results revealed growing importance of operational due diligence teams for managers since the onset of the financial crisis.
Some 73% of funds of funds and 80% of consultants said they have operational due diligence teams in place that are separate from their investment teams.
The results also revealed that investors are dedicating more time and attention to the due diligence process.
Two thirds of investors polled said they take between three and six months to complete due diligence on a manager. This proportion has doubled compared to the same survey conducted in 2003.
The due diligence teams play an important role in the fund selection process. Respondents to the survey revealed they now see these teams as "partners and peers to the investment team."
One of the tasks of these teams is to actively veto hedge funds based on their due diligence process.
Issues under consideration, for example, are lack of independent oversight, unwillingness to provide transparency, valuation issues or insufficient investment of personal wealth in a fund. All of these have led to vetoed investments in the past 18-24 months.
But it is not all bad news. Investors also say that as long as the fundamentals are in place, having the right people, approach and audit trail goes a long way to make the fund an attractive proposition.
DB's Caplan says: "Investors have a rigorous toolkit of evaluation techniques and hedge funds have responded by vastly increasing transparency and access."
The investors polled by Deutsche Bank advise hegde fund managers to be transparent, invest in people, and make sure their fund terms are appropriate for the strategy and not "over-lawyered with legal documents."
A robust infrastructure, established service providers and a culture of compliance and governance are now vital considerations in the investment process.
Chris Farkas, DB's head of European hedge fund consulting, said: "The research highlights how important the fundamentals are to the operational due diligence process - from having the right people in place to a proven audit trail."
"The growing importance of operational due diligence comes at a time when investors are better educated than ever in all aspects of a fund's business," he concluded.
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