Institutional investors are undertaking growing amounts of operational due diligence before deciding upon which hedge fund to invest in.

Institutional investors have been piling more and more money into the hedge fund industry in recent years as they look for higher returns on their portfolios.

Net inflows from institutional investors into hedge funds have been nearly $150 billion since 2010 despite the average hedge fund returning just 7.5% for the period compared with nearly 10% for global equities and around 15% for global bonds.

While a study earlier this year by the Alternative Investment Management Association, the global hedge fund industry association, and accountant KPMG found that 57% of total assets under management in hedge funds now comes from institutions.

“We continue to see a strong demand for risk transparency from a range of leading institutions that invest in hedge funds,” said Roveen Bhansali, managing director and head of the risk management analytics business at MSCI, a risk analytics provider to hedge funds.

Recent research by Deutsche Bank, Germany’s largest bank, revealed a fundamental shift in the depth and nature of due diligence carried out by hedge fund investors.

Operational due diligence teams are now viewed as a partner and peer to an investment team and now actively veto investments, according to Deutsche Bank. This level of sophistication institutional investors apply to operational due diligence has increased significantly as they demand greater transparency from managers.

And new regulations such as the Foreign Account Tax Compliance Act, Solvency II, the Dodd-Frank Act and Emir have also forced hedge funds to better manage their risk, data and reporting.

“Institutional money has definitely led to hedge funds having I wouldn’t say a revolution, but an evolution, in the way in which they operate and the way in which they generally set themselves up,” Mark Parsonson, executive director of fund of hedge funds manager Liongate Capital Management, which has $3 billion under management, told Markets Media earlier this year.

“Institutional investors demand more and better systems, better quality and they do much more operational due diligence and more transparency.”

The financial crisis and subsequent hedge fund losses have driven wide-ranging changes in the way investors evaluate hedge funds, and the emphasis is now placed on rigorous controls across the front to back office.

“The costs of doing business are a major challenge for hedge funds, with investors demanding higher standards and also regulatory compliance,” Paul Compton, head of asset management strategy at SunGard, a trading technology firm, told Markets Media.
The Madoff scandal in 2008 also exposed the alternative investment industry to widespread allegations of substantial neglect in terms of due diligence and, since then, operational due diligence has moved from a peripheral activity to center stage.

“The research highlights how important the fundamentals are to the operational due diligence process—from having the right people in place to a proven audit trail,” said Chris Farkas, head of European hedge fund consulting at Deutsche Bank. “The growing importance of operational due diligence comes at a time when investors are better educated than ever in all aspects of a fund’s business.”

Deutsche Bank found that the main reasons operational due diligence teams vetoed investments in the past 18-24 months included a lack of independent oversight, unwillingness to provide transparency, valuation issues and insufficient investment of personal wealth.

“Institutions have embraced hedge funds as a source of positive risk adjusted returns, and this runs hand-in-hand with a greater focus on control and compliance,” said Daniel Caplan, European head of global prime finance at Deutsche Bank. “Investors have a rigorous toolkit of evaluation techniques and hedge funds have responded by vastly increasing transparency and access.”