Is the alternative asset industry rife with unethical and underperforming fund managers?

Based on the results from a new survey conducted by the Greenwich Roundtable and Quinnipiac University, it appears that answer would be "yes."

The "Survey of Due Diligence Practices Among Investors in Alternative Investments" polled investors about their processes in deciding whether or not to invest in a new fund. The 62 respondents were mostly funds of funds and managers of family portfolios. Most have formal due diligence processes, and they invest in all types of alternative assets, including hedge funds and private equity funds. More than half have more than $1 billion in assets under management.

It turns out they typically do quite a bit of legwork prior to investing, which will surely be comforting news to the regulators worried about their level of sophistication. More than 86 percent said they "always" or "usually" conduct background checks before selecting new managers.

What's surprising, however, is the information they learn.

In response to the question "Has your organization ever decided not to invest with a manager because of allegations of unethical behavior?" a whopping 81.4 percent answered "Yes."

Similarly, and perhaps in direct correlation to that question, the same number of respondents (81.4 percent) indicated that their organization has decided not to invest with a manager because of "a prior fund blowup."

It's worth noting here that these surveys were distributed in September of 2007, right around the time that "fund blowup" became a regularly used term in the business press.

So, what gives? Is it really that hard to find a fund manager with a disaster-free record and a clean moral record?

Steve McMenamin, executive director of the Greenwich Roundtable, which is a non-profit research group for investors in alternative assets, didn't find those figures surprising at all. "These fund structures are based on trust," he says. "If there's even a hint of impropriety, investors tend to shy away."

Indeed, it's not clear exactly what "unethical behavior" entails. Background checks can include anything from examining public records, to calling personal references and prior clients, to hiring a private investigative service.

For some investors, "all it takes is seeing the wrong body language" from a fund manager to turn him down, McMenamin says. The most common issue uncovered by background checks is misrepresentation of credentials.

And what about the regularity of the fund blowups? Many don't make it to the front pages of the newspapers, but the word gets around the investing community.

The industry, which McMenamin says has just one or two degrees of separation between any two players, is based almost entirely on word of mouth. "Investors talk to each other," he says.

Perhaps what's really alarming here is that so many fund managers with spotty records manage to claw their way back to raise new funds again and again.

Victor Niederhoffer, anyone?

by Megan Barnett