DUBAI, 16 June 2003 — The exponential growth in both the number of hedge funds and the assets that they command is well attested. While the asset class has not yet permeated deeply into some branches of institutional investment (e.g. pension funds), the speed of the recovery in confidence after the difficult days of 1998 confirms that in other quarters the argument for hedge funds has been won. The fundamental case is clear: Investors and consultants have grown increasingly to distinguish Alpha, the non-systematic return associated with the particular skill of a (hedge fund) manager or a specialized arbitrage activity, from Beta, the systematic return potential of a market or other asset class. The negative returns in most equity markets over the last two years have sharpened the interest in absolute return investment.

A consequence of the growth of interest in hedge funds has been a tendency for proven and successful hedge fund managers to be “closed” to new investment, leaving an ever larger number of funds of funds and other multi-manager investors to consider less established managers and start-ups as candidates for allocation. A supply of new managers has emerged to fill this vacuum, but the investors’ task to select from this set those managers those that will deliver steady risk-adjusted returns and material investment capacity is complicated in most cases by the brevity or absence of track records.

Neither the search, nor the due diligence process, is straightforward. One model that has evolved is that of a partnership between the aspiring hedge fund manager and a larger player who provides an array of services ranging from initial capital on which to build or continue a track record; legal, IT, accounting and administrative support; working capital; and marketing and distribution.

In return for these services, the fund manager offers some form of revenue participation, often an equity ownership in the management company. Such an arrangement has the potential to align the interests of the end investor, the manager and the institution. For instance, the right of the institution to transparency enables an additional level of oversight, due diligence and risk management that benefits the investor. Additionally, the commitment of the institution to distribute (possibly held exclusively) allows the manager to focus on investment-related activities and guarantees access to the product to the institution and therefore the end-investor. While none of this can be considered straightforward, it is clear that the greater the resources of the institution with whom the manager forms a partnership, the more likely the eventual success. In this context, required resources range widely from skills in discovering potential managers, subjecting them to a rigorous process of due diligence, supporting an array of infrastructure needs, and being able to market and sell the eventual product.

The first step is search and discovery. Aspiring hedge fund managers tend to emerge from one of three backgrounds: Proprietary trading (typically in a banking environment); an existing hedge fund or trading business (in which the potential manager may be a senior trader or analyst, but not a partner); or traditional fund management. In all cases the manager is likely to be seeking a combination of increased compensation, greater autonomy and a more flexible investment mandate.

The strongest candidates often emerge from an existing hedge fund, in which they will have observed and/or developed successful investment models, although this culture can also lead to excessive ego and a craven interest in self-enrichment. Proprietary traders can lack entrepreneurial skills, may require greater support in building infrastructure and may acclimatize less easily to the more structured risk management procedures necessary within a fund environment (as opposed to a variable pool of notional capital supplied by a bank). Traditional fund managers usually need to develop an appropriate process for constructing short and arbitrage positions, and to move away from a fixation on a market (or peer group) benchmark toward an absolute return mentality.

The amorphous character of the hedge fund market is a particular challenge for the investor. No published database contains all managers of interest, there are no accepted common standards for reporting (indeed many very successful managers report to no-one other than their direct investors), the industry is variably regulated and spread over many different jurisdictions.

Moreover, start-ups have, by definition, very little or no formal track record. For these reasons, an approach to manager discovery that emphasizes a trawl through databases is only a small part of the solution. A practical approach leans on the construction of a network of sources — ranging from personal contacts, prime (and other) brokers, fellow investors, (more) established fund managers and traders, consultants and other intermediaries. Another source, arguably the most important, is the direct approach of potential managers to the investing institution. In this regard, the most experienced and well-resourced players have a clear advantage, as strong visibility within the business, proven distribution capability and a history of successfully backing early stage managers will naturally encourage emerging managers to make contact.

What characteristics distinguish managers that eventually succeed from those that atrophy or fail? Early success in compiling positive returns is undeniably important, and luck may play a part in this before the track record develops statistical significance. But not all aspects are comparably subject to chance, and the diligent fund-of-funds manager or other investor will aim to discern, inter alia, the answers to the following questions:

• What is the heart of the investment process? What form of market inefficiency is being targeted? Why should it persist? Is the manager able to articulate the process? Is he/she genuinely well placed to execute the strategy?

• What is the background and history of success of similar strategies?

