Hedge funds, unlike traditional asset managers, are likely to use independent parties to sell their products to investors. These parties-often called third party marketers in spite of the fact they sell rather than market a product -typically strike a deal with hedge fund manager whereby they will receive a portion of the management and incentive fees generated on the assets they raise for the fund. Seems like a pretty straightforward commercial arrangement and in most cases it is. Such an arrangement should benefit the hedge fund manager (it increase its distribution), the marketer (it generates a revenue stream) and prospective investors (it provides them with information to which they might not have access).      

Yet prospective investors need to be aware of such relationships when they are performing due diligence on hedge fund managers. In fact, they should expand their due diligence to include the third-party marketer so they can properly evaluate the information the agent is presenting.      

Investors first need to discern whether the individual presenting the hedge fund to them is an independent contractor or an employee of the firm. This makes a difference because an employee has a vested interest in the product and firm. They have made a bet (by taking a job with the manager) that the hedge fund is worthy of an investment. Moreover, they may have part of their compensation tied to the performance of the fund itself. A third-party marketer makes no such bet. These agents are independent contractors and they have no vested interest in either the strategy or the firm. Their interest is to raise assets for the manager. Certainly this is a big incentive, but it in no way indicates that they have performed any due diligence on the manager themselves. If the individual marketing the fund/manager is an independent contractor, an investor should evaluate the agent just as they would the manager.     

An investor should begin by determining what type of due diligence the agent has performed on the manager. Did they speak with the fund’s auditors? Did they meet with key personnel to ascertain the level of compliance within the firm? Have they reviewed the daily trading activity of the manager? Have they spoken with the fund’s prime broker regarding it creditworthiness and performance? Have they checked with the NASD (if appropriate) regarding disciplinary actions? Do they know the complete employment history of the manager and key staff members?     

An investor should also inquire about the specific nature of the relationship between the manager and the agent. What is its genesis? How long has it been in place? Is it exclusive (i.e., do other agents represent this manager and does this agent represent other managers)? Is there a fixed terminus for the arrangement? What is the agent’s compensation program and payout structure?      

Next, an investor should ask the agent about his/her own professional experiences. Has he/she marketed other managers? If so, whom and when? (It is certainly appropriate to check references.) Why did he/she leave and choose to market this new manager? Investors should ask what licenses the agent may hold (even though none may be required). If the agent is registered, investors should check his/her disciplinary history with the NASD.      

If investors ask no other question, they should ask whether the agent has invested any of his/her own money with the manager. If so, they should be asked to explain why.      

As I said at the beginning, most third-party marketing arrangements are solid commercial relationships. And most third-party marketers are highly professional and ethical individuals who can add real value to both the investor and the manager. Yet a recent event in the hedge fund industry should keep investors on guard. A small hedge fund with extraordinary performance numbers was approached by a third-party marketing firm about striking such sales relationship. After reaching an agreement, the agent began to aggressive market the fund to investors. The manager’s allegedly stellar performance and the agent’s strenuous sales effort resulted in a considerable inflow of assets. The situation changed rapidly after the agent began to suspect the fund was overstating its performance. The agent learned that in spite of the fund’s claim, the fund’s performance had not been audited by a major accounting firm. In fact, it had not been audited by any external organization. The agent turned tail and notified investors (and the media) of the fund’s possibly inflated performance record.      

It seems that the agent had not performed its own due diligence on the fund. It had not verified a claim in the fund’s documents that a large accounting firm was the fund’s auditor. It had not checked the veracity of the fund’s stated performance (even though it defied common sense-especially given the strategy employed by the manager). If it had, it would have likely uncovered certain “shortfalls” and, accordingly, saved investors considerable aggravation-and money.      

Even if the agent were ignorant of these issues, investors could have made a more informed investment decision if they had asked the agent about the type and kind of due diligence it had performed. If they would have asked just one question, “Have you invested your own money in the fund and if so, does the amount you have invested represent a significant portion of your investable asset?” They probably would have learned that the agent had no vested interest in the manager-other than its payout.      

Transparency is the watchword when investing in a hedge fund. Investors would be well served if they include the marketing representative in their manager due diligence process.





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