Hedge Funds: The Due Diligence Process
The hedge fund due diligence process begins with understanding the characteristics being considered for each portfolio. The previous section went into some detail about the various styles of investing. Needless to say if the manager can’t sufficiently explain his style of investing to you, beware. Use your gut instinct. If it doesn’t make sense to you, it probably doesn’t make sense to invest in it.
Define Measurement Criteria
Criteria should be defined in both quantitative and qualitative metrics. The criteria that one can use to measure hedge funds (or any other investment, for that matter) should include: returns, volatility, liquidity terms, fund size, longevity, investment style, investment strategy, fees and asset class. The main objective to consider is whether a hedge fund meets most, if not all, of the criteria set forth in the search.
Once the criteria are clearly defined, there are a variety of databases that contain thousands of hedge fund names and performance data. Such databases include HFR, Hedgefund.net, Barclay Hedge, Morningstar, and CS/Tremont. The number of hedge funds under consideration can be efficiently reduced using any number of filters available on some of the websites or through third-party providers.
In addition, there are a number of hedge fund marketers, investment advisors, and consultants that can help find suitable candidates, or they can be found within the platforms of the larger institutional brokerage firms or other industry contacts. There is no shortage of resources to find suitable hedge funds, but it is critical to understand the proper criteria to more efficiently use the resources available.
The next step in the due diligence process is to contact the hedge fund manager and request information. The most common package of information sent by hedge fund managers includes a one-page summary of performance; a pitch book (usually a PowerPoint presentation) that describes the firm, its strategy, principals, performance and terms of the investment; offering memorandum; subscription documents; and a due diligence questionnaire (DDQ). The hedge fund may send all of these at once or on request. Initially, an analyst should make sure they receive the pitch book, offering memo, and DDQ. These three documents should serve as a good starting point to better understand the hedge fund manager and generate additional questions that can be addressed during the conference call.
The preliminary analysis involves confirmation of the fund’s performance to ensure it is consistent with our expectations. We can then review the pitch book to understand the underlying strategy that generated those returns and to help us identify hedge fund peers with similar strategies. As mentioned in an earlier section of this tutorial, many hedge fund databases characterize hedge funds into certain buckets defined by strategy and/or asset class.
The first level of analysis is to compare our hedge fund to those within the same category. The pitch book will then help further refine the strategy so we can selectively pick a more concentrated group of funds for comparison to determine how our fund performed versus other funds with similar strategies. Recall that each hedge fund has unique attributes but for the sake of comparison, we will use our judgment to define a suitable list of comparable funds.
Once we have evaluated the fund’s performance and determined that it has performed well relative to our criteria and relative to other similar funds, we can schedule a conference call with the manager to ask additional questions that have arisen during our preliminary analysis. The conference call should be held with the portfolio manager, or rather, the person making investment decisions.
Later in the due diligence process, we will address questions geared toward back-office and operations personnel. For now, we want to understand the manager’s investment methodology, his or her thought process and how well each articulates ideas. Keep in mind that a manager won’t reveal any proprietary secrets, but he or she should still be able to describe how returns are generated to a level of detail that allows us to determine whether the process makes sense, and more important, whether the process is repeatable. The conference call should last about 45 minutes to one hour.)
So far we have focused on mostly quantitative factors for our analysis and although these are very important, we do not want to ignore the intangible issues related to hedge fund investing. There are too many to detail in this tutorial but should include, at a minimum: contagion risk, the risk that unrelated factors could impact the fund; geopolitical risk, particularly for funds with global mandates; manager’s education and previous experience; operations staff skills and background; staff levels and capacity for growth; and office space and working environment.
In most cases, we cannot accurately assess some of the qualitative factors until we conduct an office visit, which should be mandatory before making an investment in any hedge fund. Even hedge funds on the platforms of the large institutional brokerages should go through the due diligence process we’ve discussed. Although the institutional brokerage has conducted their own due diligence, keep in mind that they receive a fee for selling the fund to interested investors.
Finally, we should perform a thorough background check on all of the firm’s principals to ensure they do not have any outstanding liens or issues that would affect our decision to invest money with them. A thorough background check can also provide information that allows us to assess a fund manager’s character and style of living. There are third-party service providers that conduct thorough background checks on individuals, and if you don’t have the resources to conduct public record searches yourself, this will probably be the best option.
Third-Party Service Providers
There is another aspect of due diligence that often gets little attention, and that is to make sure the third-party service providers are up to snuff. It isn’t as crucial that third-party service providers are evaluated inside and out like we would the hedge fund firm. However, while there are some high-quality service providers to the hedge fund world, there are others that do not provide the level of service required to properly manage a portfolio of hedge funds.
