Financial Matters

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
  4. Ongoing Due Diligence.

The Four Phases for Hedge Fund Due Diligence

1. Sourcing Hedge Fund Investment Opportunity

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.

2. 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.

3. Formal Due Diligence

The formal due diligence phase is generally the most time-consuming part of due diligence. It requires an investor to conduct an in-depth analysis to understand every aspect of the hedge fund, validate the information provided, and identify the associated risks. The analysis is best broken down into two parts: investment due diligence and operational due diligence.

  1. Investment Due Diligence: Investment due diligence encompasses anything investment-related from both a qualitative and quantitative aspect. Because the performance of a hedge fund exists as a result of the personnel, strategy, process, and risk management, it makes the most sense to start with a qualitative review.

a. Qualitative Review: One of the most critical factors in a qualitative review is the personnel. How much experience does the hedge fund manager have implementing a particular 1strategy? What quality of work is the investment team producing? What responsibilities are being handled by the hedge fund manager? What commitments has the hedge fund manager delegated to other personnel on the investment team? An investor needs to ensure that the investment team implements the strategy, process, and risk management represented in the hedge fund documents.

A hedge fund’s strategy needs to be clear, concise, and make intellectual sense. Can any investment team member clearly communicate the strategy and the hedge fund manager’s style and approach? Has the hedge fund manager engaged in any style drift in the past? What is the hedge fund’s annual employee turnover? Suppose a hedge fund manager or member of the investment team cannot clearly and concisely communicate to an investor the investment strategy. How can an investor have confidence the individual will consistently adhere to the investment strategy once invested?

The investment process needs to be consistent and repeatable to help maintain a consistent level of quality across portfolio investments. What about the hedge fund’s investment process gives it a competitive advantage over a hedge fund running a similar strategy? How in-depth does a hedge fund’s investment process go? It is always a good idea to request a copy of the investment reports on current or prior portfolio investments to determine for yourself the consistency between investment reports and depth of analysis.

A hedge fund’s ability to consistently manage risk in accordance with its strategy is key to an investor’s ability to determine whether it will be a good fit for the investor’s risk tolerance. Does the strategy utilize leverage? Has the hedge fund’s net exposure remained consistent throughout its history? Does the hedge fund manager’s approach to risk management remain consistent during periods of both low volatility and high volatility? Is the hedge fund manager subject to any mandatory or voluntary investment restrictions? An investor needs to look at a hedge fund manager’s ability to adhere to investment restrictions, identify risks at both the portfolio and position level, and mitigate those risks in various market conditions.

b. Quantitative Review – On the surface, a hedge fund or a hedge fund manager’s track record may look amazing. However, a deeper dive into each contributing factor will help an investor determine whether the stated performance resulted from the hedge fund manager’s skill (investment edge attributed to a hedge fund’s personnel, strategy, process, and risk management) or luck. Did only a few portfolio investments drive performance, or did a majority of portfolio investments contribute to returns? How much did leverage contribute to historical performance? How much risk was needed to achieve the stated returns? How successful was the hedge fund manager at risk management during periods of high volatility and market downturns? An investor can accomplish this by performing an attribution analysis and contribution analysis.

Please keep in mind that when analyzing a hedge fund manager’s track record at a prior investment fund, always ask for a letter of attribution. A letter of attribution lets the investor know that the hedge fund manager played a role in achieving the stated returns at the prior fund.

This review should end with an investor calling references for both the investment manager and hedge fund. A reference’s answers to questions can be very telling based on their tone of voice or detail of responses. By asking difficult or targeted questions about the investment manager’s investment prowess and operations ability to handle the hedge fund’s everyday business needs, an investor can better understand what it is like to be an investor in the hedge fund or uncover new material information.

2. Operational Due Diligence: An investor should not enter into operational due diligence thinking they will discover fraud. Instead, an investor’s goal should be to determine whether the culture and environment in which the hedge fund manager operates are susceptible to fraud. Operational due diligence should focus on the aspects of a hedge fund that are non-investment related. These aspects typically include but are not limited to, an analysis of fund documentation and terms, organizational and legal structure, compliance and regulation, audit and reporting, back-office and fund accounting, administration and cash controls, valuation process, third-party service providers, counterparty risk, cybersecurity and IT, disaster recovery and business continuity plan, and transparency. Each aspect is very expansive in scope and will be covered in more detail in an article to follow. The following are some questions an investor should get answers to:

      • Does an employee play a role in both the investments and operations of the hedge fund?
      • Does the hedge fund require dual authorization for cash transfers?
      • How frequently does the administrator reconcile cash?
      • Do any of the fund’s audited financial statements contain a qualified or adverse opinion?
      • How is personal information stored? And which staff members have access?
      • What insurance policies does the fund carry? And what is the amount of coverage?
      • Does the fund have any soft-dollars arrangements?
      • How does the hedge fund vet its third-party service providers?
      • Has the fund manager ever rejected an LP’s request to withdraw capital?
      • How long is the fund’s lockup period? And what are the notice requirements for withdrawing capital?

There are many more questions to consider, but this should give an investor a good start. Additionally, an investor should always conduct an on-site visit, when possible, to help get a good sense of the hedge fund’s culture and how it operates. This may include spending a day observing and asking questions to various staff members in both investments and operations. An on-site visit is also a good time to request information from the hedge fund it deems to be sensitive in nature.

The final step of the formal due diligence process consists of compiling each analysis into a due diligence report and get answers to any outstanding questions. It helps to immediately write down any questions that arise during the due diligence process to reduce the likelihood of an important question going unanswered. The final due diligence report should also include a pros and cons section, risk analysis section, and final investment recommendation.

4. Ongoing Due Diligence

Once the investment is made, it is important to conduct ongoing due diligence on the hedge fund. What was valid at the time an investor made the investment may not be valid as time goes on. Therefore, it is essential to continually validate the rationale for making the original investment. This may include, but is not limited to, monitoring the investment portfolio for style drift or increasing volatility, staying informed on staff turnover which may result in a drop in quality or performance of portfolio investments, conduct annual background checks to check for new civil or criminal litigation, quarterly calls with manager to stay up-to-date on the portfolio, performance, and organizational changes, and review of the monthly statement, fact sheet, and audited financial statements as irregularities may arise. When the rationale for making the original investment is no longer valid, an investor should strongly consider moving on.

[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.

This article was originally posted as two separate articles in July 2021. It has been updated and combined into one comprehensive article for a better reader experience.

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