COMMON ELEMENTS IN AND AVOIDING BLOWUPS.
TECHNIQUES IN DUE DILIGENCE
Lois Peltz
Infovest21
SEC Roundtable
May 15, 2003
While an agreed upon definition of blowup does not exist, the general thread running through various definitions is performance that puts the future viability of the fund at risk or a loss far beyond the investor's expectations for that fund based on its risk profile.
Some say that the number of hedge fund blowups as a percentage of total hedge funds is extremely small and smaller than in other financial circles. For example, there were about 11 bank blow ups in the US last year, the largest number since 1994. The universe of banks and thrifts is about 9500. Others observe that in a universe of about 6000 hedge funds, ten blowups over a period of nine years is miniscule.
However, others feel the number of hedge fund blowups may increase further. The hedge fund universe is growing with more untried managers appearing daily, products are becoming more complex which may hide problems for longer periods of time, and some managers are under strong pressure to perform. With performance generally flat/negative in 2002, most hedge fund managers did not reach their high water mark which would entitle them to their incentive fee. As a result, some are living on their management fees and feeling financial pressure. In an effort to save themselves, some of these managers may actually blow up.
Recent blowups tend to be caused by five problems - mispricing, excessive leverage, strategy failure, ego or fraud. It is not uncommon to see overlap and connections among these categories. Liquidity can be said to be at the heart of most blowups because managers can not sell (or appropriate mark) positions at reasonable values or may not be able to sell positions at all. Additional information on ten of the major hedge fund blowups in recent years as well as quantitative and qualitative techniques that investors use to avoid the minefields, please refer to the Infovest21 White Paper issued on April 1, 2003 entitled. "Common elements in and avoiding blowups - Techniques in due diligence."
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