Hedge Fund Due Diligence

Thinking about buying into a hedge fund? Once a hedge fund has been chosen for further evaluation, the first step in the due diligence process is the information-gathering phase. Information can be obtained from the hedge fund manager or third-party sources, depending on the type of information and the required level of detail. (See also: Taking a Look Behind Hedge Funds.)

In most cases, when requesting information from a hedge fund manager, an investor must be able to identify himself or herself as an accredited investor or a registered investment advisor (RIA). This requirement is also becoming mandatory for obtaining information from many third-party sources. Some hedge fund managers require as little as a signed document stating that the investor is attesting to his or her accredited investor status, while others may go as far as requesting personal financial statements. In other words, you can't investigate a hedge fund carefully unless you have the resources to buy in. Assuming you do have the resources and experience required to invest in a hedge fund, it's important to conduct your due diligence to ensure that you're putting your money in the most productive place possible. Find out what you need to know to make your decision and where to find that information.

One of the simplest documents to review is what is often called a pitchbook. A pitchbook is a presentation that describes the firm and its fund strategy, and often provides details on the manager's strategy and process, biographies of firm personnel and performance history.

The pitchbook is a great resource for a preliminary determination of whether full-fledged due diligence is warranted. Up to this point, much of what an investor knows about the hedge fund is performance data, so the detailed explanation of the fund's strategy can enable an investor to determine whether it's a fund worth pursuing. Pitchbooks can vary greatly from one hedge fund to another. Some pitchbooks contain a variety of visual aids, like graphs and tables, to explain the manager's strategy and investment methodology. Others may differ in the level of detail provided, from short summaries of their investment strategy to a discussion of the portfolio and position details. Once reviewed, the pitchbook will give an investor an adequate description of the fund.

If the fund looks interesting, an investor would then review the offering memorandum and subscription documents. Both are legal documents, and an investor should pay careful attention when reviewing them. Two important areas to peruse are the stated investment objectives and the description of securities in which the hedge fund is allowed to invest. Hedge funds are becoming more flexible, which allows investment in securities outside of the fund's core capabilities and historical trends. By allowing a broader mandate, funds can make opportunistic investments in temporarily attractive sectors or shift focus when their investment style is out of favor. Although this could give a hedge fund manager more opportunities to invest, it could also raise risk management issues for the investor.

An investor should feel comfortable with the level of flexibility inherent in the investment mandate. If an investor is looking for a merger arbitrage hedge fund manager, for example, he or she should be wary of an investment mandate that also allows the hedge fund manager to invest in commodities, futures or private equity, which are not necessarily merger arbitrage-type investments. Broader investment mandates can potentially change the risk or return expectations of a hedge fund and may have liquidity implications. Be wary of very broad mandates.

An investor should also review the investment terms. Investment terms include minimum investment amounts, share classes, fee terms, redemption terms and notice periods, among others.

• Minimum Investment: Not only can an investor determine estimates of his or her own allocation amounts, but the minimum investment can also give an investor an idea of the types of investors in the fund. Higher minimums indicate a greater number of institutional investors or ultra-high net worth individuals compared to lower minimums, which would indicate a higher number of individual investors.
• Share Classes: Some funds will only have one share class. Others, however, will have multiple share classes that may have different investment terms, fee structures or investment mandates. It's important to note that some share classes allow for less liquid investments than other share classes.
• Fee Terms: The industry norm is "two and 20." That means a fund charges 2% of assets under management (management fee) and 20% of the profits (incentive fee). The fee terms should also include a high-water mark, which requires a hedge fund to exceed any prior high before collecting incentive fees.
• Redemption Terms and Notice Period: While some funds allow for monthly withdrawals, others will only allow quarterly, semiannual or annual redemptions. These terms have critical implications for liquidity and the portfolio management process. However, an investor should evaluate the terms relative to the investment strategy of the fund and determine their compatibility. Infrequent redemption periods are not necessarily a disadvantage as an investor might prefer to ensure that large, frequent investor redemptions will not occur. Some funds will be punished by frequent investor redemptions.

Before a conference call, an investor should obtain all of the information he or she needs to make an investment decision. To prepare for a conference call, an investor should complete the following activities:

1. Develop a list of relevant questions that should be answered during the entire due diligence process.
2. Make sure to review the pitchbook, offering memo and performance analysis data. This information will be the foundation upon which to build a conversation and may answer many of your questions prior to the conference call.
3. Schedule a convenient time for the call and take into consideration that the hedge fund manager may not want to speak until after market hours.
4. Make sure all of the right people are on the call so time isn't wasted looking for others. The call shouldn't last more than an hour and you want to maximize this time.
5. If more than one person will be on the call from the investor point of view, make sure to coordinate the conversation so it does not become a chaotic question and answer session. The goal is to have an in-depth dialogue with the hedge fund manager, not just fill out a questionnaire.
6. Have the fund manager describe his or her past experiences, how his or her strategy has evolved and what his or her vision is for the future. The manager should be able to tell a story that leads to his or her current investment process and how it will provide above-average returns in the current and future environment.

Depending on the type of hedge fund strategy and the amount of outsourcing a hedge fund has implemented, an office visit should range from as short as a few hours to as long as a couple of days. Many hedge funds are increasingly outsourcing their back office operations, so an office visit may not include an assessment of back-office capabilities.

Office visits should be conducted annually. Although communication should be occurring on a regular basis throughout the year, it is important to make periodic visits to not only build the relationship with a hedge fund manager, but also to visually assess any changes in the office environment, personnel, or even the physical appearance of the hedge fund manager to determine any changes that may indicate high levels of stress or poor health.

When conducting an office visit, it is important to meet with all relevant personnel and spend enough time with each to assess their capabilities and the fund's exposure to certain risks.

• Investment Decision Makers: The most important person to meet with, during an office visit, is obviously the person or people making investment decisions. This is a great time to go into detail about topics discussed during the initial conference call or issues that have come up during the continuing due diligence process.
• Idea Generators: Hedge fund managers may develop ideas on their own, rely on a team of analysts to uncover new opportunities or use a combination of the two in either an individual or team-based approach. It is important for the investor to interview everyone who contributes to the idea and investment process in the event that a top contributor leaves the firm.
• Risk Manager or Committee: Ideally, a fund will have separate investment and risk teams with the risk team responsible for monitoring the portfolio and ensuring it is maintained within the targeted risk parameters.
• CFO/Operations Manager: The back-office manager should be able to describe all of the firm's processes, and the investor's focus should be on financial controls such as signing authority, compliance, trade execution processes, and financial reporting, among others.

Some of the specific functions might include:

• IT: This includes trading software and systems, portfolio risk analysis software, database and storage systems and contingency planning in the event of disaster.
• Accounting: This includes net asset value calculations, fund auditing and fund administration.
• References: Investors who are currently or have been invested in the fund in the past can provide a good idea of a manager's communication, honesty, and consistency.

Finally, there are public and fee-based sources that can be used to gather additional information about a fund and its principals. Online and print news sources such as The Wall Street Journal, Google, FINalternatives, hedgefund.net, Aldbourne Village, Yahoo, LexisNexis and a variety of other sources can be used to search for announcements or news about the firm or the individual principals.

Proper hedge fund due diligence hinges on being able to effectively gather and analyze information about the fund. A hedge fund may offer up information that is not requested, but an investor should assume that only requested information will be provided. Therefore, a proper list of documents, questionnaires and interviews will ensure that an investor is properly informed about a fund before making an investment decision. Keep in mind that the information-gathering process presumes a hedge fund manager's honesty in providing complete and accurate information, and that intentional fraud will more likely be uncovered through a thorough due diligence process.