Don’t overlook the basics of hedge fund due diligence

By Dan Hallett, CFA, CFP on November 27th, 2011

The Ontario Securities Commission recently issued an order in the ongoing matter of Sextant Capital Management, a defunct hedge fund company.  While the order pertained to a law firm wanting to remove itself from representing Sextant and its former principals, it reminded me that it’s too easy to overlook basic steps when doing hedge fund due diligence.

Unlike my experience with Portus, I never initiated due diligence on Sextant prior to the regulators stepping in (Dec 2008).  The following list of observations (made after-the-fact) are nonetheless important considerations prior to investing in any hedge

Background Check

Any organization is only as strong and credible as its people.  Accordingly, it’s wise to become informed about a hedge fund firm’s executive team and other key employees.  In the case of Sextant, this was made easier by the fact that founder Otto Spork was a dentist.  And a phone call to the Royal College of Dentists would have been the beginning and end of the due diligence.

In a disciplinary hearing held in February 1993, Dr. Spork was found guilty of charges of professional misconduct relating to failing to maintain proper standards of practice; charging excessive or unreasonable fees; charging fees for services not performed; issuing a report containing false or misleading information; and allowing or assisting a person to practice dentistry without a license.

If all of this wasn’t enough, that February 1993 hearing was the second time Spork had appeared before the College’s Discipline Committee.  So, if a hedge fund manager – or any portfolio manager – has a history in another regulated industry, it’s usually quite easy to do a quick and cheap professional background check.

Registration Verification

In Canada, hedge fund managers have long required a license, even though the products they offer usually are not vetted by regulators.  This is perhaps one of the easiest checks to perform since anyone can check the registration of any firm or individual on the respective websites of the Ontario Securities Commission and the Canadian Securities Administrators.

In the case of Sextant, there was trouble from day one.  Otto Spork, founder and the main investment intellect, was previously licensed as a “non-advising” officer of his firm.  This implies that he did not meet the requirements to be a licensed portfolio manager.  This is understandable given that he was trained as a dentist but this may have raised questions about his overall qualifications as a hedge fund manager.  Also, periodic registration checks – part of our firm’s oversight process – would have revealed something more troubling.

By June 2008 – a full six months before regulators froze Sextant funds – Otto Spork was removed from the firm’s list of registrants, showing up only as a shareholder.  Lesson:  perform both an initial and periodic (i.e. semi-annual) registration checks on money managers that have been engaged to run money.

Tolerance for Due Diligence

Being the subject of a thorough due diligence process is not fun.  It’s invasive and it chews up a lot of time (which makes it costly).  So I understand why money managers sometimes loathe being subjected to such in-depth scrutiny.  But they also know that it’s part of gaining the trust of serious investors, financial advisors and consultants.

So think hard about moving further with any money management firm that objects to at least a basic level of due diligence.  Speaking with some of my industry contacts, I was told that Sextant was a firm that would fill out an initial questionnaire but did not want to entertain more in-depth questions.

The Madoff Test

If the above basic steps check out, it’s worth taking a quick glance at any existing performance record.  I call this the Madoff test because a key way that Harry Markopolos fingered Bernie Madoff as a fraud was because of his too-good-to-be-true performance record.

Sharp-eyed investors or analysts might have raised similar questions about Sextant Strategic Opportunities Hedge Fund LP after seeing it soar 81% in its debut month (Feb 2006) and another 73% in July 2008 – with relatively modest and infrequent losses.  Sextant’s returns were so overwhelmingly positive that a review should have at least triggered questions about how this was achieved and the specific sources of such extreme gains.

It’s easy to find the warning signs in hindsight.  But these items can be identified ahead of time if you start with the above basic steps and follow them up with more in-depth scrutiny (provided all the basics check out).  It’s no guarantee that a fraud won’t get by you but having a sound due diligence process will increases the chance of avoiding frauds and uncovering quality money managers.