Some Advice On “First Calls” With Fund Managers You Might Be Evaluating

Anectodally, it feels like more high net worth individuals are beginning to invest in funds than before. This has been happening for a while, but feels like it’s becoming even more common as individuals get nervous about having so much of their portfolio correlated to a market they don’t have a lot of faith in right now.

(1) First off: who knows if trying to time the market is a good idea? Patrick O’Shaugnessy just published his annual report, which included the following graph that demonstrated current market levels have very little correlation to 1–3 year returns, and really need to be a part of a 10-year strategy to make sense:

Correlation of short term market indicators to market performance, from OSAM’s annual letter


(2) Second off: one of the main concerns I’ve had about this shift to High Net Worth (“HNW”) investors moving into the alternatives space is their inability to underwrite new investment products. Some of these people have financial advisors that they rely on to help them pick funds, but many RIA’s are not equipped to evaluate alternative asset managers, especially those who are pursuing esoteric strategies, which have become especially in vogue based on how “uncorrelated” they all pitch themselves to be.

With that in mind, I’ve tried to compile a VERY generic list of questions to ask managers on your first couple of calls. THIS IS NOT INVESTMENT ADVICE, AND IS NON-EXHAUSTIVE.

It also lacks the context of “what kind of fund are you looking at?” So none of the questions are very specific, and each new type of fund deserves its own asset-class-specific questions.

*Once again, Please do not consider this investment advice, or a full checklist on how to do your diligence.

This is also just a set of questions that can hit “table stakes” gut check questions — but don’t serve as a full diligence process.

(1) The Thesis:

a. Why does the opportunity exist now, and why hasn’t it existed before? What has changed about the market?

b. Why do you, as a manger, have an unfair advantage over other investors in the space who might try to pursue the same strategy

i. Can I see case studies that demonstrate this ability?

c. What is your process for originating new deals? How can you make this repeatable/process oriented?

i. When people send you an investment opportunity, why does it go to you instead of one of your competitors?

d. Assuming your strategy works, who are the firms who are not competing now, but might compete with you later?

e. Can I please read through a few sample investment memos?

f. Can you walk me through some deals that you tried to invest in, and offered a term sheet to, but lost?

g. Are there any investments that used to be in the portfolio, but that are no longer in the portfolio?

h. Are there any restructurings that occurred? Were there events that ended up not effecting performance, but could have?

i. How do you think about allocation across the portfolio?

i. How many positions?

ii. Concentration?

iii. What are situations in which you would add to a position?

iv. Do you fully re-underwrite a deal when you add to a position?

v. What is a situation when you would draw down from a position?

vi. In the event you draw out of a position, and it’s a closed end fund, do you have to sit in cash? Or do you distribute money back to investors?

j. What are the odds that cash drag will occur in the fund? Especially while investing in illiquid assets?

k. What are the mechanics of your Investment Committee? What are the main disagreements that the Investment Committee has when it meets?

l. How do you think about pricing your investments? Can you give me some examples of why each deal is priced the way it is, and how much spread you get compared to what is “market?” (I heard an LP ask this recently and loved the question)

m. Any regulatory concerns about any of the investments?

(2) Communication with Investors

a. Can I please see a sample investor statement?

b. Can I see past Investor Updates that you have sent?

c. Can I see an example update in which you described a problem in the portfolio?

(3) Fund Documents

a. *Have a lawyer review fund documents before investing. Or if too expensive for you personally, try to be put in touch with a larger investor who’s counsel has reviewed docs, and ask them if any issues were flagged

b. Ask for any side letters that have been signed with any investors, that might give them an advantage over you

i. You shouldn’t care about discounted fees to certain investors, but you should care if they have easier Defaulting Partner language that could make the fund more liquid for one investor, and thus less liquid for you

c. Side Pockets: What happens if an asset in the fund becomes delinquent? Is that put into a side pocket? Or could a new investor come into the fund, once it’s marked down, and overly dilute you? (example: a $100 fund that now has 10% of the fund marked down to $0 is worth $90. A new investor coming in, who puts in $1.00 now gets 1/90% of the fund’s future proceeds. If that former $10 asset that was marked down comes back to par, the new investor got proceeds that really should have been yours)

d. Liability mis-matches: is the fund investing in long duration assets that are longer-dated than the fund life/liquidity terms? If so, what is the manager’s mechanism for getting you out of the fund?

e. Waterfall:

i. Read waterfalls carefully — and understand how your capital account is accounted for, trued up if there is a loss, and ensuring that in the event you have a loss you understand how clawbacks work.

ii. Usually a waterfall should read something like:

1. First, fund expenses

2. Second, management fees

3. Third, 100% of Contributed Capital by the Limited Partner/Non Managing Member

4. Fourth, x% of excess proceeds to the Limited Partner/Non Managing Member

5. Fifth, y% (the carry) of proceeds to the General Partner/Managing Member

f. Can the Managing Member be changed? What if you invest in a Manager who then sells the fund to someone else, and suddenly you underwrote a team no longer managing the investment

g. Make sure you understand what “allowable expenses” can be charged to the fund, and what the expense ratio will be.

h. What are the management fees? Do the management fees actually cover all the expenses of the Manager?

i. Indemnification: is there a chance you could be asked to contribute more money than initially committed to fund the defense of the fund in the case of law suits/etc (generally — is there any scenario you could be liable for more than your commitment?)

(4) Underwriting the Manager

a. What are the financials of the Management Company? Can they afford/are they liquid enough to manage the investment throughout its term?

b. What happens if there is a clawback? Has the management team already spent their carry? Can you go get it back?

c. Have any key personnel changes occurred?

d. Is everyone full time? What are outside conflicts of time?

e. What are outside personal investments that could come into conflict with the investments in the portfolio I am investing in?

f. Is the Manager invested in the fund too? You should care less about how much the $$ is, and rather how much of the investor’s personal net worth it is.

g. Any criminal record of anyone on the team?

h. Is the firm being audited?

i. What are the cash controls of the firm? Who can approve wires?

j. Non-competes/Employment contracts: do key members have appropriate employment contracts?

k. What will the firm look like 5–10–15 years from now? What is the underlying motivation behind everyone there.

l. Are there any non-active members who have ownership, and what is their level of governance?

m. Can you get references to either one of the firm’s portfolio companies, or LP’s, or both?

(5) Case Study:

a. Can I see a full diligence packet on one example deal?

b. Can I see the term sheet of the deal, and cradle-to-grave documents?

c. Can I understand the terms you wanted to get in the deal, but failed to get?

d. Can I see the base-case model, and understand what happens for me to not get 100% of my principal back? What are the range of outcomes you can imagine?

Please consider these, just a possible outline, for your first couple of calls with a manager, and a request for follow on diligence materials. You should always ask your financial advisor for more help.

Another thing that is important to remember is:

(1) New firms don’t know what they don’t know — and you should ask for a premium on your return in exchange for this (a 12% from a new firm is more risky than a 12% from an older firm that has more scars).

(2) There is nothing that can replace knowing management for a long time. Very rarely is this the only opportunity you’ll ever get to invest with them. Knowing someone for 1 year + give you data points on how they act, how the investment performs, and how the management team reacts when things don’t go well.

Lines are easier to invest in than dots are (“Invest in Lines, Not Dots” -Mark Suster).