HedgeFund.Net's Due Diligence Guide for Investing in Hedge Funds
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HedgeFund.Net (HFN) Due Diligence Guide for Investing in Hedge Funds


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Disclaimer: The “HedgeFund.net (HFN) Due Diligence Guide for Investing in Hedge Funds” (the "Guide") was written and designed by Channel Capital Group Inc. ("Channel Capital"). The contents of the Guide are protected by copyright and other laws, and the Guide may not be copied or reprinted without the express written permission of Channel Capital. Users may print and download portions of the Guide, or the entire Guide, solely for their own non-commercial use, provided that they do not change or delete any copyright or proprietary notices from the materials.

The Guide is intended to outline important areas of due diligence which should customarily be evaluated prior to making an investment in a hedge fund or fund of funds. The Guide is not intended to be an exhaustive list of all appropriate questions during the investment process but merely a foundation for such an examination. The Guide is a generic tool, and does not contain specific questions that will be important in connection with the evaluation of individual hedge funds or funds of funds.

EACH USER ASSUMES RESPONSIBILITY FOR THEIR USE OF THE GUIDE, AND EXPRESSLY ASSUMES ALL RISK IN CONNECTION WITH SUCH USE AND IN CONNECTION WITH THEIR RELIANCE UPON ANY ASPECT OF THE GUIDE. CHANNEL CAPITAL PROVIDES THE GUIDE "AS IS" AND DOES NOT MAKE ANY EXPRESS OR IMPLIED WARRANTIES, REPRESENTATIONS OR ENDORSEMENTS WHATSOEVER (INCLUDING WITHOUT LIMITATION WARRANTIES OF TITLE OR NONINFRINGEMENT, OR THE IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE) WITH REGARD TO THE GUIDE OR ANY INFORMATION OR MATERIAL THEREIN, AND CHANNEL CAPITAL SHALL NOT BE LIABLE FOR ANY COST OR DAMAGE ARISING EITHER DIRECTLY OR INDIRECTLY FROM ANY USE OF THE GUIDE. IT IS SOLELY THE USER'S RESPONSIBILITY TO EVALUATE THE ACCURACY, COMPLETENESS AND USEFULNESS OF ALL THE GUIDE, AND CHANNEL CAPITAL DOES NOT WARRANT THAT THE GUIDE WILL BE ERROR-FREE OR THAT DEFECTS IN THE GUIDE WILL BE CORRECTED. CHANNEL CAPITAL RESERVES THE RIGHT TO MAKE CHANGES TO THE GUIDE, OR TO CEASE PUBLISHING CHANGES TO THE GUIDE, AT ANY TIME, WITHOUT PRIOR NOTICE TO ANY USER.

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Each user of the Guide holds Channel Capital Group Inc., and its employees and affiliates, harmless from any liability of any type (including, but not limited to, attorneys' fees and expenses) arising out of or in connection with their use of the Guide. Users of the Guide are also hereby informed that they should not assume that any aspect of the Guide is used in Channel Capital Group Inc.’s business or that of its affiliates. Users of the Guide should also have professional experience with investments in order to fully understand and evaluate the questions contained therein. The Guide should not be used as a replacement for advice of a competent investment professional with respect to any form of investment.

Investments in hedge funds and other private investment funds are speculative and involve a high degree of risk. Investors may lose all or a substantial amount of their investment. Each fund is unique and there are unique risks involved when investing in a particular hedge fund or fund of funds. Investors should carefully read a fund's offering materials and related information for specific risk and other important information regarding an investment in that fund before investing. The Guide does not list the risk factors associated with an investment in hedge funds or fund of funds.

 

TABLE OF CONTENTS

DUE DILIGENCE PREPARATION

FUND SNAPSHOT

INVESTMENT STRATEGY

HISTORICAL RETURNS & STATS

ASSETS UNDER MANAGEMENT

AUDITED FINANCIAL STATEMENTS

PERSONNEL

FUND TERMS

FUND DETAILS

FUND SERVICE PROVIDERS

REGULATORY REGISTRATION

GOOGLE SEARCH

RISK FACTORS

RISK CONTROL

OPERATION

VALUATION

ADMINISTRATION

SITE VISIT

DUE DILIGENCE PREPARATION

Request the following:

