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How To Ace Your Hedge Fund Investor Due Diligence

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Raising AUM is a tough endeavor and one that has become even more so post 2008.  Investor roadshows are akin to marathons and “hit ratios” take all their importance.  Once the initial screening stage (where team pedigree, strategy and returns are discussed) has been successfully passed, investors will want to dive deeper through the means of a detailed due diligence (“DD”) process.

The romantic concept of “two guys, a Bloomberg and their dog” is a thing of the past. Investors will expect a solid infrastructure and will thoroughly run through a detailed checklist, covering all aspects of your fund and business. The challenge here is to avoid giving investors a reason not to invest.

It is beneficial to recognise that this process differs between hedge funds, private equity & fund of funds. Below, we look at the fundamentals of a hedge fund DD. As an asset manager, it is important to not only grasp the structure of a DD process but also how to best prepare and ensure your investor is comfortable.. The team at HedgeGuard have past experience running their own funds, a valuable experience as we also actively assist our clients during their investor due diligence meetings. Undoubtedly, hedge fund DDs have become more rigorous and we highlight below some of the key focus areas:

  • Organizational structure & regulatory set up
  • Segregation of responsibilities, staffing & key person risk
  • Strategy, portfolio concentration, liquidity terms & performance
  • Service providers, independence & timeliness of reporting

In most cases, due diligence is carried out with the help of a DDQ document review and an on-site visit to the manager’s offices. In some very rare instances, an on-site visit is not required.

How should you prepare?

First, be sure that all legal documents are complete and updated whilst any marketing/reporting material is accurate and concise. It is the job of the due diligence analyst to spot any inconsistencies, therefore attempting to hide behind circular wording such as liquidity terms or complicated gate schedules will be flagged. Be prepared for the request of any documents outside the scope of due diligence as they can be requested during an on-site, however this is down to the manager’s discretion.

As well as the due diligence being carried out on your fund, your service providers must also pass the review. When selecting third party providers, ensure that you have carried out your own due diligence first, understand their processes and that they are well structured with a business continuity and disaster recovery plan.

Getting inside the investor’s head: Why does an investor carry out a DD?

To understand the process, let’s look at things from an investor’s stance. A common concern amongst Hedge Funds is that investors want to take a peek at the “secret sauce” behind their performance. If anything, the priority in an investor’s approach has shifted significantly over the past years from understanding how a fund will generate alpha and returns to understanding how a fund will avoid losing their investment.

Risk management will be one of the cornerstones to all DD exercises and there are three main risks the investors are concerned about; 1) Market risk, this involves risk exposure through traded positions 2) Operational risk, maintaining effective processes 3) Reputational risk, avoiding association to fraudulent activity or conflicting interests with a politically exposed person, PEP.

Don’t forget about your middle & back office

The efficient alignment of front office functions with the middle and back office has been an increasingly important point for investors. Funds are confronted with a new generation of investors who are empowered by data and that want access to timely and accurate information. The right technological and operational set-up can help answer these requirements. However, the challenge for smaller to mid-sized managers is the ability to display scalability. This is a key area of operational due diligence that the investor is interested in. Today’s technologies and outsourced solutions can help manager’s display an institutional grade set-up. The section in the DDQ which can be challenging to write about is the processes of your middle and back office and the related trade workflow.  In the case that you have outsourced these responsibilities, invite the professionals to the on-site, as they will be able to answer specific queries. This will also display your positive relationships with service providers.

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