Hedge Fund Operations Checklist: What to Verify Behind the Scenes (Part 2)

In Part 1 we covered the big picture of operational due diligence and why so many hedge fund failures trace back to operational problems. Now in Part 2, Travers lays out exactly what to check, what questions to ask, and then shows us a real example interview with the operations team at Fictional Capital Management (FCM).

Disaster Recovery: Hope for the Best, Plan for the Worst

Every hedge fund needs a disaster recovery plan, and you need to verify it actually works.

Here’s the thing. A lot of smaller funds designate a partner’s home as the backup office. Bigger firms might rent actual backup space. Either way, you need to know: how long until they are fully functional after a disaster? What systems get restored? What data becomes available? What gets lost?

It is not enough to just have a plan on paper. Ask if they actually test it. Get specific dates and test results. If they use an outside consultant, ask to see the report. If they have never tested and have no plans to, well, that tells you something.

Policy: The Compliance and Ethics Layer

This section covers the internal rules that keep a hedge fund honest.

Compliance Manual. Fraud is much more likely at firms that do not monitor employees. Every fund needs a thorough, written compliance manual. Some handle compliance in-house, others outsource it. Either way, find out who the compliance officer is, get a copy of the manual, and ask about gifts, soft dollars, and how frequently checks happen.

Code of Ethics. Covers client confidentiality, employee trading, gifts, entertainment, and outside business interests. Every employee should have read and signed it annually. The key question: has anyone ever violated any provisions? If yes, what happened? That answer tells you a lot about the culture.

Valuation Policy. This is one of the most important pieces. Valuation determines the fund’s NAV, the price at which investors buy in and redeem out. For liquid equities, pricing is simple. For distressed debt or illiquid securities, it gets complicated fast. Every fund should have a formal, written policy. The administrator should have a copy too. Ask if the fund has ever restated its NAV. If yes, that is a big flag.

Board of Directors. Travers brings up the Weavering case where two “independent” directors were the manager’s brother and stepfather. They did nothing for six years and were found guilty of neglect. A board should include truly independent members with real qualifications. Watch out for “professional” directors who sit on dozens of boards. How much attention can they really give your fund?

Personal Trading. Employees should have most of their liquid wealth in their own fund. But some maintain personal accounts. Ask: does the firm require pre-clearance? Who approves trades? Do they get brokerage statements directly from brokers, not from employees? Any violations ever?

Transparency: The Eternal Tug of War

Investors want full transparency. Managers want to protect their ideas. Both sides have legitimate reasons.

Investors need transparency for proper due diligence and ongoing monitoring. But managers worry about competitors piggybacking on their ideas. Short sellers especially hate transparency because if a company finds out you are shorting their stock, they might cut off communication. Quant funds worry about competitors reverse-engineering their models.

The compromise? Third-party risk aggregators that collect position-level data and create risk reports without disclosing specific positions. Not perfect, but workable. Some managers will also give lagged position data (one to five months old) as a middle ground.

Product: Fees, Liquidity, and the Fine Print

The offering memorandum is the final authority, but Travers walks through key areas to verify.

Fees. The classic “2 and 20” structure means 2% management fee and 20% performance fee. Performance fees come with a high water mark, so the manager only gets paid on new profits. But here’s the problem: once paid, performance fees are almost never refunded. If the manager makes money in year one and loses it in year two, you paid a fee on a cumulative loss. Only a few funds include “clawback” provisions.

Liquidity. Match portfolio liquidity to investor liquidity terms. A fund investing in illiquid debt that offers monthly redemptions has a serious mismatch. 2008 taught everyone that lesson. Understand lockups (soft lets you redeem with a penalty, hard means your money is stuck), gates (limits on how much you can withdraw), and side pockets (segregated illiquid investments). If side pockets exist, find out whether they were created by design or because the manager strayed outside their mandate.

Assets Under Management. Asset size tells you if the fund is viable. Also ask: where did the assets come from? How much is internal capital? What were the largest redemptions in history and why?

Travers’ Operational Tips

Before the interview, Travers drops practical advice:

1. Check minimum standards first. Quick screen before going deep saves time.
2. Read ALL documents. Skimming is evil.
3. Cross-check with non-operations staff. Talk to traders, PMs, risk managers. Different people reveal different things.
4. Share notes across teams. A trader might contradict what the CFO said.
5. Liquidity, liquidity, liquidity. Match portfolio liquidity to investor terms.
6. Skin in the game. Managers should invest alongside you.
7. Review history. One bad fund can take down the whole business.

The FCM Interview: Putting It All Together

Travers meets with Bill Hobson (COO) and Jennifer Cassell (CFO) at FCM.

Bill is a founding partner with 20% equity. Accountant by training, moved into hedge funds in 1997. When Ted and Jaime left GCH to start FCM, they brought Bill along. The departure from GCH did not go well, the former boss Jonah took it personally. Travers plans to call Jonah for a reference.

Jennifer is a CPA from Dartmouth with 10 years at big four firms. She was actually the lead auditor on GCH’s financial statements, so Bill already knew her work. She joined in 2009 when institutional interest picked up after FCM’s strong 2008 performance.

Key findings:

• Fees: Class A charges 1.5%/20%. Class B charges 1%/20%.
• Liquidity: Quarterly redemptions, 90 days notice. Class A has no lockup. Class B has a one-year hard lockup per tranche.
• No side pockets or gates.
• Trading: 10-15 trades daily. About 70% through the prime broker, 30+ executing brokers. Daily reconciliations.
• Cash controls: All movements authorized by the administrator. Over $10,000 requires three signatures (administrator, PM, and COO). Prime broker must also approve.
• Pricing: Administrator handles everything using Bloomberg plus two additional sources. 100% Level I assets. No NAV restatements ever.
• Disaster recovery: Formal policy by external consultant. Third-party IT firm manages systems. Daily backups to separate location. RAID on critical systems. Tested twice since 2009.
• Compliance: No personal trading allowed. Outsourced to third party since September 2011.

One interesting moment: Travers asks Jennifer about partnership and she gets visibly uncomfortable, looking to Bill. Bill says no partners this year. Travers also asks about shadow equity (already knowing the investment team gets it from earlier interviews) and notices Bill is uncomfortable answering in front of Jennifer. He tactfully moves on.

This is the kind of detail you only pick up in person. The numbers and documents give you the framework, but reading body language and noticing what makes people uncomfortable, that is the art of due diligence.

My Take

This chapter is a masterclass in asking the right questions. Travers does not just list what to check, he explains why each thing matters and what the red flags look like.

The FCM interview shows how much you learn by sitting across from people. Jennifer’s hesitation about partnership, Bill’s discomfort about equity, the story about Jonah’s inconsistent references, none of this shows up in any document. You have to be in the room.

And “skimming is evil” should probably be framed and hung in every due diligence analyst’s office.

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