4.3 Due diligence and the investor's view

Choosing a hedge fund is not just about picking the best-looking numbers. As lesson 4.2 showed, figures can flatter risk, and even a talented manager can lose investors money through weak controls, poor valuation or conflicts of interest. So before investing, allocators carry out due diligence: a structured review of the fund, its manager and its operations.

Due diligence shapes much of the work around a hedge fund. Investor relations teams answer due diligence questionnaires and host on-site meetings. Administrators, auditors and prime brokers are contacted to confirm what the manager says. Analysts at pensions, endowments and funds of funds write up the findings for an investment committee. This lesson looks at the two halves of due diligence, the reporting investors can expect, and how allocators put several managers together.

Investment due diligence

Investment due diligence asks whether the manager can deliver the returns it's aiming for, and with what risks. Common questions include:

• Strategy. What exactly does the fund do, and in which markets? Does the fund's actual behavior match what the manager describes?
• Edge. Why should this manager do better than others? Allocators look for a clear, repeatable source of return, such as deep research in one sector, rather than a vague claim.
• Team. Who makes decisions, how experienced are they, and what happens if a key person leaves? Many funds depend heavily on one or two individuals.
• Track record. How did the fund perform, in which conditions, and with what drawdowns? Analysts use the measures from lesson 4.2 and check whether returns came from market exposure (beta) or skill (alpha).
• Risk management. How does the fund limit exposure, leverage, concentration and losses? Is there someone independent of the portfolio managers watching risk?

Allocators also check that the fund's size, liquidity terms (lesson 4.1) and fees (lesson 3.3) make sense for the strategy.

Operational due diligence

Operational due diligence (ODD) asks whether the fund is run safely: whether assets are where they should be, values are fair and money can't go missing. Many allocators have separate ODD teams, and some will reject a fund on operational grounds alone, however strong its returns. Key areas, many of them linked to the service providers in lesson 3.1:

Valuation deserves special attention. For assets with no reliable market price, the NAV rests on the manager's judgement, and the manager's fees rise with NAV. The fair value and Level 3 principles are the same as those in PC101 4.2 and PE101 4.3. Allocators want to see who sets the prices, who checks them, and how often the manager's prices differ from any independent sources.

Transparency and reporting

Once invested, allocators rely on ongoing reporting. Common elements include:

• Monthly investor letters, with the month's return and the manager's commentary on what drove it.
• Risk reports, often monthly, showing exposures such as gross and net exposure (lesson 2.1), sector and country breakdowns, leverage and the largest positions.
• Annual audited financial statements, prepared by the fund and audited by its auditor.

How much a fund reveals varies. Some provide full position-level transparency, listing every holding, sometimes with a delay or through a third-party risk service. Others share only summary exposures, to protect their ideas and their short positions. Allocators weigh this: more transparency makes monitoring easier, but a fund can be well run without it.

Managed accounts and funds of funds

Investors don't have to invest in a manager's pooled fund. Two common alternatives:

• Managed accounts. The investor opens an account in its own name, and the manager trades it under an agreed set of guidelines. The investor owns the assets, sees every position, and can set its own limits on risk and liquidity. If needed, it can end the arrangement and keep the assets. The trade-off is cost and effort: managed accounts need their own service providers, and managers often accept them only for large investors or through dedicated managed account platforms. Some illiquid strategies don't suit them.
• Funds of hedge funds. A fund of hedge funds invests in a portfolio of other hedge funds. Its team selects managers, carries out due diligence and monitors them. That gives investors diversification across managers and strategies, and access to expertise they may not have in-house. The trade-off is an extra layer of fees: investors pay the fund of funds' own fees on top of the underlying funds' fees, and the liquidity terms can be no better than those of the funds it holds.

Building a portfolio of managers

Large allocators, such as a fictional university endowment we'll call the Ridgemont University Endowment, often hold several hedge funds rather than one. Building that portfolio involves a few decisions:

• Role. What is the hedge fund allocation for: to reduce overall risk, to add returns not tied to markets, or to protect in a crisis? The answer shapes the mix.
• Strategy mix. Spreading across strategies from Module 2, such as equity long/short, macro, relative value and credit, which tend to respond differently to the same events.
• Correlation. Checking that managers are not all exposed to the same risks. Five equity long/short funds that hold similar stocks are less diversified than they look.
• Liquidity. Making sure the combined redemption terms, lock-ups and gates fit the investor's own needs for cash.
• Sizing and monitoring. Deciding how much to give each manager, then reviewing performance, reports and operations regularly, and replacing managers when needed.

For Ridgemont, investing in the Kessling Harbor Equity Long/Short Fund would be one piece of this puzzle. The questions are not only "is this a good fund?" but also "what does it add to what we already hold?"

Key terms

• Due diligence: a structured review of a fund and its manager before investing.
• Investment due diligence: assessing strategy, edge, team, track record and risk management.
• Operational due diligence (ODD): assessing the fund's operations, controls, valuation, service providers and conflicts.
• Position-level transparency: reporting that shows every holding in the portfolio.
• Managed account: an account in the investor's own name, traded by a manager under agreed guidelines.
• Fund of hedge funds: a fund that invests in a portfolio of other hedge funds.
• Side letter: an agreement giving one investor terms that differ from the fund's standard terms.

Key takeaways

• Due diligence has two halves: investment (can the manager deliver?) and operational (is the fund run safely?).
• Independent administration, a clear valuation policy for hard-to-price assets, strong cash controls and managed conflicts are core ODD checks.
• Reporting ranges from monthly letters and risk reports to full position-level transparency; funds differ in how much they share.
• Managed accounts give investors control and transparency at higher cost; funds of hedge funds offer diversification and selection for an extra layer of fees.
• Allocators judge each fund by what it adds to a portfolio of managers across strategies, not just on its own.