Third-party service providers can include auditors, accountants, NAV calculators, hedge fund marketers, attorneys, custodians, and prime brokers, to name a few. The implications of a prime broker being affected by counterparty risk and affecting a hedge fund’s investments are crucial. And a less serious impact is a delay in the NAV calculation, which prevents us from finalizing our monthly performance and, in turn, delays our reports to clients. The client won’t know or care that the delay was caused by another party and it could affect our service levels and reputation as well.
When performing hedge fund due diligence, it’s important to know everything that’s going on with the hedge fund and with the hedge fund management. As we saw here, due diligence is about both quantitative and qualitative aspects of the hedge fund. Thorough due diligence should be performed before an investor gets involved with any investment, especially hedge funds.
The Questionnaire starting on the following page (this sample questionnaire is designed to aid you in your due diligence process. Not all of these questions may apply)
1. Firm Name:
2. Firm Headquarters:
3. Placement Agent, if any:
4. Placement Agent Address:
5. Contact Name:
6. Contact Telephone Number:
7. Contact Fax:
8. Contact Email:
B. Firm Description: Please provide a brief description of the firm.
C. Investment Manager Entities and Organizational Structure
Please describe the relevant entities of the investment manager or adviser and their ownership structure. Have there been any material changes to the entities themselves (e.g., additions or deletions) or to the ownership structure of those entities in the past three years?
1. Please briefly describe the background of the firm’s key investment personnel.
2. For the firm’s key investment personnel that have left the firm over the past three years, please explain any non-routine reasons for the departures.
Investment Manager Overview
3. Please describe the firm’s supervisory structures (e.g., management committees).
4. How many employees does the firm have supporting investment management businesses in total? How many by function? If the firm or its affiliates maintain multiple offices, how are these employees distributed geographically?
E. Service Providers
a. Who audits the investment vehicles managed by the firm?
b. Does the auditor have an affiliation or any business relationship with the firm or any of its affiliates outside of the audit relationship itself? Has the firm or any of its affiliates retained the auditor or any of its affiliates for other engagements, such as consulting?
services, financial statement preparation, or tax services? If so, please describe.
c. Has the current auditor audited the firm’s investment vehicles in each of the last three years? If not, please describe the circumstances of any audit engagement changes made.
d. Has any investment vehicle managed by the firm ever received a qualified audit opinion? If so, please describe.
e. Has an auditor ever requested a material restatement of financial statements or performance results of any investment vehicle managed by the firm? If so, please describe.
2. Has the firm engaged any third-party marketing agent? If so, please describe the terms of this engagement.
3. Who serves as legal counsel for the firm?
4. Does the firm outsource any accounting or operational functions to third parties? If so, please describe. Does the firm periodically review the performance of any such service providers? How is this review conducted?
F. Compliance System and Registrations with Regulatory Authorities
1. Please describe the firm’s compliance regime. Does the firm have a designated Chief Compliance Officer (“CCO”)? If so, please briefly describe the background of the CCO, and explain whether the CCO has any responsibilities other than those relating to
2. Is the firm or any of its affiliates registered with any regulatory authorities? If so please describe. If the firm has not registered with the U.S. Securities and Exchange Commission as an investment adviser, please explain the exemption upon which the firm
currently relies and if it intends to register in the next 12 months.
3. Does the firm maintain and periodically review written compliance policies and procedures, including a code of ethics? If not, please explain.
4. Does the firm have a written policy on the handling and safe
guarding of any material, non-public information in its possession,
including a process to educate employees? If not, how is material,
non-public information protected, and how are these processes
communicated to employees?5. Does the firm have written policies regarding personal account
trading by employees? If so, please describe. If not, is personal
account trading monitored, and how are standards of conduct communicated to employees?
6. Does the firm maintain written procedures on the provision and
receipt of gifts and entertainment? If not, how is such activity
monitored, and how are standards of conduct communicated to
7. Does the firm maintain written Anti-Money Laundering (“AML”)
procedures? Is there a designated AML compliance officer? If not,
how are AML checks conducted?
8. Please describe any material soft dollar arrangements the firm currently maintains.
9. Please describe any material directed brokerage arrangements the
firm currently maintains.
G. Legal Proceedings
1. In the past five years: (a) have there been any criminal or administrative proceedings or investigations against the firm, a principal or key employee of the firm, or any affiliate of the firm; or (b) have there been any civil proceedings against the firm, a principal or key
employee of the firm, or any affiliate of the firm in each case that resulted in an adverse disposition? If so, please describe.
2. Is the firm currently aware of any pending criminal or administrative proceedings against the firm, a principal or key employee of the firm, or any affiliate of the firm?
3. Have any adverse dispositions materially impacted any of the funds or accounts managed by the firm?
H. Infrastructure and Controls
1. Please describe the firm’s current trading, portfolio management, and post-trade reconciliation and accounting infrastructure, identifying any significant deployments of third-party software.
