How Do You Conduct Hedge Fund Due Diligence?

Summary: This page looks at the possible approaches that a potential investor can pursue if they want to perform due diligence on a hedge fund.

There can be little doubt that hedge fund due diligence is very difficult to do. Very difficult.

As a private or institutional investor, it may not seem overly important to research the management and company structure of Fidelity, Standard Life or other large fund managers. In the world of the hedge fund, however, it is much more important, but much more difficult.

As far as we can see, there are three main avenues to understand about a hedge fund. They are the structure, the people and the trading strategy.

The Structure: Hedge funds are designed to fall through the cracks of financial services legislation. In technical and government policy jargon, this is known as regulatory arbitrage. This means that the owners and managers of a hedge fund will deliberately use the most friendly location for different aspects of it's setup.

What does that mean?

An example might be a hedge fund with managers that work in an office on Wall Street and are regulated as individuals in the United States. The money might be held in a bank account in the Cayman Islands, in a bank from the Virgin Islands, with a custodian from Bermuda. The fund might be domiciled in Jersey and clients could be from around the world.

Readers will note that the majority of those jurisdictions have some form of 'financial confidentiality' in place. In the modern world, there are very few jurisdictions that offer secrecy, but still, solid confidentiality can be difficult to penetrate.

This means that a potential investor is essentially reliant upon disclosures from the fund manager as to how the company is structured. This will be done voluntarily as part of the marketing material.

However, it will be difficult to actually verify. Enquiries into the ownership of parts of this structure in the relevant jurisdictions may receive an acknowledgement that the fund or company exists but little more. More often than not, even this acknowledgement to a private individual will be rare.

Thus, much of the company structure will be something taken on trust. It ought to be noted that the structure will almost certainly place the fund management team in a position of very limited or no financial liability.

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The People: A great many hedge funds are started by experienced fund managers. Often they have been working for some years at a well known and respected investment bank or asset management firm.

They will use this experience and these connections to help them raise the existing funds required to launch. For a fund manager with a good to great record, the starting capital will be in the hundreds of millions of US dollars.

The thought process behind why they do this is actually quite simple. For a conventional asset manager, they might be earning hundreds of thousands or perhaps even one or more million dollars per year. Nice, huh? However, the fee structure of most hedge funds is such that managing the same fund performance for their own fund might yield tens of millions or perhaps even over one hundred million per year.

This is the difference between living very well and creating a multi-generational financial dynasty.

Therefore, when performing hedge fund due diligence on the management team, there usually is something to look into. The managers will generally have been employed in a regulated role onshore and the track record of their fund has been published years into the past.

However, this is not really all that helpful. After all, if the managers had not been successful in the past, they would find it hard to raise the initial capital to launch their own hedge fund. Thus, any research will likely yield information about their above benchmark or above index returns. You knew that BEFORE you looked!

The annual reports of the funds will almost certainly reveal some information about the investment or trading strategy that they used in these funds. Investment managers will rarely switch very far from a successful formula.

No checks can help to determine the character of the managers though. As this conviction in 2011 of a leading hedge fund manager proved, no matter how rich and successful, temptation exists for us all.

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The Strategy: This is almost certainly the hardest part of any hedge fund due diligence to actually do. Why? Because if a hedge fund has found a 'secret' in the stock and currency markets of the world that gives them an edge, they will not tell anyone! Ever!

A close friend of the author works in telephone sales for a hedge fund based in Malta. The company operates in the forex environment and runs three separate funds with different levels of risk and potential return. He tells me that even internally, only four people know how the funds make their money. It seems that they are very successful, but when a potential client calls them and asks for details, they tell them, "We don't know how they do it, they won't tell us either!"

In The Quants by Scott Patterson (published in 2010 by Random House Business Books), he describes Renaissance Technologies - one of the most successful hedge funds ever. "The fact is, no one outside the offices of Renaissance Technologies knows the answer to how it detects nonrandom price movements. Few people who have joined Renaissance have ever left. Those who have aren't talking."

This kind of secrecy is very understandable, and if we were in their position, we would do the same. But it does make any form of due diligence or even basic understanding near impossible. Of course, some funds such as Renaissance use such complex methods that the vast majority of humanity could not understand it anyway!

If all this leaves you with the impression that understanding how and where a hedge fund works is not easy, you are quite correct. In fact, as has been shown since the start of 2007 and then into the financial crisis of 2008 and beyond, most national regulators have very little understanding of how and what they do.

This means that investing in a such a fund comes down to salesmanship, greed and trust. Needless to say, greed is the overriding factor. If the investment strategies themselves were not high risk (which many are), the additional risks associated with very little understanding or legal recourse means that hedge funds ought not to be an investment for most private investors - and most financial institutions and asset managers!

If you have plans to make a substantial investment, there are services that perform hedge fund due diligence services and a wide range of background checks. Unsurprisingly, there are companies and analysts that specialise in this kind of work.

Know Your Client And Anti-Money Laundering

Despite the situation described above, hedge funds need to be careful about performing due diligence on their clients to ensure that the investment funds are not accepting proceeds of crime. This means that international hedge funds still need to conduct KYC and AML procedures on their investors. This kind of task is often administered by the funds in a lower cost jurisdiction. In fact there is substantial cross-over with some other sectors. A great example is the island of Malta in the EU that has well developed fund management and gaming sectors. The KYC and AML procedures are quite similar. This means that staff can sometimes switch between sectors and move to compliance online gaming jobs in Malta.

If you would like to read more about hedge funds, please follow these links:

How Do You Define A Hedge Fund?

What Are The Best Hedge Funds?

Is There Any Regulation Of Hedge Funds?

Why Invest In A Hedge Fund Of Funds?

What Do Forex Hedge Funds Do?

How Do Real Estate Hedge Funds Work?

How Risky Are Energy Hedge Funds?

How Can You Learn About Offshore Hedge Funds?

What Can Commodity Hedge Funds Trade?