Financial collapses are no one’s favorite topic, but they are worth reviewing because they often contain valuable lessons for investors. Two events, in particular, are worth reviewing: the 1997 failure of the hedge fund Long-Term Capital Management and the 2008 unraveling of Bernard Madoff’s Ponzi scheme.
In reality, these two organizations couldn’t have been more different – one was a criminal enterprise while the other was a respected fund that simply fell victim to a failed investment strategy. On the surface, however, they appeared similar in many respects: Both were privately owned. Both claimed to have unique and proprietary methods. Both delivered superior investment returns. And, perhaps most importantly, both had an air of exclusivity that enhanced their appeal to prospective investors.
In the end, investors in both funds suffered terrible losses for the same essential reason: they were not critical enough when conducting their up-front due diligence. If you are considering investing in a private fund – whether it is a private equity, venture capital or hedge fund – you should plan to conduct extensive due diligence. While not exhaustive, the following ten-point checklist illustrates the range of questions you should ask as you evaluate any fund:
- Why does this investment interest you? The simplicity of this question belies its importance. Indeed, many of Madoff’s investors were drawn in by the so-called “country club effect.” That is, they had heard how a friend was profiting with Madoff and wanted to participate themselves. The fear of missing out can be a powerful, and unhealthy, motivator. To guard against it, you should maintain a strict, dispassionate discipline when considering investments.
- How likely is it that this fund will outperform your existing portfolio? 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…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. What it does mean is that you should think critically about the role that a fund will play in your portfolio. What gives you confidence that the fund will deliver enough value to offset its fees?
- 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. If you can’t fully understand a fund’s strategy, you can’t tell the difference between a Madoff, a Long-Term Capital and a perfectly acceptable investment.
- 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 increases your risk. This is exactly what happened to Long-Term; when markets seized up, they were unable to sell many of their assets, and this prevented them from servicing their significant debt. No one can forecast every conceivable outlier event, but a fund’s debt level will give you some indication about its ability to weather adverse market conditions.
- Does the fund have a track record through different economic cycles? The events that caused Long-Term Capital to fail were nearly unprecedented. Nonetheless, a longer track record does give you more information and therefore lowers (but does not eliminate) your risk.
- What is the fee structure? Fees and fee structures vary considerably across funds. It is important to understand all of the details.
- Are you able to speak with references? Reputable funds will allow you to speak with both current and former clients.
- Who are the funds’ vendors? Madoff was able perpetrate his scheme because he did not use an independent custodian and because he used a small-town auditing firm. You should always insist that a fund’s assets be held by a well-known third party, you should insist on a national auditing firm, and you should always verify these relationships independently.
- Can you estimate the tax impact? Many funds cater primarily to tax-exempt institutions and therefore operate without regard to taxes. Others recognize the real cost of taxes to individuals and work to avoid tax inefficiencies. You should ask to review sample K-1 forms from every historical year to make this determination. You can also use the K-1’s to calculate the fund’s after-tax returns, allowing you to make an apples-to-apples comparison to your existing portfolio.
- What is the fund’s’ liquidity policy? Most funds have policies called “lock-ups” that limit your ability to withdraw funds on demand. In contrast to publicly-traded securities, which can be sold on virtually a moment’s notice, a private fund may restrict your ability to make a withdrawal for some number of months. You should understand a fund’s lock-up policies and think about whether there are circumstances under which those policies might cause you financial distress.
In his classic guidebook for individual investors, Unconventional Success, David Swensen wrote, “successful investors in hedge funds devote an extraordinary amount of resources to identifying, engaging and managing high-quality managers…” His message: it is not impossible to profit by investing in private funds, but it requires significant time and analytical ability, as well as, perhaps most importantly, a dispassionate outlook.
 Swensen, David F. Unconventional Success: A fundamental approach to personal investment. New York: Free Press, 2005, pp. 126, 133.
 Yale University: http://news.yale.edu/2015/09/24/investment-return-115-brings-yale-endowment-value-256-billion. Retrieved February 4, 2016.
 Unconventional Success, page 132.