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
• compensation and incentive arrangements for key
• fund manager's total assets under management
• fund manager's level of investment in the fund
• performance history
• 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
• 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
• litigation and/or regulatory proceedings involving the fund or fund
• 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.,
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."
• 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
• 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
• 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
• 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
• 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
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
• 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,
• 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
• 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,
• 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
• Get at least three references from the manager: inquire as to who the
references are and conduct due diligence.