If the past few years have taught investors anything, the lesson is clearly: “Buyer, beware.” Now more than ever, investors and their financial advisers should perform careful due diligence before investing, especially if the investments involved are complex and opaque. From my perspective as a hedge fund auditor, let me suggest five practices that advisers should follow before making a hedge fund investment for their clients.
Know your investment manager. In addition to the investment management firm's general reputation and financial performance, look into how it is structured and whether there have been any recent significant changes to the organization's structure or operations. In addition, determine whether the fund has a history of barriers to withdrawal, such as closures, investments in illiquid securities, lockups, adoption of redemption fees or implementation of gates. Find out about the fund's key employees and the roles that they play in managing it. How many funds do they manage, and do the managers operate other businesses? Equally important, make sure you understand the fund's research and investment decision-making process, which is key to understanding the managers' approach to investing and their risk tolerance.
Review the fund's operations, technology, internal controls and infrastructure. Since the way a hedge fund conducts its daily business is an important factor in its success, investors and their advisers are entitled to know about the process. Therefore, it is entirely appropriate for an adviser to ask about a fund's operational risks and how they are mitigated. Does the fund have a chief risk officer who reviews and approves procedures? What kind of trading technology does the fund use — a proprietary system or one provided by a third party? And what internal controls have been instituted to prevent errors and fraud?
Determine the quality of the fund's service providers and vendors. Hedge funds don't operate in a vacuum. Ask for the names of their service providers and vendors, including prime brokers, administrators, legal counsel, marketing agents, custodians, auditors and technology providers. Ask to see an auditor's report prepared in accordance with Statement on Accounting Standards No. 70, which allows service organizations to disclose their control activities and processes to their customers and their customers' auditors in a uniform reporting format. Also ask about the level of services that the administrator provides. Identify the person at the fund who provides the administrator with initial information, and the person who reviews the final reports produced by the administrator. Also, ask about the firm's auditor. Do they have experience in the fund arena? Are they truly independent? Do they have any conflicts of interest? Has the fund ever restated its financial statements or its performance results?
Check for regulatory and legal compliance. It may seem obvious, but confirm that the investment manager has registered with the Securities and Exchange Commission or other appropriate regulatory authorities, if required, and that the investment manager hasn't been involved in major legal or regulatory matters. Whether or not the hedge fund is regulated, it should have established compliance policies and procedures, covering such matters as anti-money-laundering procedures. If the firm has a chief compliance officer, he or she can be your key contact for information.
Assess the fund's business continuity/disaster recovery plan. In the event of terrorism, a natural disaster or another catastrophe, the fund must be able to operate and meet its obligations to investors. Is there an established business continuity/disaster recovery plan? Are the fund's records secured, backed up and accessible if disaster strikes? Are key employees reachable and able to perform key functions off-site?
Kick the tires. One of the best ways to conduct due diligence is to obtain your information face to face, rather than by requesting, reading and interpreting documents. Read all you can, but also get to know the people in charge to glean the critical information that your investors need. To truly understand the strategy, operations and compliance of a hedge fund, you should directly question the fund's principals, as well as its service providers.
Finally, due diligence is more than just an initial review. Because hedge funds are dynamic vehicles, due diligence should be a continuing process, whether done by an adviser personally or by an external firm you retain.
Proper due diligence will help mitigate your clients' investment risk and help them achieve their financial objectives.
Jay D. Levy, a CPA, is J.H. Cohn LLP's financial services industry co-practice director. He can be reached at jlevy@jhcohn.com.
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