Hedge Fund Due Diligence

Stephen Brown, NYU William Goetzmann, Yale Bing Liang, U Mass Christopher Schwarz, UC Irvine

Previous Work: Lessons From Hedge Fund RegistrationBrown Goetzmann Liang and Schwarz

Is SEC registration useful?

What correlates to operational risk?

Can we predict operational event?

SEC Registration Form ADV

Form ADV Item 11: legal and regulatory problems.

A “Problem” fund = a fund whose management company answered ‘Yes’ to ANY question on Item 11 of Form ADV. Past Suspension Past Fine Other Legal or Regulatory issue

Problem vs. Non-Problem Funds

1814

358

10295

1526

0%

20%

40%

60%

80%

100%

Hedge Funds All Advisers

ProblemNon-Problem

Problems and External Conflicting Relationships

"Problem" Funds "Non-Problem" Funds

No. Funds % Yes No. Funds % Yes

Broker/Dealer 368 73.10 1929 23.70

Investment Comp 368 50.30 1929 15.80

Investment Adviser 368 73.90 1929 41.60

Commodities Broker 368 53.50 1929 20.70

Bank 368 40.50 1929 9.80

Insurance 368 39.90 1929 8.30

Sponsor of LLP 368 56.80 1929 21.50

**, * significant at one and five percent respectively Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration, Stephen Brown, William Goetzmann, Bing Laing, Christopher Schwartz, Not for reproduction or citation or quotation without authors’ permission

Problems and Internal Conflicts

"Problem" Funds"Non-Problem" Funds

No. Funds % YesNo.

Funds % Yes

Buy Sell Your Own 368 30.7 1929 8.3

Buy Sell Yourself Clients 368 84.8 1929 69.3

Recommend Sec You Own [Rec] 368 75.5 1929 50.4

Agency Cross Trans 368 30.7 1929 2.3

Rec Underwriter 368 69 1929 47

Rec Sales Interest 368 22.6 1929 15.7

Rec Brokers 368 46.7 1929 38

Other Research 368 81 1929 70.5

Conflict of Interest and Future Performance

Regression t-values. Blue = problem fund

**, * significant at one and five percent respectively From Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration, Stephen Brown, William Goetzmann, Bing Laing, Christopher Schwartz, Draft: October 11, 2007. Not for reproduction or citation or quotation without authors’ permission

4.1

7

1.3

1

-1.2

1

1.8

0.4

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-0.2

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-2.5

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0.5

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-1.5

6

4.1

9

3.5

7

-4.7

3

2.1

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8

-1.5

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0.5

8

-1.1

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-2.1

5

-6

-5

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1

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Log(Assets) Fund Age(Years)

Std Dev Onshore Incentive Fee High WaterMark

Relationship DirectDomestic

Percent own75%

t-value

Predicting Problems

We need PAST ADV problems Difficult to get from SEC

Instead, we can use observables “Rotation” of Lipper-TASS variables

and “Rotation” of ADV characteristics that are most highly correlated.

Canonical correlation. Use this model with historical data.

The ω-Score:

A propensity score for “problem” Uses TASS data (widely available) As good as we can do without a

research and due diligence team A linear factor model Does it predict fund disappearance? Back-test

Operational Risk Measure Predicting Returns

-6.0%

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Co

effi

cie

nt

-6.0

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

t-va

lue

coefficient (left axis)

t-value (rigth axis)

coefficient average value

t-value average value

From Estimating Operational Risk For Hedge Funds, The Ω-Score, Stephen Brown, William Goetzmann, Bing Laing, Christopher Schwarz. Not for reproduction or citation or quotation without authors’ permission.

How About Fund Failure?

Is the half-life of the fund related to the omega score?

Other factors – age.

Operational risk and the half life of USD funds

0.4 0.6 1.0 1.2

0.70.6

0.5

0.4

0.3

0.2

0.1

90 months

80

70

60

50

40

Half Life

Fin

an

cia

l ri

sk (p

rior

mon

thly

)

Operational Risk -Score

0.8

Due Diligence

Market alternative to regulation Not all funds register Due diligence before investing

Current Study: Private Sector Data

445 DD funds over past decade DD decision endogenous

Past returns. Different thresholds for problems based

on returns. Focus on honesty

Why DD gets Done: LogitDatabase Matches

All Funds

Coef Chi Sq Coef Chi Sq

Log Assets 0.363 91.54** 0.324 67.76**Management Fee 0.269 5.95* 0.402 18.31**Incentive Fee 0.047 14.24** 0.056 22.81**High Water Mark 0.643 12.64** 0.794 22.20**Leveraged 0.036 0.08 -0.073 0.40Red Notice Period 0.007 11.78** 0.009 25.87**Lockup Period -

0.03511.51** -0.037 16.20**

Return Mean 0.850 146.21** 0.865 149.68**Return Std. Dev. -

0.45987.88** -0.480 97.58**

Ret Autocorrelation

0.257 0.82 -0.099 0.16

Year Dummies Y YStyle Dummies Y YClustered by Fund Y YFund Year Observations

26,127

26,219

Number of Funds 9,001 9,093

R-Squared 0.25

0.25

Returns Before and After DD

Flows Before and After DD

Conditional Flow Response

DD Funds

Non-DD Matched Funds

Difference p-value

Flows 1.491 0.641 0.850 0.00Problem Flows 1.675 0.736 0.939 0.00Non-Pro Flows 1.292 0.538 0.754 0.00

Appraisal ratio 0.216 0.133 0.083 0.26Problem A ratio 0.249 0.184 0.065 0.62

Non-Pro A ratio 0.184 0.085 0.099 0.16

Problem Fund ProbitModel 1 Model 2

coefficient

Chi-sq coefficient

Chi-sq

Return mean 0.016 0.02 -0.080 0.33

Return Std. Dev.

