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Due Diligence, Disclosure and Fund Managers

by Hannah Terhune, JD LLM (Taxation, New York University)
As published on www.capitalmanagementlaw.com/

Fund managers should be prepared for the proverbial "check under the hood" when it comes to attracting new investors. While at times the due diligence check may amount to a mere formality, at other times it may seem more like a formal inquisition. Prospects not infrequently seek due diligence information beyond that provided in the fund's offering documents. When dealing with potential investors ("prospects"), it may be helpful for fund managers to understand the due diligence process in order to be better prepared for all contingencies.

Prospects may seek meetings with the officers of the fund and other persons significantly involved in the issuer's business to gain a basic understanding of the terms of the offering and its purposes; the nature of the issuer's business, including its management, workforce, creditors, major suppliers, customers, assets, liabilities, revenues, competition, and other business risks; and the regulatory schemes applicable to the enterprise. The following are areas of inquiry likely to be investigated by a prospect (or his legal counsel) before committing to an investment in your fund.

size, history and structure of the Fund and fund manager
ownership of the fund manager, including employee ownership
registrations and regulation of the fund and/or fund manager (including copies of Part II of Form ADV, if applicable)
number of employees, including descriptions and biographies of portfolio managers
compensation and incentive arrangements for key employees
fund manager's total assets under management
fund manager's level of investment in the fund
performance history
fees
maximum size of the fund
largest withdrawals from the fund since inception
types of clients and investors in the fund (e.g., institutional, high net worth, etc.)
lock-up and withdrawal periods
investment process ( i.e., the fund manager's approach to selecting investments)
portfolio characteristics (e.g., typical number of long and short positions, breakdown of industries held long and short, average holding period, turnover, volatility, etc.)
concentration of exposures and any exposure limits (e.g., a possible limit might be no more than five percent (5%) in any particular holding and no more than ten percent (10%) in any particular industry)
average holding period for investments
use of derivatives
leverage information for the fund and aggregate leverage limitations
manager's risk management processes
contingency and business continuity plans
prime brokerage arrangements
manager's front and back office operations
trade entry and trade processing procedures, as well as personnel authorized to place orders
description of trade allocation process
method for valuing portfolio holdings, including illiquid holdings
fund's accountants, lawyers and other professional advisors (including references)
litigation and/or regulatory proceedings involving the fund or fund manager
fund's most recent PPM (or similar offering document)
fund's audited and unaudited financial statements (e.g., balance sheet, cash flow statements, statement of operations)
monthly net asset values
frequency and detail of information given to investors
copies of the fund's recent correspondence to investors (e.g., quarterly letters)

Prospects may submit a due diligence checklist to the issuer's management, requesting extensive information covering every major aspect of the issuer's organization, business, and management. They may review the documents submitted to ensure satisfactory compliance with the request and to determine what additional information is required for the initial draft of the disclosure document.

In addition, prospects may prepare and distribute questionnaires to directors, officers, and principal shareholders asking for their background and experience, including any involvement in bankruptcy, criminal, civil, or administrative proceedings; ownership of the fund's securities; business transactions with the fund; and other information related to their knowledge and participation in the issuer's business.

Although the SEC has expanded the scope and reliability of exemptions from registration, fund managers nevertheless can be liable for fraud if they fail to disclose material information. To minimize disclosure problems, fund managers should be aware of the kind of questions and concerns prospects are likely to raise. The well-prepared prospect may be working with something like the following checklist: "What the astute fund investor should ask, and why."

Organizational Documents
What is the fund's mailing address? physical address? If there are multiple addresses for the fund or if the fund shares an address or office space with another fund or another business or company, require an explanation and obtain document (written contract) that enables sharing or colocation. Look for soft dollar arrangements.
Is the fund registered with the SEC? the State? Request a copy of Form D, as filed with SEC and relevant states. Verify the Form D or state regulatory equivalent filings in all states.
What state is the fund organized in? Most domestic funds are organized in Delaware, although some are organized in Nevada, and, occasionally, in another state.
What is the form of organization? Domestic funds are typically organized either as a limited partnership (in which the manager is the general partner and the investors are limited partners) or as a limited liability company (in which the manager is the managing member and the investors are non-managing members).

Obtain fund formation documents (e.g., Articles of Organization or Articles of Association).
Request State Certificate of Good Standing from fund. This can be obtained from the state of formation. Contact state to verify certificate status or request that certificate be mailed directly to you.
Is the fund domestic or offshore? If offshore, determine whether manager and/or fund are regulated by any regulator, and, if so, obtain regulatory filings. Ask about prime broker or other custodian, and administrator. Are they reputable? Where are the funds and securities custodied? If the answer is not New York, London, or some other major financial center, this is a warning sign. Inquire about the lawyers and the accountants: there is a limited universe of professionals in each offshore jurisdiction, and use of professionals who are not well known raises concerns.
What is the management fee?
What is the performance fee?
Does the manager have the right to more than 20% of the profits? If so, think twice about investing.
Does the manager's right to profits require that it first exceed a stated return to the investors (termed a hurdle rate)? If not, think twice about investing.
Does the agreement have a "high water mark" (where an investor has had profits, and the manager taken a share of profits, manager can only take profits in a later year if the losses are made up first). If not, it is probably inadvisable to invest, since this indicates unfairness on the part of the manager.
Is it a fund of funds? If the fund is a fund of funds, there are special considerations, the most important of which concerns fees and compensation to the two levels of managers. The costs should be kept to only slightly more than investment in a stand-alone fund entails.
Obtain Investment Advisory Agreement between the fund and the investment advisor. Verify that it conforms to stated relationship in the fund's Offering Memorandum.
What are the Withdrawal Terms? Does the agreement permit an investor to withdraw all or part of its capital? If so, on what conditionsСmust the investor give written notice (such as 90 days or 180 days) and how often in each year can an investor withdraw? Industry standards vary. In some cases, withdrawal four times a year is permitted, in other cases, only on December 31, after giving notice 90 days in advance. If the agreement contains very restrictive withdrawal rights, think twice about investing.
Does the fund have an Engagement Letter with an attorney on file? Obtain a copy and contact attorney to verify the client relationship.
Does the fund have an Engagement Letter with an auditor on file? Obtain a copy and verify the client relationship