• What is the background and experience of the individuals involved? How unique are their insights? What track record, quantitative or qualitative, exists? Can its completeness and accuracy be verified?

• How well do the various personalities and skill sets complement each other within the fledgling management company? What are their various motivations and commitments? and

• What systems and information flows support the trading process?

From these very broad questions, many dozens of others will follow. During this phase of due diligence, the provider of seed capital has an advantage over the ordinary, arms-length investor, in that many meetings will inevitably occur before legal documents are signed, and both this elapse of time and the intensity of contact permit a far deeper understanding of the start-up manager and the investment process.

What attributes of new managers should be of particular concern to a joint venture partner? The list is inevitably long, but the majority of investment and commercial failures relate to one or more of the following:

• Lack of integrity;

• Inadequate depth of investment skill and process;

• Variability of investment process and/or poor risk management;

• Weak insight into the potential flaws of the trading strategy in a range of different investment conditions; and

• Failure to build an appropriate and stable business environment (including the identification and management of problematic personalities and/or human relationships).

“Variability” of investment process should not be confused with a natural evolution. The latter may be regarded as a positive characteristic where it reflects either superior analytical capability leading to greater portfolio diversification and capacity or a strategic response to a changing market environment. Indeed one of the advantages of the seed capital model is that the first period of investment provides an opportunity to forge a more solid investment strategy from a possibly rough-hewn initial set of investment skills. This period also offers the provider of the seed capital a valuable opportunity for active due diligence on the manager and the investment strategy.

What are the biggest dangers when selecting and investing in early stage managers? The worst mistake in the wider hedge fund world is to invest unwittingly with a manager who proves to be fraudulent. Fortunately explicit frauds are very uncommon in the hedge fund universe, but those that have occurred have lent the business a certain, largely unjustified notoriety. For an arms-length investor the primary control is to obtain detailed independent corroboration of personal histories and track records before investing, and to pay close attention to the quality and depth of the valuation procedures and oversight of the relevant fund administrator. However, the residual possibility of fraud, however small, has led many funds of funds to follow a policy of limiting allocations to a single manager and building large, diversified portfolios. More effective oversight may be available to the joint venture partner, who may invest in the hedge fund manager through the structure of a managed account, and so maintain control over movements of cash while imposing an additional layer of risk management.

This oversight is also valuable in avoiding the next worse outcome: A substantial collapse in portfolio value arising from disastrous risk management, inappropriate leverage, unreported change to the investment process (often termed “style drift”) or forced exit of illiquid positions in difficult market conditions. By embracing the hedge fund manager into a business environment that contains independent expertise in primary due diligence, risk management, administration and valuation, the early stage investor maximizes his chances of identifying problems before they strike. These layers of expertise are obviously not cheaply acquired, and this again suggests that the larger players have an edge.

While thorough due diligence can improve the chances of success, it is not possible to avoid the occasional investment failure. The objective of the new manager business must be to ensure that, over the medium to long term, these failures are outweighed by the successful manager relationships, which will come to represent much greater assets under management. Indeed there is another risk: That of rejecting a manager who subsequently proves to be highly successful. This may be addressed by pursuing a clear and consistent set of business objectives, building an environment that can proceed with a number of initiatives in parallel, and developing a distribution capability that will attract talented nascent hedge fund managers.

What are the critical issues in building and maintaining a new manager business? Among other requirements:

• A strategy should be formed to ensure that a substantial number of potential managers are reviewed each year;

• These managers must be subjected to a rapid, but thorough, process of due diligence;

• Joint venture arrangements should be negotiated on legal terms that clearly and fairly define the respective rights and obligations of the two parties and so maintain good working relationships and incentives;

• Expectations, both of the manager (e.g. for assets raised) and the investor, need to be managed carefully; and

• Support structures (e.g. risk management; financial control) need to be built.

Any joint venture relationship can endure periods of tension. But pre-defining areas of potential dispute and agreeing terms accordingly can moderate these.

As the volume of hedge fund investment continues to grow, some compression of returns will inevitably result. Given this, the ability to discover early stage managers and assess them successfully will prove to be one of the principal differentiating features between competing investing institutions.

Those that succeed are likely to have developed an array of value-added services of use to the aspiring hedge fund manager, including the provision of seed capital, supporting infrastructure, and the ability to market and sell the eventual hedge fund product.

(Antoine Massad is associate director and head of Middle East and Asia of Man Investments.)