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The Education Committee of The GreenwichKnowledge,R Veracity,oundtable Fellowship The Greenwich Roundtable Presents Spring 2007

In This Issue

About the Greenwich Roundtable Best Practices in Fund Investing: DUE DILIGENCE FOR FIXED INCOME Research Council AND CREDIT STRATEGIES

Introduction

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NOTICE G

Greenwich Roundtable, Inc. is a not- for-profit corporation with a mission to promote education in alternative . To that end, Greenwich R Roundtable, Inc. has facilitated the compilation, printing, and distribu- tion of this publication, but cannot warrant that the content is complete, accurate, or based on reasonable assumptions, and hereby expressly disclaims responsibility and liability to any person for any loss or damage arising out of the use of or any About the Greenwich Roundtable reliance on this publication.

Before making any decision utilizing content referenced in this publica- The Greenwich Roundtable, Inc. is a not-for- The Greenwich Roundtable hosts monthly, tion, you are to conduct and rely profit research and educational organization mediated symposiums at the Bruce Museum in upon your own due diligence includ- located in Greenwich, Connecticut, for investors Greenwich, Connecticut. Attendance in these ing the advice you receive from your who allocate capital to alternative investments. It forums is limited to members and their invited professional advisors. is operated in the spirit of an intellectual cooper- guests. Selected invited speakers define com-

In consideration for the use of this ative for the alternative community. plex issues, analyze risks, reveal opportunities, publication, and by continuing to Mostly, its 200 members are institutional and and share their outlook on the future. For the read beyond this notice, you release, private investors. past 11 years, the Greenwich Roundtable has and forever discharge Greenwich hosted some of the leading managers, scien- Roundtable, Inc., its current, former, The purpose of the Greenwich Roundtable is tists, and policy makers of our day. and future members, trustees, direc- to discuss and provide current, cutting-edge The Board of Trustees, whose membership tors, officers, agents, employees, and information on alternative investing. Our mis- reflects a cross section of the alternative successors (collectively, “Releasees”) sion is to reveal the essence of both trusted investment community, sets the direction of of and from any and all actions, causes of action, suits, claims, or and new investing styles and to create a code the Greenwich Roundtable. demands whatsoever, of any kind or of best practices for the description, in law or in equity, industry. whether or not well founded in law or in fact, which you have, had, or may ever have against any of the Releasees arising out of any reliance made by you on this publication including, without limitation, partial or complete losses of the value of any investment, penalty or punitive dam- © Greenwich Roundtable 2007 ages, all legal and court costs, and attorney fees. SPRING 2007 G BEST PRACTICES IN INVESTING:DUE DILIGENCE 2 R 34724_GrRoundtable.qxp 5/30/07 11:04 AM Page 3

Research Council RESEARCH COUNCIL OF 2007

Anonymous

Four years ago we began to tap into the group small to limit our funding from the sell- Bank of America knowledge of our members under the auspices side and thus maintain our independence. The of the Education Committee. Investing in alter- trustees also restricted the number of hedge BlackRock Inc. natives is not well documented. We wanted to fund managers, and opened nominations to a conduct original research apart from our sym- few high integrity industry suppliers. Nominees were selected because their business activities posiums and so we began the task of assembling D.E. Shaw & Co., L.P. best practices from the investors’ point of view. serve as an example to all of their sincere desire However this assignment would require addi- to educate investors and of their belief in our Halcyon Asset Management tional funding and our ability to raise funds was mission. Once again the response was gratify- limited. Our regular membership is closed. ing. And so we are pleased to announce the III Associates Associate memberships do not generate much members of the Research Council of the PricewaterhouseCoopers revenue. Still we got phone calls from hedge Greenwich Roundtable for 2007. funds, from private equity funds and from Schulte Roth & Zabel LLP industry vendors asking how they can help. Greenwich, Connecticut has a long tradition of Some of these general partners began making community involvement and philanthropy. We Strategic Value Partners contributions. They simply wished to support began with the hope that the same spirit would us with no strings attached and, in some cases, extend into the alternative investment commu- anonymously. nity. We were not disappointed. Today the “The Research Council enables the Research Council serves as a small group of sus- Greenwich Roundtable to host the In this spirit, the Research Council was born. taining sponsors of our research at the broadest range of investigation that Our Education Committee has been working as Greenwich Roundtable. Our purpose is to fos- serves the interests of the limited partners and investors. ” a group of altruistic investors (curiously some ter research and publishing in the field of non- investors declined to assist us because they did traditional investing to educate sophisticated not wish to reveal their due diligence techniques investors. Dedicated to the development of best in credit and fixed income strategies) who con- practices, members of the Research Council not tributed their time and worked to raise profes- only provide no-strings funding but they have sional standards. Then the Research Council also assisted the members of our Education emerged as a group of altruistic sell-siders who Committee by rolling up their sleeves in the dis- wish to help investors document the allocation covery and editing phases. The Research process. The final result is intended to demysti- Council enables the Greenwich Roundtable to fy alternative investing and to bring about pursue the broadest range of investigation that greater understanding. serves the interests of investors. They also share our belief that education is one of the greatest In 2005, our Board of Trustees named a small needs in the marketplace. The Research Council group of high integrity institutions for Research has generously underwritten the entire Best Council appointments. These wonderful man- Practices in Hedge Fund Investing series. They agers launched us into a new orbit. Best are providing it to you with their compliments. Practices in Due Diligence for Equity Strategies For that, we are all sincerely grateful. was released in that summer to the approval of investors and the industry at large. Stephen McMenamin Chair and Executive Director, The Greenwich In January 2007, our Board again nominated Roundtable candidates to the Research Council. We kept the

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G R Introduction: Letter from the Chair

Best Practices in Hedge Fund Investing: Due mal notice in respected publications, such as the Diligence for Fixed Income and Credit Financial Times and Barron's, and we continue Strategies represents the third installment in a to be humbled by formal inquiries from institu- series and completes our survey of hedge fund tional investors as far away as Japan, the Gulf due diligence. The Education Committee of the and Scandinavia. Greenwich Roundtable began our investigation of due diligence almost four years ago and was That said, what we could not have anticipated motivated by an elegantly simple thesis: the was the level of interest generated by our publi- topic had not been explored in a comprehen- cation in the policymaking and regulatory com- sive, informed way from the perspective of the munities in Washington and beyond. It is here hedge fund investor as opposed to the hedge that the relationship between the GR's fund manager. We believed the topic of due dili- Education Committee (research and writing of gence deserved a more searching and substan- publications) and the External Affairs tive written review and set out to rectify this. Committee (articulating this educational mes- sage) warrants further explanation. The We had several goals. In broad terms, we hoped extraordinary members of the External Affairs to educate investors, policymakers, journalists Committee have played a vital role in sustain- and students of investing about the qualitative ing proper attention to Best Practices by art of hedge fund due diligence. By doing so, we explaining it to policymakers, journalists and a hoped, as we underscored in our last edition of disparate range of constituencies in the invest- Best Practices, to demystify a process that had ment community at large. The members of the been given an almost unrecognizably ominous External Affairs Committee are the GR's portrayal in the mainstream press. We also unabashed "grey-hairs" who explain our work hoped to promote an elevated standard of con- to investor groups, policy-makers, legislators duct for the community of dedicated hedge and, occasionally, the media. They have been fund investors and the alternative investment commendably dedicated to this work, having industry as a whole. Our work commanded for- traveled to Washington D.C., Hartford, Albany,

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Best Practices Subcommittee Members

Introduction: Ben Alimansky Letter from the Chair (cont.) Brooklyn NY Holdings Spencer Boggess U.S. Trust Company Colorado, West Virginia, London, Geneva and strategies, in addition to investment bankers, Chairman, Education Committee Singapore in the past year to spread this mes- credit officers, and analysts. In particular, we sage. The message was certainly heard and the would like to highlight the contributions of Rod Christine Jurinich BlackRock Inc External Affairs Committee deserves high praise Berens, Jean-Louis Lelogeais, Bill McCauley, for its work. With a view toward this point, Bob Brian Redmond, Sudhir Rani, and David Viney. David McCarthy Steele, the Undersecretary for Domestic Affairs, Collectively, they were a fount of wisdom and Martello Investment U.S. Treasury, complimented the Greenwich gave our Committee a nuanced and intelligent Management, LP Roundtable when he remarked that we are sounding board for their work. They provided widely trusted because we don't promote any the technical understanding necessary to engage Bill McCauley III Associates agenda, have no axe to grind and are not paid intelligently with this complex investment uni- to speak. We owe special thanks to David verse. Without meticulous editing and skilled Stephen McMenamin Storrs, the Chairman of the External Affairs effort to distill disparate viewpoints and styles, Indian Harbor LLC Committee, David McCarthy, Paul Roth, Steve this publication would not have made its way to Executive Director McMenamin, John Griswold, and Michael publication. For invaluable editorial assistance Brunello Nucci Castine for their extraordinary work in educat- and judgment, Susan Benjamin and Walter White Birch Associates, LLC ing the right people. Stratton deserve our praise and sincere thanks. Finally, for providing guidance, counsel and Kevin O’Brien To tackle Best Practices in Hedge Fund support throughout this long process we would Bank of America Securities Investing: Due Diligence for Fixed Income and like to thank the Research Council of the Credit Strategies, we asked a broad cross-sec- Greenwich Roundtable and the organization's Jeff Pauker Constellar Capital tion of the fixed income and credit market par- Executive Director, Steve McMenamin. Steve's ticipants for their input. Seasoned allocators passion and abiding commitment to the mission Robert Sachs were intimately involved in the painstaking of the Greenwich Roundtable has been an inspi- Constellar Capital work of research, writing and editorial review ration for everyone who has come into contact for each overview and chapter. Specifically, we with the GR, its publications and its programs. Evan Seiler Ivy Asset Management would like to thank Ben Alimansky, Christine Jurinich, David McCarthy, Brunello Nucci, Jeff In the final analysis, we hope you will find value Nancy Solnik Paulker, Rob Sachs, Evan Seiler, Nancy Solnik in this latest edition of Best Practices. In future Tremont Capital Management and Tom Williams for their authorship of the publications, we expect to take on the subjects various chapters and insights throughout the of portfolio construction and monitoring. Rich Spivey process. Our Chairman of the Due Diligence However, if we have erred in any way (with this Ivy Asset Management Corp. Working Group, Aleks Weiler, contributed a publication or any prior one), we hope you will Margaret M. Towle mammoth amount of writing, editing and take care to engage us directly. We remain com- research to the completed work and deserves mitted to improving our work and understand- Aleksander Weiler enormous credit for the intellectual clarity and ing how we can continue to fulfill our mission Holmwood Avenue, LLC substantive understanding that is reflected in to educate. Chairman, Best Practices Working Group this publication. Others provided critical input at different stages of the writing and editing Spencer Boggess Tom Williams process. We interviewed managers trading these Chairman, Education Committee Pine Grove Associates, Inc.

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Table of Contents

INTRODUCTION: OVERVIEW OF FIXED INCOME AND CREDIT HEDGE FUNDS I. Overview of Fixed Income and Credit ...... 8 II. Recent Market Trends ...... 10 III. Hedge Fund Strategies ...... 10 A. Fixed Income Strategies ...... 11 B. Credit Strategies ...... 13

INVESTMENT PROCESS: RETURN GENERATION AND RISK MANAGEMENT I. Strategy, Investment Process, and Market Opportunity ...... 16 A. Overview ...... 16 B. Investment Process: Idea/Trade Generation ...... 19 C. Portfolio Construction ...... 21 D. Trading ...... 24 E. Market Opportunity ...... 25 II. Market Risk Management ...... 27 A. Portfolio Risks ...... 27 B. Liquidity Risks ...... 30 C. Leverage ...... 31

PEOPLE, CULTURE AND BUSINESS STRUCTURE III. Team and Organization ...... 33 A. Key Investment Professionals ...... 33 B. Founders and Principals ...... 35 C. Staff ...... 36 IV. Management Company, Fund Structure, and Asset Base ...... 38 A. Management Company ...... 38 B. Fund Structure and Asset Base ...... 40

OPERATIONS AND VERIFICATION V. Operations and Technology ...... 42 A. Trade Capture and Settlement ...... 42 B. Pricing ...... 45 C. Business Continuity ...... 46 VI. Third Parties ...... 47 A. Auditor ...... 47 B. Prime Broker/Futures Clearing Merchant (FCM) ...... 48 C. Administrator ...... 49 D. Marketing Relationships ...... 50 E. Other ...... 50 VII. Documents ...... 52

VALUE PROPOSITION VIII. Fee Structure and Terms ...... 54 A. Fee Structure ...... 54 B. Terms and Conditions ...... 55 IX. Quantitative Review ...... 57 X. Intuition, Judgment and Experience ...... 61

GLOSSARY ...... 62

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G “There is an enormous diversity of fixed and credit R Introduction: Overview of Fixed Income and income strategies. In essence, Credit Hedge Funds

managers trade the entire Capital Management. However, opportunities Fixed income is thought by many to be com- for the strategies have never been better. First, length of the government yield plicated, both in terms of the instruments trad- the complexity and relative unpopularity of ed and the strategies pursued. While this is debt investing create a barrier to entry for these partly true, especially in terms of some of the curve from Fed Funds to Long strategies. Second, the revolution in debt trad- mathematics involved, a small degree of effort, ing engendered by innovations in structuring applied to understanding the instruments, Bonds, the wide and and the explosion in the notional value out- underlying markets and trading strategies, can standing of credit derivatives is hard to over- yield substantial dividends. This overview ever-expanding array of fixed state. Once a sleepy corner of financial mar- attempts to provide hedge fund allocators with kets, credit investing is now its most dynamic a sketch of the different fixed income markets, income spread product, and area. Often missed in the discussions of this a summary of recent market trends and a phenomenon is the resulting improved ability to description of major hedge fund strategies and to target risks in the credit universe. all of the employed by fixed income and credit managers. A hedged approach can now be more easily A Glossary at the back of this paper covers pursued. Third, there exists the secular trend of instruments relating to some concepts needed to understand the instru- financing activity moving out of banks and into ments and strategies as well as to navigate hedge funds due to these latter’s advantages in these securities. through the industry’s jargon. , risk-taking incentives and, ” ultimately, staffing. I. Overview of Fixed Income and Credit Despite trading one of the largest asset classes In our interviews in preparation of this paper, and one of the broadest arrays of instruments, even seasoned hedge fund investors admitted to hedge fund managers focused on fixed income us some level of discomfort with fixed income and/or credit oversee a relatively small amount and credit strategies due to (a) the complexity of the industry’s total capital. At the time of of the instruments and trading approaches, (b) writing, the Lipper-Tass database contained the leverage levels habitually employed, (c) the 185 fixed income funds out of a total of 2,891 rapid changes in the marketplace, (d) a seem- hedge funds; of the $1.5 trillion of hedge fund ingly low return-to-effort ratio, and, quite assets under managment in the HFR database, frankly, (d) a lingering suspicion from the 1998 only 10% are credit managers and 6% are fixed implosion of fixed income trader Long-Term income managers. Contrast this allocation with

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Table 1 – Classifications of Debt Markets Fixed Income Corporate Credit Securitized Instruments

Developed Markets Bank Debt/Loans Mortgage-Backed Securities (MBS) – Supra-nationals Investment Grade Asset-Backed Securities (ABS) – Sovereign Debt Crossover Commercial Mortgage-Backed – Inflation-Protected High Yield Securities (CMBS) – Agency Distressed/Defaulted Collateralized Debt – Municipals Hybrids and Convertibles Obligations (CDOs, CBOs, CLOs, etc.) Emerging Markets Private Debt

the Federal Reserve Flow of Funds Accounts most markets’ ‘risk-free’ rate, and their related that, for the end of 2006, listed $44.5 trillion of derivatives. Corporate Credit (and its deriva- U.S. credit market debt outstanding as com- tives) represents the primary claims on compa- pared to $20.6 trillion of U.S. corporate equi- nies’ earnings and cashflows (with equities ties.1 However, the fundamentals that underlie being the residual claims) and, since the credit- these strategies are important to the balance of worthiness of corporations is generally less than the hedge fund universe. Interest rates are not that of sovereigns’, these securities trade at a only the building blocks for debt trading, but spread to the risk-free curve. Securitized are also one of the main ingredients in asset val- Instruments are debt securities whose underly- uations of all kinds. Indeed, fixed income ing collateral is some income-producing asset, traders originally honed many of the common or a pool of such; the securities are usually , structuring, financial analysis, portfo- ‘pass-through’ or ‘flow-through’ structures for lio construction and financing techniques used the cashflow from the underlying assets. by all hedge fund managers. Debt securities from the same issuer can be highly standardized from issue to issue, such as Though large, the world’s debt markets are gen- Treasury debt or papers issued by a corporate erally divided into three groups: Fixed Income, Medium-Term Note (MTN) program, or they Corporate Credit and Securitized Instruments. can be highly differentiated, such as those span- Each of these groupings is composed of differ- ning the entirety of a given company's capital ent markets outlined in Table 1; hedge fund structure (given the multiple entities issuing strategy classification follows a similar arrange- paper, each with their own jurisdiction, and ment. Other important dimensions further dis- business and tax objectives). While the latter tinguish securities within these sub-groups: may appear daunting to the non-specialist, it is remaining time to maturity; issuing entity; geog- this heterogeneity that allows managers to raphy; and cash versus derivative instrument. extract from debt trading.

Fixed Income instruments include debt issued In actuality, these diverse instruments tend to by governments and their agencies, which set coalesce into discrete markets, each with its

1 Federal Reserve Board of Governors, Flow of Funds Accounts of the United States, Fourth Quarter 2006, Table L.4 Credit Market Debt, All Sectors, by Instrument.

