http://www.capitalmanagementlaw.com/hedgefunds/duedilgence.html
Organizational Documents
What is the fund's mailing address? Physical address? If there are multiple addresses for the fund or if the fund shares an address or office space with another fund or another business or company, require an explanation and obtain document (written contract) that enables sharing or colocation. Look for soft dollar arrangements.
Is the fund registered with the SEC? the State? Request a copy of Form D, as filed with SEC and relevant states. Verify the Form D or state regulatory equivalent filings in all states.
What state is the fund organized in? Most domestic funds are organized in Delaware, although some are organized in Nevada, and, occasionally, in another state.
What is the form of organization? Domestic funds are typically organized either as a limited partnership (in which the manager is the general partner and the investors are limited partners) or as a limited liability company in which the manager is the managing member and the investors are non-managing members).
Obtain fund formation documents (e.g., Articles of Organization or Articles of Association)
Request State Certificate of Good Standing from fund. This can be obtained from the state of formation. Contact state to verify certificate status or request that certificate be mailed directly to you.
Is the fund domestic or offshore? If offshore, determine whether manager and/or fund are regulated by any regulator, and, if so, obtain regulatory filings. Ask about prime broker or other custodian, and administrator. Are they reputable?
Where are the funds and securities custodied? If the answer is not New York, London, or some other major financial center, this is a warning sign. Inquire about the lawyers and the accountants: there is a limited universe of professionals in each offshore jurisdiction, and use of professionals who are not well known raises concerns.
What is the management fee?
What is the performance fee?
Does the manager have the right to more than 20% of the profits? If so, think twice about investing.
Does the manager's right to profits require that it first exceed a stated return to the investors (termed a hurdle rate)? If not, think twice about investing.
Does the agreement have a "high water mark" (where an investor has had profits, and the manager taken a share of profits, manager can only take profits in a later year if the losses are made up first). If not, it is probably inadvisable to invest, since this indicates unfairness on the part of the manager.
Is it a fund of funds? If the fund is a fund of funds, there are special considerations, the most important of which concerns fees and compensation to the two levels of managers. The costs should be kept to only slightly more than investment in a stand-alone fund entails.
Obtain Investment Advisory Agreement between the fund and the investment advisor. Verify that it conforms to stated relationship in the fund's Offering Memorandum.
What are the Withdrawal Terms? Does the agreement permit an investor to withdraw all or part of its capital? If so, on what conditions must the investor give written notice (such as 90 days or 180 days) and how often in each year can an investor withdraw? Industry standards vary. In some cases, withdrawal four times a year is permitted, in other cases, only on December 31, after giving notice 90 days in advance. If the agreement contains very restrictive withdrawal rights, think twice about investing.
Does the fund have an Engagement Letter with an attorney on file? Obtain a copy and contact attorney to verify the client relationship.
Does the fund have an Engagement Letter with an auditor on file? Obtain a copy and verify the client relationship
Financial Statements
Obtain copies of the last three years audited financial statements directly from the auditor. Do not accept copies provided by fund. Review them to see whether they agree with what the manager has represented to be the fund's results.
Obtain copies of filed tax returns for last two years directly from the fund's accounting firm. Do not accept copies provided by the fund. Tax returns should include schedules and statements (except Schedule K-1, which discloses each investor's position in the fund). Compare results to audited financials, and reconcile tax results with financials (through unrealized gain/loss). Determine whether for tax purposes the fund is treated as a trader in securities (favorable treatment) or as an investor (unfavorable treatment).
If the fund is a fund of funds, when does the manager issue its financials and tax returns are they timely, or are there extensions (it takes longer, and more work, for the fund and its accountants to issue the results in the case of a fund of funds)? What are the strategies employed by each of the sub-managers in the investee funds, and are they sufficiently diversified to spread risk?
Obtain Performance Reports for the past 5 years. If PPM gives statistical history, review this and compare to audited financials. If manager supplies historical results, ask if these results are presented in compliance with AIMR (industry association) guidelines for presentation of results.
Does the fund report far superior results to other funds in its investment strategy group? If so, ask for an explanation since there have been a number of frauds involving purportedly excellent results that ran counter to prevailing trends.
Offering Memorandum
Review the fund's Offering Memorandum. If there is a Form ADV (there will be if the manager is a Registered Investment Advisers), compare the Form ADV to the PPM (search for Form ADV Part I at
www.adviserinfo.sec.gov/IAPD/Content/IapdMain/iapd_SiteMap.asp and ask manager for Form ADV Part II).
What is the fund's brokerage firm(s)?
Who are the prime brokers or other custodians for the fund? It is common for a hedge fund to have one or more prime brokers, who track the investments and custody the funds. Use of a prime broker is a positive indication. However, if the fund invests in commodities, that part of the investing cannot be done through a prime broker. Also, very large funds ($500 million and up) do not use a prime broker because it is not cost efficient.
Investment Manager
Is the investment manager registered as an investment adviser with SEC? If yes, review Form ADV. Review entire form and, in particular, look for number of personnel employed, number of clients, and funds under management. Also look for whether any advisee clients are SEC registered investment companies or nonregistered funds, and whether the adviser has had problems with regulators, has other business activities, etc.
Is the investment manager registered with any state regulatory authority as an investment adviser? If so, review forms. If not registered as investment adviser with SEC, or state level, higher level of scrutiny required.
Examine investment manager's Articles of Organization and Certificates of Formation for form of entity, jurisdiction of organization, location of office, and EIN letter from the IRS. Note that it is very rare for the investment manager of an onshore fund to be organized in a foreign jurisdiction
Examine the Operating Agreement of the investment manager.
What licenses do individuals employed at the investment manager possess? Many management personnel possess a securities license, such as Series 7 (registered representative of a broker-dealer) because the manager is itself registered with the SEC as a broker-dealer. If individuals are investment advisers, they will be required to have the Series 65 or equivalent.
What are the educational and professional credentials of the personnel? Verifycredentials listed. What institutions of higher learning did they attend? Do they have a graduate degree in business or economics; sometimes, engineering, or mathematics, medicine, can be relevant? Are they a CFA (Certified Financial Analyst), which is the standard industry credential for professional investment managers?
What are the employment histories of the personnel? Were they employed at other hedge funds? If so, verify employment and review the history of those funds. Were they employed at major financial institutions, and, if so, in what capacity?
Examine the investment manager's past performance (if applicable).
Obtain photo identification from the manager (driver's license, passport, etc.).
Perform background checks on the manager and the principals of the manager. Useful places to look are Dun & Bradstreet report (credit check) and KnowX.com (background check with information on bankruptcies, liens, lawsuits, judgments, and UCC's). Be sure to obtain permission from each individual to run a background check.
Check on court decisions against the manager and its principals. Get state and federal filings on the manager â such as state doing business certificates. Run check on FACTIVA (Dow Jones news retrieval service) or similar service to obtain media articles about the manager and its principals.
Get at least three references from the manager: inquire as to who the references are and conduct due diligence.