  • Company’s current marketing materials
  • Fund’s offering and subscriptions documents for onshore and offshore funds
  • Fund’s due diligence questionnaire
  • Fund’s audited financial statements since inception (onshore and offshore)
  • Monthly performance track record since inception
  • Breakdown of the firm’s assets under management by funds and managed accounts
  • Copy of recent portfolio (within last 6 month), including a description of securities & quantity of shares held. If possible, receive it directly from the prime broker/custodian.
  • Firm organizational chart
  • Names and phone numbers of contacts at service providers
  • Access to website
  • Two professional references on each principal
  • A copy of the most recently filed Form ADV (if the company is Registered Investment Advisor)
  • Copy of fund’s code of ethics, compliance manual, and annual compliance review
  • Copy of most recent SEC audit with response letter (if applicable)
  • Schedule a site visit with CFO or COO to discuss operational infrastructure of the firm

  Table of Contents

FUND SNAPSHOT

  • Name of Hedge Fund
  • Management Company
  • Portfolio Manager(s)
  • Address
  • Phone Number
  • Fax Number
  • Website (include login details)
  • Chief Executive Officer
  • Key Contact Person
  • Hedge Fund Style
  • Assets Under Management
  • Years of Operation

  Table of Contents

INVESTMENT STRATEGY

  • What is the investment strategy employed in the fund?
  • What are the financial instruments traded in the fund?
  • What are the fund’s geographical focuses?
  • How is the portfolio’s exposure determined?
  • What is the fund’s target return?

  Table of Contents

HISTORICAL RETURNS & STATS

 

  Table of Contents

ASSETS UNDER MANAGEMENT

Date:

Firm:

Fund:

  Table of Contents

AUDITED FINANCIAL STATEMENTS  

  • What was the auditing firm’s opinion?
  • Verify the fund's historical track record
  • Have there been any changes in the fund's structure?
  • Verify that the fund is in compliance with the terms outlined in the private offering documents (fees, expenses, classes of shares, strategy, etc.)
  • Review the condensed schedule of investments

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KEY PERSONNEL  

  • What are the biographies of principals and key management?
  • References on principals (include contact name, title, firm, address, phone, & email)
  • Background checks on managers (verify education, employment, litigation)
  • What is the ownership structure of the company?
  • Do the fund's principals invest their own money in the fund?
  • Do any of the firm's principals have other business involvements?
  • If yes, how much of their professional time is dedicated to each?

  Table of Contents

FUND TERMS

  • Minimum Investment
  • Subscription (frequency, notice)
  • Redemption (frequency, notice)
  • Early Redemption Fee
  • Management Fee
  • Incentive Fee
  • Other Fees
  • Lock-up
  • Hurdle Rate
  • High Water Mark
  • Leverage
  • Exposure Limits/Position Limits

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FUND DETAILS

  • What were the three largest withdrawals in the fund since inception (include date, percentage of equity, and the reasons for withdrawals)?
  • What is the total number of investors in the fund?
  • What is the percentage of ownership of the three largest investors in the fund?
  • What is the investor composition of the fund (institutional Investors, pension plans, endowments, high net worth individuals, etc.)?
  • Do any of the fund’s investors currently receive preferential treatment?
  • Does the fund use side letters?
  • Does the fund have soft dollar contracts?
  • Is there a soft dollar usage policy?

  Table of Contents

FUND SERVICE PROVIDERS

Obtain confirmation & references from each of the service providers below. Include contact name, title, address, phone, & email.

  • Offshore Administrator
  • Onshore Administrator
  • Prime Broker/Custodian
  • US Legal Counsel
  • Offshore Legal Counsel
  • Auditor

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REGULATORY REGISTRATION

Does the company, fund, or principals hold the following regulatory registrations?

  • Registered Investment Advisor (If yes, request and review the latest filed Form ADV)
  • Registered Investment Company
  • Broker Dealer
  • Commodity Trading Advisor
  • Commodity Pool Operator
  • Futures Commission Merchant
  • Introducing Broker
  • Other?

Have there been any private or public investigations by the SEC, NASD, CFTC, NFA, exchanges, state authorities, foreign authorities, or other governmental or regulatory authority?

  Table of Contents

INTERNET SEARCH

Search the Internet for additional information about the fund, management company, and portfolio managers.

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RISK FACTORS

What are the greatest risks to the fund portfolio and business?

  Table of Contents

RISK CONTROL

  • How does the fund company measure risk?
  • Are options used in the trading strategy?
  • Are swaps, forwards, and/or futures used to hedge portfolio risk?
  • What is the maximum, average, and minimum position size as a percentage of capital?
  • What is the maximum, average, and minimum leverage?
  • Is the maximum ever exceeded?
  • What is the loss tolerance for a position?
  • Are strict stop loss rules employed?
  • What is the maximum, average, and minimum number of positions in the portfolio?
  • Is the maximum ever exceeded?
  • Does the firm calculate VaR for the portfolio?
  • Is the portfolio stress tested?
  • If so, how often is this done and what factors are examined?

