Hedge Fund Investing Chapter 11 Part 1: Due Diligence Preparation

Due diligence. Sounds boring. But this is the chapter where you learn how to not lose your money to the next Madoff. So maybe pay attention.

The book defines due diligence as the process of evaluating a fund before you hand over your cash. You investigate the strategy, the people, the track record, the operations, the business model. Everything. The goal is to understand what you are buying into and whether the people running the fund can actually do what they claim.

Three Skills, One Fund

Here is something I did not think about before reading this chapter. Running a hedge fund requires three completely different skill sets:

1. Investment skill - can the manager actually pick good trades?
2. Operational skill - can they run the back office, handle settlements, manage risk?
3. Business skill - can they run a company, manage cash flow, retain talent?

Almost nobody is good at all three. The book says managers who try to be the CEO, CIO, and risk manager all at once are “dinosaurs.” Modern funds need teams where different people cover different areas. A brilliant stock picker who cannot run a business is a ticking time bomb.

This matters for due diligence because you need to check all three areas. Not just “does this guy make money” but also “can this operation survive when things get rough.”

Be Prepared

Simple advice but easy to ignore. Before you evaluate any manager, understand the strategy they are running. Know how that strategy behaves in different market conditions. If you understand the strategy beta, you can focus on whether this specific manager adds alpha compared to others doing the same thing.

Too many investors skip this step. They get excited about returns and forget to ask basic questions about how the strategy actually works.

Learn From Past Failures

Everyone wants to find the next George Soros or Jim Simons. Nobody wants to admit they found the next Madoff.

Funds fail for many reasons. The book lists them and it is a long list:

• Bad investment decisions, especially concentrated bets that go wrong
• Fraud: accounting fraud, valuation fraud, stealing investor money
• Too much leverage
• Unexpected tail risk events
• Mass redemptions at the worst possible time
• Short squeezes
• Insider trading violations
• Prime broker failures (Lehman, MF Global)
• Liquidity drying up so you cannot sell anything

The lesson is clear. Assume things can and will go wrong. The more pessimistic your due diligence, the better your results. Past success means nothing if the controls are not in place to handle the next crisis.

If It Looks Too Good To Be True

Trust your gut. The book makes a strong point here about committee decision-making. In many firms, allocation decisions are made by groups. One person, usually the boss, dominates the discussion. Junior analysts who spot problems feel too intimidated to speak up. Or they do not want to say bad things about a well-connected manager.

This is how Madoff happened. People saw the red flags. They just did not escalate them. The returns were suspiciously consistent. The operations were opaque. But the name was big and nobody wanted to be the person who said no.

The book says analysts must raise their hands when something smells wrong. If things do not pass the smell test, say it before it gets to the investment committee. Not after.

Don’t Forget About Returns

Here is a counterintuitive point. After 2008, everyone got so focused on operational due diligence and risk controls that some investors started picking funds with great infrastructure but terrible returns. You can have the best compliance department in the world and still lose money.

There needs to be balance. Yes, you need independent administrators, proper audits, and real service providers. These are non-negotiable. But do not overweight infrastructure so much that you forget the whole point of investing: making money.

A small new fund does not need multiple prime brokers, real-time disaster recovery, and a succession plan on day one. Requirements should be proportional to the fund’s strategy and lifecycle stage.

Common Elements of Due Diligence

The process has changed a lot over the years. In the old days, if a manager had a good reputation and strong returns, you were in. Ask too many questions and you would be told to go elsewhere. Investors felt “lucky” just to get into a well-known fund.

Not anymore. After high-profile frauds and the 2008 crisis, both sides spend serious time on due diligence. Today it has two main parts:

1. Investment process and risk controls - how does the fund make money and manage risk?
2. Operations and business model - how does the fund run as a business?

Both are considered equally important now.

Evaluating The Investment Process

The book provides a long list of questions investors should ask. These are not “nice to have” questions. These are “ask them or risk losing everything” questions.

Start with the basics. What is the strategy? How does it work? What are the current portfolio themes? What are the biggest positions? How has the portfolio changed over recent quarters?

Then get more specific. What are the gross and net exposure targets? How does the fund use stop losses? How quantitative is the process? How are short sales and derivatives used? Is the strategy capacity constrained?

Key question that many investors miss: is the firm focused on generating returns for existing investors or growing assets under management? These two goals often conflict. A fund that is great at $500 million may be mediocre at $5 billion.

Who Owns The Firm?

Understanding equity ownership matters more than you might think. Some firms share ownership with portfolio managers and traders. Others keep it all at the top. Neither model is automatically better. But you need to understand how ownership affects talent retention, incentives, and culture.

If the best people have no stake in the firm, they will leave when a better offer comes. If they own a piece, they have skin in the game.

Is The Track Record Real?

Do not just look at the numbers. Ask whether the track record has been audited. Check if it is long enough for meaningful statistical analysis. Find out if the team that generated those returns is still at the firm. A great 10-year record means nothing if the people who produced it left three years ago.

Also check how the fund performed during market stress. Smooth returns through 2008 and 2020 should trigger questions, not comfort.

Are The Principals Trustworthy?

Background checks cost as little as $750. For a basic one. More thorough checks cost more but they are worth it.

In many hedge fund frauds, a simple search of public databases would have revealed lawsuits, criminal accusations, or civil disputes. These were not hidden. People just did not look.

The book recommends a 360-degree approach: call former employers, check credit reports, contact auditors and administrators, verify prime broker relationships. Search SEC databases. Read the Form ADV. Look for related party activity. Does the manager own other businesses that do deals with the fund?

And most importantly: get access to the actual decision makers. If you cannot talk to the people running the fund before you invest, you definitely will not get access when things go wrong.

Previous: Chapter 10 | Next: Chapter 11 Part 2

This is part of a series retelling of “Hedge Fund Investing” by Kevin R. Mirabile.