In the summer of 2000, the Art Institute of Chicago fell under the spell of a young hedge fund manager named Conrad Seghers. The allure? Seghers claimed that his funds, called Integral, offered “the highest Sharpe ratios in the industry.” The Sharpe ratio is supposed to measure an investment’s risk relative to its returns and is popular in the world of hedge funds. Convinced by this pitch, the Art Institute committed more than $40 million of its endowment to Seghers’s funds.
But a year later, the investments unraveled. In all, the Art Institute lost 90% of its money.
How can you avoid a similar fate? The simple answer is to avoid private funds. But if you do want to try your hand with a private equity, venture capital or hedge fund, I recommend an extra dose of due diligence. As a starting point, you could ask these ten questions:
1. How did you find this investment? In the case of the Art Institute, they thought they were employing best practices by hiring an investment consultant to screen prospective hedge funds. What they overlooked, however, was that their consultant had a financial relationship with Integral and received a hefty match-making fee. The lesson: If you are paying someone for advice, be sure there’s no one else on the other side also paying them.
2. What is the fee structure? David Swensen, manager of the Yale University endowment, cautions: “Investors in hedge funds face dramatically higher levels of prospective failure due to the materially higher level of fees.” As a result, “generating risk-adjusted excess returns [is] nearly an impossible task.” This is not to say that you should never invest in a private fund. Indeed, Swensen invests the majority of Yale’s assets in private funds. But you should think critically about a fund’s ability to offset its fees.
3. Have you thought critically about the fund’s track record?You need to be able to understand how the fund is generating its returns and should not hesitate to ask questions. If you can’t understand the explanation, you should not invest. Complexity does not necessarily indicate that something is wrong—and indeed many perfectly reputable funds pursue highly complex strategies—but it does mean that you are not in a position to make that determination.
4. Does the fund use leverage, and if so, how much? It is very difficult for any entity to collapse if it has no debt. If a fund does use debt, it can amplify your returns, but it also amplifies your risk. No one can forecast every conceivable negative event, but a fund’s debt level will give you some indication of its ability to weather adverse conditions.
5. Does the fund have a track record through different economic cycles? By the time the Art Institute met Conrad Seghers, he had been in business just two years. A long track record certainly doesn’t guarantee success, but a limited track record makes it harder to know how your investment might perform.
6. Have you read the fine print? In the end, Seghers was convicted of fraud. Still, Integral’s investor agreements included disclosures that perhaps the Art Institute should have read more carefully. While probably a stretch, Integral’s attorney argued that the Seghers, “could have bet on the Super Bowl if he wanted.” The lesson: Be sure you understand the fund’s mandate and that the documents reflect this understanding. Never write someone a blank check and never rely on verbal assurances.
7. Are you able to speak with references? Reputable funds will allow you to speak with both current and former investors. In the case of Seghers’s funds, another investor decided it was “hocus pocus” and pulled his money out before the collapse. I suspect he wasn’t the only one. If you’re looking to make an investment, it’s worth making some calls first.
8. Who are the fund’s vendors? You should always insist that a fund’s assets be held by a well-known independent custodian, and you should insist on a national auditing firm. And verify these relationships independently.
9. Can you estimate the tax impact? To calculate a fund’s after-tax returns, ask for copies of all past years’ K-1 forms. At the same time, ask when K-1s are issued. Private funds have a habit of being late with K-1 forms, causing investors to put their own tax returns on extension.
10. What is the fund’s liquidity policy? Most funds have “lock-up” policies that limit your ability to withdraw funds on demand. This might restrict your ability to make a withdrawal for some number of months.