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own participants, market conventions and liq- subject to ‘squeezes’ in repo – and arranging the uidity. Different actors, valuation metrics and attendant financing and hedging trades. In fact, tools dominate a given market. Hedge fund broker dealers have been paying millions of managers who look across the many markets dollars in fees to companies and the are able to detect mispricings overlooked by like to be able to borrow corporate debt securi- single market investors. So, when looking at a ties (and, increasingly, high yield issues) in manager it is important to understand in which order to facilitate the underwriting and trading particular sandbox he is playing. of credit derivatives. Since shorting is now so much easier, hedged strategies in credit are now more Traditional lenders There are some important notes of caution in practicable, allowing for long/short approaches to “ approaching this space. First, markets are frag- exploit inefficiencies in the credit world. are shedding risks to more mented and mostly over-the-counter (OTC) in nature. Unsurprisingly, each market has its In a parallel development, bank debt has efficient holders. They are idiosyncrasies. And second, operations are emerged as an important asset class for credit involved, and can be heavily manual, especially managers, especially for High Yield traders. motivated by pressures from in comparison to equity-based and This is partly as a result of the increasing inter- approaches. To successfully trade in these mar- national focus of hedge funds, with foreign high Basel II standards, return on kets, managers require sophisticated systems yield markets being mostly composed of bank and robust back offices. Investors should debt. In the United States, the market is rough- capital, regulatory capital and understand the important roles these play in ly evenly split between leveraged loans and junk order to properly evaluate allocation decisions. bonds, whereas in Europe the split is closer to 80/20 and in Japan and Emerging Markets it is equity holders. Opportunity II. Recent Market Trends more like 95/5. It is also partly due to the gen- erous premium paid, even after adjusting for comes to lenders who are The revolution engendered by the development default losses, for investing in what was an illiq- of the credit derivatives market is hard to over- uid instrument. willing to own the state. Originally issued on emerging market sovereign debt in the mid-1990s, enabled by And finally, all of this activity can be thought of residual risks. standardized definitions and documents cour- as being part of the larger disintermediation of ” tesy of ISDA in 1999, the credit default swap banks in the lending world, with hedge funds (CDS) has broadened to become the de facto moving in to take their place. Direct lending, credit trading instrument. These swaps cover participation in loan markets, and credit deriv- Michael Rosenberg, the entire Investment Grade universe and, late- atives trading all allow hedge funds to provide June 15, 2006 ly, larger and larger portions of the High Yield cheaper financing to companies – since funds universe. The more recent introduction of CDS have no BIS/regulatory capital requirements – indices (such as iTraxx in 2004) and the wide- while still earning attractive returns for their spread creation of collateralized structures have limited partners. led to an explosion in the notional value of the instruments issued and a revolution in how It is for these reasons that fixed income and credit is traded. credit hedge funds are attracting increasing amounts of capital. In practice, this has dramatically expanded the debt-trading manager’s ability to short. Now it III. Hedge Fund Strategies is just a matter of buying protection on a name or an index, as opposed to borrowing the cash There is an enormous diversity of fixed and bonds – which may be difficult to obtain and credit income strategies. In essence, managers

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trade the entire length of the government yield carry trades (such as swap spread arbitrage); or curve from Fed Funds to Long Bonds, the wide by employing convergence trades (such as yield and ever-expanding array of fixed income curve arbitrage). Given their nature, the strate- spread product, and all of the derivative instru- gies can be highly technical and statistically hese results suggest ments relating to these securities. Furthermore, based. However, successful managers blend T managers are increasingly trading this entire strong quantitative skills with fundamental “ that there may be more spectrum of products globally, both within and analysis to understand the reasons behind the between markets. Ranging from the largest and dislocations, and the timing of when they will economic substance to fixed most liquid (the short end of the government narrow. With the proliferation of derivative curve and associated futures and swaps) to instruments and increasing liquidity of other some of the most illiquid (distressed debt, mort- global sovereign debt markets, even simple income arbitrage than simply gage derivatives, private loans and bespoke approaches have become highly complex. In credit derivatives), the markets traded also run fact, a solid understanding of fixed income ‘picking up nickels in front of from the most mature and efficient ones (again mathematics, of derivative securities (options, the short end of the government curve and asso- swaps, futures, swaptions, etc.) and of the oper- a steamroller.’ ciated futures) to some of the youngest and ational issues is required to develop an edge in ” most dynamic ones (credit derivatives). As with this space. hedge funds trading other asset classes, fixed income and credit funds range from those with It is close to scripture among allocators that the a conservative, low volatility focus to those returns managers gen- seeking higher returns with commensurately erate are normally steady but have considerable higher volatility. downside during a crisis. This is not borne out by research. The leverage applied to trades is A. Fixed Income Strategies large, and so large negative returns can and do • Fixed Income Arbitrage occur, but most managers attempt to run • Mortgage Arbitrage hedged books and actively focus on mitigating • Municipal Bond Arbitrage short volatility exposure. In a recent paper, academics concluded that “the strategies requir- Hedge funds trading fixed income typically ing more ‘intellectual capital’ to implement tend focus on more relative value trades using sover- to produce significant alphas after controlling eign and quasi-sovereign debt. With a multitude for bond and equity market risk factors. … In of securities making up the yield curve and contrast with other hedge fund strategies, many numerous derivatives based on the curve, the of the fixed income arbitrage strategies produce matrix of possible relationships within this asset positively skewed returns. These results suggest class is large. Given the efficiency of the mar- that there may be more economic substance to kets traded, most strategies involve applying fixed income arbitrage than simply ‘picking up large amounts of leverage to small inefficiencies, nickels in front of a steamroller.’”2 yielding steady returns that can be sensitive to liquidity crises. Mortgage Arbitrage traders focus on the com- plex world of mortgage pass-through securities Traditionally, as the name implies, Fixed and their various derivatives. The importance Income Arbitrage managers have traded various of this market derives from its size: as of the end ‘’: true arbitrages such as basis trades; of April, Mortgage-Backed Securities (MBS)

2 Duarte, Jefferson, Longstaff, Francis A. and Yu, Fan, "Risk and Return in Fixed Income Arbitrage: Nickels in Front of a Steamroller?" (March 2006). Available at SSRN: http://ssrn.com/abstract=872004

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comprised 38% of the U.S. Lehman Aggregate Hedge Fund AUM by Asset Class Traded FI: Arbitrage 3% Fixed Income Index, a portion greater than that of U.S. FI: MBS 2% 6% FI: Diversified 1.4% Global Markets Treasuries (23%) and Government-Related 11% entities (14%) combined and over double that Diversified of Corporates (19%). The possibilities for gen- 31% erating alpha in mortgages would seem to be Equities large for a number of reasons. Each mortgage 42%

pool is unique. There is considerable disagree- 3% 5% Credit FI: Convertible Bonds 0.1% 10% ment on how to price MBS and what prepay- FI: High Yield 1.6% ment assumptions should be used. The pass- Source: HFR throughs are variously ‘guaranteed’ by entities long/short strategies applied to the world of such as Freddie Mac or Fannie Mae, whose municipal bonds. These securities are issued by hedging activities and accounting scandals have states, cities, local governments and their agen- invited considerable scrutiny of late. The secu- cies and have tax advantages that engender a rities can be ‘stripped’ into Principal-Only (PO) high participation rate by non-fundamentals- and Interest-Only (IO) pieces or packaged up driven investors. This arbitrage strategy gener- into Collateralized Mortgage Obligations ally consists of building a leveraged portfolio of (CMOs). The innovation in lending to house- high-quality, tax-exempt municipal bonds and holds (whose borrowings form the raw materi- simultaneously hedging the duration risk in that al of this market after all) has been great, with municipal bond portfolio by shorting the equiv- new and difficult-to-price instruments created alent taxable corporate bonds. These corporate (such as option ARMs). However, these same equivalents are typically interest rate swaps ref- characteristics, coupled with the illiquidity of erencing Libor. Muni arb is a relative value some parts of the markets, and the embedded strategy that seizes upon an inefficiency that is leverage and negative convexity of many of related to government tax policy; interest on these instruments, also mean that, even at the municipal bonds is exempt from federal income best of times, pricing a portfolio can be difficult tax. Because the source of this arbitrage is arti- notwithstanding any misrepresentation such as ficially imposed by government regulation, it with Beacon Hill in 2002. When the mortgage has persisted (i.e., it has not been ‘arbed away’) market faces tougher times and trades go for decades. Given this and the very different wrong, they tend to go seriously wrong, as tax and credit characteristics of each class and investors in Askin Capital Management and the each individual ,3 managers who per- Treasurer and taxpayers of Orange County form detailed can often found out in 1994. Managers skilled in gener- have an edge in this arena. The assets in this al fixed income arbitrage techniques, possessing trade are small, with most Fixed Income knowledge of mortgage instruments’ particular- Arbitrage managers allocating a small portion ities and capable of better dissecting the under- of their book to it when spreads are wide, and lying pools, will come out ahead. a few dedicated managers consistently plying the trade. Returns tend to be steady, as they are Managers invested in Municipal Bonds mostly carry-based, but losses occur when Arbitrage (or Muni Arb) follow similar spreads widen.

3 Examples would be General Obligation (GO) bonds that are based on the taxation power of the issuer as opposed to Revenue Bonds whose payment depends on a specific project or revenue stream (such as from an utility or a regional airport or road authority). There can be additional event risks and rewards from municipals such as the large re-rating from the tobacco settlement bonds issued by states over the past half decade.

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B. Credit Strategies: each debt security is as important to the analy- • Investment Grade sis as is the understanding of the reference enti- We believe playing • Credit (High Yield) Long/Short ty’s fundamentals. Most Credit strategies tend “ • Distressed Securities to demonstrate a heavy net long bias to portfo- between the cash and • Capital Structure Arbitrage lios, as carry constitutes a substantial portion of • Structured Credit returns. While some managers are quantitative- derivative markets offers • Asset-Based Lenders (or Direct Lenders) ly focused, qualitative and fundamental research methods seem to predominate. This is opportunity. Cash players Five years ago, the credit universe was an often- true both of Investment Grade and High Yield overlooked area of hedge fund investing. While managers, with the composition of each uni- talk about defaults, severity Fixed Income Arbitrage managers traditionally verse determining the opportunity set and the dabbled in credit instruments at the and leverage used (High Yield tends to be less lever- of loss and collateral quality. Distressed Securities traders represented core aged than Investment Grade as the carry is high- allocations for many limited partners, the capi- er). In either case, returns produced tend to be Derivative players talk about tal devoted to credit-specific trading was a frac- steady until one of the credits owned is down- tion of that devoted to equity- and global mar- graded or defaults, though the ability to easily correlations, risk neutral ket-specific approaches. Today, Credit man- short credit indices has allowed managers to agers are increasingly seen as core allocations in hedge systemic spread widening. The periods pricing and attachment- their own right, with the dynamism and relative following credit market retrenchments tend to adolescence of the market providing ample be best for these managers. detachment points. Yet opportunity for hedge fund managers to ply their trade. As with Fixed Income managers, the The largest style within Credit (in terms of dol- their markets share the breadth of instruments and approaches is wide. lar allocations) is Distressed Securities, the act In some senses it is greater, as the universe of of buying the debt securities (usually bank debt company earnings and events is opened up to or bonds) of companies in ‘distress’ (often same risk. investment. Hedge funds trading in Credit, bankruptcy or heading in that direction), either ” while borrowing some of the technical and rel- as an active investor shepherding the company ative value techniques used by Fixed Income through the bankruptcy and restructuring managers, tend to have a more fundamental process or as a passive investor looking for Christian Zugel, basis to their investment strategies. Credit man- value. By buying the debt at fractions of face June 16, 2005 agers, after all, are trying to assess the health of value and having the enterprise’s capital struc- the underlying enterprise, and the changes in ture and/or business reorganized, Distressed expectations surrounding it, in order to deter- Debt managers can often sell their holdings for mine value. multiples of what they bought them for; they can also be left holding worthless and illiquid The simplest style to understand is that of paper should restructuring fail. The skills Credit (High Yield) Long/Short, which, as the required for success include detailed financial name implies, involves managers constructing analysis, an understanding of covenants, indus- portfolios of bonds and/or bank debt based on try expertise, an investment banker’s ability to assessments of security over- and under-valua- manipulate capital structures, creditor commit- tion. Like their Equity Long/Short cousins, tee management talent, and deal sourcing abili- these managers use fundamental analysis to ties. In contrast to most other Fixed Income construct long/short portfolios of high yield and Credit styles, this approach is very direc- bonds and/or loans. In credit investing, though, tional (long-only), is categorized as Event- an understanding of the specific covenants of Driven (as opposed to Relative Value) and is

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approached with little or no leverage. Returns assets which, given the declining supply of con- and risks can be quite high, but the painstaking vertible bonds, led to the bonds trading at a analysis involved, coupled with a degree of con- premium to the embedded option. The 2004 trol over the outcome, somewhat mitigate the GM and Ford downgrades engendered wide- downside. spread losses among convertible arbitrageurs and capital exiting the strategy. Of late, man- Capital Structure Arbitrage is the process of agers have become much more credit-focused being long or short the different securities and event-driven in their approach, leading to issued by the same company with the idea of more credit spread sensitivity in their returns. taking advantage of the mispricing of securities within a capital structure. The opportunity Given the gallons of ink and acres of forest arises because there is a delineation of buyers devoted to the credit derivatives market, it is and valuation methodologies between the buy- not surprising that this area has produced its ers of bank debt, bonds and equities. Because own sub-strategy within Credit. Loosely companies construct their capital structures to grouped under the heading of Structured optimize a combination of funding costs, Credit, managers in this style generally use a accounting treatment and tax burden, this can fundamental research-based approach to create lead to multiple entities and Special Purpose long/short portfolios of credits expressed using Vehicles (SPVs) with varying degrees of credit default swaps (CDS) and other credit recourse back to a given company or set of derivatives. With the “tranching” of credit assets. This factor can create bountiful oppor- resulting from the proliferation of structures tunities for the trader willing to understand the such as Collateralized Debt Obligations idiosyncrasies of each security within a given (CDOs) and its offshoots (loans, asset-backed enterprise (especially to what assets and with securities, etc.) as well as the establishment of what degree of seniority). However, as some CDS indices, additional more technical strate- capital structure traders have found, failing to gies such as correlation trading have been understand these particularities can lead to added to managers’ toolboxes. Managers enormous losses. Returns tend to be better when require credit analysis skills, derivative security there are more defaults or corporate events. understanding coupled with the quantitative and technical skills needed to model complex It can be argued that Convertible Arbitrage is a instruments and trades in order to be success- sub-set of Capital Structure Arbitrage; after all ful. Returns from this strategy tend to be lower you are long a bond and short the stock of a volatility if the manager pursues long/short given company, but most allocators and man- strategies and considerably more volatile if they agers consider it a separate strategy. In this focus on correlation trading. investment style, managers buy various securi- ties convertible into others (convertible bonds Asset-Based Lenders managers are a fast-grow- or preferred stock, warrants and the like) and, ing group whose fundamental credit analysis against those, short the underlying equity. To and world-class deal sourcing and servicing be successful, managers need to be able to prop- infrastructure allows them to construct portfo- erly determine the hedge ratio in order to mon- lios of asset-backed loans, direct financing deals etize the embedded option. Once among the and other high carry paper, in addition to col- most touted hedge fund strategies overall and lecting origination (arrangement) fees. These the highest returning in the 2000-02 bear market, managers (also called Direct Lenders) closely in recent years managers attracted considerable resemble commercial lenders (such as Goldman

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Sachs, Cargill or GE Capital) and the old British merchant banks, in that they provide private funding to any entity in need of liquidity. Their portfolios are just as likely to contain corporate loans as they are to have pools of parking tick- et receivable, airplane EETCs, real estate or non-performing loans. The skills required would thus be excellent credit analysis (espe- cially an understanding of collateral values), a strong ‘servicing’ (read collection) ability and a proprietary deal sourcing infrastructure. The returns can be high and uncorrelated, but a manager must have a strong and stable capital base in order to be successful.

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INVESTMENT PROCESS: RETURN GENERATION AND RISK MANAGEMENT

I. Strategy, Investment Process, and Market Opportunity

A. Overview Fixed Income and Credit Strategies hold an almost unique position in hedge fund investing. • How is the strategy best categorized? Is the The variety of financial market instruments, strategy primarily focused on sovereign debt their complexity, and the substantial opportuni- and its derivatives or is it mostly dealing in ty to employ both directional and relative value corporate credit? Does the strategy focus on ry to assess how T strategies, offers an extremely wide opportunity a particular region? Within fixed income “ set. But, this opportunity set bears a special bur- strategies, does the fund profit from Yield genuine a manager’s edge is. den as well. Curve Arbitrage, Basis Trading, macro trad- ing, Mortgage Arbitrage or some other Is the edge intangible as in a The material in the section emphasizes the approach? Within credit, does the manager importance of understanding each of the under- select securities that are current pay/current sixth sense, or derived from a lying strategies used in an individual hedge fund. coupon or securities that are defaulted, but And, it focuses on the need to relate each where capital appreciation is expected from tangible mix of experiences, or specific strategy to both the performance oppor- positive events? tunity in the style as a whole and to the relative a certain quality of experience? performance among managers engaged in this Strategies within fixed income include style of investing. In some cases, directional sov- Fixed Income Arbitrage, Mortgage How is the edge different ereign debt trading for instance, managers will Arbitrage and Municipal Bond Arbitrage. need to demonstrate significant ability in macro- For credit managers, the strategies include from that of other major economic analysis. In other cases, distressed Investment Grade, Credit (High Yield) security investing for instance, managers will Long/Short, Distressed Securities, Capital need to demonstrate superior skills in under- competitors? How sustainable Structure Arbitrage, Structured Credit, standing all aspects of the legal documents and Asset-Based Lending (see the Introduction environment surrounding an individual debt is this edge? for more complete description.) issue. The complexity of many of these fixed ” income and credit instruments and strategies are Strict classification is easier said then done an important source of performance opportunity for many managers, and looking at a port- for skilled managers. Directional trading folio alone may be misleading, as many of opportunities arising from economic imbalances the standard funding and hedging instru- within or across countries, between securities of ments are common to all approaches. an individual company, or securities across Further compounding this problem is the companies provide an enormous source of tendency for many managers to migrate to return potential for the successful hedge fund. where the opportunities are and to become more multi-strategy in their approach. The material below is designed to aid investors Asking the manager who he considers to in identifying the particular opportunities that be his closest competitors can be helpful in hedge funds focus on in Fixed Income and both classifying his approach and estab- Credit investing, what some of the factors of lishing an appropriate peer group to com- successful investing are, and assessing whether pare him to. an individual manager involved in these strategies has the specific skills to generate attractive returns. • What specific securities and markets does the fund trade (e.g., OECD sovereign or

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I. Strategy, Investment Process, and Market Opportunity (cont.)

agency debt, mortgage-backed securities, While the general advice advanced in previ- emerging markets sovereign debt, investment ous Best Practices publications – “beware of grade credit, high yield, distressed securities, the reduced liquidity and latitude for hedging structured credit/CDOs/CLOs, asset-backed in certain markets, especially emerging mar- securities, bank debt, loans, futures, options, kets” – still holds in the case of both fixed swaps, swaptions, forwards, convertible income and credit investing, in contrast to securities)? Do the key investment profes- equity investors in emerging markets, sover- sionals possess the specialized knowledge eign debt investors are generally able to short and experience to invest successfully in the both in the derivative and in the cash mar- identified securities? kets. The genesis of the credit derivatives market was credit default swaps on emerging Does their experience permit them to operate market sovereign debt. It has expanded to successfully in the range of markets required include most developed market Investment by the strategy? Grade paper, regardless of type, and, addi- tionally, an increasing amount of High Yield This question is of particular importance securities worldwide. Fixed income and given the apparent complexity of many debt credit hedge funds thus ought to be able to and derivative instruments. Not understand- run hedged books in most markets. ing the dynamic of even simple instruments (for example the convexity of a bond or its • What is the manager’s investment philosophy cheapest-to-deliver status) let alone the intri- and what are the core principles that inform cacies of corporate debt covenants and this strategy? Were there any professional indentures is a recipe, at best, for disappoint- experiences that were instrumental for the ing results or, at worst, for serious losses. manager in developing his investment philos- The innovation, rapid and ophy or approach? structuring currently characterizing the cred- it universe means that even plain vanilla debt The core philosophy may require some elab- instruments can now be subject to more com- oration but the manager should be intellectu- plicated technical forces arising from collat- ally disciplined enough to articulate this in a eralized structures or index trading. clear, concise and easily understandable way.