  Table of Contents

OPERATION

  • How many trades does the fund execute per day?
  • List the executing brokers
  • Are trades reported to the prime broker manually or via an interface?
  • Who executes and supervises daily trades at the firm?
  • What are the systems used in the front office, operations, and accounting?
  • Describe the trade allocation process
  • Describe the daily trade reconciliation procedures
  • Is there a written policy on error correction?
  • If yes, obtain a copy.

  Table of Contents

VALUATION

  • Describe the security valuation?
  • How are the securities marked to market?
  • What method do they use?
  • What is the frequency of administrator’s reconciliation procedures?
  • Does the administrator price securities in the portfolio to an independent pricing source?
  • Does the firm approve the NAV calculated by the administrator before it is sent out to investors?
  • Has the firm ever had to revise the NAV after it was final?
  • If yes, explain.

  Table of Contents

ADMINISTRATION

  • Describe the internal control procedures for cash (who can move cash, including disbursement for expenses and redemptions).
  • What internal records are kept, in what form are they maintained, and what security is in place for these records?
  • Describe the firm’s disaster recovery plan.
  • How often are the firm’s systems backed-up?
  • Does the company carry professional liability insurance?
  • Describe the firm’s human resources department
  • Describe the compensation structure
  • Describe the firm’s back office
  • What are the possible conflicts of interest?
  • Does the firm have plans to launch any new funds?
  • Provide the fund name, inception date, strategy, AUM for all of the firm’s funds under management.
  • Is there a compliance manual & code of ethics?
  • What are the personal trading policies?
  • What is the total number of employees at the firm?
  • What is the breakdown by department?
  • What has the employee turnover been like (departures and new hires) for the last three years?
  • Have there been any past, threatened or pending customer or other complaints, litigations, or administrative actions?
  • Are there branch offices or other locations?
  • If so, what functions are performed at these branches?

  Table of Contents

SITE VISIT

If a site visit is not performed, indicate what alternative procedures have been done to ensure existence of the fund operation.

Below is a comprehensive list of suggested site visit talking points and due diligence questionnaire follow-up questions:

Back Office
Ask who is in charge of compliance and find out about the custody and security of assets. How are the relationships with their service providers?

Trading process & Portfolio Characteristics
Speak with the traders. What is the trade volume (daily/weekly/monthly)? Find out how many different exchanges they are trading on, and who has signing authority for the firm, funds, and trade settlements. (Is there a dependence on any key person?) Verify the approved broker/dealers and their policy on soft dollar arrangements. Finally, explore their safeguards against irregularities in trading.

Valuation and NAV Calculation
Discuss the valuation process and the sources used for pricing. If there are any illiquid securities, find out what percentage of the portfolio they make up and the guidelines that are used for pricing. Additionally, verify how they measure illiquidity risk.

Speak with the portfolio manager. Does he have override capabilities (when system based)? If leverage is used, who is the leverage provider? Finally, what time is the NAV calculated?

Risk Management
Ask about their risk philosophy, how risk is calculated, and how long it would take to exit of their positions. Find out if there is a risk committee and a description of the supervision of the traders.

Performance
Confirm how often performance is reported and who prepares the monthly performance? Ask for an example of a market environment that would be extremely difficult for the fund’s strategy and what global factors impact the portfolio.

Subscription & Redemptions
Discuss the firm’s new capital growth since inception and the number of investors gained or lost by year. What money laundering checks are in place?

Legal and Compliance
Meet the in-house general counsel and confirm the last time the firm was audited by a regulatory body (SEC, NFA). If there are any side letters, are they fully disclosed to all investors and do they entail preferential terms to an investor? Ask if there is professional liability insurance in place.

If outsourced, how often is the legal counsel in the office?

PPM & Marketing Materials
Find out who in the industry the firm respects and who they do not want to be like. Inquire about the potential for any new funds in the near future.

HR
Meet with the head of human resources. What was the growth in personnel over the last year, and what is the anticipated growth in the future? Have there been any terminations over the last year?

Discuss trader compensation and find out if there are any non-compete agreements. Are any portfolio managers located outside of the office, and has the firm ever operated capital under a different name?

Miscellaneous
Discuss the disaster recovery plan and find out if it has been tested. Are there back up systems in place?

  Table of Contents


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