0.073 1.16 0.110 1.97

Return Autocorr

0.186 0.34 -0.019 0.00

Log(assets) 0.022 0.20 0.015 0.08

Fund age 0.004 0.02 0.027 0.59

Management fee

-0.222 2.06 -0.175 0.84

Incentive fee -0.012 0.46 -0.014 0.41

Lockup period -0.005 0.15 0.003 0.05

Notice period 0.007 0.11 -0.001 0.29

Non-Verification

0.505 12.09** 0.369 4.66*

Signature 0.115 0.45 0.032 0.03

Self-Pricing -0.253 6.56* -0.298 5.77*

Big 4 auditor -0.444 8.31** -0.470 6.53*

# Ind Board -0.274 1.14

Lambda 0.247 0.92 0.045 0.02

Style Dummies Y Y

Misrepresentation ProbitModel 1 Model 2

coefficient Chi-sq coefficient Chi-sq

Return mean -0.007 0.00 -0.073 0.21

Return Std. Dev. -0.008 0.01 0.036 0.15

Return Autocorr 0.279 0.63 0.175 0.17

Log(assets) -0.102 3.14 -0.102 2.42

Fund age 0.035 1.19 0.048 1.25

Management fee 0.131 0.58 0.025 0.41

Incentive fee -0.008 0.17 -0.017 0.13

Lockup period 0.009 0.50 0.003 0.03

Notice period -0.002 0.00 -0.005 1.21

Inconsistency 0.295 2.70 0.390 3.26

Signature IQ -0.027 0.02 -0.045 0.04

Pricing -0.065 0.37 -0.049 0.12

Big 4 auditor -0.388 5.37* -0.544 6.94**

# Ind Board 0.232 0.59

Lambda -0.244 0.63 -0.397 1.20

Style Dummies Y Y

Num Obs. 380 287

Fund Flows and Operational Risk

All Funds Non-Problem Funds Problem Funds

Coeff. t-value Coeff. t-value Coeff. t-value

Lawsuit 0.714 1.67

Regulatory 0.461 0.88

Misrepresentation 0.468 1.02

Return Mean -0.547 -1.34 -0.062 -0.11 -1.628 -2.72**

Return Std. Dev. 0.073 0.36 -0.072 -0.27 0.377 1.27

Return Autocorr 1.118 1.32 0.517 0.46 0.689 0.56

Log(assets) -0.911 -4.81** -0.533 -2.25* -1.604 -5.39**

Fund age -0.120 -1.38 -0.220 -1.87 0.081 0.66

Management fee 0.165 0.39 0.432 0.70 0.649 1.13

Incentive fee 0.013 0.21 0.009 0.13 0.070 0.62

Lockup period 0.026 0.81 0.061 1.49 0.040 0.86

Notice period 0.000 0.00 0.003 0.28 -0.005 -0.47

Non Verification -0.556 -1.24 -0.643 -1.14 -0.311 -0.46

Signature IQ 0.480 0.92 -0.753 -1.09 1.608 2.12*

Pricing 0.196 0.75 0.388 1.07 -0.197 -0.54

Big 4 auditor 0.387 0.87 0.814 1.28 -0.396 -0.64

Lambda -1.125 -1.33 -0.050 -0.05 -2.926 -2.38*

Style Dummies Y Y Y

Adjusted R-squared 0.17 0.07 0.33

Num Obs. 197 95 102

Performance and Operational Risk

All Funds Non-Problem Funds Problem Funds

Coeff. t-value Coeff. t-value Coeff. t-value

Lawsuit -0.115 -0.68

Misrepresentation 0.397 2.18*

Regulatory -0.141 -0.69

Log(assets) -0.026 -0.43 -0.079 -1.46 0.009 0.07

Fund age -0.069 -2.06* -0.020 -0.69 -0.110 -1.77

Autocorrelation -0.081 -0.24 0.533 1.81 -0.325 -0.52

Management fee -0.253 -1.56 -0.272 -1.82 0.000 0.00

Incentive fee 0.038 2.01* 0.002 0.16 0.113 2.49*

Lockup period -0.013 -1.11 -0.019 -1.89 0.001 0.03

Notice period 0.009 3.26* 0.003 1.36 0.012 2.58*

Inconsistency -0.005 -0.29 0.104 0.72 -0.154 -0.49

Pricing -0.284 -2.82* 0.040 0.44 -0.606 -3.45**

Signature IQ -0.066 -0.04 0.003 0.02 0.072 0.21

Big 4 auditor -0.196 -1.14 -0.265 -1.60 -0.340 -1.16

Lambda 0.507 2.55* -0.053 -0.31 0.933 2.63*

Style Dummies Y Y Y

Adjusted R-squared 0.12 0.09 0.15

Num Obs. 266 138 128

Conclusion

Hedge fund opacity demands trust Problem funds have:

Verification problems Minor auditors More likely to self-price