Since the skills and knowledge needed differ While the market crises of 1994 and 1998 widely from strategy to strategy, it is impor- should have been particularly instructive to tant to familiarize one’s self with how each fixed income traders and the summer of market trades and what skills are important. 2002 would have been similarly so for credit Asking a manager what he would look for in managers, what the manager learned from a candidate to fill his role may help you other periods and/or trades is likely to be understand this better. more of a differentiating factor.

• In which countries or regions does the • How has the current strategy evolved over manager invest? time? What factors might cause the strategy to be altered – however subtle these changes might be?

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I. Strategy, Investment Process, and Market Opportunity (cont.)

How does the manager plan to introduce is the hedge fund manager’s ‘edge?’ new strategies to the portfolio? What is the process for allocating capital to new strate- Try to assess how genuine a manager’s edge gies or systems? is. Is the edge intangible as in a sixth sense, or is it derived from a tangible mix of expe- When analyzing changes to strategies, it is riences or a certain quality of experience? hat conditions W important to assess the scope of the change. How is the edge different from that of com- “ Is it a refinement to an existing strategy or petitors? How sustainable is this edge? In would create the perfect storm, an expansion into new areas? If it is an both fixed income and credit investing, edge expansion, how has the expertise for this can just as readily derive from trade struc- where portfolio leverage would extension been developed? Will the manag- turing, greater understanding of inden- er be making new hires? Does the firm have tures/covenants and operations as from pose problems for the strategy the appropriate operations and infrastruc- insights about markets and/or companies. ture to handle the expansion? Is the firm or the portfolio manager? missing certain systems or operations that • What are the best environments for the ” may be important or crucial to its success? strategy? What are the worst environments for the strategy? Examine examples of each. Try to assess if the manager has fundamen- To what macroeconomic factors is the strat- tally changed his strategy to accommodate egy most/least sensitive? an undue increase in assets or to capitalize on opportunities in which he has little Fixed income may appear ‘unvolatile’ rela- expertise. Or, is the manager making logical tive to equities and commodities, but it too adjustments to profit in a changed environ- has cycles. There are both bull and bear ment that is still fundamentally consistent markets in credit products and particular with his/her investment philosophy? The segments of markets. Distressed securities pace of innovation in the credit derivatives are more abundant and better priced during arena has changed the nature of credit a recession than during mid-cycle. Interest investing and opened up a new realm of rates both rise and fall. The Fed is more opportunity for managers. You have to ask active during certain segments of an eco- yourself if they have the expertise to fully nomic cycle. And finally, investment strate- participate in what is a relatively adolescent gies wax and wane in popularity with com- and sometimes illiquid market. mensurate asset flows, with a resultant impact on returns. While coupon payments One way to measure style drift is to watch mitigate return volatility, they do not elimi- the degree of realized volatility for the strat- nate it. Understanding when a manager’s egy. Is the manager taking more or less risk particular style is in the sun and when it is over time? Why? Does the current invest- not goes a long way in completing fruitful ment profile of the fund seem justified given due diligence on and making a successful the manager's expressed views of the market? investment in a given hedge fund.

• How unique is the strategy? Does it attempt • Which indices or investment manager peer to exploit persistent market inefficiencies or group would be most appropriate to under- is it a less viable longer-term strategy? What stand the market dynamics relevant to the

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I. Strategy, Investment Process, and Market Opportunity (cont.)

strategy? Are there certain indexes or strate- cost something to hold (the option premium) gies that might be ideal for “benchmarking” but will pay nicely as either volatility increas- purposes? es or the option becomes “in the money,” and is often compared to buying an insur- Most arbitrage-focused managers will tell ance policy. Short option strategies will pay you that their approach targets absolute the option seller, but will be costly if the returns and so has no index proxy. However, inverse occurs much like an insurer who the level of rates matters significantly in writes only one policy that is triggered. determining the basic carry they can earn. Optionality can arise implicitly from the Higher volatility (in the level and shape of trading strategy employed or explicitly from the curve) and lower correlation between being long or short options overall. securities increase returns to relative value trading in general. Tail risk is what happens when market crises occur and liquidity disappears. It has a coin- For credit-focused approaches, the perform- cident relationship with volatility and a ance of corporate credit, particularly sub- direct relationship with correlations, which investment grade debt, often goes some way underlie all relative value trading. Arbitrage in explaining the performance of these man- strategies may or may not be short volatility, agers. For Distressed Securities traders, the but they tend to be short tail risk. quantity of defaults relative to the capital investing in them is important to understand B. Investment Process: though the last few years’ industry-specific Idea/Trade Generation “rolling bankruptcies” has meant opportuni- ty despite low default rates. • What is the process for generating invest- ment ideas or the selection and implementa- In short, peer groups may be of greater use in tion of trades? understanding what to expect from a manag- er than particular market indices are. Asking It should be noted that the structuring of a manager who he thinks his competition is trades constitutes an investment edge for usually provides some good insight into his both fixed income and credit managers. strategy as well as providing good fodder for further inquiry. In the case of fixed income, the large array of seemingly fungible instruments is actually • Is the strategy long or short volatility? Is the composed of differentiated securities with a strategy long or short tail risk? wide opportunity for creative structuring and a number of pitfalls for the less initiated aris- As part of understanding a manager’s funda- ing from market idiosyncrasies such as the mental strategy as well as his ability to man- dynamics surrounding cheapest-to-deliver age risk, it is often helpful to think of a strat- note, the role of on-the-run versus off-the- egy in the concept of optionality. In other run paper, how a particular bond trades in words, is the strategy similar to owning repo, and the large difference between mort- (being long) an option or selling (being short) gage pools. an option? Long volatility strategies may

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I. Strategy, Investment Process, and Market Opportunity (cont.)

In the case of credit-focused approaches, Credit: Corporate debt-focused hedge funds, understanding the instrument’s indenture while employing many of the tools of their and its covenants – the seniority of the fixed income cousins (technical screening, paper, the assets it has recourse to, its pay- etc.), tend to focus more on the fundamen- ment and redemption schedule (including tals of the enterprises and industries targeted put and call provisions) – form the basis of a as well as the specific covenants and inden- hedge fund’s value added. As can be seen tures of the paper being investigated. from even this short list, how a trade is Consistently understanding any of these structured and the investment idea itself are items better or sooner than the competition often inseparable in both fixed income and can be a huge edge. For managers more credit strategies. focused on the private transactions, the additional skills of deal structuring and col- • Research: How does the manager approach lateral collection are required. For dis- investment research? Does the manager tressed security hedge funds, the manager’s employ a bottom-up or top-down security ability and desire to shepherd a creditor selection or asset allocation approach? How committee and the restructuring process to a are potential positions identified or successful conclusion must also be investi- screened? Are quantitative models or soft- gated on the part of an allocator. ware used? To what degree does the manag- er use primary research (and/or consultants) • Modeling and Valuation: What are the secu- and how rigorous does this effort appear to rity valuation methodologies that are impor- be? What is unique about this approach to tant to a manager? Do the analysts create research? What capacity does the manager their own financial models? How do man- have to generate, consistently, a truly origi- agers develop research ideas in concert with nal investment thesis? less experienced analysts? Or, more broadly, how does the manager leverage the capabil- Fixed Income: Many of the strategies ities of all investment professionals involved employed by hedge funds, while dubbed in the research process? ‘arbitrage,’ have historically been better described as ‘’ approaches. • Carefully review current and historical Given the wide range of instruments traded, investment examples. Ensure that these most managers employ some form of quan- examples represent a broad mix of invest- titative screening tools in the initial research ment outcomes (i.e., both good and bad). efforts. While whole textbooks have been written on the mathematics behind these cal- Try to make sure that you are being present- culations (dealing with the tricky issues of ed with more than just a select number of rolldown, carry and the like), for an alloca- highly polished and carefully vetted “exam- tor it is simply a matter of establishing a ples.” Those included in the marketing doc- manager’s ability to build appropriate sys- ument are likely of this type. The best tems and, just as important, to understand approach is to randomly choose current and how he sources and cleanses the data used as historical portfolios, select positions either inputs. that you know had very good or adverse outcomes in the marketplace and are

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I. Strategy, Investment Process, and Market Opportunity (cont.) “Above all, understand the effect of meaningfully-sized and then engage the man- trast, great portfolio construction can make ager in a dialogue on his rationale for both up for a multitude of idea generation errors leverage on a manager’s ability adding the position and sizing it as he did. (i.e., the mistakes are sized small). Understanding the particular dynamic at the to hold onto a good position This should also include an examination of manager being examined is crucial to under- historical portfolios, using dates chosen by standing what the return stream will look that may have a temporary the potential investor, and risk reports asso- like. ciated with them. Many managers are espe- mark-to-market loss. cially sensitive about this request and refuse • What are the targeted position sizes and to provide them. This should be a red flag exposure ranges for the fund? What is the for allocators, who have a fiduciary obliga- typical, minimum, and maximum sizing for Leverage cuts both ways and tion to their clients to understand what they positions within the portfolio? What have are buying when they hire a manager. the historical sizes and exposures been? more good traders have been What is the leverage target and how is it Do the examples tie in with your under- measured? Consider stress tests, DV01, undone by applying increasing standing of the manager’s philosophy and country and region, asset class and credit perception of an investment edge? rating limits for each. Are the limitations leverage to a diminishing noted in the offering memorandum (rarely) C. Portfolio Construction or are they set by the investment team (and if return opportunity than have so, by whom)? • What is the overall approach to portfolio been lucky enough to have construction? How does it enable the fund Develop a solid understanding of the way in to reach investment targets? which the manager approaches position con- survived the inevitable centration in the portfolio. Historically, how Next to idea generation, this is the most large has the manager let positions grow and denouement. important area to focus on. Understand how in what context? Was this discipline always ” a manager allocates capital to individual applied or was it adjusted in practice? This trades and themes. Portfolio construction applies also to the number of positions, as expresses the balance between a manager's fixed income traders tend to be heavy users conviction in his ideas, the capacity available of swaps in their various forms. Because in it and the risk of it to the investor (both at most positions are closed out with offsetting a position level and in terms of the portfolio swaps rather than unwinding the original as a whole). Managers can be entirely bot- trade with the original dealer, a fund with a tom-up in assigning capital, or they can long history may have a substantial book of employ a more top-down approach, or even swaps whose DV01 risk is technically zero a blend of both. Some managers use heavily but whose counterparty risk and operational quantitative approaches while others rely on complexity can be substantial. manager discretion and judgment. Improperly-sized positions will mean that Try and understand the degrees of risk creat- good ideas contribute too little to profits and ed by position concentration especially in less bad ideas generate too great a loss. A collec- liquid markets; alternatively, try to under- tion of great individual ideas does not auto- stand the analytically dilutive effects of an matically create a great portfolio. In con- over-diversified portfolio – the risk of not

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I. Strategy, Investment Process, and Market Opportunity (cont.)

knowing the portfolio as well. Do you sense haircut changes by prime brokers, or some of that the number of positions in the portfolio the ‘permanent capital’ vehicles being cur- is a function of the fund’s (possibly too rently issued, are preferred. large) asset size and less driven by a “risk management” discipline? Tie your under- This skill should be evident in both the standing of concentration to the fund’s per- front- and back-offices of leveraged man- formance characteristics to aid in your agers as technical issues surrounding both understanding of how the manager will per- investment concerns, such as a security’s form going forward. inclusion in CDOs, and operational con- cerns, such as trade failures, can both be • What is the typical number of positions in costly. Good communication between the the portfolio? two areas is key.

How many of the positions are really mate- • For credit managers, does the fund have a rial to the portfolio? Is the number of posi- bias toward specific sectors of the market tions realistically manageable? In other (e.g., merchant energy or air transporta- words, can the manager (and his team) real- tion)? Does the manager have specific sector ly know the positions well? Does the infra- concentration limits? Look at how the man- structure of the business support the number ager’s sector or industry concentration has of positions, in terms of asset and liability changed over time. tracking and stress tests? Both the number and the complexity of the instruments in the Similar questions should be posed about portfolio impact operations. issuers, credit ratings and instrument types.

• Does the portfolio manager have experience To what degree does the manager seem to managing liabilities (i.e., funding, repos, appreciate the risks posed by excessive con- term financing, structuring CDOs/CLOs if centration? Does the manager demonstrate applicable) as opposed to simply managing an appreciation for the risk posed by rating, assets (i.e., picking securities or analyzing market, issuer, industry or duration mis- credits)? matches potentially embedded in a given investment portfolio? Given that funding is such an important part of some fixed income strategies, the impor- • What is the size of issuers and issues which tance of this question cannot be overstated. managers are generally targeting for their For leveraged books typical of ‘arbitrage’ investments? Do they invest in private secu- styles, this is particularly true; for unlever- rities (sometimes termed 144As), structured aged styles, such as Distressed Securities, this products (CDO equity for example) or other is less of a concern. Mismatches between asset-backed strategies? Compare AUM to investor liquidity, underlying security liquidi- market size, issue size or sector size for any ty and financing terms have undone some of fund you are evaluating, and try to aggre- the best and brightest in the business. All gate hedge fund activity to judge market effi- other things being equal, longer-term financ- ciency. ing in the form of long notice periods for

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I. Strategy, Investment Process, and Market Opportunity (cont.)

Be careful to scrutinize the liquidity risk • How is leverage used in the portfolio? implicit in smaller asset classes within fixed income and credit markets. Try to assess the To what degree will leverage be employed in additional impact of other variables on liq- the portfolio and in what context? What par- uidity such as position concentration, issue ticular environments or circumstances would size, market size, asset growth, investor con- prompt a reduction in the use of leverage? An centration and redemption terms. increase? Fixed income managers will use varying degrees of leverage, also tied to the Credit managers may refer to the middle underlying types of strategies they implement. market: this is normally companies with Credit managers may leverage securities where enterprise value between $100MM and they believe downside risk is both well under- $2BN. This may be related to the types of stood and limited. Ask the manager to detail risks the manager is willing to take and the his use of leverage by trading strategy. size of their funds. As has been noted before, fixed income strate- • Does the manager target a general allocation gies, specifically in the world of yield curve of capital to various sub-strategies, such as arbitrage, tend to be much more highly lever- yield curve arbitrage, mortgage-backed or aged by the standards of equity strategies. asset-backed trading in the case of fixed income? There are many technical reasons for this, which is why managers tend to see dollar Understand how this is set, by whom and leverage as less important than risk-based how often. measures such as 10-year equivalents, DV01 and stress levels. For investors, it is crucial to • What kind of geographic exposure does the understand a manager's leverage in all of its fund’s strategy have? dimensions: on an absolute basis (both gross and net notionals), relative to peers, how it Credit managers will generally have greater responds to market conditions (does the concentrations in the U.S. and Europe than manager maintain leverage in periods of ris- other markets such as Asia or traditional ing volatility or reduce it) and, most impor- emerging markets. Due to the less developed tant, how the liabilities are dealt with opera- nature of credit markets outside the U.S., it is tionally (especially the terms of the financing important to understand how much capital is – the longer-term the better). Above all, allocated to these markets and how it is man- understand the effect of leverage on a man- aged. ager’s ability to hold onto a good position that may have a temporary mark-to-market Fixed Income managers may focus on similar loss. Leverage cuts both ways and more strategies both in the U.S. and abroad. Be good traders have been undone by applying sure to ask how much is allocated and to increasing leverage to a diminishing return what markets, as well as how the opportuni- opportunity than have been lucky enough to ty may be different there than in the U.S. have survived the inevitable denouement.

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I. Strategy, Investment Process, and Market Opportunity (cont.)

D. Trading corporations’ capital structure undergoing bankruptcy reorganization might depend on • Who makes trading/execution decisions? the priority designation of the courts. Who is the backup? • Are there different types of positions such as Is there separation between PM and trader? “core” and “trading” positions? he liquidity on T Who reviews and oversees trades? Does the “ trader only execute trades, or does he have • What is the average holding period? What is the way out is not the some portfolio management authority over a the annual average turnover of the fund? prescribed carve out of capital? How does liquidity on the way in. the fund avoid the problems that can arise Some credit strategies may try to be tax-effi- ” from having multiple traders? cient on the long-side, holding credits for more than a year to capture capital gains. • Are there systematic or quantitative ele- Fixed income managers may have varying Gregory Jacobs, ments to the strategy? If so, what are they, holding periods depending on the nature of May 17, 2007 how were they developed? When is the man- underlying trades. ager’s judgment sufficient to “override” such a systematic or quantitatively driven invest- • Is there a “stop-loss” policy? How is it exe- ment discipline? cuted?

