Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance

Common Elements of the Due Diligence Process

The due diligence process today is very different than it was in the past. In the past, manager reputation and performance were the most important factors. Investors did little digging into the how and why of performance and the safeguards in place to protect assets. This was due in part to the lack of leverage that individual investors had with the managers. They were often considered “lucky” just to have gotten into a well known fund with limited capacity. Institutions had relative small exposures to hedge funds at the beginning and need to have a high return to have the investment matter to the portfolio. Finally, managers were rather selective and if you asked too many questions you would simply be told to go elsewhere.

As the industry matured and as more institutions came into the market, not to mention some very high profile frauds, the due diligence process expanded. Today, both managers and investors spend a great deal of time trying to learn where a manager's “edge” is coming from and that their investment is safeguarded and properly valued.

The due diligence process involves two separate but closely related evaluations. One evaluation is of the firm's investment process and related risk controls. The other is related to the fund's operations and business model. Today both are considered almost equally important and are often interrelated.