Financial Statements
Obtain copies of the last three years audited financial statements directly from the auditor. Do not accept copies provided by fund. Review them to see whether they agree with what the manager has represented to be the fund's results.
Obtain copies of filed tax returns for last two years directly from the fund's accounting firm. Do not accept copies provided by the fund. Tax returns should include schedules and statements (except Schedule K-1, which discloses each investor's position in the fund). Compare results to audited financials, and reconcile tax results with financials (through unrealized gain/loss). Determine whether for tax purposes the fund is treated as a trader in securities (favorable treatment) or as an investor (unfavorable treatment).
If the fund is a fund of funds, when does the manager issue its financials and tax returnsСare they timely, or are there extensions (it takes longer, and more work, for the fund and its accountants to issue the results in the case of a fund of funds)? What are the strategies employed by each of the sub-managers in the investee funds, and are they sufficiently diversified to spread risk?
Obtain Performance Reports for the past 5 years. If PPM gives statistical history, review this and compare to audited financials. If manager supplies historical results, ask if these results are presented in compliance with GIPS (CFA Institute industry association standard formerly AIMR-PPS) guidelines for presentation of results.
Does the fund report far superior results to other funds in its investment strategy group? If so, ask for an explanation since there have been a number of frauds involving purportedly excellent results that ran counter to prevailing trends. Offering Memorandum
Review the fund's Offering Memorandum. If there is a Form ADV (there will be if the manager is a Registered Investment Advisers), compare the Form ADV to the PPM (search for Form ADV Part I at http://www.adviserinfo.sec.gov/IAPD/Content/IapdMain/iapd_SiteMap.asp and ask manager for Form ADV Part II).
What is the fund's brokerage firm(s)?
Who are the prime brokers or other custodians for the fund? It is common for a hedge fund to have one or more prime brokers, who track the investments and custody the funds. Use of a prime broker is a positive indication. However, if the fund invests in commodities, that part of the investing cannot be done through a prime broker. Also, very large funds ($500 million and up) do not use a prime broker because it is not cost efficient.

Investment Manager
Is the investment manager registered as an investment adviser with SEC? If yes, review Form ADV. Review entire form and, in particular, look for number of personnel employed, number of clients, and funds under management. Also look for whether any advisee clients are SEC registered investment companies or non-registered funds, and whether the adviser has had problems with regulators, has other business activities, etc.
Is the investment manager registered with any state regulatory authority as an investment adviser? If so, review forms. If not registered as investment adviser with SEC, or state level, higher level of scrutiny required.
Examine investment manager's Articles of Organization and Certificates of Formation for form of entity, jurisdiction of organization, location of office, and EIN letter from the IRS. Note that it is very rare for the investment manager of an onshore fund to be organized in a foreign jurisdiction
Examine the Operating Agreement of the investment manager.
What licenses do individuals employed at the investment manager possess? Many management personnel possess a securities license, such as Series 7 (registered representative of a broker-dealer) because the manager is itself registered with the SEC as a broker-dealer. If individuals are investment advisers, they will be required to have the Series 65 or equivalent.
What are the educational and professional credentials of the personnel? Verify credentials listed. What institutions of higher learning did they attend? Do they have a graduate degree in business or economics; sometimes, engineering, or mathematics, medicine, can be relevant? Are they a CFA (Certified Financial Analyst), which is the standard industry credential for professional investment managers?
What are the employment histories of the personnel? Were they employed at other hedge funds? If so, verify employment and review the history of those funds. Were they employed at major financial institutions, and, if so, in what capacity?
Examine the investment manager's past performance (if applicable).
Obtain photo identification from the manager (driver's license, passport, etc.).
Perform background checks on the manager and the principals of the manager. Useful places to look are Dun & Bradstreet report (credit check) and KnowX.com (background check with information on bankruptcies, liens, lawsuits, judgments, and UCC's). Be sure to obtain permission from each individual to run a background check.
Check on court decisions against the manager and its principals. Get state and federal filings on the manager -- such as state doing business certificates. Run check on FACTIVA (Dow Jones news retrieval service) or similar service to obtain media articles about the manager and its principals.
Get at least three references from the manager: inquire as to who the references are and conduct due diligence.

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Author: Hannah M. Terhune, JD, LLM (legal@capitalmanagementlaw.com), is
Partner and Chief Attorney of Capital Management Law Group, PLLC, an
international law firm (www.capitalmanagementlaw.com). Ms. Terhune specializes in
hedge funds, international and domestic tax, shareholder litigation, and business law.
In addition to practicing law, she lectures about tax, accounting, and business law at
two universities in Washington, D.C. She also contributes articles to prominent
publications.
Copyright 2006 Hannah Terhune

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Status: 18. Januar 2008