This is particularly relevant for fixed income Strict stop loss procedures are more impor- strategies. Certain strategies lend themselves tant for some strategies than for others. For to systematic identification of the opportu- example, in more trading and arbitrage ori- nity. However, it is important to understand ented strategies within Fixed Income arbi- the interaction of the manager and systems trage, strict stop loss procedures are vital he relies on. Does the system simply output due to the amount of leverage and position potential trades which are then up to the concentration that is sometimes employed. manager’s discretion? With many distressed managers, stop loss disciplines are explained with a greater • How are positions exited? Does the manag- degree of ambiguity. The sell-discipline is er set a target, rely on a set of rules, or base understood to be more “art” than science. the sell decision on a catalyst or event? Understand the portfolio manager’s toler- Fixed income managers may set price, yield, ance for losses. What is the manager willing spread or volatility targets – depending on to lose in a position before cutting it back, or the nature of the underlying strategy or in the portfolio before reducing total lever- trade. age? “Getting married” to a position(s) or a story is one of the most common reasons for Credit managers will typically see the exit as incurring a substantial portfolio loss. ‘event driven,’ meaning that a realization of value arises from some catalyst or event. Understanding the risks a manager is willing For example, the value of a class of debt in a to take if he is meaningfully profitable or unprofitable for the year is extremely useful.

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I. Strategy, Investment Process, and Market Opportunity (cont.) “Once a strategy is broadly defined, when an Some more trading-oriented managers (and • What conditions are favorable to the strate- strategies) will tend to press their bets when gy? What are the current conditions for the index is formed, capital will they are up and invest more conservatively strategy? How much capital is being when they are down. deployed against the opportunity in aggre- flow in, the trade gets crowd- gate? • Shorting: What specific shorting experiences ed and it’s time to move on. do the manager and trader have? If short- How much money is currently flowing into ing is meant to generate alpha, then has it the strategy? Is the strategy congested? How It’s important to understand actually done so in practice? Will the man- are the conditions for issuance, gross and net, ager employ any other shorting/hedging versus historical levels? Is there any reason strategies? What range of instruments will be to suspect that it is poised to suffer from the cycle. My first bank debt used to short or hedge (e.g., credit derivatives diminished returns going forward? Does the or bonds)? How costly has the use of hedg- manager’s size mean that they are less or trade took longer to settle ing instruments been YTD and, on average, more affected by capital flows? As a bench- annually? mark for the appropriate size of the fund, than the entire distressed cycle consider the asset size of other successful Fixed Income: Unlike in most equity strate- funds that employ the same strategy. Then lasted. When correlations gies, fixed income and credit managers rou- aggregate the AUM of similar hedge funds tinely short instruments to create hedges and and compare it to the market size. Can the blew up in May 2005, we had so shorting most frequently acts to reduce particular market or set of securities absorb risk, not increase it. that much leveraged capital? 3-5 days to act.” Credit: Are short positions created using • To what degree can the strategy be under- physical bonds or via derivative instruments? stood to have “cycles?” If physical bonds are used, how do they Eric Mindich, locate the bonds and borrow them, prior to Where is the cycle today? Beware of conspic- November 17, 2005 shorting them? If Credit Default Swaps are uous outperformance when the strategy is used, then evaluate the notional size of the concluding the most attractive segment of an positions and overall hedges, and the cost of investment cycle. How does the strategy CDS. Since CDS are priced at a spread to change at different parts of the cycle? LIBOR, ask what the spread is, how fre- quently the contracts reset, and who the • What kind of external shocks is the strategy counterparties are. most vulnerable to?

E. Market Opportunity Ask the portfolio manager to decompose the strategy into the risk factors for which it is • What is the breadth of the investment uni- most sensitive. As part of the basic strategy verse that the manager’s strategy will target? discussion, how is the manager’s investment How diverse or liquid are the companies, approach designed to hedge against signifi- sectors or regions that are targeted for the cant external shocks? Note that shocks may strategy? or may not be directly related to the market - they could be political or legislative in their origin.

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I. Strategy, Investment Process, and Market Opportunity (cont.)

• How tax-efficient is the strategy?

Credit managers will employ a mix of carry and capital appreciation strategies. Capital gains and income are taxed at very different rates for U.S. onshore investors. Fixed Income managers may not capture income but may rather be short-term traders of secu- rities - which has its own tax implications.

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II. Market Risk Management

considerably between the more quantitative Greater separa- Fixed Income and Credit strategies use a broad Fixed Income shops and the discretionary “ array of financial instruments, more so than many and private-focused Distressed Securities tion of duties can enhance other hedge fund styles. Some of these instruments players. No one philosophy covers all mar- are reasonably straightforward to analyze (e.g., G7 kets and all situations but the beliefs the long-term vitality of a sovereign debt). Others are quite complex. Even at expressed should be appropriate for the mar- the simpler end of the spectrum, non-sovereign kets being traded and reasonable in light of hedge fund. It can also fixed income investing requires consideration of the risks being taken. risks such as rating changes, calls, prepayments (in help reassure investors the case of mortgage obligations), and varying lev- Why do they believe what they do? Often els of instrument liquidity. There has been signifi- the experiences of losses are felt more acute- that multiple sets of unre- cant volume growth in fixed income markets over ly than those of gains. A string of losses may the past ten years. But, perhaps more important, engender tighter controls while a series of lated eyes are watching the complexity of the financial instruments current- gains can lead to increased laxity. ly in use, and the even greater complexity of their Understanding the balance between caution over the business and related derivatives, has expanded even more dra- and abandon possessed by a particular man- matically. ager, goes a long way to understanding what the portfolio. the return stream will look like. The following section draws the reader’s attention ” to risks to consider when allocating to hedge funds Does this philosophy take into account both employing fixed income and credit strategies. As “normal” market conditions, and the noted below, leverage will usually be an insufficient inevitable “tail” event? indicator of market risk in fixed income investing. Other risk measures beyond leverage, and even • Does the manager have written policies and VaR, are usually employed in this hedge fund style procedures that communicate an approach (e.g., measuring DV01 risk). The common use of to risk management? relative value strategies in this hedge fund style increases the importance of “tail” risk analysis. Obtain a copy of any relevant documenta- Some of these relative value strategies may have a tion or procedures. Make a detailed review significant short volatility aspect to them. Finally, that includes operational, liquidity, and the use of more exotic, often less liquid, instru- counterparty risk. ments in these strategies raises an important due diligence focus on the independence of instrument • How does the manager gauge risk? What pricing. The section below attempts to highlight risk measures does the hedge fund use inter- some of these very important issues. nally? Which measures are most important? How often are these risk measures calculat- A. Portfolio Risks ed? Are they calculated internally or by an external vendor? • Invite the manager to articulate his risk man- agement philosophy. Does the manager measure risk in terms of stress levels, volatility, leverage, or in some Is the process systematized or does it seem other fashion? more intuitive? Risk management can vary

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II. Risk Management (cont.)

Does the manager conduct statistical cal- Again, it is worth highlighting that Fixed culations, such as DV01 or Value at Risk (VaR)? Income strategies tend to have risks that dif- fer materially from those of Credit strate- It is important to remember that various risk gies. Since the former are based on intra- measures, like VaR, might understate risk and inter-country yield curve arbitrage, fac- during periods of low market volatility. tors related to sovereign debt and foreign Stress testing and scenario analysis help exchange markets dominate investment risk. gauge portfolio risk during periods of high In the case of Credit managers, credit market volatility and high correlations. spreads and company-specific events will They provide a more accurate picture of tend to dominate investment risk. Both of potential losses in difficult environments. In these areas will be subject to counterparty, essence, they help gauge “tail risk.” leverage and volatility risks. It should be noted that there is volatility in many differ- Fixed Income strategies tend to be highly ent markets, even seemingly ‘docile’ ones leveraged by the standards of other hedge like fixed income. fund strategies. This is both because they are relative value-focused in highly efficient • To what extent does the manager trade markets and because of technical and opera- derivatives? What instruments are used? tional factors peculiar to these markets (e.g., How are these instruments modeled and val- swaps are rarely unwound with the original ued? If options are used, does the manager counterparties but rather an offsetting swap have a bias to buy or sell options? is put in place to exit the trade; thus coun- terparty exposure is high but economic Derivatives can give rise to non-linear port- exposure is not). folio risks so focus on understanding the tail risk that may be inherent in some of these • Which portfolio, market, factor, or security- strategies. They also can hedge these risks. specific risks are most relevant to consider? Focus also on the trading and liquidity char- Are these particular risks in specific types of acteristics of these instruments. As a rule of investments or trades? The list is not meant thumb, the more ‘exotic’ and structured a to be comprehensive but it may serve as a derivative is, the more likely there is only rudimentary point of reference: one source of liquidity: the originating dealer.

– Interest Rate Risk Fixed Income managers will likely be heavy – Foreign Exchange Risk users of derivatives as they are both impor- – Credit Risk tant tools (for instance using swaptions in – Equity Market Risk ‘conditional’ trades) as well as a strategy in – Basis Risk its own right (). It goes – Liquidity Risk without saying that the revolution in credit – Position Concentration Risk derivatives has meant that Credit managers – Correlation Risk have become heavier users of derivatives as – Volatility Risk opposed to their historical focus on cash – Counterparty Risk instruments. As an allocator, you would be – Leverage wise to familiarize yourself with the various

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II. Risk Management (cont.)

instruments, their investment profiles and concentrations? Does the manager monitor In all of these their operational issues. correlations among trades? “ discussions, understand the The distinction of being, in aggregate, short or A manager may appear to have a diversified long options is not a trivial one. Many ‘arbi- book but in actuality have a book full of distinction between being trage’ strategies may be short volatility given trades implicitly expressing the same view. the ‘normal’ conditions necessary for ‘mean Understand if the book expresses a unitary short volatility and short reversion’-type trades. Short option strategies view structured differently or a true collec- have attractive statistical properties – consis- tion of uncorrelated idiosyncratic ideas. tail risk. Being long or tent monthly income in times when markets are generally directionless – until they do not. • Is the portfolio stress tested? What method- short volatility tends to be Because of this, increasing leverage tends to be ology and assumptions are used? applied to the shrinking returns it produces an idiosyncractic trading resulting in a blow-up. Portfolio insurance in How often are they performed? Who reviews 1987 and Yield Curve Arbitrage in 1998 are the stress tests? Have they ever been acted choice made by a manager. examples of where short optionality produced upon? Ask for examples. Well-constructed enormous losses. stress tests go a long way to addressing short Begin short tail (or liquidity) optionality and tail event risk, and revealing Many new derivative structures are being inappropriate correlation assumptions. invented daily, though they are generally risk tends to be inherent to built from basic instruments (futures, • Does the fund have an individual who is options, swaps). Hedge funds may be early responsible for risk management? Who does a strategy. adopters of these structures, in some cases the individual report to and how is he or she ” driving their creation. Credit default swap compensated? indices are proliferating across all debt instrument markets, most recently across the • What training has this individual had? What various asset-backed and mortgage-backed other responsibilities in the firm does this markets. You should evaluate how skilled individual have? What is the scope of his/her the manager is at using the new instruments, authority? Does the risk manager have the especially if he is using them extensively. independent authority to liquidate positions New markets tend to be somewhat adoles- if risk guidelines are violated? cent initially, with unpredictable moods and liquidity availability. Of all of these items, the combination of authority, reporting lines and compensation In all of these discussions, understand the incentives for the risk manager bear the clos- distinction between being short volatility and est scrutiny. Having a Risk Manager who short tail risk. Being long or short volatility cannot effectively ‘police’ risk limits is often tends to be an idiosyncractic trading choice worse than not having one at all as a false made by a manager. Begin short tail (or liq- sense of comfort may be created. uidity) risk tends to be inherent to a strategy.

• Does the manager monitor position, sector, credit rating, and geographic or thematic

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II. Risk Management (cont.)

• Has the manager ever had a significant Try to assess the additional impact of other drawdown? If so, what were the circum- variables on liquidity such as position con- stances? centration, asset growth, investor concentra- tion and redemption terms. These last three What is the value of the manager’s largest items are critical as a sudden, large redemp- peak to trough drawdown? How long did it tion may push a manager to fund it with the take the manager to recover? Was this draw- most liquid items on the book, leaving a sub- down within expectations? How did the stantially less liquid book for the remaining timing of the drawdown compare to their investors. peers’? Has the manager made any changes to his investment approach or risk manage- • How do reduced trading volumes affect the ment policies as a result of this drawdown? liquidity of the relevant markets or instru- ments? Is the manager nimble enough to What are the manager’s largest daily and handle varying liquidity environments? monthly losses? Describe the reasons for What is the market impact of a typical trade these losses and any changes in investment for this strategy? approach or risk management policies that came about in response to these losses. Who is on the other side of the trades that the strategy typically executes? Is there a B. Liquidity Risks dominant dealer? Is the dominant dealer monopolizing the liquidity in that instru- • What is the hedge fund manager's definition ment? Who are the pricing sources? of liquidity? How many days would it take to liquidate the portfolio in an orderly fash- Familiarize yourself with the dynamics of ion? What is the definition of an orderly liq- the markets in which your manager trades. uidation? What is the bid-ask spread on the Get a sense of how large a manager’s posi- securities in the portfolio? tions are with respect to the markets in which he trades. This is particularly impor- It is also important to determine the liquida- tant for less liquid markets. tion price under various market scenarios. If a manager can liquidate 100% of his portfo- Will a significant redemption alter the port- lio in one to two days, but only with a sub- folio by leaving the most illiquid instruments stantial loss, the portfolio is not really liquid. with remaining investors? Be wary of this Similarly if it takes two or three days to liqui- possibility, particularly if there are side let- date 75% of the portfolio with little impact, ters and preferred redemption terms for and three months to liquidate the remainder, some investors. it is important to understand what constitutes the less liquid 25% of the portfolio. • Do the liquidation terms of the fund make sense or match the liquidity of the fund's Be careful to scrutinize the liquidity risk instruments or marketplace? implicit in particular regions or derivative structures that managers may employ. Be very wary of funds that provide generous liquidity terms relative to the liquidity of the

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II. Risk Management (cont.)

instruments and securities trafficked in by cheapest-to-deliver Treasury Notes and the Derivatives are, that given strategy. Make sure that the fund’s Note Future in 2006 to see how this can be a “ cash is actually unencumbered and that it is problem or be manipulated. This is likely either by their nature or by truly cash, not invested in some other term doubly true in the burgeoning credit default instrument. swap market where the notional positions their margining, leveraging are now multiples of the underlying instru- • Has the manager installed appropriate terms ments, though most of these instruments are instruments. Leverage is a to prevent a run on the bank? Are there now cash settled. Understand the liquidity of ‘gate’ provisions installed to protect remain- the markets the manager trades and how this double-edged sword: in ing investors? How do any gate provisions relates to the size of the manager's positions. impact your specific interests as an investor? good times you can never One final caveat, for some approaches, such The liquidity offered by hedge funds to their as Distressed Securities, control positions of be too leveraged whereas clients, like that of a bank, generally exceeds the senior-most or the pivotal securities may their ability to deliver on it should a substan- represent an important ingredient in the suc- in bad periods never tial portion of investors demand it at the cessful application of the strategy. same time. Most offering memorandums too little. contain language allowing for a manager to • Does a manager intend to hold any private suspend redemptions to protect the remain- issues? Will private issues be side-pocketed? ” ing investors in a fund. Be aware that these How are they marked and what is the proce- trump all other liquidity provisions should dure for marking them? they be triggered. C. Leverage • What is the maximum position size long and short with respect to average daily trading • Is leverage used in the portfolio? volume or issue size? Has the manager ever exceeded this parameter? Given the manag- How does the manager define leverage, espe- er’s AUM, how do these maximums compare cially in the context of options, futures and to the outstanding issue and market size? swaps (i.e., market value or face value)?

This is going to be somewhat harder to To what degree is leverage employed in the objectively measure than in equity- or portfolio and in what context? What is the futures-based strategies (where publicly- maximum leverage that could be employed available information such as 13D filings and at any time? What is the historical average, open interest can help you) as most fixed maximum, and minimum leverage used by income and credit markets are OTC. You the manager? What particular environments will have to get this information from the or circumstances would prompt a reduction manager and/or counterparties. in the use of leverage? An increase?

Even in seemingly large markets like the U.S. Familiarize yourself with the nomenclature Treasury market, there are multiple securi- of leverage and leveraging practices in differ- ties, some with less liquidity than others. It ent markets. Options require payment or only takes a cursory look at the tussle over receipt of a premium up-front in exchange

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II. Risk Management (cont.)

for economic control over larger notional Given the events at Refco two years ago, amounts. Futures require a small amount of counterparty risk is no small affair. An margin funding. Swaps require some cash insolvent counterparty cannot pay a fund its that can be posted in the form of bonds as a gains on a transaction. The practice of clos- ‘haircut.’ ing swap positions using offsetting swaps with a different counterparty may eliminate Derivatives are, either by their nature or by economic risk but it has just doubled coun- their margining, leveraging instruments. terparty risk. Leverage is a double-edged sword: in good times you can never be too leveraged where- Review any arrangements the manager as in bad periods never too little. Be aware maintains with counterparties. What are the that the extensive securitization and struc- terms of the manager’s ISDA agreements? turing of credit that has occurred in the past few years tends to involve elements of lever- • What is the tenor of the manager’s borrow- aging as well (somebody is holding the equi- ing terms? ty piece after all). It is important to under- stand both how much leverage a manager Are the liability resets synchronized with the has as well as how he generates it. asset resets, or is there curve risk embedded in the financing structure? How much is less • What conditions would create the “perfect than 90 days? How much is greater than 90 storm” where portfolio leverage would pose days? How has that changed over the past problems for the strategy and/or the portfo- 12 months? Do the terms of their assets lio manager? match their liabilities? Can counterparties change the “[financing] haircut” with less • How many brokers and/or banks extend than 90 days notice? It goes without saying leverage to the fund? Who is the manager's that longer-term financing is preferred to prime broker(s)? shorter-term liabilities. Many managers have worked assiduously to ensure that their Understand the hedge fund manager’s own borrowings are termed out and many are process in analyzing and diversifying his looking to capital markets to avail them- counterparty risk? selves of more stable sources of financing than prime brokers (who may also double as their trading counterparties).