2. Please describe how trades are generally executed. What types of controls are typically used to help prevent unwanted executions from occurring?
3. Please describe the typical trade reconciliation process and frequency. What segregations of duty are generally employed in the
4. Please describe how cash or other asset transfers can be authorized, both for transfers within a vehicle managed by the firm, as well as to external parties. What types of controls are generally used to prevent unwanted transfers from occurring?
5. Please describe how the firm handles trading errors.
6. Does the firm or its affiliates retain errors and omissions insurance?
I. Business Continuity
Does the firm maintain a written BC/DR plan? If not, how does the firm plan to maximize its ability to recover from business interruptions?
II. Overview of Activities of the Investment Manager
A. Vehicles Managed
2. What are the aggregate assets under management of the investment manager?
3. Does the firm manage separate accounts? If so, please describe.
4. Does the investment manager or any of its employees have an interest in any of the investment vehicles managed by the investment manager? If so, what is the amount of this interest in the aggregate?
B. Other Businesses
Does the investment manager engage materially in other businesses apart from asset management? If so, please describe.
1. Please provide a description of the major investment vehicles managed by the investment manager.
C. Conflicts of Interest
1. Please describe those conflicts of interest that you consider material to the management of the investment vehicles. How do you address these conflicts?
2. Does the firm engage in cross-trades or principal cross-trades in monies that it manages? If so, what controls are generally in place to protect the participating investment vehicles or accounts?
3. Does the firm have any affiliates or subsidiaries that are broker dealers or execution agents? If yes, do these broker-dealers or execution agents: (a) execute on behalf of investment vehicles managed by the firm; and (b) charge commissions or mark-ups
on these executions or otherwise bill expenses to investment vehicles managed by the firm in instances in which the investment vehicle is not the sole owner of the execution agent or broker-dealer? If so, please describe these arrangements.
III. Fund Information
A. Fund Overview and Investment Approach
1. Please describe the fund’s legal structure.
2. Please provide a brief description of the investment strategies generally deployed by the fund.
3. What types of financial instruments does the fund generally trade?
4. In which geographical markets does the fund generally trade?
5. Approximately how many positions does the fund generally hold? What is the typical maximum position size?
6. Please describe the portfolio turnover.
B. Fund Capital and Investor Base
1. What is the capital base of the fund?
2. How many investors are currently invested in the fund?3. If the fund maintains a master-feeder structure with both U.S. and non-U.S. “feeder” entities, what percentage of the capital base is invested in the U.S. fund? The non-U.S. feeder fund?
C. Fund Terms
1. Are there multiple classes of interests or multiple “feeder” entities in the fund?
2. Please list, for each class of interest or feeder:
a. Investment minimum;
b. Management fee;
c. Performance fee, including hurdle rates, high-water marks, and loss carry forwards, if any; and redemption terms, including any fees payable, lock-ups, gating provisions, or other restrictions
3. Can the investment manager suspend redemptions, suspend the payment of redemption proceeds, pay redemption proceeds in-kind, or otherwise elect to deviate from the redemption terms described in 2 above? If so, please describe.
4. Have gates been imposed in the past? If so, under what circumstances were the gates imposed? If gates have been imposed in the past, have those gates been lifted? If so under what circumstances were the gates lifted?
5. Does the firm generally charge additional expenses to the fund, including operating expenses, audit fees, administrative fees?
Fund organizational expenses, legal fees, sales fees, salaries, rent, or other charges not detailed in (2) above? If so, please describe. What was the total amount of these expenses in each of the last three calendar years as a percentage of total fund assets under management, if applicable?
6. What is the firm’s policy with regard to side letters? Do any investors in the fund experience fee or redemption terms that differ materially from those listed above? If so, please describe.
D. Performance History
Please provide a performance history for the fund.
E. Risk Management
1. Please describe the firm’s risk management philosophy and discuss the approach used by the firm in the management of the fund’s exposure to: equity, interest-rate, currency, and credit market risk (as applicable); financing and counterparty risk; and operational risk.
2. Does the firm rely on third parties to perform any portion of its risk management function?
3. What types of risk measures does the firm use in its risk management function?
1. Please describe the process of valuation of the fund’s positions, including valuation process for positions that do not have a market price. Please discuss in particular the frequency of valuation and whether any third-party services are employed in the valuation process (and, if so, how these third parties are monitored).
2. Has the fund had a material restatement of its financial statements or any prior results since inception? If so, please describe. Was the restatement the result of an audit by an
external auditing firm?
G. Fund Service Providers
1. If the fund employs an administrator, please provide its contact information.
2. Please provide information concerning legal counsel used by the fund, if any.
3. Please name the main prime brokers used by the fund.
H. Investor Communications
1. How and what frequency are investor communications done? What tax forms are provided by the fund?