The release of a study of hedge fund due diligence reports last week was met with predictable headlines such as “Hedge funds misrepresent facts, says research“, “Is Your Hedge Fund Manager Lying To You?,” and “Some Hedge Fund Managers Don’t Tell the Truth.”
The paper, “Trust & Delegation,” was penned by an all-star cast including Stephen Brown of NYU, William Goetzman of Yale, Bing Liang of UMass and Christopher Shwarz of UC Irvine. The quartet found that 21% of fund DD reports studied contained “misrepresentations” about past legal or regulatory problems and over a quarter contained “incorrect or unverifiable representations about other topics.”
Regular readers may remember a study of the “Form-ADVs” of many hedge funds. That paper (covered in this AAA post), found that 15% of funds disclosed past regulatory infringements right on their Form-ADV (assuming, of course, they were registered with the SEC and therefore required to file one).
This new study found that over 40% of funds studied actually had such problems (around 25% fully disclosed them). So are hedge funds lying? Or is there a major difference between SEC registered funds and the universe of funds for which DD were commissioned? After all, as the authors point out:
Previous research has found investors are more likely to invest in hedge funds that have certain characteristics such as higher historical performance. Investors may also be more likely to request a DD report when they do not trust self-reported measures of historical performance. For these reasons, funds in our DD sample may not represent a random sample of funds from the entire hedge fund universe.
At around $100,000 a piece, these bespoke reports are generally only commissioned by investors when they are on the brink of making a significant investment in the fund. So you might expect that the typical DD-report fund is different from your average hedge fund.
It turns out you’d be right. In fact, the answer to this question is one of the most interesting (and un-reported) conclusions in this paper.
To begin with, the authors found that DD reports were usually commissioned on funds that had recently experienced stellar performance. This makes intuitive sense when you consider than many investors are return chasers. This creates a situation reminiscent of the so-called “Sports Illustrated cover jinx.” It raises the uncomfortable conclusion that any fund worthy of a due diligence report, may in fact be about to experience lower returns.
Assuming that a DD report would have been commissioned by a potential investor after several months (at least) of tire kicking, then you could conclude that the point of maximum enthusiasm for the fund would have lined up with the period of maximum returns (i.e., a few months before the report date).
Not only did the commissioning of a DD report signify a performance peak, but the authors also found that it coincided with a peak in asset flows into the fund.
It appears that the creation of a DD report usually occurred a few months after the peak in a gradual growth in monthly asset flows. It’s almost as if the “smart money” is perennially late to the party.
DD reported funds also tended to be larger than average. This makes sense when you consider the significant cost involved with commissioning such a report.
Funds with non-Big 4 accountants also tended to be over-represented in the sample of DD funds. As the authors guess, this is because investors are slightly more comfortable with funds using big auditors with a lot to lose (as opposed to, say, an office in a strip mall and a leased VW). Notably, funds with a Big 4 auditor tend to have less regulatory infractions – possibly because those auditors may not want transgressors as clients.
Finally, funds with higher performance fees and a high water mark also tend to be the targets of DD reports. They suggest that these factors signify “higher quality” funds that tend to attract large sophisticated investors.
Perhaps the most startling conclusion of all, however, is that “strategic liars” (those who told the truth about infractions – but not the whole truth) actually performed better in the post-DD period than their more honest counterparts. In fact, a lack of honesty in the DD process was not correlated with a drop in future fund flows at all.
This suggests that there may not be enough of an incentive for managers to tell the whole truth about past regulatory infractions. (Then again, they could just be lying about their performance and their subsequent asset flows…)