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PEOPLE, CULTURE AND BUSINESS STRUCTURE

III. Team and Organization

strategy you are trying to evaluate? H ow the front- A competent hedge fund organization is a critical “ variable in its potential long term success. This is no It is difficult to make any blanket statements and back-offices relate is less true in Fixed Income and Credit hedge fund of what constitutes the ‘right’ background for investing than in other hedge fund styles. Indeed, a fixed income and credit generally as the particularly important in strong case can be made that it is even more impor- investment disciplines are so broad. Suffice it tant in Fixed Income and Credit strategies, both for to say that focusing only on the names of firms fixed income and credit front and back office operations. For instance, worked at would be overlooking equally many strategies and instruments found in this style important specific skills acquired, as well as strategies as these are relatively new and have only recently gained personal characteristics demonstrated over widespread use. Analyzing the investment team’s time: desire to succeed, integrity, ability to lead markets are particularly research capabilities and adaptability is important and motivate, inquisitiveness and flexibility. in long-term investment success. Similarly, assessing operationally the operational ability to track, price, and settle a • How do the firm’s principals make invest- large number of often-complex financial instru- ment and business decisions? What is the intensive. ments is no less important. structure for investment decision-making versus operational decision making and busi- ” The following section highlights issues to review ness management? What kind of input do when considering an allocation to Fixed Income other investment professionals and senior and Credit hedge funds. The heterogeneity and back-office professionals have in their complexity of strategies and instruments places a respective areas of responsibility? special burden on investors to understand and be able to assess the strengths and weaknesses of the How the front- and back-offices relate is par- firms engaged in this investing ticularly important in fixed income and cred- it strategies as these markets are particularly A. Key Investment Professionals operationally intensive. While equity and futures markets tend to be relatively stan- • Review the academic training and profes- dardized with the potential for operations to sional background of the key investment pro- be highly automated, the converse is true for fessionals. Carefully assess the quality of debt markets. For example, the terms and work experience of those individuals. Is the conditions of a typical debt security may length of work experience appropriate? Do number in the dozens as compared to a much the principals have any hedge fund experience? lower number for equities. In another exam- ple, trade settlement can be tricky when non- Does the experience of the principals suggest standard instruments are traded. they will be successful in the execution of their current strategy? Be careful with man- If the front office trades actively and is con- agers who recast or re-invent their skill set stantly adding new securities and security based on market demand. types to the portfolio without adequate infra- structure in the back-office, the result could Does the manager have any prior perform- be disastrous. Having the proper level of dia- ance record that can be shared? Is the per- logue and respect between the two areas is formance/track record relevant for the key in fixed income and credit strategies.

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III. Team and Organization (cont.)

• What were the circumstances that caused complement one another? Is there a skill set them to leave their previous positions? Are or role that is missing? there any non-compete or legal issues from previous positions? Every team takes some time to gel. These issues are more or less important depending If relevant, is their former employer invest- on the size of the shop and the eteris paribus, C ing in their current fund? If not, why? Keep structures/culture in place. “ in mind there are circumstances where an an honest, honorable, investment by a previous employer may not One way to address this topic is to imagine be appropriate or even desirable. Is the pre- what an ‘ideal’ shop plying that strategy ‘hungry,’ harmonious and vious employer a reference? would look like in terms of people, then ask yourself how the one you are examining hard-working team will • How are investment professionals compen- compares. While no shop is perfect, obvious sated? To the degree possible, review com- deficiencies should at least be recognized tend to outperform one pensation for all investment professionals. and a plan to address them in place.

lacking any one of Try to understand whether the proper incen- • Assess the personality and character of the tive structure exists both for principals and team members with respect to their integrity, those traits. employees to pursue investment success in a attitude, work habits, reputations and ” productive way. expectations for success. The taxation environment for deferred com- Ceteris paribus, an honest, honorable, ‘hun- pensation plans – whereby portions of peo- gry,’ harmonious and hard-working team ples’ bonuses are invested in the fund – is will tend to outperform one lacking any one both dependent on jurisdiction and currently of those traits. subject to considerable political scrutiny. As such, understand how much, absent the tax • What is the policy for personal trading advantages, would be deferred in the fund. accounts? What is the process for reviewing personal account activity? Who reviews it • Does one of the key principal(s) have mana- and how often? gerial, operational or marketing experience? Assure that if personal trading is monitored, There can be advantages in having at least the compliance person receives statements one partner experienced in and focused on directly from the employee’s broker rather running the business to allow a fund manag- than from the employees themselves. er’s undivided attention on making share- holders money. This is especially true in If trading is permitted, are there any limits fixed income and credit investing where the placed on the amount of time spent and the needed business and operational infrastruc- kinds of instruments traded? What instru- ture can be considerable. ments are traded separate from fund activi- ties? Is there a potential for any individual • Has the team worked together in the past? to “front-run” the fund's trading or invest- Do the skills of the investing team appear to ment activity?

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III. Team and Organization (cont.)

Pay particular attention to this in a private create potential disincentives for appropriate lending or control-based credit strategy risk-taking? Have former “alpha-generators” (especially Distressed Securities and those turned into mere “asset gatherers?” involved in PIPEs) as the examination of companies may lead to the possession of • What are the provisions for the absence of the Material Non-Public Information (“inside “key man?” Who has the ability to fill in on information”), whose use in buying or selling a short-term or longer-term basis? What publicly-traded equities is illegal. arrangements are in place for this eventuality? If the fund would be liquidated, how long • Have any of the fund principals ever been would this take, who would do it and what involved in a lawsuit? Do any of the fund are the estimates of the cost of doing so? principals possess an official disciplinary record (pending or past)? Have there ever B. Founders and Principals been any regulatory infractions, fines or sus- pensions from any regulatory agency or pro- • Are the founders/principals the key invest- fessional organization? What are the details? ment professionals? What is their level of Do any of the fund principals have a criminal involvement in the firm/fund? history? With some hedge funds having become It is crucial to perform thorough examina- multi-billion dollar investment organiza- tions of an individual's entire background: tions, the original founders may no longer education, employers, civil courts, tax liens, directly be making investment decisions, criminal convictions, bankruptcies, regulato- focusing instead on running a medium-sized ry agencies and general news services. The enterprise. Understand how this could web has made a number of these checks impact returns going forward. much easier and a simple search using the principals’ names will often yield surprising • Have there been gaps in their professional results. Needless to say, discrepancies or history? Have there been failed funds or omissions should be a major red flag for an other ventures? investor. Be wary of unexplained gaps in resumes in • Are key investment professionals’ incentives general. In addition, be wary when failed aligned with the overall fund? What are their predecessor funds are involved. Discover personal capital commitments? Of the entire specifically what happened and understand staff, what percentage of their net worth what the manager may have taken from the resides in the management company and in experience. Although failure can be instruc- the funds? Will the portfolio manager com- tive, multiple failures or a string of brief pro- municate a reduction in the level of personal fessional stints can be a red flag. investment held in the fund? • Has the business been floated publicly or are Alternatively, for more long-standing fund any plans for such a float underway? managers with very substantial sums invest- ed in the fund, does the current fee structure

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III. Team and Organization (cont.)

The history of an investment management turnover, and possibly elevate key man risk. firm’s results following public floatation or acquisition is both short and, to date, not • Is the depth of the organization sufficient for promising. the ? What are the growth plans for the fund and the organiza- C. Staff tion as a whole? Look for general “ • How many staff members are there? What It is better to grow assets into infrastructure partners with strong is the ratio of back office to investment pro- than vice versa. fessionals? Review (or sketch out) an orga- infrastructure and nizational chart. • Are there any branch offices? What activi- ties are done there and by whom? operations. This a business There are no hard-and-fast rules in regards to the proper level or ratio of staffing. While branch offices for a large research rather than a fund. Rather ask yourself if it seems adequate for team may be beneficial, long distance “port- ” the strategy being pursued and any growth folio management” has shown a less com- being contemplated. pelling track record of success. Portfolio management by principals in disparate Dan Zwirn, • How many investment professionals are on branch offices often suffers from poor com- June 15, 2006 staff? Review their biographies. How long munication and isolated decision-making have they been employed by the firm and in and can even create conditions for rogue the industry? Has there been a pattern of trading. organizational turnover? • Regardless of the size of an organization, who A significant number of new staff can is responsible for the following function? require time to work effectively together and such a phenomenon can influence the effec- – C.I.O. (Chief Investment Officer) tiveness of an investment organization. – C.O.O. (Chief Operating Officer) – C.F.O. (Chief Financial Officer) Beware of heavy turnover at either senior or – Research junior staff levels. Portfolio managers who – Trading/Risk Management seem unable to preside over a stable organi- – IT/Systems/Programming zation should be evaluated with greater – Operations/Back Office/Audit scrutiny. The ability and commitment to – Compliance/Legal keep talented professionals and employees – Marketing/Investor Relations – are these who have been encouraged to develop their separated? skills should be evident for any firm that plans to grow. An inability to do so may in • Are there backup provisions in place for key fact be a sign of a congenitally poor business functions/people in case of the unexpected and/or personnel manager. It also may departure of a key employee? reflect an unhealthy ego on the part of the principal. Broadly constructed, these cir- To the degree possible, separation among cumstances can breed employee disloyalty, key professional functions (i.e., COO, CIO,

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III. Team and Organization (cont.)

CFO, Marketing, and Compliance) is better. Try to understand where the range of profes- Greater separation of duties can enhance the sional responsibilities naturally lies in what- long-term vitality of a hedge fund. It can ever size organization you are attempting to also help reassure investors that multiple sets assess. Specifically, try to understand how of unrelated eyes are watching over the busi- smaller organizations concentrate the num- ness and the portfolio. In the case of trading ber of professional responsibilities managed versus broker/position reconciliation, separa- by key individuals. This can represent a tion of duties is vital. However, be realistic potential “hidden level” of investment risk. given the asset size of the hedge fund. Greater specialization of duties is more realistic for a Under-qualified employees in key roles billion dollar plus fund. And some strategies and/or nepotism in the hiring of personnel are more operationally expensive, such as for key organizational roles should be viewed Fixed Income Arbitrage, Structured Credit, with caution. Leveraged Loans and Direct Lending.

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IV. Management Company, Fund Structure, and Asset Base

Luxembourg and Cayman. For onshore Some common themes run across all hedge entities, Delaware is the usual domicile. fund due diligence analysis. This is especially true in examining the legal and operational • What is the history of the hedge fund man- framework of the investment management agement company and what is the compa- company, the structure of the underlying hedge ny’s development plan? fund, and the impact of asset growth on a spe- cific strategy. Aggressive asset gathering in one or many funds may reveal business priorities that are The section below draws the reader’s attention not aligned with the interests of most to some of the issues common to all hedge investors. Is the management company more funds. Further, it attempts to highlight issues focused on gathering assets than on generat- particular to Fixed Income and Credit strate- ing performance? Again, explore the details gies. For example, many investment manage- of the principal’s and the institution’s level of ment companies in this space manage multiple co-investment and business ownership. Are investment products. Some offer long only the incentives greater for earning manage- products. Some, in the distressed investment ment fees rather than for generating incentive area for instance, sit on bankruptcy commit- fees? tees. Investors need to understand the full investment implications of the choices that • Are they registered as an Investment investment management companies make. For Advisor, Commodity Trading Advisor (CTA) example, how trades are allocated across prod- or Bank Holding Company? Are they regu- ucts, whether there are restrictions on specific lated under the U.S. Securities and Exchange types of trades as a result of other investment Commission (SEC), National Association of activity, or whether trading in any individual Securities Dealers (NASD), the National instrument is restricted because of other activi- Futures Association (NFA), the Financial ties of the investment management company Services Authority (FSA), Bank of England are critical points to understand. Further, impli- or the Federal Reserve Bank? cations of hedge fund asset growth on the com- plex and often less liquid instruments in this Do you understand fully the kind of infor- space also need to be fully understood. mation implied by the various mix of regis- trations that may apply to a portfolio man- A. Management Company ager or investment advisor? Use an in-depth review of these information sources to deep- • What is the legal entity? What are the en your understanding of the investment details of its state or country of formation? professionals and the organization as a Where is it domiciled? whole. Anticipate your plan for consistently reviewing these affiliations and registrations Is the country of domicile a well known or for your eventual monitoring regimen as you an unknown jurisdiction? Is it a well- consider a prospective investment. respected jurisdiction? For example, rep- utable jurisdictions have been known to be • What is the ownership structure? Dublin and Bermuda, followed by

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d IV. Management Company, Fund Structure, and Asset Base (cont.)

Simple is better. Ask who are the ultimate hedge fund provide seed capital? Is that seed Undue adminis- owners? Is it certain employee(s), an institu- money from the hedge fund manager’s per- “ tion(s) or public shareholders? Bear in mind sonal capital or is it provided by his/her trative and business that a cultural difference may be reflected in investors? the ownership structure. For example, U.K.- complication is always the based funds will often be owned by institu- Seed capital from a larger hedge fund can tions, whereas U.S. funds tend to be employ- mitigate start-up risk when it acts as a men- enemy. Less complicated ee-owned. tor to the new fund. This stands in contrast to broker-sponsored funds whose mentoring business and decision-mak- Watch out for funds where principals have ability is limited. recently sold a significant equity stake and ing structures generally evaluate them closely to avoid an investment Are there any special arrangements with the with a manager suffering from the “wealth sponsor that can create a burden on the new allow for better effect.” manager? Is there a “sunset” provision for this relationship? In other words, is the eco- professional focus and • Does the manager own a significant percent nomic relationship designed to diminish over of the fund or management company? What time? Does the portfolio manager retain the tighter alignment of percentage of his net worth is invested in the right to buy back the sponsor’s interest? fund or the management company? Does the manager have an upfront policy for high- • If the hedge fund has a sponsor relationship, incentives between the lighting any material changes in his personal seek to understand the agreement. Does the investment in the fund? sponsor have capacity or other special manager and the arrangements? • Are there any joint ventures or partnerships investors’ interests. through which business is conducted that Does a sponsor dominate a new fund’s ” may cause a conflict? capacity?

• In what other partnerships and businesses do • Does the sponsor share its infrastructure the principals operate or maintain a signifi- with the hedge fund? If so, can the sponsor cant interest? see the trades?

Does the Management Company own a bro- Can the sponsor “piggyback” on these trades? ker dealer? Is it disclosed? Are trades recap- Do they share ideas which can negatively tured by the hedge fund? Does that present impact capacity and/or trading nimbleness? any conflicts or does it add value? Why or why not? Has the management company recently reor- ganized itself out of a mutual fund structure? Do the principals sit on any boards or have Why? If yes, how is its investment strategy time consuming obligations such as private different? equity investments? • Who is on the Board of Directors? What • Are there any direct relationships with other authority does the Board have, if any? If the hedge funds? For example, does another fund has an advisory board, what

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IV. Management Company, Fund Structure, and Asset Base (cont.)

specifically has been the value-added and • What are the total assets under management how is it expected to add value in the future? of each fund and of the management com- pany? What is the historical growth in Do not overestimate the influence of a Board assets under management for each vehicle of Directors or an Advisory Board. and in the aggregate? Currently they are hired by the Hedge Fund Manager and have little independence. • Are the assets under management appropri- Many boards are rather transparently estab- ate for the strategy? What is the anticipated lished for marketing and public relations growth in assets and does this appear to be during an initial capital-raising phase. measured/disciplined? Are the strategy and investment process scalable as assets under B. Fund Structure and Asset Base management grow?

• What funds do the management company Is the manager realistic in determining the offer? How are they structured? For exam- capacity? Is the manager creating a false ple, is it a master-feeder structure? sense of urgency? Is the manager manufac- turing hype to raise money by setting a soft Does the offshore fund run pari-passu? If close? not, why? Compare the performance of the two funds over time to see if this is really the Will growing the assets beyond a certain case. point result in “style drift?”

Understand the allocation process between This may be a good time for you to under- funds if they are not organized as a master- stand the composition (and stability) of the feeder structure. manager’s investor base. It may also be an opportune time to discuss your potential This is especially true for private placements future capacity needs to determine if the and Direct Lending. Onshore and offshore manager will be able to meet them. funds’ regulatory regimes may prevent them from participating in certain classes of trades. • Have there been periods of substantial Understand which types you are getting. redemptions? If so, is there a reasonable explanation? Were redemptions met with- • Is there more than one strategy? If so, is out delay, a ‘gate,’ or interruptions? Was there synergy in the application of the vari- performance negatively affected by the ous strategies? redemptions?

Ideally, you should want the key profession- • What has been the rate of asset inflows? als’ investment and business success to be focused on the fund in which you are invest- Does the fund have a disciplined policy for ed. You want them to have a substantial per- taking money in? Have the principals estab- sonal investment in the same fund in which lished any limits on inflows? Does the port- your capital is invested. folio manager have control over inflows?

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d IV. Management Company, Fund Structure, and Asset Base (cont.)

• Are there separately managed accounts? Are Is it diversified or is there concentration these accounts subject to special arrange- among a few outsized investors? Is it con- ments like structured notes? What percent- centrated in one category of investor? For age of assets is managed separately from the example, how big is each one of the three fund? How are the separate accounts struc- largest investors? tured? Are the liquidity terms of the fund dif- ferent from the separate accounts? Try to understand the relative stability and sophistication of the marginal fund investor. Undue administrative and business complica- Also, pay attention to the mix of offshore tion is always the enemy. Less complicated and onshore investors and the manager’s (or business and decision-making structures gen- organization’s) level of direct familiarity with erally allow for better professional focus and those investors. tighter alignment of incentives between the manager and the investors’ interests. • Is there a “Most Favored Nations” clause? If so, get an explanation of any different terms • What is the composition of the investor base? offered to other investors such as better liq- uidity, fees, transparency, etc.

