“Trust and Delegation” Paper Highlight Problems with Current Hedge Fund Due Diligence Processes
A stunning study released by NYU’s Stern School of Business entitled “Trust and Delegation” finds significant problems with the due diligence reports which are currently heavily relied on by the industry in selecting managers for investment. The authors of the study reviewed a sample of due diligence reports collected from hedge fund managers by a major professional hedge fund due diligence firm, and found an abundance of misrepresentations being made. In particular, 21% of managers misrepresented their past legal and regulatory problems, and 28% had incorrect or unverifiable representations about other topics. In addition, the paper highlights the fact that due diligence reports are typically issued by managers 3 months after historic high performance levels, and at the point of highest cash flow into the fund, thereby indicating that investors, despite conventional wisdom to the contrary, are indeed chasing returns.
“Due Diligence” is one of those terms that can mean different things to different people Is meeting a potential manager for lunch and feeling that you “trust” him doing adequate “due diligence”? Most sophisticated investors would say “no” to that one, but most probably would have said “yes” to reliance on a professional due diligence provider. Apparently, however, there are significant problems with that as well.
Regulatory requirements could conceivably reduce the level of misrepresentations and we continue to monitor developments in that area. The paper itself can be viewed at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1456414#.
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