“Its four O'clock on Wall Street …
do you know where your money is?”
Why Hedge Funds Require Operational Due Diligence
Sophisticated Investments
On any given day, a hedge fund manger may be trading numerous securities and/or derivative contracts in vast geographical locations with differing regulatory regimes. Many of these trades will be directly with counterparties and not through a regulated clearinghouse. There may also be numerous counterparties settling at various prime brokers or custodians. There likely will also be multiple currencies involved. So where exactly is your money at any given instance? The manger and investor accept the investment risk associated with each trade. But what about the operational risks involved?
Complex Structure
Hedge funds can take various legal structures and managers often advise on numerous funds simultaneously some of which may have competing strategies. There is no standard business model. There may be domestic partnerships and various offshore funds. There may be side pocket investments and side letters affording certain investors preferential fees or other rights.
Small Size
The size of a hedge fund manager's operations is usually relatively small with few having greater than 50 employees. The small size may or may not be cause for concern. But the risk must be assessed. Are there additional conflicts of interest due to lack of segregation of duties? Are their adequate internal controls? Does the manager have the necessary resources?
Unregulated
Regulators are heavily involved in the operations of main stream investments like mutual funds while traditionally believing that sophisticated investors are better able to evaluate and assess the risks involved with hedge funds. This lack of regulatory oversight increases the probability of a negative event occurring.
Conflicts of Interest
The rich fees associated with most hedge funds create potential conflicts of interest with regards to valuation. The manager may be buying in one fund and selling the same security in another fund. What are the controls around these events to ensure there is no self-dealing? Does the manager have a code of ethics? Does the manger monitor personal trading? Does the manager have outside business interests?