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OPERATIONS AND VERIFICATION

V. Operations and Technology

human resources, and investment. Ultimately, Operational robustness is often a good indi- the key issue is the degree of trust and comfort cator of a manager’s overall strength and stabil- you have in your relationship with the portfolio ity, and a necessary precondition to any invest- manager and whether you believe you have the ment. A stable operating platform enables latitude to stay on top of the risks that matter. portfolio managers to focus on alpha genera- The best insurance policy for this is an n alarmingly A tion, while an unstable platform could impede investor’s conviction about the integrity of the “ or eliminate their best efforts. person with whom they are investing and the high proportion of hedge depth of the organization. When it comes to Fixed Income and Credit fund failures can be instruments, operational due diligence is partic- A. Trade Capture and Settlement ularly important owing to the preponderance of attributed to complex OTC instruments in these two sectors. • How are the distinct responsibilities for the Many of these instruments are naturally opaque fund’s front and back office arranged and, operational issues. as only the two counterparties of the contract ideally, separated? ” know them, and they are full of many unique attributes. Accordingly, a rigorous process of Lack of separation of front and back offices Understanding and contract comparison, review and execution is has historically been an ingredient in many Mitigating Operational critical. of the operational and investment blow-ups Risk in Hedge Fund across all types of financial institutions. The challenge for investors new to this sector is Investments: A Capco Hedge funds are not exempt from this fact. to know where potential problems could arise. White Paper. Besides contract confirmation processes, anoth- March, 2003 • Are the operational, back-office, and admin- er good place to explore for operational risk is istrative professionals seasoned? What chal- the link between hedge fund managers, their lenges have these professionals encountered prime brokers, pricing services, third party risk since the fund’s inception (or at a prior systems and the various clearing agencies, such firm)? In general, how do they appear to as DTCC. Even if managers have a solid con- have adapted to these challenges? With what firmation process, that doesn’t assure that they frequency have issues or problems been sur- have timely and accurate reporting of their facing? Are there any current “operational positions, their valuation and their risk metrics issues” the firm is dealing with? To what from their service providers. degree do you sense that problems are being anticipated? An earlier section of this report emphasizes the importance of understanding the operational Fixed Income and Credit strategies are the sources of hedge fund “investment” risk. This most operationally intensive trading section’s goal is to ensure that the business approaches employed by hedge funds. This operations fully support all investment activi- is due to the large array of instruments (cash ties, as well as an unforeseen market or shock and derivatives), the complexity of the event. A hedge fund is, in the end, a small asset instruments themselves, the need for exten- management firm and all areas need to be sive documentation in many trades (e.g., addressed: accounting, IT, operations/disaster credit default swaps), the variegated settle- recovery, cash management, legal/compliance, ment practices and venues used, and the usu-

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V. Operations and Technology (cont.)

ally private or OTC nature of the transac- At one end of the spectrum, U.S. Treasury tion. Not having both an operational and IT securities as well as the related futures are infrastructure and an operations team capa- traded electronically and settle quickly and in ble of handling these complexities could easi- straight-forward fashion (either via Fedwire ly spell disaster for managers in these spaces. for Treasuries or the relevant exchange’s clearing house for futures). At the other end • Follow the trade. After an investment deci- of the spectrum, bank debt involves an sion is made, how is the idea executed? By entirely manual settlement taking as long as whom and how is the trade executed? How six months while lawyers review the sales- are the trades captured? Is there an order and-purchase agreement (whose form is gov- management system (OMS), a portfolio man- erned by the Loan Sales & Trading agement system (PMS) and a back office sys- Association (LSTA) in the U.S. or the Loan tem? How are they all related and recon- Management Association (LMA) in Europe). ciled? Who reads the indentures and inputs Generally-speaking, the more liquid instru- the terms and conditions? What is the settle- ments are more easily settled while less liquid ment process and what is the role of the var- instruments and markets (especially bespoke ious parties (the fund, its administrator, its derivatives) require manual confirmation and prime broker and its custodian)? What is the settlement. For any non-current pay (dis- frequency of broken trades and the reasons tressed) securities this is especially true. In a for them? cautionary example, in 2005 the Federal Reserve chastised credit derivative dealers for An allocator must understand and be com- having a massive backlog of unsettled trades. fortable with the trading and settlement process, along with the cash controls and Equity-, foreign exchange- and futures-based cash management processes, of any Fixed strategies are much simpler operationally Income or Credit manager they intend to than fixed income and credit-based ones. invest in. Familiarize yourself with the settlement process for the securities being traded. Capturing and confirming the terms and con- “Broken trades” – those that fail to settle ditions of the securities is a vital and difficult properly – cost money, often lots of it in the part of the operations job. Allocators should case of debt securities. understand how and by whom this is done, whether they are independent of the front • What is the process for OTC contract com- office, whether they have the necessary parison? Are all contracts compared by expertise to do so, how quickly this is done T+1? Is the manager working on any T+0 and how much of a backlog exists. These initiatives? What is the manager’s contract have to be right to both properly value a backlog? Is the comparison process inde- position and to allow back-office staff to pendent of trading? Does the manager use process any payments due or owed on the straight-through processing? trade. • How does the manager assure that all varia- Settlement procedures vary considerably tion margin is collected by the funds or their across the instruments and markets traded. prime brokers every day so that he is not

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V. Operations and Technology (cont.)

over-collateralized with any counterparties? example of managers getting creative in Does the manager have global netting agree- both diversifying funding sources and lower- ments with any counterparties? Do any of ing borrowing costs. his counterparties use a VaR-based margin system? If so, can the funds revert to • Is all of the fund’s cash unencumbered, or is straight variation margin following a volatil- some of it invested in short term instru- ity spike? ments?

• How does money flow into and out of the • How often has the fund experienced opera- fund? Where is it kept? Who signs checks tional or back-office errors? Who pays for for the company and for the fund in which those errors? Is the manager content with you are investing? Is there a co-signer? Is one the service provided by the prime broker(s) of these individuals a third party? Do you and other key back-office service providers? fully understand the path that the money takes? What is the role of independent third How fluent (and comfortable) does the man- parties? ager seem in discussing the character of the fund’s back-office processes and operational What is the fund’s cash management policy? discipline(s)? Does the manager seem dis- tracted or preoccupied with trade reconcilia- There are two risks expressed here: that of tion or broken trades? misappropriation of funds from the portfo- lio and that of proper cash management. In Because of the importance of funding in the case of the former, understanding the Fixed Income and Credit strategies, make controls in place or lack thereof should be sure you have a sufficient understanding of high on an allocator’s to do list. Two or some of the following risks: more signatures should be required for large transfers out of the fund with one of them – Counterparty Risk preferably from a senior back-office person. Ratings of Counterparties Degree of equity concentrations by coun- In the case of the latter, fixed income and terparty credit instruments are by their nature cash – Financing Liquidity Risks flow-focused and so income will form an Tenor of financing terms (maturity or term important part of returns. Cash manage- of financing or period during which hair- ment will be much more active for managers cut cannot be reset) in these strategies and may actually be a Sensitivity of income to change in financ- source of returns as well. Given the sub- ing rates stantial leverage levels applied to small mis- pricings that is characteristic of managers in • Has the manager ever done a SAS 70 fixed income (and some credit strategies), review? Has he considered using one of the access to the cheapest funding at the longest operations rating services? Has the firm tenor is often necessary for success in this ever had an external operations audit or space. Citadel’s recent debt issue is an consultant review their processes?

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V. Operations and Technology (cont.)

B. Pricing pricing sources (e.g., Markit Group, Lone X, IDC) have arisen and the NASD rolled out • What is the fund’s portfolio pricing policy? Is TRACE in 2002 for corporate bond transac- it marked to the mid or the unwind side of tions in the U.S., making the task of obtain- the trade? Is there a liquidity adjustment for ing independent marks on credit derivatives less liquid or large positions (relative to mar- and corporate debt possible. Despite this, ket size or trading volume)? Who prices the understand that, for some portion of a man- portfolio? How often is the portfolio priced? ager’s book, pricing is largely based on Is the fund self-administered? What data assumptions and models and may (or may sources are used for pricing purposes? Are not) reflect the true economic value of the there differences in the way daily or weekly positions. estimates are calculated versus the official monthly NAV? Has the manager ever restat- Ask the manager how much of the book can ed an NAV? If so, find out why. be priced by independent sources as opposed to dealer marks, marks-to-model or private It is crucial for allocators to understand how equity techniques. a fixed income or credit manager prices the fund. • Has the hedge fund manager ever delayed his/her estimates of the fund’s net asset First and foremost, pricing should be done value? Why? Is the delay out of the manag- independent of the front office. It should be er’s control? a red flag if it is not. • How frequently are performance estimates Second, most instruments traded are OTC available to investors? Are mid-month or and many are illiquid, so determining an weekly estimates available? appropriate value for them is neither simple nor uncontroversial. Government securities, • Would the manager allow the prime broker interest rate swaps and futures, and some of to provide a monthly or quarterly portfolio the larger corporate issues all trade regularly for the investor’s review? and can be independently marked-to-market. Less liquid securities and derivatives general- This procedure can significantly reduce the ly require dealer marks or model-generated potential for manager fraud, as well as give pricing to be valued. For many derivatives, the investor insight as to how the manager the only price (and liquidity) source is the invests. originating dealer. Private securities (such as direct loans) are often treated like private • What information is available to investors on equity: values are maintained at cost unless a monthly, quarterly, and annual basis? The there is an impairment or position sale. following list represents ongoing information Distressed securities are usually treated in a which should be considered fundamental for similar fashion. educated investors: – Size of fund and growth of assets under In the past few years, a number of third-party management?

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V. Operations and Technology (cont.)

– Net and gross performance by share class? C. Business Continuity – Top 10 holdings? Position weightings? Industry concentrations? Many funds will • What are the backup procedures for the not reveal current short positions, but hedge fund’s operations? Is offsite trading should agree to characterize the positions. readily available? Are there frequent back- – Participation by sector, market cap, geo- ups of trade, client accounts, and research graphic region or asset class? data? – Net and gross exposure information? – Duration and Credit exposure informa- Is there a disaster recovery plan? What pre- tion? cautions has the portfolio manager taken in – Information regarding any changes in the light of a possible catastrophic failure firm, fund strategy and personnel? prompted by a computer, systems, software, telecommunications, fire, or terrorist attack? • How does the manager communicate to investors? How often? Are intra-month esti- • Is the manager’s data backed-up offsite on a mates of performance provided? real-time basis? Is his Business Continuity Plan tested? Can all key individuals access Does the manager’s letter to investors reveal the firm’s systems via a secure connection what is really going on in the portfolio? Is from outside the office? there a commitment to maintaining a dia- logue of substance and quality? • Are all trading lines recorded? Emails? IMs? • Are manager meetings with investors dis- couraged? If so, why? • Are there provisions for the loss of the port- folio manager or other key investment pro- • Are those responsible for investor relations fessionals? sufficiently experienced and informed enough to provide a useful and in-depth dia- logue?

• Is there appropriate disclosure of the charac- ter of the fund’s overall balance sheet and/or the degree to which certain asset/liability “gaps” may be present? Is the notional value of derivatives disclosed?

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VI. Third Parties

• Has the auditor ever been changed? Why? Intelligence collec- Third party service providers support the Carefully scrutinize turnover in key vendor “ operations of hedge funds in a variety of ways. relationships but especially with the prime tion consists of three basic Administrators, custodians, prime brokers, broker and the auditor. If fraud is occurring, auditors, and law firms each may have an these vendors will likely know before you do, elements: finding people important role to play in a successful hedge fund and many firms have shown a willingness to investment. Independent pricing sources, the shun business they think will eventually who have insights that are degree of dependence on a single prime broker, bring them trouble. and the degree of segregation of the fund’s cash important to your making assets are all substantive issues faced by hedge • Where did the audits take place? How was funds. There are a variety of ways that individ- information collected? How often are the an informed decision, ual hedge funds address their needs in this area. books audited? Investors should understand these and become getting them to speak to comfortable with the approach of any individ- • Is there also an outside accountant? ual hedge fund. But, as importantly, the choices you candidly, and using made by any individual hedge fund may be an • Have there ever been any valuation issues indication of the degree of importance they that have arisen during an audit? Any other the resulting information attach to this issue themselves. Investors will be issues? interested in this as well. Ever since the episode of fraud at Manhattan to draw accurate The following section focuses on the principal Capital where the auditor failed to identify third party relationships found in most hedge the fraud, auditors are reluctant to release conclusions. funds. A few of these (e.g., administrators) may any details to investors. They usually refer ” be more common in offshore hedge funds. But, the investor to the annual audited financial all have an important role in assuring the statements. This is why it is essential that an integrity of the underlying assets in the fund. investor read through the audited financial Jim Roth, statements as far back as they are available. March 9, 2006 A. Auditor • Ask for the financial statements to come • Contact the Auditor. Cultivate a relationship directly from the auditor. Review them in and speak with the account leader. detail, paying particular attention to the Auditors Notes to the Financial Statement Auditors – like almost all service providers – and the Auditors Report or Statement. Go are becoming reluctant to even acknowledge back to the auditor directly to clarify any- they service a fund because this may establish thing in these sections or for the statements that they owe a direct duty of care to the in general. What is the auditor’s reputation? investor. Thus, investors may be forced to get audit information from public filings, if Compare year-end assets, subscriptions and available, or from the manager. redemptions (cash flows) and NAV to your notes with the manager. • When was the last audit? Was the audit opin- ion “clean” or was there a “qualification?” If Review expenses. Do they seem in line with there was a qualification, what was the reason? those of the fund’s peers and, in percentage

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VI. Third Parties (cont.)

terms, have the expenses changed materially B. Prime Broker/Futures from year to year? Clearing Merchant (FCM)

Often “hidden” expenses are disclosed in • Contact the prime broker/FCM. Cultivate a the footnotes. relationship with the prime broker/FCM and speak with the account representative. et’s not forget, in L Look for any additional information in an “ audit such as a condensed schedule of invest- Does the fund use multiple prime the end, the funding ments. This schedule will force the manager brokers/FCMs? Who are they? to provide a reasonably detailed breakdown counterparty says: ‘I’m the of the portfolio. Has the fund manager ever changed prime broker/FCMs? Why? house. I make the rules. Are there any other share classes disclosed with better terms or superior performance Understand that the prime broker, as a The game is over when I that might imply a lower fee class not lender, stands ahead of the investor in the shown? fund’s capital structure in the event of a liq- say it is.’ uidation. Understand that the prime broker ” Major changes to the Management can and will liquidate the fund to take its Company or fund are often disclosed in the capital first, leaving what is left for the footnotes, including changes to the adminis- investor. However, they also have an incen- Gregory Jacobs, trator, prime broker, directors, and to tive to shun relationships that might create May 17, 2007 changes of ownership. liability and many firms have demonstrated a record of doing so. The recent $160 mil- Is there any litigation noted? Have any pro- lion ruling against Bear Stearns in the case of visions for possible liability been made? Manhattan Investors Fund will likely increase prime brokers’ scrutiny and over- • Does the auditor provide any other services sight of their hedge fund clients. to the fund or the management company? • Who are the counterparties? Who is the cus- The past five years have seen auditors todian? exposed as having, at times, been less than thorough when auditing tax and other con- For many strategies, it is very important that sulting clients. The margin on auditing busi- there be a prudently diversified group of ness is much lower than on these other serv- counterparties to the fund. This helps to ices. That being said, most of the large insulate the fund’s operations from market accounting firms have recently moved to dislocations that could affect a counterpar- sever their links with their consulting ty’s ability to meet its contractual responsi- brethren and return to their roots as unbi- bilities. ased auditors. • What are the credit ratings of any counter- parties to the fund?

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VI. Third Parties (cont.)

Ideally, the disposition of the fund’s assets • Do they have a full service agreement or just should reflect proportionally the different a record keeping agreement? ratings of its counterparties. • How often is NAV calculated? When can • Has the fund been assessed fees by their investors expect to receive estimates and final prime brokers for operational errors? NAVs?

Operational errors in fixed income and cred- • By what means and how often does the it will be particularly expensive given administrator receive the trades? Do they get accrued income and financing penalties trades from the manager or from a direct assessed. Consider this a good check of the feed provided by the prime broker? soundness of the back office. Position and trading information must come • Obtain permission from the portfolio man- from an independent source, and not the ager so that you are able to contact the prime manager. broker directly to confirm the fund’s assets under management before formally investing • How do they receive pricing? Do they in the fund. receive it directly from a market data vendor, from the prime broker(s), from a third party As mentioned before, any discrepancies pricing agency, or from the manager? should be reconciled as this is one of the cru- cial checks an allocator makes. That said, The administrator should price a portfolio there may be good reasons for the differ- independently from the manager. ences: multiple prime brokers, separate accounts and capital market-based financing. Understand the administrator’s capabilities However, these should all be able to be ascer- for pricing complex securities. For complex tained. models that might be required, from what source does the administrator get his input C. Administrator for the models?

• Contact the administrator. Establish a rela- Some illiquid or privately traded securities tionship and speak with the account leader. may be difficult to price. In those situations, the administrator should have written poli- Is it a respected, well-known administrator? cies on valuation.

In many of the cases of investment fraud, a If the manager prices some of the portfolio, little known or fabricated administrator was what percent of the portfolio does he price? used. Since you, the shareholder or limited Be very diligent in understanding a manager’s partner, would be paying for this service, you influence on the portfolio valuation. should question why an unknown name is being used since generally minimal cost is • In the case of less liquid securities, do they involved. determine prices with quotes from more than one source?

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VI. Third Parties (cont.)

It should be noted that even esoteric securi- • Does the agent add value or communicate ties are beginning to have independent pric- with the investor after the initial introduc- ing services available for them (e.g., Markit tion? Is there a sunset provision for their Group for credit default swaps) so this prob- involvement? lem is less pronounced that it used to be. For private securities and control positions, • What is the reputation of the marketing it is still an issue though and a thorough agent? understanding of how they are priced is essential. Good agents are concerned with fund due diligence, determining investor suitability • Has there been any restatement of month- and managing appropriate expectations. end NAV? When? How often has this Some agents are more focused on rapid asset occurred? gathering rather than creating a stable base of long-term investors. Agents can often • Through the administrator, develop an have a crude incentive to encourage a man- understanding of the pattern of recent ager to raise more capital and raise it more redemptions and subscriptions. Compare abruptly than might be prudent. this information to what has been discussed with the hedge fund manager. Does the agent clear trades for the fund? This may create a conflict of interest. • Ask the administrator for NAVs since incep- tion. Compare this to performance numbers Remember that introductions by reputable given by the hedge fund manager. brokers do not constitute an endorsement. Moreover, prospective investors must under- D. Marketing Relationships stand that prime broker-sponsored market- ing introductions do not include due dili- • Is there an external or outsourced marketing gence. relationship? • Is the Agent registered with the National What kind of an agreement exists between Association of Securities Dealers (NASD) in the fund and the marketing agent? Is it an the U.S., the Financial Services Authority exclusive agreement? Are there multiple (FSA) in London, or any of the relevant marketing agents? authorities in other jurisdictions?

