How Are The Books Kept?!?

It is well known that most hedge funds hire fund administrators to maintain their general ledger. The ledger is usually maintained on a brand-name system with appropriate quality assurance features and is reconciled daily to street side custody accounts.  But what about the "other" set of books ... the books where the Investor Capital Accounts are kept?

The traditional process that a hedge fund investor follows in making allocation decisions usually takes three steps: Step 1 - Due Diligence Questionnaire; Step 2 - Investor Office Visit; Step 3 - Fund Office Visit.  Months pass between each step and only those funds that survive move onto the next round.

There probably are a couple of questions asked during Step 1 about the book keeping for investor capital accounts.  However, these questions only scratch the surface with open-ended queries such as "Describe your partnership allocation system?" 

In Step 3, rarely does a due diligence team ask to actually see the investor capital accounts, fearing a privacy rebuff from the fund manager.  In fact the easy way to go about this is for the team to inform the manager that it is perfectly acceptable to redact all investor names from the books, since all they're really interested in is the mechanics, not the names.

If the due diligence team was to actually make this request, it would likely be surprised to find that these "books" are usually nothing more than a glorified Excel spreadsheet that someone took the time to build-in all the intricacies that fee structures can create:

• Share classes with different fee structures
• Accruing performance fees for underwater vs. above water investors
• Excluding IPO income from ineligible investors

Life in the Trenches

While we confess that Excel is a natural home for the type of complex calculations needed when books are closed monthly and capital account balances are rolled-forward, if you've ever worked with these capital account spreadsheets then you'll immediately know how sensitive they are to slight (but all too common) human error.

 As a fund manager, the last thing you want to hear from your back office is:

The manager's day officially ruined, and wincing behind palms covering his face, he asks the only question that matters at this moment:  "How far back does the problem go?"

"Trust, but Verify"

This is but one example of the many operational risks hidden within hedge funds.  When it comes to the safeguarding of your investments, you deserve experienced professionals (but more importantly you deserve independent professionals) to carry-out the "verify" portion of your due diligence. After all, when it comes time to redeem your investment, it's your capital account balance in this rickety old spreadsheet that you receive. 

- Sleep well.

To learn more about our due diligence service visit our site or contact Jeff Rathgeber at jrathgeber@pelorusadvisors.com

About Pelorus Advisors

Pelorus Advisors is staffed by a team of hedge fund experts that have spent years operating inside complicated hedge fund structures.  Only from this vantage point can an advisory firm gain the experience needed to identify the true risks that hide within hedge funds.  It is exactly this kind of experience that is missing from most hedge fund due diligence firms and, in our opinion, moves them into the category of Data Regression Analysts, and not Hedge Fund Risk Experts.

Unlike other due diligence firms, Pelorus only offers its service to investors. We view it as a conflict to be paid by the same funds we cover. This market has seen more than enough target-sponsored "independent" report cards. We'll let other firms issue their seal of approval based on manager-supplied data. 

Another distinction that separates our service offering is that we don't harvest massive amounts of publicly available data, crunch it, and issue armchair reports. We do only on-site engagements to dig into a hedge fund's operations. We do not use data that is supplied by the target funds, instead, we run through the hedge fund's control structure to ensure that our client's money is properly protected.