The right way to do hedge fund operational due diligence

Posted by Andrew Borowiec on Mar 22, 2018 9:00:00 AM


Drawing from high profile case studies and 18+ years of specialist experience in hedge fund investigations, Rajiv Jaitly shared his thoughts on the right way to do hedge fund operational due diligence. The full recording of the on-line workshop “Case Studies of Hedge Fund Failures and Lessons to be Learned” is available to download now, or you can dive into some of the key takeaways below:

The Right Attitude To Hedge Fund Due Diligence

A lot of people in our industry say “trust, but verify”. Jaitly prefers a more cautious outlook when it comes to hedge fund due diligence. He says “be skeptical and verify.”

Professional skepticism is key to the operational due diligence mindset and this is a s true when dealing with hedge funds as anyone else. You need to have this mindset in order to be able to properly assess the environment and culture at a fund to see whether they are things you could or should trust.

This is backed up by the academic literature of professional ethics which advises operating from either a position of neutrality or a position of presumptive doubt.

The Right Practices In Hedge Fund Operational Due Diligence

Examine Environment And Culture

If you go into an operational due diligence investigation expecting to uncover fraud, you’ll likely be disappointed. It is very rare that you’d find evidence of this or any other poor practice that would give you a clear red flag against an investment.

Instead you need to examine the environment and culture of a hedge fund to see whether they would be conducive to letting things like that happen. Most issues that lead to hedge fund failure are identifiable prior to investment, if the operational due diligence professional asks the right questions.

Cover The Hygiene Factors

The reality is that as a small organization with limited resources, you’re unlikely to be able to do a comprehensive operational due diligence investigation on a large hedge fund. Your limited resources and their unwillingness to cooperate will prevent it. But that doesn’t mean you do nothing. Any operational due diligence professional can cover the hygiene factors, the basic checks and verifications of suppliers, controls and the stated procedures and policies around risk.

Get On Site

Wherever possible, you need to get on site at the hedge fund. You need to talk to the people actually doing the work, not just the investor relations personnel. Ask the same question of multiple people. You need to go beyond the boardroom and the flashy reception and actually sit with the traders. Another great tactic is to attend hedge fund industry functions and social gatherings which will give you a more honest insight into what issues are at play.

Collaborate With Investment Due Diligence

Often your operational due diligence team won’t have the specialist knowledge to be able to identify possible red flags such as style drift, over exposure to or lack of understanding of certain markets or the true nature of counterparty relationships. Working collaboratively with your investment managers will allow you to build a more complete picture of the risks associated with a particular hedge fund.

Be Honest About What Your Hedge Fund Due Diligence Procedures Actually Are

A lot of the issues around hedge fund operational due diligence arise from the discrepancies between what you promise in your marketing materials to investors and stakeholders and the reality of what you are able to deliver. Saying that you do comprehensive due diligence on each and every investment opportunity sounds great in a brochure, but if the reality is that you are only able to cover the hygiene factors for smaller investments or those deemed low risk, then you need to be transparent about this.

Hopefully this brief overview of best practices in hedge fund operational due diligence will equip you to effectively manage risk when making investment decisions regarding hedge funds. However, if you want to know more about this critical area, you can listen to the full IMDDA webinar “Case Studies of Hedge Fund Failures and Lessons to be Learned” here:

Access our webinar recording on Hedge Fund Operational Due Diligence

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Tags: Due Diligence, Hedge Funds

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