• From where do the fees payable to the mar- E. Other keter come? • Try to understand the marginal benefit of Investors who come into a fund through a additional third party providers versus the marketer or placement agent should not be added complication of additional vendor disadvantaged in any way, and shouldn’t pay relationships. Also, attempt to understand higher fees or expenses. what services may be better handled in- house.

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VI. Third Parties (cont.)

• What other functions are outsourced by the management company?

– Trading – Front/Back Office – Accounting – Research Consultants – Risk Management – Operational Consultants – Compliance – Political Consultants

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VII. Documents

context of manager interviews regarding A full review of all documents associated expenses, transparency and legitimate admin- with a hedge fund investment is a necessary step istrative expenses. in the due diligence process. There are a variety of documents to consider. In many cases, the Pay particularly close attention to a change in review should cover the consistency of key auditor because here such changes may very t is essential that an I terms across these documents, if only to verify well entail a vendor seeking to avoid liability “ that the investment manager has shown proper associated with fraudulent practices. investor read through the care in their preparation. For instance, investors in an offshore fund normally review the fund’s • Marketing Materials audited financial statements Offering Memorandum. However, the fund’s Memorandum and Articles of Association may Qualitative review of the marketing material as far back as they are ultimately be a more important document. and the manager’s own correspondence Surprisingly, there may be inconsistencies in should help delineate particular nuances of the available. these documents. While the investment manag- strategy that is being executed as much as the ” er may quickly fix these, the issue may offer philosophy that animates the approach. insight into the overall quality of the hedge fund’s management. – Marketing Materials

The following section highlights some of the – Monthly/Quarterly/Annual Reports to documents investors need to review before investors (2-3 years’ worth) making an investment. Assuring consistency, completeness, and accuracy of these documents • Due Diligence Questionnaire are all necessary conditions prior to a hedge fund investment. RFP’s might be seen as akin to Wall Street research. A due diligence questionnaire can be • Offering Memorandum and Subscription a nice way to fill in any gaps in the story but Agreement. it is not a substitute for doing your own home- work on the fund, strategy, principals, and the Take note of the quality of the prospectus. organization as a whole. Does it include the appropriate biographies of the management team? Is it written in clear, • Investment and key personnel biographies, understandable language? Is there a clear and an organization chart of the hedge fund’s statement of the fund strategy and investment management company and for the hedge process? Are the risks disclosed? Are the risks fund's investment team. clearly explained? Review the biographies of each of the key • Audited Financial Statements investment and back office professionals to understand the strengths and weaknesses of It is essential that an investor read through the the organization. Try to conceptually link the audited financial statements as far back as precise skill sets the key professionals possess they are available. Audited financial state- and the ideal requirements for an organization ments should be closely investigated in the trying to execute that strategy.

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VII. Documents (cont.)

• List of references that should be contacted by • Several historical portfolios – dates chosen by the evaluator: you (the evaluator) rather than the hedge fund.

To the degree possible, the evaluator should Try to understand if past portfolio holdings seek to complement formally offered refer- mesh with your understanding of the invest- ences with supplemental industry references ment strategy and risk management disciplines generated through your own network of you have read about in the prospectus and investment industry contacts. have come to understand in the interview process. Careful interviewing of current and, especially, past vendors and third-party service providers As outlined earlier in the document, historical should also help. risk reports for these same dates may aid in understanding the risks in the portfolio as a Do a background check on the manager, key whole, as well as how the manager looks at employees, and the firm. This can be out- risk and what he feels is important. sourced to an investigative firm. • agreements and other financ- The added expense of a full background check ing agreements. can help add a level of fiduciary comfort but is unlikely to convey much color on key intangi- Independent confirmation of the fund/firm’s ble areas such as motivation, work habits, and assets via the prime broker(s) is often consid- managerial or operational expertise. ered an important final step before a formal investment is made.

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VALUE PROPOSITION

VIII. Fee Structure and Terms

term performance? Fees and terms go to the heart of the investor- manager relationship as they represent payment How does the portfolio manager make use made for investment services rendered. While of his management and performance fees? Is Fixed Income and Credit hedge funds usually the management fee invested in the business? demand no overly unique fees or terms from investors, the specific details of each hedge fund Who participates in the ‘carry’ (performance offering are necessary to understand to the fees), and to what degree are less senior pro- fullest extent. In fact, it may be argued that fessionals given incentives to contribute to investors need to take some special care when the investment success of the fund? Is this investing in this style. For example, they need to expected to change over time? assure themselves that the redemption terms of an individual fund are appropriately matched • Is there a high-water mark or hurdle rate for to the underlying market liquidity. the performance fees? How are they calcu- lated? Is the high-water mark reset? The material below draws attention to variabil- ity in hedge fund terms. It highlights the impor- Ask what percentage of assets is ‘underwa- tance of understanding all aspects of liquidity ter’ and for what period of time they have and fee terms. And, it looks to heighten an been so. If the fund has experienced a draw- investor’s ability to seek clarification of the down, how much performance does the basis for non-standard fund terms. Further, it fund have to accrue to earn performance focuses on potential issues an investor faces in fees? If this is an unreasonable amount, individual fund structures, such as the possible beware of the built-in temptation for a man- cross-collateralization implications of multiple ager to ‘swing for the fences’ and risk even share classes. As investors know, investing in more substantial capital losses. hedge funds involves much more than simply understanding management and incentive fees, • What expenses are charged to the fund, in and redemption terms. This section is designed addition to management and performance to help guide investors to seek out more fees? nuanced fund information. Standard fees usually include items such as A. Fee Structure administration, audit, and other profession- al expenses. However, a manager sometimes • What are the management and incentive fees will expense the entire firm’s overhead to the for the fund that is being evaluated? How fund including travel and entertainment, are these fees calculated and accrued? rent, and salaries and bonuses. If this is the case, understand what the percentage charge Are the fees for this fund appropriate given to the fund has been in prior years. Is it in what other similar funds charge? line with industry standards? Are you will- ing to accept this? How often does the fund pay itself fees? Does the fund use a “rolling clawback” for Needless to say, check the audited financials, its fees or similar device to encourage longer- especially the footnotes, as well as the prospectus!

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VIII. Fee Structure and Terms (cont.)

• Are soft dollars employed? What are they Ask if any investors have side-letters with Generous used for? What are they in relation to all more forgiving liquidity terms. If so, in a liq- “ operational costs? uidity crunch these investors will have an liquidity terms coupled unfair advantage. However, realize that this • Do the management firm and/or principals advantage may be ephemeral as managers with illiquid positions gone receive revenues from sources other than the can redeem (or not) investors as they see fit, management and performance fees charged side letter notwithstanding. The offering wrong has been a primary to fund investors? If so, what are they and memorandum, which trumps all other who receives them? arrangements, usually contains language per- ingredient in many hedge mitting the Investment Manager to suspend As hedge funds, private equity and invest- redemptions should he deem it in the “best fund catastrophes. ment banking activities continue to overlap, interest of all shareholders.” investors should closely examine the issue of ” advisory fees (bankruptcy proceedings or Understand how much of capital base is still restructurings), and loan origination and subject to lock-up and when those lock-ups syndication fees. Other fees include the pro- roll off. Once investors are free of lock-ups, ceeds from lending securities owned by the the fund’s redemption profile deteriorates portfolios. Suffice it to say that, in this as in markedly. all cases, managers are working on behalf of their investors and so the fees should go to • If there is an early redemption fee, is it the fund. payable to the fund or the management com- pany? B. Terms and Conditions The fee should be payable to the fund, not to • What is the liquidity/redemption policy? the management company. Lock-up? Notice period? Is the liquidity provision for investors consistent with the • Have there been any prior liquidity suspen- liquidity of the underlying securities of the sions? Are there pending changes to the fund? Does the Fund have a ‘gate’ or a limit redemption policy? on withdrawals? What are the terms of the gate? • How many share classes are there for each fund? If there is more than one class, what Beware of funds that give unduly accommo- are the various fees and terms for each class? dating liquidity terms to investors when the Are there different fees and terms for onshore underlying assets are themselves not highly and offshore investors? Are the employees of liquid. Generous liquidity terms coupled the fund subject to the same fees and terms as with illiquid positions gone wrong has been a outside investors? primary ingredient in many hedge fund catastrophes. Note that being a large per- Does the class structure allow one class to centage of the float or open interest of even a inherit risk of the other? Do cross-liabilities highly liquid security creates an illiquid posi- exist between the classes or funds? For exam- tion. ple, does the class with lower leverage assume the risk of the higher leverage class?

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VIII. Fee Structure and Terms (cont.)

Try to appreciate the character of the strate- Sometimes a large fund will begin to incubate gy’s liquidity relative to the liquidity of the start-ups to access emerging talent (and to different share classes and how much capital develop a promising sub-strategy that can resides in each share class. Is the bulk of the help diversify firm capital) or have the prox- capital principally invested in one share imity of a talented individual who could not class? What are the implications for the sta- be persuaded to become a regular employee. bility of this fund’s capital base? If there is a If this is the case, what is the fund’s arrange- gate, does it apply to each share class, or to ment with the newly incubated manager the overall Fund? strategy and has the larger fund informed Limited Partners as to how they are compen- • Is the manager incubating new or separate sated? strategies at the expense of current investors?

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IX. Quantitative Review

pro-forma track records to carry much ana- Investors will immediately know that a quanti- lytical value. tative review of any hedge fund is important but also has significant limitations. In fact, similar • What are the return and risk goals for the to other areas of this document, it can reason- fund? Have the performance and risk objec- ably be argued that quantitative analysis of tives been consistently achieved? Fixed Income and Credit strategies has more Suffice to say that potential pitfalls than analysis of other hedge • Is performance consistent with your – the “ allocators should be fund styles. For example, it is often more diffi- prospective investor’s – expectations? cult to benchmark some of the relative value strategies in this style than more directional Compare monthly, quarterly and annual cognizant of the dual, strategies in other styles. Further, the significant track records to those of appropriate peer (and continuing) increase in fixed income and groups and to market indices. How does state-dependent nature of related instruments presents special challenges performance compare with that of similar in evaluating historical track records. Finally, funds and strategies? returns, and not be fooled the short volatility risk of some of these strate- gies may not be fully reflected in a simple quan- • What are the volatility parameters for the by low volatility returns in titative analysis of historical returns. fund? Does the fund's recorded standard deviation fall in line with what the portfolio calm times. The following section looks to make investors manager has suggested in interviews, in mar- ” more aware of the general difficulties in quanti- keting documents or in the prospectus? tative performance reviews. And, it tries to help guide investors to more explicitly consider issues Is the Fund’s volatility outside of its expected necessary to interpret historical performance parameters or the volatility you would rea- given its limitations. sonably expect of others trading similar strategies or assets? A volatile track record • Review monthly performance of the Hedge for a manager trading ‘un-volatile’ assets is a Fund since its inception and confirm the sure indication of a substantially leveraged ownership of the record. Consider prior book (either explicitly through borrowing or track records for key principals if the degree implicitly through concentrated positions or of ownership is material and can be account- investments in leveraged entities). ed for. There is considerable debate surrounding the • Is the track record audited? actual volatility of Fixed Income Arbitrage and other Relative Value approaches. Since Note any caveats offered by the auditors in it involves applying substantial amounts of their letter and beware any unaudited track leverage to small inefficiencies, the strategy records. tends to produce steady, low-to-average level returns in ‘normal’ market conditions. • Is the track record pro-forma? However, since many convergence trades involve buying the less liquid security, during Be wary of pro-forma track records. Most times of market stress this can lead to loss- investors do not consider the evaluation of es as market participants look to buy safest

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IX. Quantitative Review (cont.)

and most liquid securities to hedge them- What kinds of drawdowns are acceptable to selves and dispose of less liquid positions (so the manager? Ask the manager, “what kind of managers’ shorts go up and longs go down). drawdown should prompt a call from me?” Hence the strategy being characterized as “picking up nickels in front of a steam- As an investor, what is the maximum draw- roller,” especially in light of the losses seen down you would expect from this manager? by traders of this style in 1998. Ask the manager to tell you the fund’s A large positive It is open to debate whether or not the strat- largest intra-month drawdowns. This can egy could be outright characterized as ‘short be significantly different than what the “ volatility.’ Certainly volatility tends to monthly data discloses. Again, be cognizant outlier, however pleasant, expand during market crises, when fixed of valuation methodologies as a large book income arbitrageurs tend to be losing of illiquid securities that are infrequently should be reviewed with money. But it may be more appropriate to priced can understate drawdowns. describe the strategy as being short “tail the same care as a similarly risk” or “liquidity risk” rather than outright Finally, review the timing of drawdowns short volatility (which the arbitrageur could compared to the drawdowns suffered by sized negative month. This be long courtesy of option positions). peer funds and relevant indices. This is Suffice to say that allocators should be cog- often a more fruitful exercise than simple is because large returns, of nizant of the dual, state-dependent nature of correlation analysis as it measures a manag- returns, and not be fooled by low volatility er’s ‘edge’ in the terms that matter most: either type, indicate the returns in calm times. Talking to the man- gains and losses. ager about his stress testing results and cor- presence of leverage, roborating that with your understanding of • What are the biggest positive and negative a manager’s overall leverage levels will help months? investment in volatile to overcome this. Do these outlier months make sense in the securities, or both. In a different vein, Distressed Securities and context of your expectations for the fund’s ” Asset-Based Lenders tend to have books performance and its supposed risk manage- replete with illiquid and private securities ment disciplines? A large positive outlier, whose valuation depends on private equity- however pleasant, should be reviewed with like approaches (i.e., keep it at book value the same care as a similarly-sized negative until an event realizes value or an impair- month. This is because large returns, of ment occurs). Allocators should be aware either type, indicate the presence of leverage, that this approach will understate the actual investment in volatile securities, or both. volatility of the return stream. • Understand drawdowns and large upswings • Review all drawdowns from peak to trough. in the context of the market environment in How quickly did the Fund recover? What is which the fund has operated. Is the fund’s the longest monthly return streak both posi- performance too dependent on a lucky call tive and negative? or two? Is good performance the result of a single outsized bet that worked out and is unlikely to be repeatable? Has the basic

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IX. Quantitative Review (cont.)

portfolio posture (and the returns the Examples of this may include a new hedging strategy has generated) simply been the ben- discipline or a marked increase and/or eficiary of a market environment that is per- decrease in gross exposure. fectly suited for it? Quantitative New funds often require time to “ramp up” “ • Consider how assets under management may exposure. analysis can help shed new have changed over the life of the track record. Gather data on the assets by fund, by If some key investment disciplines are being light on the character of a strategy, and for the firm in aggregate. applied differently due to adjustments or “lessons learned,” be certain to segment the strategy but should be Did rapidly increasing assets diminish the performance history accordingly. performance? Fund size has consistently evaluated in the context of been the enemy of performance. • Review the correlation of the hedge fund’s track record to relevant market indexes and, all other research, including Was the track record achieved with a tiny to the degree it’s appropriate, the portfolio amount of assets? If so, was the manager for which inclusion is being considered. qualitatively drawn able to use smaller capitalization instruments Review correlations over different and possi- that the fund may be too large to take advan- bly revealing intervals of time such as periods judgments. tage of now? In general, is the process that of market dislocation. Understand the fund’s generated the present track record repeat- correlations in the context of its strategy, its ” able? chosen exposures and its performance during notably difficult market environments. Are separate accounts included in the track record? If not, are they attempting to dis- Use correlation analysis as a tool to enhance guise the true amount of assets under man- your understanding of the fund strategy but agement in the strategy? Be aware that sep- beware of its obvious limitations. In partic- arate accounts can hide a fund’s true measure ular, correlations can be relatively unstable of capacity and continued growth. and may change dramatically in different market environments. Quantitative analysis • What percent of the track record is attribut- can help shed new light on the character of a able to the current team managing the hedge strategy but should be evaluated in the con- fund? Are the individuals who created the text of all other research, including qualita- track record still there and are they still as tively drawn judgments. Correlation analy- actively involved in the investment process? sis is considered most helpful as a comple- ment to rigorous qualitative assessments. Seek to understand the ownership of a track record. Understand who was responsible in • Gather detailed return attribution data on precise terms. Understand who had authori- longs and shorts, sectors, different instru- ty for investment decision-making. ments, sub-strategy, and/or credit rating. Review your understanding of the fund’s • Have there been any changes to the strategy return drivers and contrast it with your study over the life of the track record that should of the fund’s actual sources of return in prac- cause the record to be reviewed in segments? tice.

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IX. Quantitative Review (cont.)

Does the attribution analysis confirm your Note that for many fixed income strategies understanding of where the fund made and technical credit strategies as well as money? Is there surprisingly strong or weak large multi-strategy shops, the fund’s portfo- performance in certain segments of the port- lio may contain hundreds or even thousands folio? of positions, which may significantly degrade the usefulness of this exercise in What does the attribution analysis suggest helping an investor understand the risk of about the manager’s true level of trade con- the portfolio. .In these cases, risk reports for struction or portfolio management skill? the same days may be required as well.

Is the manager a proven talent as a hedge • Is the fund managed with a degree of tax fund manager or in deploying portfolio sensitivity in mind? What percentage of hedging strategies and how can you tell? returns is realized versus unrealized and how much is ordinary income? • Obtain, if it is permitted, a few historical portfolios using dates chosen by the evalua- Bearing in mind that the offshore investor is tor for review prior to an investment. indifferent to tax consequences, are the onshore and offshore funds being managed These portfolios should be obtained directly in a substantially different way? Are differ- from the prime broker rather than the hedge ences in the application of the onshore and fund manager to ensure data integrity and offshore strategies a source of distraction? independence. This test should demonstrate Compare the performance of the onshore the manager’s consistency in the application of and offshore funds. If there are differences, the strategy over time as well as the portfolio ask the manager why. manager’s adherence to stated risk disciplines.

