Key Concepts for Manager Due Diligence: Alternative Investments1 +1 (888) 819-2330 [email protected] www.lenoxparkllc.com Lenox Park Lenox Executive Summary The financial crisis of 2008 sharply illuminated the growing importance and substantial Table of Contents: allocations made to Alternative Investments among Institutional Investors. According to a A Constructive Approach report published by McKinsey & Company2, in the 5 years since the crisis, Alternative to Due Diligence (pg 2) Investments grew 7 times faster than traditional investments. Unfortunately, many Investors SEC Risk Alert: Due have experienced losses or underperformance in this segment of the investment management Diligence for Alternative industry under the weight of some type of Investment Manager dysfunction: malfeasance, poor Investments (pg 2) or non-existent risk management, inadequate operations or controls, unhealthy cultures, etc. Investors that have been unscathed most likely take comfort in the fact that they or their Why the Qualitative Elements Matter (pg 5) “Advisors” (for this paper, meaning Investment Consultants, Fund-of-Funds or Due Diligence Advisory firms) performed more robust and comprehensive due diligence on their select Lenox Park Due Diligence investments and the Investment Managers behind them. It’s true that some aspects of the due Dashboard (pg 6) diligence process have become easier due to technological advances and the availability of data. Case Study: The Galleon This has led some firms to become data aggregators. But the elements of due diligence that have Group Closed Down due to always been difficult to grasp are still difficult; and they remain largely unchecked. In this paper, Insider Trading (pg 7) we will provide support for our belief that more attention should be paid to the Operations & Lenox Park Experience & Oversight functions governing organizational controls, policies and procedures; and the Firm Overview (pg 8) qualitative aspects of the Manager Background - its people, its culture and ownership Endnotes (pg 8) structure. We will also affirm that this work is only done effectively when performed by experienced professionals who will conduct the work independently and free of conflicts. About Lenox Park: Lenox Park is an independent Due Diligence Advisory firm with offices in Westchester, New York and Austin, Texas. The firm’s clients include a broad network of Investors including Pension Funds, Family Offices, Endowments, Foundations and Financial Institutions. Lenox Park was established in 2009 to address a Mar growing need in the Investment Management industry for independent, conflict-free Advisory work. The firm has been retained by some of the largest institutions in the U.S. to assist in evaluating Investment Managers & Strategies, Emerging Manager Internal Audit and Derivatives & Regulatory Exposures. The firm also provides 2014 technology solutions to its institutional client base through it subsidiary, Lenox Park Solutions LLC. LENOX PARK | Key Concepts for Manager Due Diligence A Constructive Approach to Due Diligence Regulatory Outlook: When Alternative Investments were only accessible to a small, select group of Investors, SEC Office of Compliance the due diligence required to analyze them consisted primarily of interviewing Managers Inspections & about strategy and examining track records and past performance. The explosive growth Examinations (“OCIE”) in this segment over the years has corresponded to increased accessibility and availability Risk Alert - Due Diligence of data and metrics for potential Investors. Consequently, due diligence evolved to reflect Policies & Procedures this new reality and many Advisors now rely too heavily on an ability to aggregate vast The proliferation of Alternative amounts of data in order to examine the health and potential of an investment and its Investments, in concert with the Manager. In our view, this approach unfortunately overlooks the importance of the problems revealed by the 2008 qualitative elements of due diligence, which too often seem to be put on the back burner. financial crisis, has resulted in Some of the largest Investors in the Alternatives space, including Pension Funds, regulators keeping a more watchful eye on due diligence Foundations and Endowments, appear to be shifting away from Fund-of-Funds and practices. increasing direct exposure to Managers3. As they do, we hope a more comprehensive approach to due diligence will be employed. Budget constraints sometimes prevent these th As recently as January 28 organizations from assembling all the necessary resources internally in order to conduct 2014, the Securities Exchange Commission (“SEC”) through comprehensive due diligence. In such cases, substantial portions, if not all of the work may the OCIE signaled that it may be outsourced. We believe that much of the risks and rewards of investing in Alternatives tighten regulatory expectations can be determined by using a multifaceted approach that includes both a robust qualitative that govern the due diligence analysis of Managers, staff and the culture of their organization and a strong quantitative responsibilities of Investment assessment of the fund’s data. Advisors that allocate to or recommend Investment Managing Conflicts Managers. Investment Consultants, Fund-of-Funds or Due Diligence Advisory firms (referred to in The SEC notes that Investment this paper as “Advisors”) may become conflicted when charged with performing due Advisors are fiduciaries and are diligence. This is particularly true if, in addition to conducting due diligence, their parent required to act in their clients’ companies or affiliated companies are promoting proprietary fund management best interests and identify any businesses. In some cases, Advisors are affiliated with investment banks or conflicts of interest they may have when recommending broker/dealers. These potential conflicts certainly do not imply any impropriety, but they investments. Our interpretation have not gone unnoticed by Investors and regulators, and they do need to be investigated is that this risk alert is targeted before any engagement. In fact, the SEC recently alerted Investors to these concerns (see at Fund-of-Funds and Pension “Regulatory Outlook”). We believe the first step to a robust due diligence process is an Investment Consultants. assurance that an independent, conflict-free Advisor will conduct the work. By examining more than 10 Experienced Professionals to Conduct Due Diligence Investment Advisors, the SEC revealed some concern about The engagement of seasoned professionals from the beginning to the end of a due deficiencies in due diligence diligence assignment has several distinct advantages. First, experienced professionals are practices as they relate to usually better equipped to question a Manager’s assumptions, ask detailed follow-up compliance with the Investment questions and explore every possible line of inquiry. Sniffing out inconsistencies or subtle Advisors Act. Material concerns problems comes more naturally to experienced professionals. Second, the process of due in their findings include: diligence requires a certain amount of diplomatic skill that most junior staff lack. Seasoned . False marketing claims professionals conducting due diligence can more effectively interview the founders, board members or decision-makers at a Manager, many of whom are highly accomplished . Failure to include due diligence policies and individuals. In some cases, managing sizable egos can present challenges to the work. procedures in annual Ideally, the relationship between Investors and the Manager will be a positive, long- reviews running partnership. An experienced professional conducting due diligence can convey this ideal in a way that results in a process where the Manager is open and forthcoming . Failure to fully disclose practices to clients, and with information. Conflicts of interest that Accommodate Nuances to Each Manager & Strategy contaminate an Investment Because each investment opportunity is unique, the due diligence employed to examine it Advisor’s due diligence should be customized to some extent. While many aspects of the due diligence process will process remain consistent, each mandate should have some tailoring to reflect its unique situation. The SEC suggests that firms A large, established hedge fund with a long track record would likely require a different that recommend or allocate to approach than a new Manager who may have just launched their first fund. Investment Advisors on behalf of clients adopt firm due Conducting comprehensive due diligence often feels like investigative journalism: we diligence policies and know there is a story behind every Manager, and we want to examine it from all angles procedures and then and pursue every lead. Sometimes the legal documents or data provided by the fund may communicate them clearly and spark a storyline; in other cases we may discover that an organizational structure is regularly to their clients. lacking in accountability or proper controls. In both cases, we should aggressively search *Source: www.sec.gov for explanations. Page 2 of 8 LENOX PARK | Key Concepts for Manager Due Diligence Rigorous & Disciplined Framework Examining the potential and health of an Alternative Investment opportunity requires assembling copious amounts of data, interview notes, financial statements and the like. In order to conduct a thorough analysis and make sense of the information gathered, we must proceed with