Hedging Your Bets: Researching Hedge Funds and Other Private Equity Vehicles

October 2007

IN THIS ISSUE

— Looking Over the Hedge: The Basics About Hedge Funds
— Managing Risk When Clients Consider Investing in a Hedge Fund
— In the next issue

GREETINGS!

Welcome to the October edition of our newsletter. In this issue, we’ll explain how to research private equity entities such as hedge funds. While many of these groups operate in an ethical manner, some use deceptive means to achieve high rates of return, and there are some relatively simple checks you can perform which will help determine if the hedge fund in which your client is considering an investment is acting in good faith.

LOOKING OVER THE HEDGE: THE BASICS ABOUT HEDGE FUNDS

A “hedge fund” is an unofficial term of art used to describe a limited partnership whose investment strategies differ somewhat from more traditional investment pools like mutual funds. Each hedge fund has its own strategy, but many are more aggressive than mutual funds, employing techniques such as “short selling” (buying a position in a stock where profits will be made if the stock’s per share value falls, essentially betting against the stock’s value over a period of time), or arbitrage strategies that seek to exploit pricing differences between similar financial instruments. This can often be done, but is by no means limited to, investments made in foreign markets dependent upon currency exchange rates.

By law, hedge funds must have no more than 100 investors, and this limitation tends to draw high net worth individuals and organizations as investors. These investors, which can also include not-for-profit institutions, seek extraordinarily high rates of return. (To determine if a charitable organization is investing in a hedge fund, you can analyze their Form 990 filings made with the Internal Revenue Service.)

MANAGING RISK WHEN CLIENTS CONSIDER INVESTING IN A HEDGE FUND

Although hedge funds have a public image of being a mysterious and super-secret investment playground for the very wealthy, there is information available to the public. Each investment partnership, at least those based within the United States, must be officially formed with the secretary of state where it plans to exist as a legal entity. (Be careful to note that where a company exists legally can, and often will, differ from where it does business, although it is often required to file with that state’s secretary as well.)

On the federal level, many hedge funds are considered “investment advisers” and are thus registered with the Securities and Exchange Commission, which maintains a database providing basic information from Form ADV, including initial assets under management, the structure of the company and general information about its initial investors.

As noted before, some hedge funds act unscrupulously to drive down a stock and profit from short-selling or convertible debt arrangements. We have investigated many of these tactics, which are often successful if a fund can, often through an intermediary, spread false or misleading information about the target company, either through bogus press releases or anonymous postings on message boards, similar to “pump and dump” schemes described in a previous issue. Most hedge funds do not do this, of course, and many that do are disciplined by the SEC or taken to federal court by the other investors whose stock lost value because of these actions. A Certified Fraud Examiner will be able to make discreet inquiries with these entities and others to determine whether a hedge fund has employed such techniques.

IN THE NEXT ISSUE

In the next issue, we’ll look at the importance of obtaining good information from customers, former employees and other persons of interest when conducting due diligence work.