CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

40.1 OPERATIONAL DUE DILIGENCE

Hedge fund due diligence is the process by which a potential investor obtains a sufficient understanding of a hedge fund in order to make an informed decision in regard to investing. Issues typically considered during the due diligence process include the hedge fund's investment strategy, the character of the organization, the way the fund operates, the management of its associated risks, and the credibility of its business model. Not surprisingly, due diligence is considered by many as the most critical stage in hedge fund investing due to regulators' relatively light oversight of hedge funds, the general lack of transparency regarding hedge fund portfolio positions, and the difficulty of establishing reliable performance benchmarks. If performed well, due diligence can reduce risk, increase returns, and make investors more secure in their investment. On the other hand, if performed poorly, it can put investors' capital at risk.

Although there appears to be a wide variation in due diligence standards between different hedge fund investors, most generally agree that due diligence should include a review of the fund's marketing materials, investor correspondence, legal/audit documents, regulatory and professional records, background checks, and investment performance. Generic due diligence questionnaires are usually a good starting point in understanding how a hedge fund operates. To be effective, however, due diligence must involve significantly more ...