Hedge Fund Compliance Chapter 8: How Investors Check If a Fund Is Compliant

Up until now in this series, we talked about compliance from the hedge fund’s point of view. How they build programs, hire people, write policies. Chapter 8 flips the script. Now we look at it from the investor side. How do investors figure out if a fund’s compliance is actually good?

Because here’s the thing. Not all compliance programs are the same. Some are strong. Some are just there to check a box. And if you’re putting your money into a fund, you better know the difference.

Two Types of Investors, One Goal

Scharfman splits investors into two groups. First, prospective investors who are thinking about putting money in. Second, existing investors who already have money in the fund.

Both groups care about the same thing: is this fund’s compliance function solid? But they approach the question at different times and with different resources.

Due Diligence: Where Compliance Fits In

When investors evaluate a hedge fund, they do something called due diligence. It splits into two categories:

• Investment Due Diligence (IDD) focuses on returns, strategy, and investment-related stuff.
• Operational Due Diligence (ODD) looks at everything else: back office, operations, and yes, compliance.

Compliance evaluation mostly falls under ODD. But there’s overlap. For example, how a fund prices its assets involves both valuation procedures and compliance rules about those procedures. You can’t cleanly separate the two.

Investors also look at the overall “culture of compliance” at a fund. What does that mean in practice? They check things like: how strong are the controls, how independent is the compliance team, how often does training happen, and does the fund have a history of violations.

Initial Analysis vs. Ongoing Monitoring

There are two stages of compliance evaluation:

Initial compliance analysis is when an investor looks at a fund’s compliance for the first time. This happens in three stages:

1. Collect and review documents. Get the compliance manual, code of ethics, due diligence questionnaire. Read them. Understand what the fund says it does.
2. Interview compliance people. Best done in person, at the fund’s office. This lets you confirm what the documents say, ask follow-up questions, and see their systems in action. Some funds won’t share full compliance manuals, so visiting onsite might be the only way to read the whole thing.
3. Check service providers. Confirm that the fund actually has the service providers it claims. Collect documents from those providers. Interview them too. You want to make sure nobody is making up relationships that don’t exist.

Ongoing compliance monitoring happens after you’ve already invested. The steps are similar, but since you already have a baseline, it takes less time and fewer resources. Most investors do this at least once a year. If something unusual happens, they might check more often.

Here’s a point that surprised me. Some investors skip compliance due diligence entirely before investing. They just don’t do it. Maybe they lack resources or knowledge. Then years later, they realize they should have checked. At that point, their first review is technically still an “initial” analysis, even though they’ve been invested for years.

Best Practice vs. Minimum Compliance

This is an important distinction. There’s a floor: what the law requires. If you don’t meet that, you’re out of compliance, and regulators can fine you or shut you down. This is called minimum regulatory compliance or rules-based compliance.

But most serious funds go beyond the minimum. Two things push them:

1. Regulatory guidance. Regulators put out additional recommendations through speeches, webcasts, reports, and examination priorities. These aren’t laws, but they carry weight. Think of it as regulators saying “we’d really like you to do this too.”
2. Investor pressure. If your compliance is weak, investors won’t give you money. Simple as that. And if enough investors walk away, the fund dies.

Now, funds love to say they follow “best practices.” But what does that actually mean? Scharfman gives a good example with mock audits. A fund might brag about doing mock audits every three years when the industry norm is every five. Sounds great. But if those audits are shallow and don’t cover much, the frequency doesn’t matter. Best practice means both how often you do something AND how well you do it.

There are also real problems with benchmarking compliance across funds. The hedge fund industry is not transparent about compliance practices. There’s no public database. Funds trade different things in different countries under different regulations. Comparing a simple equity fund in New York to a distressed debt fund in Hong Kong is not straightforward.

Personal Account Dealing: Employees Trading for Themselves

One area investors pay close attention to is how a fund handles employees trading for their own personal accounts. This is called personal account dealing.

The big worry is front running. Imagine you work at a hedge fund that’s about to buy a huge chunk of a small company’s stock. You know this will push the price up. So you quickly buy some shares for yourself first, then sell after the price jumps. That’s front running, and it’s illegal in most places.

Many funds just ban personal trading entirely to avoid even the appearance of conflict. But when personal trading is allowed, investors look for these controls:

• Preclearance. Employees must get their trades approved by compliance before executing them. Best practice says that approval should expire by end of trading day. Markets change fast.
• Postclearance. Compliance checks actual brokerage statements against what was approved. The statements should come directly from the broker, not from the employee. Otherwise, someone could fake them.
• Penalties. Forgetting to get approval once is human. Doing it repeatedly should result in consequences, up to giving back profits or getting fired.
• Restricted lists. Compliance maintains a list of stocks employees cannot trade because the fund itself is active in those names. Software systems now automate this, blocking restricted trades at the preclearance stage.
• Minimum holding periods. Employees must hold personal purchases for a set time, like 60 days. There’s usually a hardship exception if the stock tanks right after purchase. Some funds also cap the number of personal trades per month.

Material Non-Public Information (MNPI)

The second major area investors scrutinize is how funds handle insider information. MNPI is information that a reasonable investor would consider important and that hasn’t been made public yet. Think: upcoming earnings, merger plans, big pending trades.

Trading on MNPI is illegal. Penalties in the US include permanent bans from the industry, giving back all profits, fines up to three times the profit made, and even jail time.

One growing risk area is expert networks. These are companies that connect hedge funds with industry specialists. A fund researching semiconductor companies might pay to talk to a retired executive from that industry. The expert isn’t supposed to share insider info. But the risk is always there.

Investors look for several controls around expert networks:

• Does the fund do due diligence on the expert network itself?
• Does the fund share its own MNPI policies with the network?
• Do employees get expert calls precleared by compliance?
• Are there restrictions on talking to experts who currently work at public companies?
• Does compliance listen in on expert calls?
• Do employees write summaries of every expert call?
• Does compliance monitor whether the fund trades in stocks discussed during expert calls?

That last point is critical. If an analyst talks to 15 different experts about one company in a month, and then the fund starts trading that stock heavily, compliance needs to look very carefully at whether MNPI was involved.

What This All Means

Chapter 8 boils down to this: investors have both the right and the responsibility to evaluate compliance. The tools are straightforward. Read documents, talk to people, verify relationships, check back regularly.

The tricky part is that “best practices” is a fuzzy term. Funds will always claim they follow them. Smart investors dig deeper. They look at the actual quality of controls, not just whether a fund uses the right words in marketing materials.

Previous: Chapter 7 - Key Compliance Documents

Next: Chapter 9 - Real Compliance Case Studies