Hedge Fund Due Diligence - How to Check Before You Invest

Chapter 6 of The Hedge Fund Book is all about due diligence. Basically, it is the homework you do before handing someone your money. And after Madoff, after LTCM, after Bayou, everyone agrees on one thing. That homework was not being done properly. This chapter shows what good due diligence looks like and what happens when people skip it.

The chapter was written by Gregory Schink, who helped build the CHP Designation Level 2 Program on due diligence. He interviews two experts and Richard Wilson himself. Three different people, three different approaches, but they all land on the same core ideas.

Scott Freund on Being Thorough

Scott Freund runs GCC Family Wealth Management. Background in mechanical engineering, years at Morgan Stanley and Bank of America. His philosophy is simple. “Don’t trust and definitely verify.” He takes nothing at face value. His due diligence on a single fund takes three to six months. That is not a typo. Months.

Here is what Scott watches for. If a manager is rushing you to invest, if they say they “need the money right away,” that is a red flag. Good managers will encourage you to talk to their auditors, attorneys, and shareholders. They have nothing to hide.

Scott also stresses checking the board of directors. Not just seeing who is listed. Actually calling each board member. Verifying they are still involved and proud to be associated with the fund. He recommends using a standardized Due Diligence Questionnaire (DDQ) and says fund managers should just provide their background checks upfront. The due diligence team is going to find out everything anyway.

Brian Reich on Being an All-Around Athlete

Brian Reich founded Atrato Advisors after working at Deutsche Bank, Cantor Fitzgerald, and other big names. His advice for due diligence work is to become a good “all-around athlete.” You need quantitative skills, investigative instincts, and strong communication. If you are good at one thing, work on the others.

Here is the thing about Brian’s approach. He does not like standardized questionnaires. He thinks they let fund managers predict your questions and rehearse polished answers. He prefers unstructured conversations because that is where the candid stuff comes out. He also watches for subtle behavioral patterns. How does a manager act under pressure? What does their career history say about risk-taking tendencies?

Brian shared a great story from 2002. He interviewed a fund manager with an impressive track record. But there was a gap. No performance numbers for August and September 1998, right during the Russian financial crisis and LTCM collapse. The manager claimed he just “sat out” those months. Brian pushed harder. The manager got so angry he stormed out of the meeting. Brian never learned the truth. But that reaction told him everything he needed to know.

One interesting point. Bad performance can actually be a sign of honest management. If a fund’s holdings suggest it should have lost money in a given period and it actually did, that checks out. But if the numbers look suspiciously good when they should look bad? That is when you start asking serious questions.

Richard Wilson on the Marketing Problem

Wilson brings a different angle. His background is in capital raising, so he sees due diligence from the manager’s side too.

Here is the problem. Most hedge fund managers are great at trading but terrible at marketing. Their materials are weak, their sales processes are messy, and they are not prepared for due diligence calls. Poor presentation can kill a deal before the actual analysis even starts.

Wilson says due diligence phone calls are an art. Consultants keep databases recording every conversation with every manager. Blow one call and it might take three or four more just to fix the damage. His advice is to practice answers, coordinate who speaks, and think about how every sentence could be interpreted.

Organization matters too. The best funds have everything ready before anyone asks. Compliance reports, holdings, team bios, audit reports. All of it. The best due diligence Wilson has seen comes from firms that take on very few clients each year so they can dedicate real resources to each fund. The worst? Firms that filter out funds based mostly on how much money they manage and skip the rest. That is bad for everyone.

Three Hedge Fund Blowups That Prove the Point

The chapter wraps up with three case studies showing what happens when due diligence fails.

LTCM started with $1 billion in 1994 and was making 40% returns doing fixed-income arbitrage. Then they drifted into exotic derivatives, borrowed $124.5 billion (25 to 1 debt ratio), and got destroyed by the Russian financial crisis in 1998. The lesson? Make sure your fund manager sticks to their stated strategy.

Bayou Hedge Fund Group raised $450 million. A basic background check on the founder would have shown an NASD violation, no actual college degree despite claiming one, and a DUI with marijuana possession at age 43. Any one alone might be forgivable. All three together? Clear picture. A simple background check would have caught it.

Bernie Madoff had credibility. His firm helped build what became the NASDAQ. But he refused third-party administrators, handled all custody and trading himself, and would not give clients electronic access to their accounts. There was zero transparency. Proper due diligence should have caught those red flags. Interestingly, about half of Madoff’s investors actually came out ahead. They had withdrawn more than they put in before the collapse.

What I Think

This chapter is probably the most practically useful one so far. The interviews with Freund and Reich show you two different but equally valid approaches to checking out a hedge fund. One loves standardized questionnaires, the other hates them. But both agree on the fundamentals. Verify everything. Check the board. Watch how managers react under pressure. Take your time.

The case studies hit hard because they show that basic due diligence could have prevented huge losses. A background check here, an electronic records request there. Nothing fancy. Just doing the work.

If you are ever thinking about putting money into any kind of managed fund, this chapter is worth reading carefully. The principles apply well beyond hedge funds. Verify the people, verify the process, and never rush.

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