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What Is Hedge Fund Due Diligence?

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  • Written By: Terry Masters
  • Edited By: Allegra J. Lingo
  • Last Modified Date: 03 July 2014
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Hedge fund due diligence is an investigatory process used by investors to determine the stability and legitimacy of a fund prior to making an investment. It requires the managers of a fund to answer questions and produce documentation on a wide range of managerial and operational topics. Hedge fund buyers are typically major institutions, university endowments, and pension funds, which often commit money entrusted to them by less sophisticated parties. The due diligence investigatory process protects these institutions by showing that they exercised the highest duty of care and made every reasonable effort to determine the appropriateness of the investment.

Due diligence is a legal notion that applies in many contexts across industries. It evidences a standard of care that a buyer must meet to demonstrate that he made every effort to determine the legitimacy of a sales transaction. Oversight agencies, salespersons, accountants, and legal professionals in many industries with common transaction types develop standard due diligence checklists that can be used by any buyer to educate him about the kinds of information he should seek and to make sure nothing is forgotten.

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In the financial industry there is a standard procedure for conducting hedge fund due diligence. Hedge funds are not regulated in the same way as ordinary stocks, bonds, or mutual funds that are sold directly to the public. Only a certain type of major institution or wealthy individual buyer is able to invest in a hedge fund. These types of investors are considered by regulatory agencies to be more sophisticated and able to do their own screening of investments without the need for the same laws that protect ordinary consumers.

Consequently, hedge fund due diligence is critically important in the financial industry. It is typically the only way for an investor to determine the legitimacy of the investment because of the lack of regulatory disclosure requirements that apply to this type of fund. Due diligence checklists and questionnaires for hedge fund transactions that request standard information and documents are normally easy to find.

Hedge fund due diligence should require the fund to produce certain documents, such as the fund’s marketing materials, audited financial statements, and breakdown of assets under management. It should also require the fund’s managers to answer certain questions about its viability, such as fund investment strategy, historical returns, fund terms, and regulatory registrations. The fund managers should also be vetted and provide personal information that attests to their experience, acumen, reputation, personal stability, and affiliations or conflicts. These examples are illustrative and not exhaustive, and a complete due diligence checklist contains many more items under these broad categories.

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