Financial Matters

Hedge Fund Due Diligence – Part 1

At Schultz Financial Group (SFG), we view wealth differently through our Four Capital approach. Our team works with you to build your wealth across Four Capitals – Financial Matters, Physical Well-being, Intellectual Engagement, and Psychological Space. This Financial Matters article focuses on Hedge Fund Due Diligence.

There are no guarantees in investing, just varying degrees of potential risk vs. potential reward. Identifying the degree of risk versus reward associated with a particular investment requires a carefully thought-out due diligence process. This is especially true in the context of hedge funds. With an estimated 11,000[i] active hedge funds in existence implementing numerous strategies that generate a wide-ranging dispersion of returns, the task of identifying the best of the bunch can seem daunting. This article is meant to help guide investors through due diligence, which is best broken down into four phases: 1.) Sourcing; 2.) Initial Due Diligence; 3.) Formal Due Diligence; and 4.) Ongoing Due Diligence. Part 1 of this article focuses on the first two phases:

Sourcing

Before conducting due diligence, an investor first needs to source a hedge fund investment opportunity. To increase the odds of identifying the highest quality managers, investors need to utilize as many quality sourcing mediums as possible. This reduces the risk of negative sourcing bias that may occur when an investor generates new investment opportunities from only a few sources. Comparing many hedge fund investment opportunities against one another is important to reduce negative sourcing bias. Further, an investor that fails to source investment opportunities continuously risks losing out on a possibly better opportunity. Typical sources may include, but are not limited to, third-party marketing firms, data aggregation platforms, direct solicitation, investor conferences, and personal relationships. From time to time, a hedge fund that previously stopped accepting outside capital will re-open to new investors, or a skilled manager will leave a firm to start a new hedge fund. Once an investor identifies the available investment opportunities, the initial due diligence phase starts.

Initial Due Diligence

Due diligence is a very time-intensive process, so it is essential to focus your resources on the best investment opportunities by implementing a screening process to identify the strongest candidates. The initial due diligence phase generally entails a call with the hedge fund manager, a review of the marketing materials and fund documentation, and a review of the completed due diligence questionnaire. Upon examination, an investor should have enough of an understanding based on investment team experience, fund track record, investment process, risk management, liquidity, third-party service providers, organizational and legal entity structure, internal policies and insurance, and legal terms to decide on whether to move forward with formal due diligence. Keep in mind that the initial due diligence phase is not an in-depth analysis. It is merely kicking the tires to determine whether it is worth spending the time looking under the hood. Although specific to each investor, reasons a particular investment opportunity will fail initial due diligence may include but are not limited to, high fees, strategy drift, poor historical performance, lack of experience, increased utilization of leverage, use of unknown third-party service providers, lack of LP oversight, or lack of standard documentation. Typically, only a small number of investment opportunities from the original pool of sourced investments make it past this phase and move on to formal due diligence.

The Formal Due Diligence and Ongoing Due Diligence processes are covered in Part 2 of this series.

[i] https://www.statista.com/statistics/721153/number-hedge-funds-worldwide-by-region/

Tony Miller is an Associate Wealth Manager with Schultz Financial Group Inc.

Schultz Financial Group Inc. (SFG) is a wealth management firm located in Reno, NV. Our approach to wealth management is different from many other wealth managers, financial advisors, and financial planners. Our team of fee-only fiduciaries strives to help our clients build their wealth across four capitals: Financial Matters, Physical Well-being, Psychological Space, and Intellectual Engagement. We provide family office and wealth management services to clients located in Nevada, California, and other states. If you’d like more information, please check out our website or reach out to us via our contact page.

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