Sun Venture’s Serene Tan looks back on years of manager due diligence and distills some key point to look out for
Investment funds due diligence is never an easy task – how do you rightfully and respectfully judge the investment acumen of an investment manager and his team in just a couple of due diligence meetings?
How is spending a few hours listening to an investment manager’s process and investment thesis sufficient to encapsulate his and the team’s many years of hard work, 10 (or even more) hours a day, 5 days a week? How do you ascertain that a fund’s recent under or out-performance is transient or structural?
In the fund management industry, high doses of “marketing” and “packaging” by these firms add another dimension to the difficulty. People tell you what they want you to hear. It takes a lot of energy and drive to unearth the truth.
It is not easy, but after many years of doing this, I found that being methodical, knowing what to look out for and doing homework before the investment due diligence meeting helps.
Rule number 1: set your own agenda. Never let a portfolio manager dictate how the meeting should be run.
Rule number 1: set your own agenda. Never let a portfolio manager dictate how the meeting should be run
At the same time, a proper fund evaluation framework helps – in ways that are not commonly articulated. A framework helps you to spot and ask questions which the fund managers sometimes tried to hide or sweep under the carpet.
It helps in ways in which you can cross-check the fund managers’ answers and spot any inconsistencies which could be deficiencies in the managers’ investment process. It helps in ways in which we at Sun Venture can analyse across many managers managing assets in the same universe and make useful comparisons.
But having a framework is never enough. A critical mind is essential. Some time back, we researched a particular hedge fund very thoroughly, talking to their founder/CIO a few times, his entire investment team members, as well as the COO.
It was during a period in which there was a lull of issuances in the fund’s particular target investment universe. When we analysed the strategy’s allocation, we noticed a style drift. We believe then the fund was operating outside of its core competencies where their past alpha generation is unlikely to be sustained going forward and we decided not to invest.
We believe that this fact, together with other factors, had been the fund’s undoing performance-wise. The fund subsequently underperformed its peers.
Due diligence, on paper, can only go so far. During the COVID years, virtual meetings were the norm and everyone thought that the days of ‘kicking the tires’ were gone. How wrong.
We made a trip recently to Europe and met with some short-listed managers. On paper, these managers ticked most of the boxes – sufficient AUM, good performance, sufficient years of track record, good downside volatility, good Sharpe and Sortino ratios.
One particular due diligence visit was an eye-opener and a testimony to the importance of on-site due diligence. In past on-site due diligence visits, we were able to discern how important the compliance culture in the firm is by observing even the smallest thing: if there are separate entrance doors (with access controls) to different affiliates under the same group companies, whether data is hosted in separate servers in a dedicated cage, whether there are practices of Chinese walls, et cetera.
Do bear in mind, up to 80 per cent of hedge funds failure is due to operational risk issues. This industry is full of brilliant minds, but that alone does not guarantee success in an industry that is highly pressurizing, high portfolio turnover, often highly leveraged and performance-wise very unforgiving.
Do bear in mind, up to 80 per cent of hedge funds failure is due to operational risk issues. This industry is full of brilliant minds, but that alone does not guarantee success in an industry that is highly pressurizing, high portfolio turnover, often highly leveraged and performance-wise very unforgiving
Furthermore, fund investors need to recognise that, as with any investment, change is the only constant. Macro conditions (such as rates, valuations, debt maturity schedules, etc) could be tailwinds for some strategies and headwind for others.
For example, should interest rates continue to remain higher for longer, companies may opt to seek alternative avenues for refinancing once their debt is due in the next one to three years. What would this dynamic mean for different strategies? What is the impact on our research pipeline? These are some examples that will drive our constant evaluation of the investment landscape.
Beyond investments and operations, we must also understand the people behind processes. Pedigree, while important, is not pivotal nor indicative of future performance. A recent due diligence visit was done on a hedge fund that also seemed to tick all the right boxes. It was run by co-founders with high pedigrees, a well-built research team, differentiated investment process and an impressive proprietary research database.
However, we found that a key edge of strong risk management in the co-founder’s past fund was not apparent in their current set up. We opted to not pursue due diligence as an immediate pipeline name as it was not in line with our capital preservation requirement. However, the co-founders’ obsession to analyse the industries from a holistic angle is really commendable and we would like to one day establish long term relationship with this manager. We’ll see…
How about growth-oriented, long-only equity managers when the chips are down and the market sentiment go against their style? Many investors are attracted to past performance without properly dissecting if these past performance are a function of a growth orientation focus that benefitted immensely during the pandemic years (2020-2021).
When the bubble deflated, what should the portfolio managers do? What should they not do? How to draw a fine line between recognising that market conditions have changed (it’s not ‘Growth-at-any-Price’ anymore) and being true to one’s investment philosophy? How to draw a fine line between over-reacting unnecessarily to short term earnings disappointments (after all, we are long term investors), and being nimble?
Ignoring short term earnings disappointments or losing visibility over the company’s next one to two years earnings trajectory in an extremely unforgiving market environment such as 2022-2023 is very detrimental to performance.
Re-writing the story that one knew so well in the past (especially during 2020-2021) and benefitted immensely from is difficult for any portfolio managers to do. However, perhaps on hindsight, that should be the one thing that the portfolio managers ought to think about during the difficult times – the key to sustained out-performance is also knowing that minimising being “wrong-footed” in an unforgiving environment is important.
In short, fund due diligence is not an easy task, and the ultimate outcome is determined by a confluence of macro and micro factors, but this is what makes the work so interesting.
However, this is not all – from a portfolio construction perspective, considerations need to be given to sub-strategy mix, how it marries with our top-down views, as well as correlation with other existing funds.
Serene Tan is Head of Investments at Singapore-based investment firm Sun Venture. There she assists the principal in the management of the investment portfolio. Prior to Sun Venture, she spent 14 years as a consultant to the regional institutional clients at Mercer Investment Solutions Singapore. Her views are her own.
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