Proper Hedge Fund Due Diligence

The Principles and Best Practices for Hedge Fund Investors report was issued during the financial crisis ten years ago. In it you will find a good set of due diligence questions you can borrow to evaluate a prospective hedge fund manager.

Proper due diligence needs to be tailored to the circumstances and objectives of each investor and to the particular circumstances of each hedge fund investment. No universal handbook can serve adequately as a guide for due diligence in every circumstance. Instead, a well-tailored due diligence questionnaire (“DDQ”) may serve as a useful tool to aid investors in understanding a hedge fund’s opportunities and risks and provide structure to the overall due diligence and monitoring process. A DDQ, which should contain probing questions regarding the material aspects of a hedge fund’s business and operations, may include, but is not limited to, the following:

      • Process: What is the manager’s investment process? In what markets does the manager invest? How does the manager have a comparative advantage or “edge” over other managers (or passive investment alternatives)? What instruments does the manager use to carry out investment themes? Under what environments should a fund’s strategy perform particularly well or poorly? What risks is the manager comfortable taking? Why are those risks acceptable?
      • Performance: How has the fund performed historically? If the fund has had periods of particularly strong or poor returns, is there a reasonable explanation for the unexpected returns? How has the manager performed in running other funds? Have previous efforts to manage a fund failed or succeeded, and if so, why? How has leverage contributed to past fund performance? Will leverage in the future be similar to or different from what the manager has previously employed? If the hedge fund is a new organization and there is no performance record, what is the manager’s prior experience, and how has that experience prepared the manager to run a successful hedge fund?
      • Personnel: Who will be managing the fund on a day-to-day basis? Who assists the fund’s managers in reaching investment decisions? Who is responsible for back-office functions such as accounting or cash and trade reconciliations? How long have the fund’s personnel worked together, and how much experience do they have individually? Do the fund’s personnel have or do they intend to have a significant portion of their own assets invested in the fund? Are the fund’s key personnel willing to provide references to substantiate their character and skills?
      • Risk Management: How does the manager assess and manage risks? Risk management extends beyond market risks to liquidity, counterparty, operational, and other risks (discussed below), and these could adversely affect investment returns as well as the fund management firm’s overall business. What contingency and business continuity plans are in place in the event of a disaster or other significant business interruption?
      • Third Parties: What third-party service providers, such as administrators, prime brokers, auditors, legal counsel, and other vendors, does the fund employ? Who are the fund’s material trading counterparties? Investors should assess the adequacy of the manager’s approach to selecting third parties to determine that they are known, reputable, financially stable, and experienced in the hedge fund industry. Are there structural or contractual relationships between third parties and the fund that may give rise to conflicts (for example, when an executive of a third party serves as a member of the fund’s board or when a fund’s management firm and administrator have the same corporate parent)?
      • Structure: Is the hedge fund a partnership, corporation, or other entity? Is the entity structured to limit investor or manager liability? Is the fund operated by a large management firm or is it managed by a small team in a “boutique” firm format?
      • Domicile: Is the fund domiciled onshore or offshore? Are the fund managers familiar with the legal, regulatory, and tax regimes of the jurisdiction where the hedge fund is domiciled? For offshore funds, are the fund managers prepared to fulfill all obligations (e.g., regulatory filings or taxes) that may arise in that jurisdiction? Are assets within the purview of an appropriate judicial system? If an investor needed to pursue legal claims against the fund or its managers, what law would apply and what jurisdiction would provide the appropriate venue for such claims?
      • Legal Matters and Terms: What are the fund’s fees and other material terms, such as liquidity, limitations on investments, and leverage? Are “side pocket” investments allowed, in which certain illiquid investments are placed in segregated pools? If side pockets are allowed, is participation by investors voluntary or required by all investors? What regulatory regimes is the fund subject to, and with which regulators is the fund (or manager) registered? How might changes in regulation affect the performance of a fund’s strategy? How do taxes impact the fund’s net returns and does the investment strategy, structure, domicile of the fund, or the places where it invests have additional tax implications?
      • Compliance: How are risk-management and regulatory compliance policies managed and documented to ensure compliance by the fund and its management with applicable regulations and fund documents? How does the fund’s management respond to a breach of compliance or risk management policies? Is there a chief compliance officer or other individual ultimately responsible for regulatory and risk-management compliance? What is his or her prior experience and regulatory history?

Principles and Best Practices for Hedge Fund Investors

Inside the Rose Main Reading Room at the New York Public Library.
Photo by Dimitar Belchev on Unsplash

Post by Marcelino Pantoja