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X. Intuition, Judgement and Experience

ment will be enhanced. Recognize that nearly all Excellence in due diligence requires thorough of the decisions made about investment opportu- and thoughtful quantitative and qualitative analy- nities are judgment calls. Develop a process that ses. This section focuses on the “softer” side of the provides the discipline to constantly examine Finally, and most due diligence process by exploring the qualitative your assumptions and conclusions. “ tools of Experience, Intuition and Judgment. importantly, would you • Do you feel comfortable with your level of Experience derives from procedural knowledge. understanding of the strategy and risks that invest your own money or One generally gains experience over a period of attend to it? Can you explain it well to oth- time from exposure to different situations. In an ers? Investors and allocators should stick to your family’s money with evaluation of potential investments, it is useful to the rule that they only invest in what they include at least one person at the on-site due dili- understand and where they can properly this manager? gence visit who has extensive experience in the assess the risks. industry, and ideally the specific sector such as ” Credit. In evaluating potential investment oppor- • Can you trust this manager? Does he have any tunities, it is essential to determine the depth and personal or emotional issues? Are there hints of diversity of experience among the key players at issues with integrity, ego, arrogance, pride, the firm. In most cases, experience builds over an affluenza, complacency, carelessness, excessive extended period of time. However, a single event optimism or any personal difficulties? can provide valuable experience as well. Thus, it is useful to question management and investment • Do you feel pressured to make an invest- staff about their experiences, both good and bad. ment? Is this a “hot” manager? Have you been given enough time to properly perform Intuition is really a form of common sense. A good your due diligence? Does the manager appre- practice in the due diligence process is to hold a ciate your fiduciary obligation to do com- brainstorming session after a due diligence meet- plete and proper due diligence? Were you ing. In this way, an investment group can harness expecting to “fill in the blanks” later? the intuitive insights of the team and identify the various opinions regarding the investment oppor- • Do you believe the manager is truly commit- tunity. It is important to recognize intuitive reac- ted to the fund and the interests of the LPs tions, but we must use our experience and knowl- and Shareholders? edge to find out what is causing them. • Fundamentally is the manager staying true to But, we need more than experience and intuition his core investment philosophy and doing to follow best practices in due diligence. We also what he said he always would be doing? need good judgment. Good judgment integrates facts, assumptions, knowledge, and personal • Finally, and most importantly, would you experience into an informed opinion. In follow- invest your own money or your family’s ing best practices and using good judgment, it is money with this manager? If you cannot critical to consider multiple opinions in forming a confidently answer yes, you should not invest judgment. Follow a process that includes channel with this manager personally or on behalf of checking, Internet searches, outside investigative your client. reports, etc. and the ability to develop good judg-

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Glossary

This Glossary is intended to highlight the con- – Duration: The weighted average maturity cepts allocators investing in Fixed Income and of a bond's cash flow(s). Duration is also Credit should be familiar with in order to com- the linear approximation of a bond’s price prehend the space. It is not meant to be com- change for a 100 bp yield change, and so can prehensive, and we offer the following refer- also be used as a risk measure. A higher ences as good places to start in dealing with the duration bond/portfolio is ‘riskier’ than a minutiae and theory in fixed income and credit: lower duration one. Since it is a linear approximation, it will be less accurate for Further Reading larger changes in yields and/or more convex securities. The web is a great source of information, defi- nitions and articles on fixed income and credit. – DV01: The Dollar Value of a Basis Point In particular we found Wikipedia’s treatment of (DVBP) measures the change in price of a the various topics useful (http://en.wikipedia. bond (or portfolio of fixed income securi- org/wiki/Fixed_income). Other useful refer- ties) for a one basis point decline in yields. ences we found were: Of the basic measures of interest rate sensi- tivity, it is the most widely used. PIMCO, “Bond Basics: Everything You Need to Know About Bonds,” PIMCO website – 10-year Equivalent: A measure of the interest rate sensitivity of a debt security in Freddie Mac, “Glossary of Fixed Income terms of 10-year Treasury Notes or swaps. Market Terminology,” Freddie Mac website Mathematically it is the ratio of the DVBP of the bond divided by the DVBP of a 10-year Fixed Income Glossary instrument. This can be used as a hedge ratio for parallel shifts in yields. • Basis Point (bp): A basis point is 1/100th of a percent or 0.01%. It is the basic unit used • Yield Curve: The imaginary line drawn in fixed income and credit to describe yields through all of the yields to maturity of a and spreads. given class/issuer’s debt securities. It expresses the relationship between the yields • Measures of Interest Rate Sensitivity and the maturity date and is also called the term structure of interest rates. – Convexity: A measure of the non-linear relationship between price and yield for a • Benchmark Securities: The basic security debt security. Prices increase at an increas- against which all others are compared. This ing rate as yields fall, and vice versa, for debt is normally a U.S. Treasury security or local securities. A bond’s convexity depends on equivalent (the “risk-free” rate) or a LIBOR its coupon and whether it is callable or not. (London Interbank Offer Rate) loan. For Convexity is a measure of risk with higher Treasuries, there are scheduled auctions as readings being riskier (as it indicates greater part of the U.S. Government’s regular bor- changes in price for a given change in rowing program. Treasury market trading is yields). most active around the newly-issued Bills (4, 13- and 26-weeks), Notes (2-, 3-, 5- and 10-

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Glossary (cont.)

year) and Bonds (30-year), so these are con- swaps). IRS are the most commonly-used sidered the most accurate indications of mar- instrument for trading interest rate risk as ket yields and are deemed the true “bench- well as the most common derivative instru- mark” Treasuries. These newer benchmark ment (the Bank for International Settlements securities are termed “on-the-run” estimates that, of the $370 trillion of out- Treasuries, with the remaining, less liquid standing OTC derivatives globally in June Treasuries (previous “benchmarks”) called 2006, IRS represented $207 trillion) and are “off-the-run.” Due to the high liquidity in a highly liquid market with bid-ask spreads the U.S. Dollar swap market, the swap curve of around a basis point. Of note, margin offers an alternative to Treasuries for maturi- requirements for IRS can be as low as 1% of ties exceeding one year. notional so considerable leverage can be achieved in trading them. When closing a • LIBOR: The London Interbank Offered Rate swap position, traders can either unwind it is the daily reference rate at which banks with the original counterparty or enter an offer to lend unsecured funds to each other in offsetting swap with another one; while the the London wholesale . As result is economically the same in terms of such, it is not a “risk-free” rate as the credit interest rate exposure, the latter case involves risk of the counterparty bank – however low greater counterparty risk and operational – is present. U.S. Dollar LIBOR is widely complexity. used as a reference rate for many financial instruments and transactions, notably the • Interest Rate Derivatives: There are many Chicago Mercantile Exchange's Eurodollar other interest rate derivatives than IRS, with contracts (three-month LIBOR) and most interest rate futures being quite commonly interest rate swaps. used and very liquid. Other derivatives of note are swaptions (an option to enter into • Interest Rate Swap (IRS): An agreement in an IRS and the most common method to which two parties exchange periodic interest trade interest rate volatility) and caps or rate payments in the same currency (conven- floors (the buyer of a cap receives a payment tion is quarterly) on a predetermined notion- at the end of each period that interest rates al principal amount; payments are usually exceed the agreed strike price, whereas the settled on a ‘net’ basis. The most common buyer of a floor receives a payment if interest form is the ‘fixed-for-floating’ whereby one rates are below the strike price). party ‘pays’ a fixed rate of interest while the other ‘receives’ a floating rate of interest; • Repo: A Repurchase Agreement (“repo”) is these are called “vanilla” swaps. Floating- the standard funding/leveraging vehicle in floating interest rate swaps are known as interest rate markets. In a repo (or Sale and basis swaps. The floating rate for all IRS is Repurchase Agreement), the “buyer” loans normally 3- or 6-month LIBOR (or Euribor the “seller” cash for a specific period (either for Euro-denominated swaps). Market con- “overnight” or “term”) in exchange for vention is based on the fixed rate (versus a receiving a security (usually a fixed income flat LIBOR) with payors of fixed quoted in one) from the seller as collateral; at the end of terms of spread-over-Treasuries that the the period, the seller ‘repurchases’ the original receiver gets (hence to pay or receive in collateral in exchange for the cash loaned

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Glossary (cont.)

plus interest (at the “repo rate”). The title of default losses in exchange for a higher the collateral passes to the buyer during the coupon whereas the senior tranches pay repo while, by convention, the buyer passes lower coupons but are over-collateralized. any coupons paid during the repo to the sell- At the time of writing, the MBS market in er. Buyers use repos to finance long posi- the U.S. was larger than the Treasury mar- tions, to obtain cheap financing (since it is ket. “collateralized”) and to cover short positions. – Municipal Debt: A bond issued by a state, • Security Types city, local government or their agencies. Bonds can either be General Obligation – Agency Debt: The debt issued by both fed- (repayment is based on the credit of the eral agencies and government-sponsored issuer) or revenue bonds (repayment is based enterprises (GSEs). Due to explicit or on the income of a specific asset or project). implicit Federal Government guarantees, The income from municipal debt is tax- they possess little credit risk. However, since exempt in specific cases. they are not the direct obligation of the Federal Government they tend to offer a • Yield Curve Arbitrage (Curve Trades) slightly higher yield than comparable Treasuries. The largest borrowers in this – Basis Trades: A trade involving long (or category are the housing GSEs: Fannie Mae short) position in a Note future and a short (FNMA) and Freddie Mac (FHLMC). (or long) position in the corresponding Note deliverable into the future. This trade would – Mortgage-Backed Security (MBS): A secu- be initiated when there is a mispricing rity backed by an underlying pool of mort- between the two. Since the two securities gages. The principal and interest payments (future and Note) are completely fungible, actually made by the pool are “passed- this trade would be a true arbitrage. Since through” to the security holder (usually delivering a range of securities to the futures monthly in the case of U.S. MBS) and since holder can satisfy obligations from Note mortgage-holders can prepay the principal, futures, the short futures trader tends to pro- the actual stream of payments is unknown in vide the Cheapest-to-Deliver security. advance. This prepayment ability function- Occasionally this security can be in short ally renders the bondholder short a call supply leading to being “special” in repo option on interest rates and creates negative (short squeezed) such as occurred in 2006 convexity in MBS. There are a number of with Citadel and PIMCO and the 10-year types and derivatives of MBS. In addition to Note Future. the most common Residential MBS, there are are Commercial MBS and Stripped MBS – : Not a strict ‘arbi- (where MBS are divided into Interest-Only trage’, it is a trade between two related secu- (IO) and Principal-Only (PO) portions). rities (either economically or statistically) Collateralized Mortgage Obligations whereby the arbitrageur would be long- and (CMOs) represent a ‘tranching’ of the mort- short- securities with an economic or statis- gage pool into securities of differing credit tical relationship but whose prices have quality; the junior securities absorb the first diverged from historical norms. The trade is

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generally constructed to be neutral to market cantly more face value of the shorter-dated factors (such as interest rates). The expecta- security is required for the trade to be dura- tion would be that the price relationship tion-neutral; flatteners are thus negative would ‘converge’ to the historically normal carry trades. one. An example is long off-the-run and short on-the-run Treasuries: since the current – Conditional Trade: A steepener/flattener benchmark securities are more liquid, their constructed with swaptions. Because it is yields are lower than the less liquid off-the- being done with options, there is a capped run securities; eventually, as new benchmarks downside in exchange for a premium pay- are auctioned and the current ones lose their ment. The trade allows greater flexibility in status, their liquidity premium disappears. expressing a view as well as the advantage of The risk in this trade is a as premium take-in if it is a contrarian view. market participants bid up the most liquid security. • ISDA Agreements: For Fixed Income, Credit or FX trading, managers set-up counterparty – Butterfly: A trade consisting of the pur- trading agreements which are governed by chase or sale of one note (usually 5-year) and standards established by the International the simultaneous sale or purchase of both a Swaps and Derivatives Association (ISDA). longer- and a shorter-duration note from the Individual terms are negotiated by the coun- same issuer. The key is the weighting of the terparties themselves (notably the trading three legs, which is usually done to ensure limits, margin requirements, and borrowing interest rate neutrality. The trade will be terms). profitable if the three legs converge to the expected (historical) relationship. Credit Glossary

– Barbell: A trade consisting of the purchase • Credit Rating: The quality of a credit securi- (or sale) of a long-dated bond and the simul- ty as deemed by a recognized credit rating taneous sale (or purchase) of a shorter-dura- agency. The largest three are Moody’s, tion one. This can be constructed in a dura- Standard & Poor’s and Fitch. Ratings tion-neutral fashion with the trade being express an estimation of the default proba- profitable if the yield curve between those bility of a security over its lifetime. Overall, two points flattens (or steepens) more than is securities are classified as Investment Grade, currently implied by forwards. Non-Investment Grade (or High Yield or “junk bond”) or Defaulted. Ratings are – Steepener/Flattener: Curve trades designed important since many entities are limited to to profit from changes in the steepness of the investing only in securities with a certain rat- yield curve. A steepener involves buying a ing (either for regulatory capital treatment in shorter-dated security and selling a longer- the case of broker-dealers, banks and insur- dated one (or paying the fixed rate in the ers or by investment mandate in the case of longer-term swap and receiving it in the mutual funds). Because of this restriction, shorter-term one) while a flattener is the holders may be forced to make non-econom- opposite. Since longer-dated securities pos- ic sales if a security is downgraded below sess greater interest rate sensitivity, signifi- Investment Grade status.

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• Credit Spread: The extra yield (above the tory, and either at the option of the holder or benchmark rate) that a corporate security the issuing company. Convertible bonds are offers to compensate for assuming credit considered a hybrid security that are akin to risk. owning a corporate bond and a call option on the common equity of the company. • Default: A default occurs when a company or government does not meet its obligations • Asset-Backed Security (ABS): Any security as set forth in its debt covenants. The type whose collateral and payments are backed of default (a missed coupon versus renegoti- by a specific asset and/or revenue stream. ating terms) can be important as the default The most-common type are Mortgage- provisions in the swap agreements trigger Backed Securities but any asset can underlie payments by credit default swap sellers. an ABS. An example would be the This can be costly for either party Enhanced Equipment Trust Certificates (buyer/seller of protection) as was seen in (EETCs) that airlines issue on specific air- the litigation surrounding the Argentina craft or pools of aircraft. The airline pays a debt restructuring in 2002. lease fee to the EETC entity that is passed- through to the note holders. • Covenant: The covenant outlines the terms of the debt offering and generally contains • Asset Swap: The combination of a debt secu- indentures that specify obligations that the rity and an interest rate swap. It allows the issuing entity must abide by. Important fixed rate investor (holding the corporate items in a covenant are the security’s collat- bond) to turn a credit spread in the bond eral and seniority within the capital struc- into a spread over a floating reference rate. ture. As such, it allows investors to manage dura- tion and to trade credit risk opportunities. • Capital Structure: A corporation or entity finances itself by issuing a variety of securi- • Credit Derivatives: ties. Debt securities confer no ownership but tend to be the senior-most instruments in – Credit Default Swap (CDS): A contract the capital structure (with bank debt the sen- between two parties that requires the buyer ior-most of all). Since corporations may cre- of protection to pay the seller a periodic ate multiple entities to optimize their opera- amount (the credit spread) in exchange for tional, legal and tax situations, the entire the seller agreeing to pay a pre-determined capital structure may include the various amount should a credit event occur over the debt and equity instruments of the main cor- life of the swap. An event is typically poration as well as those of the affiliates and default, bankruptcy or the violation of a Special Purpose Vehicles (SPV). covenant. Originally the buyer would deliv- er the reference bond and be paid par value • Convertible Security: A security that can be but most contracts have moved to cash set- converted into another. Usually it is a bond tlement. The terms of a CDS have become that can be exchanged for a certain number increasingly standardized by ISDA over the or quantity of the firm’s common equity. years. Since the CDS involves payment for This conversion may be optional or manda- insurance against corporate defaults, it is a

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Glossary (cont.)

pure expression of corporate risk and has – Bespoke derivatives: Customized credit become the de facto credit-trading instru- derivatives, typically single equity or mezza- ment. nine tranche structures. Since they are cus- tomized to the buyer, they tend to be highly – Collateralized Debt Obligation (CDO): A illiquid with only the issuing dealer willing to series of securities collateralized by an under- trade it. lying pool of debt instruments, either cash bonds (“Cash CDOs”) or credit default – Correlation Trading: There are a number of swaps (“synthetic CDOs”). This pool may ingredients involved in pricing individual or may not be actively managed. The impor- CDO tranches: default probability, default tant characteristic of a CDO is the ‘tranch- severity (or recovery) and default correlation. ing’ of risk, with Senior, Mezzanine and Correlation measures the distribution of Equity tranches issued. The Equity tranches defaults throughout a portfolio and the like- suffer principal impairment for the initial lihood of a single default causing a succes- defaults (typically the first 0-3% of defaults), sion of defaults. The value of the lowest the Mezzanie tranches are impaired next parts of a CDO (equity or mezzanine (typically the next 4-7%) and the Senior tranche) increases as the correlation between tranches are impaired last. For bearing this defaults rises and decreases as default corre- default risk, Equity tranches are paid the lation falls. The more the defaults within a highest coupon and represent a leveraged basket become correlated, the more the port- play on credit spreads. folio behaves like a single credit, and so the probability of the equity tranche being wiped – “Waterfall”: The order in which tranches out becomes more similar to the probability and/or securities are paid out of the underly- of the most senior tranches being wiped out. ing collateral and cashflows. These are spec- Hence a long correlation trade would involve ified in the indenture. Normally payments buying subordinate tranches and selling sen- are made to the senior-most tranches first, ior tranches of a given CDO. while defaults are applied first to the junior- most ones.

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Founders Council Officers Board of Trustees

Robert M. Aaron Stephen McMenamin Edgar Barksdale Executive Director Sandard & Poor’s Stephen Bondi Toni Robinson Tudor Investment Group William Brown Business Manager Dennis Keegan Marc Goodman Susan Benjamin John Griswold Kevin Mirabile Program Director Vice Chairman of the Board Donald H. Putnam Vasso Gotsis Peter Lawrence Robert W. Stone Membership Development Manager Stephen McMenamin Chairman of the Board Toni Robinson Secretary Ken Shewer

Fred Baker Treasurer

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SPRING 2007G BEST PRACTICES IN HEDGE FUND INVESTING:DUE DILIGENCE 68 R FOR FIXED INCOME AND CREDIT STRATEGIES