Red Flags To Look For In Hedge Funds

Here’s a news flash: many hedge funds lie.  Whenever I am conducting a due diligence, I feel like I’m watching the music video for Michael Jackson’s “Thriller.”  It is flabbergasting that even in the post-Madoff era, you never know what will pop up during a due diligence inspection.  Here are some of the red flags that investors may want to be on the lookout for.

Strange financials.  I once noted a fee deferral entry that conveniently moved an expense from the income statement to the balance sheet in a hedge fund’s financial statements.  This may be a shenanigan to reduce fees, thereby artificially boosting performance.  Although a full accounting forensic assessment may not always be possible, attention should be paid to any abnormal items or accounting methods.

Large subscriptions or resumptions.  Sometimes institutional money can be quick to depart; that is not necessarily any wrongdoing.  Nonetheless, it is a good idea to map out the assets by month, and note any changes over 5% of total assets under management.   It may be a sign that the managers are funelling money somewhere else. 

Unexplained lags to process routine requests.  If audited financials, the compliance manual, or the contact information for service providers (prime broker, administrator, etc) can not be produced within 24-48 hours, there may be something fishy going on.

Board positions.  Insider trading is hard to detect without the power to subpoena or use wire taps.  The investment decision makers should be interviewed.   Any positions that don’t seem to fit within the investment strategy are red flags.  If no consistent and rational process for decisions is articulated, it is possible that investment ideas are originating from insider sources.

Change of auditor.  Be sure to talk to the predecessor auditor.  It’s possible that a fund would switch auditors in stringent standards could not be met, engendering the risk of failing an audit.

You don’t have to be Harry Markopolos to smell a rat.  Many times, common sense and an eye for deviations from basic policy will expose the lies.